Financing UK renewables
Philip Wolfe
Renewable Power Association
The renewable energy industry in the UK is expected to treble in the next seven
years and double again in the following decade. This is an exceptional long term
high growth opportunity in a national economy with few other highlights. So is the
financial community queuing up to invest in expansion in this sunrise industry? RPA
Chief Executive, Philip Wolfe, finds that the answer is “not yet”.
Major growth in renewables is accepted as a crucial brick in the wall of a 60%
reduction in CO2 emissions by 20501. Industry and Government share a 10% target
for electricity from renewables by 2010, up from between 3 and 4% today. Looking
further ahead, Government aspires to 20% in 2020, while industry is aiming for 30%
in 2027.
The RPA Renewables Yearbook 2003 shows total installed renewables capacity of
3.9GW. Achievement of the 10% target would require new capacity to be installed at
a rate of about 1.3GW per annum. Based on the expected mix of renewables
technologies between on- and off-shore wind, biomass, biogas, wave, tidal and
solar, this will require new capital investment of at least £100bn over this period.
From many aspects the outlook is encouraging. However there are several
underlying reasons why, on the present track, the quantum changes necessary to
achieve the targets will not be materialise. The most fundamental is finance.
Where will the capital come from?
Much of the existing capacity, and of the short term growth in the industry, is in the
hands of the large domestic electricity companies, both generators and suppliers.
Historically these companies have funded renewables developments on balance
sheet, and they continue to do so. Many of the independents have done the same.
However the power sector has had a rough ride over the last few years, with several
high profile collapses and corporate rescues. Their pockets are therefore less deep,
and certainly not sufficient to meet more than a minority of the new investment
required. Indeed several of the majors are already refinancing their existing
renewables portfolios, to provide the headroom for new investments.
So most of the capital needs to come from traditional financial sources mainly in
project finance, debt and equity. They have participated in renewables in the past,
and many continue to do so, but most have reservations. These centre around the
areas influencing all investment decisions, the balance of anticipated return on
investment against the perceived operational, commercial and political risks.
It is the latter, most of all, which concerns investors in UK renewable power. A
survey now undertaken for the DTI’s Renewables Advisory Board highlights intense
investor concerns over the Government’s intentions in the sustainable energy sector.
These are focused in particular on the Government’s primary support measure, the
Renewables Obligation.
1
Target established by the Royal Commission on Environmental Pollution and accepted by the
Government in this year’s Energy White Paper.
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The Renewables Obligation (RO)
The Renewables Obligation is a requirement on electricity suppliers to meet a
growing proportion of their electricity from renewable sources.
Most renewable energy sources are eligible for the RO except energy from waste
and hydro power from large or old stations. It also includes biomass co-fired in fossil
fuel stations subject to prescribed limits. There is no selection between different
renewables technologies; they all compete on purely commercial terms.
Qualifying plants are accredited by the regulator Ofgem, and then receive one
Renewables Obligation Certificate (ROC) for each megawatt-hour (MWh) generated.
These ROCs are tradable.
This required percentage (or RO Quota) started at 3% of electricity in 2002/3 and
rises to 10.4% in 2010/11. Suppliers evidence their adherence to the obligation by
providing ROCs to Ofgem. The companies can obtain ROCs in three ways:
 They can get ROCs by generating renewable power themselves.
 They can buy green power from others complete with the related ROCs
 They can buy the ROCs alone on the open market.
If they fail to deliver enough ROCs for the year in question, they have to pay a fine or
buy-out set at £30/MWh (in 2002/3 and index-linked). In a clever twist to the
mechanism, the buy-out fund obtained from those companies with inadequate ROCs
is returned to the electricity supply companies, but in proportion to how good they
have been in meeting their obligation. This so-called ‘green smear-back’ therefore
provides a Robin Hood effect whereby suppliers who produce enough green power,
not only pay no fine, but actually get money back.
The financier’s view of renewables under the RO
ROC price
Clearly the Renewables Obligation provides significant financial support for
renewable generation and is expected to stimulate growth in the sector. The
Government is proud that it is a ‘market-based’ mechanism, and so offers the
potential to deliver their targets at lowest cost. Investors do not, however, see it as a
panacea for a number of reasons, mostly rooted in the way in which markets
respond to such ‘market-based’ incentives.
The effect of the ‘green smearback’ is that ROCs have a higher
Figure A ROC price vs. RO achievement
£80
effective value in the case of a
shortfall against the RO Quota.
£60
This relation can easily be plotted
mathematically, as illustrated in
£40
Figure A. This shows the cliffedge in price, which might be
£20
experienced by independent
generators. Supply companies
£0
would have less exposure,
50%
60%
70%
80%
90%
100% 110% 120%
because they would still be able
to redeem some or all of their
Achievement of RO quota
ROCs.
However, this effect is likely to
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ensure that the RO acts as a ceiling on capacity. It is highly unlikely that any
participant would risk exceeding the RO Quota for fear of the impact on ROC prices
throughout the market.
Because markets usually act rationally, actual achievement can be expected to
remain comfortably below the RO Quota. The extent of the shortfall will be affected
by longer-term figures.
Renewables projects
typically have working
Figure B
Projected output based on present RO
lives of fifteen years or 15% Quotas
more, so investors will
Government target 10% Projected achievement
be considering the
returns
over
that 10%
period, by projecting
future ROC market
performance.
5%
Industry
analysis
(illustrated in Figure B)
RO Quota
indicates
that
the
Projected outcome with this quota
present Quotas will
0%
result in the 10%
2002
2006
2010
2014
2018
2022
target being achieved
in about 2022 - twelve years late.
But a single Government action can transform the situation. An alternative projection
in Figure C shows what would happen if the Quotas were extended now to 2016.
This transforms the situation. We now miss the 10% target by two years - perhaps
only one when you add back the contribution from RO-ineligible renewables. This
change therefore represents a dramatic improvement in economic efficiency,
especially as the RO costs consumers the same, whether the target is met or not.
This figure also shows
that the two scenarios
Figure C
Projected output based on
diverge as early as
extended RO quotas
15%
2004. The change
must be made now if
Government target 10% Projected achievement
it is to succeed. We
can already say that 10%
without extending the
RO Quota now, the
2010 target will be
missed.
5%
In fact the industry
Previous projection
RO extended
would prefer to see the
Revised projection
quotas set all the way
0%
to the end of the
2002
2006
2010
2014
2018
2022
Obligation in 2027,
and as a minimum to
2020. These would lead to even better results than that shown above. The
discussions leading up to the publication of the White Paper suggest that the
Government is reluctant to set quotas that far ahead. The RPA has therefore
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suggested an alternative approach to give the Secretary of State the ability to
annually update rolling quotas for the 10, 12 or 15 years ahead.
Because of the supply and demand issues discussed above, this quota review would
need to permit only neutral or upward adjustments. We would urge the Government
to set the quotas as far ahead as possible, in recognition of the fact that they
influence investment decisions about projects with 15 to 25 year lives.
The future – Funding is the key
Renewables is certainly a dawning industry. The speed with which the sun rises will
be affected fundamentally by the success in bringing in the investment to build new
capacity.
As things stand today, that investment is hard to find on acceptable terms. The
industry has made huge progress in reducing technology and implementation risks
and this is continuing. The commercial risks we all have to learn to accommodate.
It is political risk that represents today’s biggest financing constraint. The
Government can improve that dramatically by the means shown above. But is
anybody listening?
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