Facing up to the Energy Trilemma - Meeting the Financing Challenge

Ernst & YoungCurrent debate around the UK’s energy policy centres on the need to find the right balance between environmental, security of supply and cost factors, in order to arrive at the best outcome for the country as a whole. Given the natural tensions that exist between these factors, this challenge is increasingly being referred to as the UK’s ‘energy trilemma’.

In this context, environmental now means the low carbon agenda. The Large Combustion Plant Directive has already forced existing coal-fired generation plant to clean up emissions of sulphur dioxide, oxides of nitrogen and dust, or else cease operations by the end of 2015. From an energy perspective, therefore, carbon dioxide has become the single most important pollutant that needs to be controlled and the UK is playing a world-leading role in taking the low carbon agenda forwards. Legally binding, five-year carbon budgets are now in place covering the period out to 2022, for which the government of the day will be held to account by the Committee on Climate Change. This should drive significant cuts in CO2 emission levels, as will EU commitments which dictate that 15 per cent of the UK’s overall energy usage should be met from renewable sources by 2020.

At the same time, maintaining security of supply in the energy sector must remain a priority. This applies to both gas and electricity supplies. The level of gas that can be produced from the UK Continental Shelf is now declining as our North Sea gas fields grow older. Reliability of gas supply will come to depend in future upon import infrastructure and higher levels of gas storage. Meanwhile our electricity networks will have to cope with intermittent wind capacity being deployed on an increasingly large scale in response to the environmental targets.

Improved environmental benefits, and enhanced supply security should not be expected to come without a price tag attached. In addition to renewables, the UK will have to build new nuclear and clean coal plant with its associated carbon capture and storage infrastructure, on top of which major investment will be required in the networks necessary to transport energy to where it is needed. If demand to 2020 and beyond were to continue on its pre-recession track, energy utilities will need to finance over £230 billion of new investment in order to meet the UK’s energy goals. This is the stark conclusion of a recent study from Ernst & Young, Securing the UK’s energy future – meeting the financing challenge1. Such is the scale of the investment required that, after taking into account depreciation, the value of the UK’s energy supply asset base would have doubled by 2025.

Funding investment on this scale will be a challenge in itself. It is clear that the financial crisis has changed the basis on which the energy supply industry is able to raise capital. We estimate that over half of the £230 billion that is needed will have to come from equity sources, principally due to a significant tightening in the availability of debt finance. Competition for capital is only likely to intensify: for example, in the utilities space alone, the water sector is also looking to finance over £20 billion of investment by 2015. With shareholders having to take on more of the responsibility for funding capital expenditure and an increased cost of debt, even for utilities, the framework for investment by the energy supply industry will have to give sufficient confidence that projects can earn acceptable returns in future. Our analysis suggests that this will mean generating an average return on capital employed of c.12% from the future project pipeline. Without such confidence, there is clearly a risk that the energy supply industry will not be able to attract the funding that it will need to meet the UK’s energy goals.

We believe that energy efficiency has a key role to play in resolving some of the tensions implicit in the energy trilemma, not least by reducing the overall level of capital that needs to be found. If annual demand for electricity and gas can be shifted onto the future track that was envisaged by the government in its 2007 Energy White Paper, there are immediate benefits for energy security of supply, as capacity margins are enhanced. In addition, less supply-side investment would then be needed to hit the environmental goals – perhaps as much as £35 billion less.

The Energy White Paper’s future track equates to a 7% cut on 2008 demand for gas by 2020 and holding demand for electricity in 2020 to its 2008 level. This is undoubtedly a very challenging target, which will require energy saving across the board, but demand destruction caused by the current recession has moved it unexpectedly closer. Demand for electricity and gas are believed to have fallen by 5% and 6% respectively as a result of the recession. The nationwide roll-out of smart metering that has now been mandated by government provides a foundation upon which energy efficiency measures to reduce demand in future can be based.

Moving to this energy-efficient demand track would then represent a double benefit for customers. They will gain directly as their energy bills fall due to their own reduced consumption. They should also gain indirectly since, as overall demand falls, the capital investments that are needed in low carbon energy assets are lower than would otherwise be necessary and so unit prices for energy do not have to rise by as much.

Meeting the UK’s energy goals is already beginning to cause a long-term structural change in the underlying cost base of the industry. While the prices ultimately charged to customers will remain commercial decisions for the energy supply industry, all customers, not just those in the residential sector, may have to face up to a world of higher prices going forwards. However, energy efficiency offers an opportunity to mitigate the impacts of the higher price environment, moving demand for electricity and gas on to a fundamentally different track.

1. Securing the UK's energy future - meeting the financing challenge can be viewed in full at www.ey.com/uk/powerandutilities

The authors:
Steve Jennings, Partner, Power & Utilities, Ernst & Young – sjennings@uk.ey.com
Duncan Coneybeare, Senior Manager, Power & Utilities, Ernst & Young – dconeybeare@uk.ey.com