Securing our Energy Future
Just over a year ago, the new UK Government won plaudits from the energy sector by recognising the need for policy changes to help meet the 2020 carbon reduction targets in the first Queen’s Speech of the new Parliament. The positive climate was maintained with the publication of the Electricity Market Reform (EMR) consultation paper in December which proposed four potentially significant reforms to encourage investments in low carbon generation. However, six months on, the mood music in the industry is in danger of changing. With around a month to go until the EMR White Paper is due to be published, Bill Easton and Filippo Gaddo from Ernst & Young’s Utility Sector team look at the complex challenges facing the industry and the Government.
Solving the investor’s trilemma
Over the last two years, there has been much debate about the trilemma faced by energy policy, as potentially competing dimensions of efficiency, carbon reduction and security of supply need to be balanced. This trilemma was at the heart of the initial thinking around the EMR and the core objective of encouraging investment in low carbon without increasing risks to the security of supply.
This presentation of the trilemma facing policymakers recognised that investors faced difficult decisions around their choice of generation technology. However, events over the last six months have emphasised that this is actually only one of the critical questions facing investors. Arguably, investors face their own trilemma of issues:
• Which generation technology to invest in?
• How much generation to invest in given all of the things happening elsewhere in the energy value-chain?
• And last, but no means least, where to invest – recognising that other energy markets also offer opportunities in addition to those in the UK?
Since publishing the EMR paper, the Government has also been actively progressing substantial policy measures around smart metering, energy efficiency, the Green Deal, distributed generation, feed-in-tariffs and the encouragement of active demand response. To illustrate the challenges for investors here, the recent paper published at the first meeting of the Smart Grid Forum identified no less than 19 different policies impacting on the potential value of smart grids. While this admittedly was a slightly different context, the great majority of the policies identified are entirely relevant to an investor considering a generation project.
These policies are potential game changers for utilities, both because of the transformation they will create in the role of suppliers and their relationship with consumers, and because of the potential to significantly reduce the demand for ”traditional” centralised generation and alter the daily and seasonal production profiles required. So investors in generation may no longer focus solely on the technology and engineering considerations such as the speed with which new technologies will become commercial or the challenges of project planning and construction. They must now also consider the commercial risks faced by different forms of generation under a wide range of demand scenarios depending on how well, and how quickly, these other policies deliver results.
Although other countries are also seeking to increase their use of renewable generation, the UK alone has made the achievement of carbon reductions a statutory requirement. Combined with the reduction in available indigenous fuel sources, this has made the policy trilemma particularly acute in the UK. So when combined with the rapid growth potential in markets such as China and India, along with the progressive regulatory squeeze on returns in parts of the UK energy industry, there is a danger that the UK could potentially lose ground as a preferred option for international investment
A difficult six months for investors
The investor’s trilemma has been heightened by a number of regulatory issues in the UK and also international energy market developments. Alongside the EMR, Ofgem has launched Project Transmit which looks at the pricing for the usage of, and connection to, the three electricity transmission systems in the UK. Given the potential changes to the generation fleet in the next few years, the underlying issues are clearly important. Indeed the range of outcomes from Project Transmit could have a material impact on siting decisions for new generation.
Additionally, Ofgem’s review of the retail market (RMR) has created an element of uncertainty in the marketplace. While Ofgem will point to their primary duty to protect current and future customers as the reason why they felt compelled to investigate following domestic price increases in 2010, it remains important to ensure the right connections are made across the different points of the value chain.
Gaining consumer acceptance is key to getting adequate and sustainable rewards from investments. There is an argument that repeated regulatory reviews will impact adversely on consumers’ confidence and their understanding of the underlying drivers of energy prices. Concerns on pricing in the retail market may risk making it more difficult for investors to raise the finance necessary for the £200bn investment programme that is essential to achieve the statutory requirements of the Climate Change act. Indeed, there is also a risk of undermining consumer acceptance of the whole thrust towards a low carbon energy sector, especially when set alongside recent international developments following the nuclear accident in Japan and the political instability in the Middle East.
The complex task facing the EMR White Paper
First and foremost, it is essential that the White Paper provides real clarity on how the four different EMR policy strands will be implemented, and how they will work together. Critical investment decisions have been put on hold while the EMR consultation process has run its course. While this has not yet impacted on projected go-live dates to any great extent as preparatory work has continued, a number of key commitment decisions do need to be made in the next 12 months or else dates will start to slip. Ideally, there will also be clarity from Ofgem or DECC around the same time as to how Project Transmit outcomes will be managed to allow siting decisions to be finalised.
These tasks are demanding enough, but after developments in the first half of 2011, there is also a real need for the White Paper to address issues around the confidence of both investors and consumers in energy policy and the energy market. Given the costs of the transition to a low carbon energy sector and all the associated policy initiatives, some further increase in costs is inevitable even without any further developments in international commodity prices. Equally, the financeability of the necessary investments does depend on there being adequate returns in the UK, both in absolute terms, and also relative to returns in other countries. Since these are inevitable consequences of the chosen energy policies, it is becoming essential that Government, Regulator and Industry work together in gaining consumer acceptance for these. Failure to do so risks creating a vicious circle that the transition to a lower carbon energy sector becomes progressively less effective and more costly.
Further information from:
Bill Easton
beaston@uk.ey.com
Filippo Gaddo
fgaddo@uk.ey.com
www.ey.com
First published in Utility Business
