The UK must reform its power market. As old coal-fired power plants increasingly go out of commission, new means of generation are necessary to meet the country’s power needs, supporting the transition to alternative, clean sources of energy. Yet upgrading the UK’s energy sector will require significant capital investment – to the tune of around £100 billion.
Aiming to accelerate the investment that low-carbon power projects need, the government has introduced the ‘Contracts for Difference’ (CfD) scheme. Offered to a group of power projects last year, this feed-in tariff scheme stabilises costs for producers, allowing them to offer reliable sources of low-carbon energy at prices competitive for consumers.
Although the scheme has faced some recent uncertainty over delivery details – due to the change in government after last summer’s general election – by reducing exposure to market volatility, and taking risk away from the shoulders of generators, CfDs are still seen as a way to ensure low-carbon energy projects get the investment they need.
With the UK government set to allocate more contracts this year, investors need to know what effects this scheme is likely to have on the creditworthiness of power projects.
The UK needs low-carbon energy
The UK’s energy sector is certainly in need of investment. Up to a fifth (about 8 gigawatts) of the country’s power generation will be decommissioned by 2020 – leading the regulator Ofgem (Office of Gas and Electricity Markets) to suggest that as much as £100 billion of financing will be necessary to meet the national demand for electricity.
Indeed, investing in low-carbon power generation – through offshore or onshore wind farms, solar plants or converting coal stations to use biomass – is also essential if the UK is to help combat climate change, and clamp down on its greenhouse gas emissions. The British government has pledged to generate at least 30% of power from renewables by 2020.
Yet building renewable plants – or upgrading existing energy infrastructure – requires significant upfront capital, and the new technologies involved in low-carbon energy generation currently bring high costs. Such costs, often greater than the prevalent market price for power, threaten to deter investors from the sector.
CfDs will be key
That is why the CfD scheme will be vital to the UK’s energy future. By offsetting these costs – ensuring both that power prices from generators are competitive, and revenue streams are predictable – CfDs can incentivise crucial investment in low-carbon electricity.
Under such contracts, a power generator locks in a pre-agreed ‘strike price’, set by government and linked to inflation. While the generator still faces the volatile market prices, the contract ensures that a government subsidiary, the Low Carbon Contracts Company (LCCC), will pay an energy generator – such as a wind farm or a solar plant – when the market price for electricity is below this strike price.When electricity prices rise above this measure, a generator will pay back the difference to the LCCC. This offers low-carbon energy generators consistent, predictable revenues, while reducing their exposure to volatile market prices over around 15 years. It allows investors to enjoy a rate of return not otherwise possible.
CfDs were first awarded, through an auction, to a group of British energy generators in February 2015. The East Anglia ONE Offshore Wind Park is now underway, having secured £2 billion in financing. In fact, total investment in projects from the first round set to reach up to £14 billion by 2020.
The impact of CfDs on creditworthiness
With a second round of contracts set to be allocated to more generators later this year – and given such substantial potential investment flows – it makes sense for investors to understand the implications CfDs have on the creditworthiness of low-carbon energy projects before they commit their capital.
“CfDs can play a vital role in inducing investment in the sector”
First and foremost, a CfD considerably reduces a power generator’s exposure to market risk. Since the contract mitigates against fluctuations in wholesale electricity prices – and preserves revenue flows – S&P sees a CfD as a positive factor in a project’s creditworthiness.
By transferring revenue risk away from the project itself, a CfD makes the LCCC a crucial, irreplaceable counterparty – exposing related projects to an element of counterparty risk. However, the UK’s 25-year track record of providing a robust economic regulatory framework for the electricity sector means that the LCCC is likely to be a strong and stable counterparty, and therefore introduces limited additional risk into the mix.
Finally, a CfD’s mitigation of market risk means that our analysis of a project’s creditworthiness would likely be more dependent on an assessment of performance risk: that is, how well the asset generates energy when it is up and running. This relies, in large part, on technology and the ability to secure adequate resources such as wind or sun. Encouragingly, however, technology continues to advance rapidly in this field, making for increasingly efficient low carbon energy production.
Reducing financial obstacles, CfDs can play a vital role in inducing much-needed investment in the sector. For the incentive to be fully efficient in the long run, the implementation details of the CfD regime must be finalised, with minimal policy volatility arising from changes in the political landscape. But all in all, the CfD regime has much potential to secure a bright future for the UK’s low carbon energy sector – aligning financial goals with environmental ones.
Michael Wilkins is Managing Director at Standard & Poor’s.