Back in the black: fixing the Levy Control Framework

£1.5bn: that’s a big hole in anybody’s budget. So the revelation last year that the government was set to overspend its budget for renewables subsidies, the Levy Control Framework, by that amount had alarming repercussions. Ministers scrambled to cut subsidies to put the budget back in the black, and even put the second auction for a key set of subsidies, Contracts for Difference (CfD), on hold.

This is bad news for a crucial set of stakeholders: investors. Unless the government paints a clearer picture of what money is available for renewable subsidies in the future there will be a “real hiatus” in investment, industry figures have told Utility Week. They are particularly concerned with the absence of an LCF budget beyond 2020/21; a lack of transparency about how the LCF is set; and the rising cost of CfDs.

To begin with, the overspend. Last July the Office for Budget Responsibility projected that by 2020/21 yearly spending on the three elements of the LCF – CfDs, the Renewables Obligation (RO) and the Feed-in Tariff (FiT) – would reach £9.1 billion; well above the £7.6 billion budget cap. Since then the government has been urgently cutting back subsidies to try and bring costs under control; closing elements of the RO early and significantly reducing many of the FiT rates.

Investors crave certainty, and the first problem with the LCF is the lack of clarity over what happens beyond the end of the current budget in 2020/21. Chairman of the Institutional Investors Group on Climate Change Donald MacDonald recently told the Energy and Climate Change Committee: “Without having clear plans, without having a clear pipeline, without having the mechanisms of the levy understood on a longer-term basis, then the cost of capital will increase because of the uncertainty”.

Shadow energy minister Alan Whitehead says the lack of a clear budget is “potentially quite crippling for the industry”, adding that it could “create a real hiatus in terms of decision making and a very uncertain climate for the future.” This week trade body Energy UK called on Decc to review the LCF “as a matter of urgency”, and set out a budget post-2020 “as soon as possible”.

So, why no budget yet? Perhaps because the government is currently considering its fifth carbon budget, which runs into the 2020s. “They could well be thinking about the Levy Control Framework at the same time”, says head of environment and energy at the Policy Exchange Richard Howard.

Nevertheless, with the delayed second CfD auction due before the end of the year, there is some urgency. Senior consultant at NERA Economic Consulting and former head of LCF strategy at Decc, Alon Carmel tells Utility Week the next round seems likely to be dominated by offshore wind projects that start spending from 2020 onwards.

“How can the government really commit to and start signing CfD contracts unless they have an agreed envelope beyond 2020?”, he asks.

According to RenewableUK’s director of policy Dr Gordon Edge the budget needs to be set by the middle of the year: “You can’t wait around until the day before the round starts.”

He says investor confidence would take a “massive knock” if the second CfD auction was delayed again because of the lack of a budget: “…people will say government doesn’t know what it’s doing.”

A spokesman for Decc said: “The Government is now setting out the next stages in its long-term commitment to move to a low carbon economy, providing a basis for electricity investment into the next decade.” The department would not say when it expects to publish the budget for the next period.

The second problem is the lack of transparency over how the budget is calculated. Principal of the Townsend Group Morgan Angus told the ECCC the government needs to show its workings; explaining on what assumptions the budget is based, how those assumptions are formed, and how they are used to calculate the spending cap.

Doing so, he said, would allow investors to react to changes in the market and “start pricing [them] in way, way, way before any sort of government announcement is made”.

However, ministers have shown little enthusiasm for more transparency. Responding to a parliamentary question in January energy minister Andrea Leadsom played down the issue, saying many bits of key information were already in the public domain.

The third issue that needs addressing is the cost CfDs. Under the mechanism generators receive, or pay back, the difference between an agreed ‘strike price’ and the wholesale cost of electricity. The collapse in wholesale prices over the last year or so has made that difference much larger, cutting into the LCF budget.

There are currently 35 projects which have been awarded CfDs; eight of them through the final investment decision enabling for renewables (FIDeR) process and the rest through the first CfD auction.  

According to analysis conducted by NERA, if prices are ten per cent lower than Decc’s latest forecast, the annual cost of these CfDs could be £295m, or 16 per cent, higher in the final year of the LCF period than was expected in 2014. If prices remain at current levels they could cost as much as £200m more.

According to Edge a possible solution is to stop using the market price to calculate the cost of CfDs for the purpose of the LCF: “The benchmark should be what’s your alternative investment – new gas plants.”

“You set a price and say stuff above that is what you need to measure through the levy control framework,” he adds.

Another alternative might be to index the size of the budget to the wholesale cost of electricity, so as the price goes down the limit goes up. 

A spokesman for Decc said that the government “regularly monitors changes in wholesale fossil fuel prices and the impact on support for renewable energy”, and that it will publish updated LCF projections “that reflect market developments in due course”.

It’s a complicated set of problems – and time is running out to solve them. If ministers want to keep investors on board, and avoid another embarrassing multi-billion pound hole in their budget, they need to come up with some answers – and quickly.