‘Extraordinarily vague’ revenue cap has spooked investors

The government’s “extraordinarily vague” plans to introduce a cap on the revenues of low-carbon generators have spooked the sector and will increase financing costs for future investments, industry experts have warned.

Renewable generators including Greencoat Capital and Vattenfall, as well as policy experts, spoke to Utility Week on the back of the government announcement of a new Energy Prices Bill, which includes a “cost-plus revenue limit” to recover windfall profits from low-carbon generators benefitting from “abnormally high” power prices.

The temporary cap on wholesale revenues will be introduced at the beginning of 2023 and is intended to end the situation whereby the price of low-carbon electricity is tied to the cost of marginal gas generation, which has increased massively this year as a result of the current gas crisis. It is expected to apply to existing low-carbon generators whose revenues are not already fixed through Contracts for Difference (CfDs).

The level of the cap will be partly based on pre-crisis wholesale prices. The government said generators will continue to receive existing subsidies, for example through the Renewables Obligation (RO) scheme, and may also receive a proportion of revenues in excess of the limit.

According to the initial draft of the Energy Prices Bill, which was published on Parliament’s website on Thursday (13 October), the limit will only apply to generators themselves, who will be required to pay excess revenues to an unspecified “payment administrator”. The document said this money will be used to cover the costs incurred by the government through its energy bill support schemes for both domestic and non-domestic customers.

The draft bill also contains provisions to extend CfDs to existing generators – a move which the government had previously been trying to negotiate with industry as its preferred option for addressing windfall profits and had received the backing of the trade bodies Energy UK and Renewable UK.

Radical intervention

Adam Bell, the former head of energy strategy at the Department for Business, Energy and Industrial Strategy (BEIS), said: “The revenue cap as announced is extraordinarily vague to say the least.”

He said the government “wants to take on some quite broad powers to implement a levy on particular types of generators that it chooses”, adding: “It doesn’t even define in the bill whether they’re going to be renewable or low carbon. The size of that revenue is unclear, how it will be recovered is unclear, although there is a reference to some sort of payment body that would handle the levy so there might be a role for the Low Carbon Contracts Company”.

Bell said there is a “real sense” in the renewables sector that this is a “radical government intervention,” adding: “For the first time, the government has effectively said we are willing in the face of this crisis to confiscate your revenues and we’re not going to tell you how or when. We’re going to put together a scheme which is basically a cudgel to get you to comply with our preferred route, which is voluntary CfDs.”

He continued: “The sheer bloody mindedness of this astonishing. It’s really something that government has done in order to help reduce the load on consumers this winter but the problem with it, even from the vague details we have, is it’s unclear whether it will actually work.”

Bell, who is now head of policy at the consultancy Stonehaven, said it is “absolutely understandable” that the government wants to claw back windfall profits for consumers and he agrees with the idea of trying to move legacy low-carbon generators onto CfDs.

However, he pointed out it had failed to reach an agreement with generators, who had expected “effectively an NPV methodology that would have seen their overall take remain effectively constant but just smeared over the length of the contract”.

He said: “The government instead wants them to take a haircut and they have been unable to get them to sign up to that, although I think some generators, especially in the nuclear space, have been a bit more comfortable with that than others.”

Bell said the government’s efforts to encourage low-carbon generators to sign up to CfDs have been undermined by prime minister Liz Truss’ earlier refusal to threaten a windfall tax: “If you wanted to maximise the number of generators in the market who took up the voluntary CfD arrangement, you were going to need a stick and my worry when the government went into this process was that they said they weren’t going to do any windfall tax and they no longer had a stick.

“They’ve now invented the stick. It’s a windfall tax under another name but it’s a really, really large and very, very heavy, and very, very clumsy stick, which they’ve pulled together at the last moment, having realised that they needed this leverage.”

The big hole

Bell questioned whether the revenue limit will actually achieve its stated aim. He noted that the non-CfD generators which will be subject to the cap will either have sold their output to an offtaker through a power purchase agreement; sold their output on the forward market to a trader or supplier; or be selling their output on spot markets.

“Out of all those, the only place where this will actually reduce the wholesale cost stack is where generators are still selling direct on the day-ahead markets,” he said.

“However, what I expect a lot of those generators to do in the face of this risk is to immediately sell on the forward market where it’s possible to do so at the best price they can get. And what this means is lots of the revenue that the government is expecting might not turn up.”

He described this as “the big hole in the scheme”, which he views as more of “a punitive measure to compel people to get into CfDs” than something that will reduce costs this winter by the necessary level.

“Right now, I’m sure there’s a lot of bets going around, among traders in particular, on the price cap level and what the percentage of the take will be,” he added. “Without that information, there’ll be some exciting bets being made today, I’m sure.”

Bell said the intervention will “absolutely increase capital costs” because it is sends the signal that the government is willing to retrospectively change the rules to ensure revenues can be recovered even from generators going to market under a CfD.

Investor confidence

Richard Nourse, founder and managing partner of Greencoat Capital, said the impact of the revenue cap will be determined by its still undeclared parameters, which will need to be “set against a background of investor fragility”.

He said the defined-benefit pension schemes which are the main investors in the private funds parts of Greencoat’s UK business will be vital to the future of build out of low-carbon generation: “These are the class of investors that were recently calling on the Bank of England after the recent sell off in the bond market.”

Ministers therefore need to be “careful not to do something that means that the investors they need to fund the build out of new nuclear and renewables are scared off investing. If the proposed cap is struck at the wrong place, this could very quickly happen.”

“Clean, secure affordable energy has to be the goal of any government,” said Nourse. “If this is going to be delivered as the government seeks to implement its energy security strategy and moves the economy towards net zero, then the capital for the transition needs to be secured at the lowest possible cost and at huge scale.

“While everyone sees that customers have been suffering from the effects of the invasion of Ukraine, it would be unwise to ignore the legitimate interests of capital providers.  The right balance must be struck to keep long term costs down.”

Barnaby Wharton, director of future electricity systems at Renewable UK, expressed disappointment that the government had not been successful in expanding the CfD scheme through a “pot zero” auction as originally proposed by the UK Energy Research Centre earlier this year.

“We’ve been working with industry and government to come through with this pot zero idea, which is effectively CfDs for these companies, which we think would be much better and much more secure and clear for everybody,” he explained.

“The government is extremely keen to see something done this winter and I think they feel the pot zero couldn’t be delivered in time.

“However, the vast majority of generators have sold their power ahead of time, and often at what are pretty reasonable prices given where things are. I’m not sure how impactful this will be this winter because lots of companies sold this power this time last year.”

Regarding the planned revenue cap, Wharton said: “It certainly is damaging to investor confidence and the conversations I’ve been having in recent days with industry have been that people are really concerned.

“They are seeing investors question and back away from things so it is definitely having a material effect”.

“If they are taking 100%, and some of the numbers that are being bandied about are pretty low, I think that’s hugely problematic,” he added.

“If they, as we think they should, put this in line with the EU cap of €180/MWh and only take a proportion of revenues over that, then that will be much better because that will still incentivise some investment.”

A solution for extraordinary times

Danielle Lane, UK country manager for Vattenfall, said the company would have preferred a windfall tax to a revenue cap but that an intervention of some kind was “not unexpected”.

“I think we’re in special times and everybody has to do their bit so I think from a generation perspective it’s not a surprise,” she stated.

Lane said it is also unsurprising that the government was unable to negotiate an expansion of the CfD scheme in time for this winter given the complexities involved: “The CfD was designed for new assets that were coming on for a 15-year period and then they would be on market prices for the remainder.

“What you’re talking about here is a whole range of different assets with different lifetimes left so you could be awarded a 15-year agreement, if it was a 15-year agreement, to an asset that was due to be decommissioned in five, so what does that mean and what are the implications there. And also finding a price for a range of assets, that is a fair price, is actually quite difficult.”

She noted concerns that these contracts could have ended up “locking in” higher than normal prices “for quite a long period” and “may not have been the best outcome for consumers on that basis.”

Lane said investor confidence was inevitably going to take a hit given the “extraordinary times” we are living through: “We’ve just come out of two years of great uncertainty that have come from the pandemic and we’ve entered into another period of uncertainty because of a major war in Europe.”

“But,” she added, “I do think we should take confidence for renewables that there’s a very clear desire to have them across Europe and the UK and it still remains a sector there is an interest in investing in.”

One area for complaint for Lane is the apparent disparity between renewables and the oil sector, with the latter being subject to an additional windfall tax of 25% on profits, but also benefitting from tax relief on future investments in return: “From a government perspective it does appear they are more worried about investor confidence in the oil and gas sector than the renewables.

“They may argue otherwise but from our position it would have been nice to have seen a more complete package that would encourage our future investment as well as the intervention they are making now.”

To see these issues debated in more detail, join us for Utility Week Forum on 8-9 November in London