On the reband

Will the Renewables Obligation rebanding put a spring in the step of green energy investment, ask Arnaud Bouille and Kinga Duerrbaum?

Recent regulatory and financial uncertainty in Europe has had a knock-on impact on the cost and availability of capital for renewables infrastructure projects. Here in the UK, the long-awaited Renewables Obligation banding review has finally been published by government, signalling further changes. What does this mean for the future of UK renewables and the energy mix for 2020?

Industry reactions to the banding review have been predominantly positive. Although it is naturally disappointing that government support for most technologies has been reduced, the industry recognises that this reflects actual cost reductions achieved and was determined through a comprehensive, evidence-based review process. Despite the reductions, the government has renewed its commitment to the sector by introducing grace periods before any changes come into effect and by allowing grandfathering – both of which will provide some comfort to investors.

Offshore wind has been hailed as the “winner” of the review, with the industry welcoming lower than expected cost reductions. The government’s decision to introduce a gradual, carefully phased reduction in support means the industry retains 2 Renewables Obligation Certificates (Rocs) per megawatt-hour until April 2015, when support will be cut by 5 per cent, with a further reduction the following year. This is a clear indication that offshore wind is expected to be the largest future contributor to the renewable energy mix by 2020.

There is comfort, too, in the prospect of cost reductions in offshore wind technology, predicted to bring costs down by up to 30 per cent by 2020. As the sector develops, and a successful track record can be demonstrated, risk premiums should also fall, making the sector attractive to a wider range of investors and giving it more access to debt finance.

With over 4GW of installed and operational capacity in the UK, onshore wind is currently the single largest contributor to the renewable energy mix, as well as the cheapest form of renewable energy in the country. It is expected that costs will fall even further in the future, allowing onshore wind to contribute up to 13GW to the energy mix by 2020. Given abundant wind resources and the maturity of onshore wind technology, this energy source represents a very attractive and economical investment opportunity.

Concerns have surfaced about support being reduced by 10 per cent from April 2013. This, combined with the launch of a further cost review, will create uncertainty for investors. However, we do not believe the reduction of support will have a significant impact on deployment, given that this reduction is a direct reflection of the reduction in costs realised in this sector. Nevertheless, to ensure that development and investment in onshore wind is not jeopardised, the government needs to react in a timely manner to provide clarity on future support levels.

Marine energy is still an emerging technology and it will receive a boost from the increase in support from 2 Rocs/MWh to 5 Rocs/MWh. This should help secure some investments for commercial deployment despite the immaturity of the technology and the risk associated with it. The contribution of wave and tidal technologies to the energy mix by 2020 is still envisaged to be marginal.

Support for large-scale solar will remain at current levels of 2 Rocs/MWh for the short term. However, similarly to onshore wind, the government has launched a consultation which may lead to further reductions in Rocs after 2013, given evidence of falling costs. The costs of photovoltaics have fallen drastically in recent years, with technology maturity and increased competition from cheaper Asian technology entering the market. Clear and timely policies will be required quickly to ensure solar energy meets its potential as a major contributor to the UK’s 2020 targets.

Biomass co-firing has been recognised by the government as a major contributor to decarbonising electricity produced from coal. The banding structure in support levels has been increased around co-firing, although support levels for biomass conversion have been reduced to reflect current economics.

The clear losers in the review may be onshore wind, solar, hydro and anaerobic digestion projects smaller than 5MW. The Department of Energy and Climate Change is currently deliberating on excluding new projects from being able to claim Rocs after 1 April 2013 and to limit support only to the feed-in tariff subsidy.

Political pressure on the government to reduce subsidies for renewable energy and to keep energy prices affordable is increasing in light of rising energy bills for consumers. At the same time, measures need to be taken to ensure long-term energy security and supply, as well as ensuring ambitious targets for the 2020 energy mix are met.

With onshore wind and solar being proven technologies that have already achieved significant cost reductions in recent years, it is expected that offshore wind will be the key focus of the cost reduction efforts of the future. Offshore wind, at about £140-£190/MWh, is still approximately two to three times more costly than onshore wind. However it represents a significant opportunity and could be a key contributor to the targets if the correct policies are adopted to achieve the £100/MWh mark by 2020.

According to the Offshore Wind Cost Reduction Task Force, an industry-led group, costs could be cut by 30 per cent by 2020, primarily through working smarter with the supply chain. Several utilities have already made moves in this direction through alliancing and partnering. This should contribute to increased competition between the different national and international suppliers, ultimately driving down costs. From an investment perspective, these cost reductions and collaborations with the supply chain will reduce regulatory risk, which should incentivise capital flows into these technologies.

Today, much is expected by the capital markets and other institutional investors who require a long- term policy environment as well as stable cashflows to match their long-term liabilities. As such, reliable technologies with a proven operational track record are favoured, which makes it particularly challenging for certain renewables sectors.

In addition, the provision to the sector of long-term financing from banks and institutional investors is now subject to stricter capital adequacy and risk management requirements following the introduction of Basel III and Solvency II.

One of the key trends that we are seeing as a result is that project finance markets are returning to mini-perm financing structures, which embed refinancing risks. This, combined with increasing pressures on utilities and project developers to free-up their balance sheets, ultimately inhibits much-needed capital flows into the renewable sector.

Project bonds are also gradually emerging as an alternative way of structuring investments into large infrastructure projects. While still a relatively new form of financing in the sector, the European Union’s Europe 2020 Bond Initiative should encourage investments into project bonds. This enhances credit ratings through support measures provided by the European Investment Bank. Bonds could be used as a single source for finance or alongside other investors. In addition, following the trend for mini-perm financing structures, they may be used to refinance debt facilities post-construction, realising more attractive terms for the investor.

Large-scale onshore wind and solar power infrastructure are most likely to benefit from this source of capital inflow, especially where project developers or utilities wish to rebuild their balance sheet. For offshore wind, the Green Investment Bank is expected to play a crucial role in facilitating capital inflow.

As a result of the Renewables Obligation banding review, the government is expecting £20-25 billion of renewable energy investment between 2013 and 2017. For this to be achievable, the government will have to ensure that it provides a stable and predictable investment environment to the different pools of capital available to the renewable energy sectors. It also needs to introduce measures to promote the necessary cost reductions for renewables anticipated in the review, because affordability and increasing electricity prices dominate the political agenda.

Specifically, for onshore wind and solar energy a cloud of uncertainty remains, with a significant risk of further cuts, which may affect investors’ appetite for these sectors if the government does not act quickly to remove that uncertainty.

In the longer term, ongoing Electricity Market Reform and its policy decisions will ultimately decide whether the UK achieves its 2020 targets and if the government has deterred, or indeed instilled, investment in the renewable sector for the future.

Arnaud Bouille is environmental finance director, and Kinga Duerrbaum sustainability and cleantech assistant director, at Ernst & Young

This article first appeared in Utility Week’s print edition of 7th September 2012.

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