The UK energy system faces a number of challenges as existing infrastructure closes, domestic fossil fuel reserves decline, and the system increasingly requires adaptation in order to meet low  carbon objectives. Changes are required to ensure that the UK has a secure energy supply in years  to come and, already, the threat to supply security has been brought to the top of the agenda this  year due to the political troubles in the Ukraine.

Background

The UK government has recognised that changes are critical to maintain security of supply and  deliver the energy people need, where they need it. In its own words “Large-scale investment is  required in order to achieve security of supply as the UK makes the transition to a lower – carbon  economy”.3

This is reflected in the fact that GBP 147 billion of the  total GBP 375 billion required  investment in the National Infrastructure Plan (NIP) is earmarked for electricity generation. In  fact there is a view that this may not be enough. A joint report by the London School of Economics  (LSE) and nPower suggests that the energy sector needs record levels of investment of up to GBP 330 billion by 2030 if security of supply is to be  achieved while carbon emissions are reduced. This in turn would enable the UK to achieve  the EU’s  long term 2030 emissions reduction target.

Where is the energy investment required?

HM Treasury’s “National Infrastructure Plan: finance update March 2014” (Treasury Update) accepts  that the historical model of large utilities financing electricity generation on balance sheet is  unlikely to deliver the scale of investment required. This is particularly the case when the  traditional utilities are seeking to reinforce their balance sheets  through asset sales and cuts  in capital expenditure4. As a result, the way forward must include project specific investment in the electricity sector with  finance through separate vehicles where the return is directly related to the performance of  specific electricity assets.

The Treasury Update gives a useful summary of where investment is required and the total value of  projects (by technology type) which are in the pipeline for the period up to 2020 (excluding those  in construction or already part of an active programme).

Nuclear

It is no surprise that a sizeable chunk of funds are required for Hinkley Point C, which is the  first nuclear plant in the nuclear renewal programme regarded as essential to ensuring that the UK has a secure and low  carbon electricity supply. In order to give investors the confidence to commit the billions necessary, the  UK government has provided price certainty through contracts for difference  for the power off-take  at what is generally regarded as a very generous strike price. It also intends to provide support  through the UK Guarantees Scheme.

Off-shore and on-shore wind

The off-shore wind sector potentially offers the largest investment opportunity pre-2020 with an  estimated value of GBP 18.3 billion. On-shore wind, which is thought to  have an existing  established investment model using debt markets, is expected to generate projects with a value of  up to GBP 10.4 billion. There is also help for developing offshore marine renewable energy (both tidal  and wave) through demonstration projects such as the publicly owned Wave Hub in Cornwall.

Other renewables

While large scale renewable projects may provide suitable investment opportunities for project  specific finance, small scale renewable projects (including solar, wind and anaerobic digestion),  are generally considered too small individually to be suitable for a project finance solution  unless bundled up into a portfolio sale. The government intends to continue the support for smaller  scale projects through measures such as feed-in-tariffs.

However large scale renewables (including solar) which have historically been supported through the  Renewables Obligation regime, will continue to receive support as part of the government’s Electricity Market Regime (EMR) policy through ‘contracts for difference’.

Biomass

There is a GBP 900 million potential opportunity for investment in biomass where the government has  supported conversion of one engine at Drax, the UK’s largest coal power station, to biomass by  providing a GBP 75 million UK Guarantee.

Gas

One of the key issues facing the UK energy market is the extent to which gas-fired capacity will be  developed and a “dash for gas” will slow down the need for structural changes which are required to reduce carbon emissions. Although the construction of combined cycle  gas   turbines (CCGT) could result in short term price gains by switching from coal to  competitively priced gas (while initially achieving moderate reductions in greenhouse gas  emissions), this delays the long term investment required in low carbon plant if required emissions reductions are to be achieved.

It is interesting in this context to see that the government regards investment in CCGT as part of  the energy mix. The Department of Energy & Climate Change’s (DECC) EMR policy is to create a  capacity market with 15 year capacity agreements available which should provide sufficient  certainty to unlock investment in new gas plant. The government’s recognition of the continued  importance of fossil fuels as an important source of the electricity generation mix is also implicit in the  allocation of GBP 1 billion of public funding to help develop Carbon Capture and Storage through a  commercialisation competition.

Will investment be made?

The reality is that the government’s energy and climate change policy has three competing  objectives: energy security; decarbonisation; and affordability. These are enshrined in the Energy  Act 2013 (Energy Act) which contains the legal framework for the government’s EMR policy for long  term support for low carbon electricity generation.

The conflict is reflected in the factors the government must take into account under the Energy Act  when setting its decarbonisation target range. While the impact of climate change is relevant it  must also consider the need for economic growth and the cost to consumers. There is no easy way to  reconcile the fact that it costs more at the moment to provide power from low carbon technology than from traditional fossil fuel sources. The Labour opposition has politicised energy prices  making it difficult to retain the current green levies which add a substantial amount to the cost  of household bills. However some sting has been taken out of this debate by Ofgem’s referral of   the energy market to the Competition Markets Authority (CMA) who are unlikely to report until after  the next election.

Given that the CMA’s main focus will be to assess whether the “big 6” suppliers should be broken  up, there are significant concerns that this will put a halt to the investment needed in UK power  generation.

Despite this, there are a number of hopeful signs that investment to create green growth has  started. A recent EY Renewable Energy Country Attractiveness Index5 indicates that the UK is now  the fifth most attractive place in the world for renewables, the second for biomass and the first  for off-shore wind. Further, according to Bloomberg, Britain saw record levels of investment in  renewable energy in 2012 to 2013 which rose 59% to GBP 7.3 billion; placing the UK third in the  world behind China and the US.

Finally, in late April, the DECC announced the first tranche of support under the new legislative  framework for eight major new renewable projects ranging from off-shore wind to the conversion of a  unit at Drax to biomass which will attract around GBP 12 billion in private investment. This will  be followed by auctions for ‘contracts for difference’ to assist the low carbon transition. The UK is also now benefitting from some foreign direct  investment in its renewable supply chain with ABP and Siemens making a GBP 310 million investment  in Hull in two new factories to make turbine blades and assemble off-shore wind turbines.

The future of UK energy depends on continued investment. This in turn depends on ensuring the  investment environment is favourable and one of the key conditions that must be satisfied to enable  development is regulatory certainty. With more clarity emerging on the detail of EMR and the  announcement of the first awards for support, there may now be a base on which investors can rely to unlock their funds.