After a gestation period sufficient for not one but two baby elephants, the moment has finally arrived: this month the process to award the first Contracts for Difference (CfDs) under EMR (in the UK) begins.
It has been a long, sometimes painful process. The CfD terms and conditions run to several hundred pages, and it is not easy reading. But we have a contract and, quite frankly, most people in the business now just want to get on with it and move to full implementation.
When the first draft CfD was issued there were some major concerns for both developers and financiers about the terms that were on offer under the CfD. The principal concerns were broadly grouped into 3 categories, namely the timetable that underpinned the CfD (including the start date and the termination arrangements), the change in law provisions and the allocation and budget process for contract award.
The originally envisaged structure for the start of the CfD has survived relatively intact. DECC were keen to ensure that the final timetable reflects the stages that a project in development actually goes through. The CfD contains a milestone requirement, whereby the generator must certify that at least 10% of the Total Pre Commissioning Costs have been spent, a Target Commissioning Window (TCW), within which the facility must start commercial operations (the point at which payments to the generator start), and a longstop date (occurring after the end of the TCW) by which, if commercial generation has not started, the CfD Counterparty can terminate the CfD. The date on which the milestone requirement must be met, the duration of the TCW and the date of the Longstop Date are all determined by reference to the technology deployed at the facility, as is the amount of Total Pre-Commissioning Costs. The most significant change since the original draft has been the inclusion of the possibility of extensions to the various deadlines. Originally no extensions of time were permitted, now however Force Majeure affecting the generator and delays due to problems with grid or DNO connection works will lead to a day-for-day extension in the timeline. The obligations with regard to the delivery of contracted capacity have also been simplified, so that the generator now has a one off opportunity, exercisable prior to the milestone delivery date, to give notice of a reduction in capacity of up to 25 % of the original contracted amount. The generator may also reduce capacity by notice where an unforeseen event renders construction of the entire contracted capacity uneconomic.
The Change in Law provisions are still long and somewhat convoluted, particularly when compared with the normal industry approach traditionally used in PPAs. However, despite 30 odd pages, the final drafting keeps the generator in a position that is no better and no worse than it would have been but for the change in law. The provisions actually give better protection to the generator than it would get under a typical PPP contract, and the protection is better than generators have now under the Renewables Obligation. The general view seems to be that what we have ended up with, whilst unfamiliar, is fit for purpose.
The allocation process has been developing in parallel with the terms of the CfD itself. The process involves allocation rounds which at present are going to take place annually – the first one starts on 16 October 2014 and the second will take place in October 2015. Initial auctions will use administered strike prices, with the intention being to eventually move to strike prices set by competitive auction. The funding pot for the CfDs falls under the Levy Control Framework, controlled by the Treasury. The final budget notice for the October 2014 allocation round was published on 2 October and sets the budget available in the 2014 round for CfDs to be awarded up to 2020/21. The budget is higher than had previously been published however, the strike prices have been reduced which will cancel out at least some of the increase in overall budget. Obtaining ROC accreditation was automatic, assuming that the relevant criteria were met, but obtaining a CfD is not, and the point in the development of a project when support is granted is completely different. What no-one knows at this stage is how the current "bulge" of projects that are hastening to gain ROC accreditation (but are increasingly unlikely to get it, given lead times) will affect the first few CfD allocation rounds when the decision is made to switch from ROC to CfD support. Developers are also unused to dealing with the new timing requirements so it is probably fair to assume that there will be a few projects that fail to meet milestone dates and fall by the wayside.
The biggest concern when the first draft CfD was issued was that there were provisions, such as those raised above, which made the CfD unbankable. Whilst there is not yet any market practice to go on, there is a general consensus that the CfD does now contain a bankable risk allocation. However there is another factor besides the CfD itself that needs to be taken into account when assessing project revenue, and that is the project PPA. The CfD does not involve the sale of electricity and therefore there will need to be a PPA sitting alongside each CfD to deal with the physical offtake of electricity. The CfD of course works by reference to the difference between the strike price and the reference price. What is not clear is the extent to which renewables projects will be able to capture the reference price. Given that at present renewable facilities selling into the market would expect a discount to market prices, and the £25/MWh discount to market price under the offtaker of last resort mechanism, it is not unreasonable to assume that it may be difficult to get the reference price that is set out in the CfD. The resulting hole in project income is likely to mean that the gearing on projects will have to reduce, possibly significantly. This in turn will lead to different financing structures to those we have become used to. It may even mean that a new breed of long term investor enters the market looking for stable, long term returns of the type provided by the CfD. One thing is for sure, it's going to be a learning curve for everyone.
First published in Utility Week on 10 October 2014.