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 Electricity Market Reform (EMR) begins.
It has been a long and 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 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 developers and financiers about the terms that were on offer. The principal worries were broadly grouped into three categories: 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. The Department of Energy and Climate Change (Decc) was keen to ensure 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 per cent 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 longstop date are 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 were permitted; now, however, force majeure affecting the generator and delays due to problems with transmission or distribution 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 per cent 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 convoluted, particularly when compared with the normal industry approach used in power purchase agreements (PPAs). However, despite running to 30-odd pages, the final drafting keeps the generator in a position that is no better or worse than it would have been but for the change in law. The provisions actually give better protection to the generator than it would enjoy under a typical public-private partnership contract, and the protection is better than generators have now under the Renewables Obligation. The general view is that what we have ended up with, while unfamiliar, is fit for purpose.
The allocation process has been developing in parallel with the terms of the CfD. The process involves allocation rounds, which will take place annually – the first 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 eventually to 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 Renewables Obligation certificate 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 Renewables Obligation certificate 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 Renewables Obligation certificates to CfD support. Developers are also unused to dealing with the new timing requirements, so it is probably fair to assume 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, that made the CfD unbankable. While 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 works by reference to the difference between the strike price and the reference price. What is unclear 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 it may be hard to get the reference price set out in the CfD.
The resulting hole in project income is likely to mean the gearing on projects will have to reduce, possibly significantly. This will lead to different financing structures from 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 certain: it’s going to be a steep learning curve for everyone.
Lis Blunsden, of council, Hogan Lovells