The problem arises after the project is up and running. Hindsight is a curious thing and brings on a selective amnesia. A rate of return that seems merely reasonable, even minimal, when there is nothing but risk and expenditure on the horizon, can look over-generous, and even excessive, once the project has been built.
This is the political risk that investors fear. And it’s very real. In the past couple of years we have seen major and retrospective changes in payments for renewable energy across Europe. Those of us with long memories will remember the late 1990s, when long-term power supply contracts in Asia set up so that investors would build and operate so-called independent power projects were “renegotiated” once those much-needed power plants were built. The price paid for the plants’ output – and consequently the return on investment – came down sharply.
Investors are ready for this. They know that no matter how risky the construction and start-up phase of a project, once it is built the political risk is bigger, and longer lasting. So they assume there will be a “haircut” – a bit of jargon that means that at some point during the contract, their returns will be cut. But, crucially, the risk of that haircut, and its expected severity, is factored into the cost of the project.
All a government can do is try to establish and maintain a reputation for not reneging on its agreements. It won’t make cautious investors discount the risk entirely – that will never happen. But the lower the risk, the lower the premium that investors will build into the cost of the project. That’s also why scheduling tough reductions from the start of a programme is positively beneficial. It adds a certain amount of future-proofing.
All this is a long preamble to saying that the British government needs to maintain its reputation of trustworthiness, and not just on major projects. If it doesn’t, it translates directly to the cost of investment and for us that means the price we pay for some very big ticket items: offshore wind and high-speed rail being just the most immediate.
Up to now, UK plc has maintained a very favourable record. Governments try to maintain a consensus about the direction of travel. Care has been taken to “grandfather” subsidy regimes, so new ones don’t leave existing investors high and dry.
That brings us to the PV debacle. It’s a relatively small programme and it is not, as it happens, one that has called on big investors to underwrite it. Clearly, the government got its sums wrong. It underestimated how much costs would come down and how popular the take-up would be. That proved costly. But the decision to rectify the situation by changing the terms of the agreement at such short notice, and before the consultation has ended, will do reputational damage that in the end could cost the country much more.
The Department of Energy and Climate Change is in a hole. It’s time to stop digging and try to make a graceful end to the dispute.
Janet Wood