ROC and a hard place

Elisabeth Blunsdon analyses the relative risk attached to CfDs over Rocs for the period between 2014 and 2017 when green generators can choose which to receive.

As of 1 April 2017, all new renewables generation will be supported by a feed-in tariff (FIT) with contract for difference (CfD). The current support regime, the Renewables Obligation, will close to new entrants. In the period between 1 April 2014 and 31 March 2017, however, renewables developers will be able to choose between the Renewables Obligation and the FIT CfD. That choice has inevitably given rise to the most common, and arguably the most difficult, question about Electricity Market Reform (EMR) posed to advisers in the sector: should we go with the Renewables Obligation or the FIT CfD?

The publication in June this year of draft CfD strike prices (the price against which difference payments will be calculated) has allowed the number crunching to begin, but risk analysis is about more than numbers. Legal risks need to be analysed too. There are key differences between the two and some areas where further clarity is needed.

CfD Counterparty. The most immediately obvious difference between the Renewables Obligation and the CfD is that the CfD is a contract, which implies the need for a contract counterparty. The Energy Bill states that this will be a CfD counterparty, which will be a government-owned limited liability company or public authority, designated as a CfD counterparty by the secretary of state. However, the Energy Bill also provides that in certain specified circumstances there can be more than one designated counterparty at a time (there must always be at least one).

It is not immediately obvious why there ever needs to be more than one counterparty – in the event of a CfD counterparty default, the legislation could simply provide that all existing contracts would be transferred to a new counterparty – and there are risks of stranding and discrimination against generators associated with having multiple counterparties.
While this issue would benefit from more clarity, the more fundamental issue around the CfD counterparty and how it will operate is the way its obligation to pay difference payments is qualified.

Insolvency remoteness. Under any contract, each party is exposed to the possibility that the other party will fail to perform, known broadly as counterparty risk. Back at the beginning of the EMR process, the government proposed that the CfD counterparty should be “insolvency remote”, presumably the thinking being that the fact that the counterparty cannot ever become insolvent would give generators comfort that it would not default. Scroll forward in the process and we get to clause 44 of the CfD, headed “Limited Recourse”, whereby the counterparty is not in default if it fails to pay a generator because it has not itself been paid under the supplier obligation – the “pay when paid” provision. Given that this is the CfD counterparty’s principal obligation, it is indeed insolvency remote.

However, this is of little comfort to a generator, whose cashflow, and therefore its chances of staying out of insolvency itself, will depend on being paid on time under the CfD (the counterparty remains liable to pay, and must do so promptly after it receives the funds, but there is no time frame within which the generator must be paid, and in the meantime the generator’s obligations to third parties remain very much in place). This provision is of particular concern to potential financiers who rely on regular cash for debt service.

The supplier obligation. The means by which the CfD counterparty will be funded to pay out difference payments under the CfD is the supplier obligation. Under the Renewables Obligation there is also a supplier obligation, but the two operate differently. Directly related to the point above about pay when paid is the situation where there is a shortfall in the payments being made by the suppliers to the CfD Counterparty.

Under the Renewables Obligation regime, suppliers bore the risk of a shortfall in funds via the mutualisation provisions set out in Part 8 of the Renewables Obligation Order, not generators. Under the proposed CfD supplier obligation, the generators will bear the risk that the counterparty is not paid in time under the pay when paid provision. The most recent draft of the Energy Bill makes provision for a reserve account, to which ­suppliers would have to contribute, to meet any shortfall arising from a supplier insolvency.

There are also other means of dealing with supplier insolvency, including collateral, the energy supply company administration arrangements and the supplier of last resort regime, which the government feels will ensure that payments continue to be made. The latest policy update on the supplier obligation also makes reference to a mutualisation process, but we will have to wait for further detail on how this would work. However, as long as the pay when paid provision remains in place, the risk of supplier payment default and insolvency leading to a shortfall in the funds available to the CfD counterparty remains on the generator, whatever other arrangements are in place.

The level of payments to be made by suppliers under the supplier obligation has been the subject of recent consultation. Under the Renewables Obligation, the annual obligation was fixed in advance, whereas the payments under each CfD will vary according to the variations in the reference price and in generation levels.

This will be particularly acute for intermittent generation such as wind where the reference price will be day ahead. The CfD counterparty will not know how much it will need to pay out under each CfD in advance. Clearly, suppliers will be keen to keep ­volatility in their payment obligations to a minimum, while the CfD counterparty will want to minimise its exposure to volatility under the CfD. Industry responses strongly favour a fixed payment obligation, and the government will work on this over coming months.

Much has been made of the risks faced by generators under the CfD regime, but it is also the case that licensed suppliers will see their own risk profiles changing under the new supplier obligation. Suppliers have the ability to pass costs through to consumers, but the government is keen to keep costs to consumers as low as possible. There are also acknowledged concerns about the effect of the supplier obligation on smaller, independent generators, and the possible increase in vertical integration in the market as vertical integration will allow access to the “natural hedge” between generation and supply.

Elisabeth Blunsdon, of counsel at Hogan Lovells LLP