Mutualisation of the Buy-Out Fund: Securing the Renewables Obligation

30.09.04 Share

 

Supplier default, leading to a shortfall in the buy-out fund, has occurred in each of the two completed renewable obligation periods to date. Confidence in the renewables market has been weakened as a result. Ways in which to safeguard the buyout fund and secure the Renewable Obligation (RO) were discussed at length during the Energy Bill's progress through Parliament, and new powers to address the issue were granted under the Energy Act.

The department of trade and industry (DTI) has now published a statutory consultation setting out its intentions in relation to this and a number of other topics it intends to legislate for early next year, with the intention that the relevant order will come into effect on 1 April 2005.

Some may argue that the failure of companies is a fact of economic life and that bad debt under the RO should be treated no differently to any other debt. However, the Government is clearly set upon some form of intervention. The market is factoring in a credit risk that was not previously perceived, and Renewable Obligation Certificates (ROC) prices have been reduced as a result. The Government is determined to bolster prices in what is its main tool for encouraging renewables development. Three means to secure the RO were put forward in Parliament: securitisation; mutualisation; and shorter obligation periods.

The alternatives

Securitisation would arguably have been the most straightforward of the three. Suppliers would have provided security (e.g. bank guarantees) to cover their expected buy-out payment. This would have virtually guaranteed the buy-out fund with little administrative difficulty. However, securitisation was rejected. The cost to suppliers (and therefore customers) was considered too great, and a possible barrier to entry. A further disadvantage was that securitisation would involve extra cost whether or not any future shortfall actually occurred.

The Energy Act therefore provides generally worded powers that allow the Government to introduce shorter obligation periods and/or a scheme of payments to be made by suppliers in respect of a shortfall (i.e. mutualisation). Having considered its options, and generally in accordance with the recommendations of a study funded jointly by the DTI and the Scottish Executive, the DTI has proposed a form of mutualisation (but no shortening of the obligation periods).

The introduction of shorter obligation periods would not have prevented shortfalls occurring on supplier default, but would have reduced the size of each buy-out fund and consequently the size of any shortfall. Although not a means of preventing shortfalls, this initially appears a straightforward and effective means of reducing the risk to ROC holders. However, the current cumbersome and lengthy compliance process is not easily compressed, and opponents (not least Ofgem) argue that the increased administrative burden would be unjustified. Most participants would welcome a more streamlined process and the increased administrative cost seems unlikely to be material. However, a convincing argument is made that the introduction of shortened obligation periods would alter market mechanics. For example, obligation periods of less than a year would introduce a novel element of seasonality, which may disadvantage technologies such as hydro and wind that tend to generate more in the winter.

Mutualisation

Having eliminated the only other apparent options, the Government is left with mutualisation. The scheme proposed by the DTI would work as follows:

  • ordinarily the process would work just as it has to date, with no additional costs incurred by any party;
  • mutualisation would be triggered where a shortfall of at least 10% of the buy-out fund's total arises;
  • all non-defaulting suppliers would then make up the shortfall, by making additional payments;
  • but if a shortfall exceeded 50% of the buy-out fund's total, the amount over this 50% would not be recovered;
  • suppliers would be required to make these additional payments over the course of the obligation period following the October default;
  • the contribution required of each supplier would correspond to its share of the overall Renewables Obligation in the obligation period in respect of which the default occurred.

This sharing of the shortfall risk amongst non-defaulting suppliers could be criticised for punishing compliant suppliers for the failure of a competitor. In reality though, the cost is likely be met by customers, and, as a quantifiable sum, should be passed on in a fairly transparent and uniform manner.

The risk of shortfall would not be entirely eradicated. A 'small' shortfall would not trigger mutualisation (though 5% would appear a better measure of 'small'), and a very large shortfall would be subject to the cap. However, the risk should be vastly reduced, as 'small' shortfalls will have a lesser impact on price and large shortfalls are unlikely to occur. Mutualisation should therefore achieve its aim of reinforcing market confidence.

However, there are inherent problems in a 'post event' approach such as this. A shortfall in respect of obligation period 1 (obligation year) will not be apparent until part way through obligation period 2 (default year) and so will not be recovered until the end of obligation period 3 (reconciliation year). In addition to the obvious cash flow issues, an interesting question arises as to the point at which a supplier's share of the Renewables Obligation, and therefore the shortfall, should be measured. There may be significant differences between a supplier's market share in each of these three years, especially for new entrants and those withdrawing from the market. The DTI has chosen the obligation year, arguing that calculations based on either of the other two would require new or growing suppliers to contribute to a buyout fund they have no means of benefiting from. This logic seems flawed as mutualisation merely makes ROC holders whole, it does not provide any additional benefit. If the cost of mutualisation is intended to be spread equally among suppliers (and passed on equally to customers), surely all suppliers in the market at the time the cost is levied should be treated equally. Using the obligation year will give new and growing suppliers a price advantage over other suppliers during the reconciliation year. There must also be an increased risk of a company that was a supplier in the obligation year having ceased trading in the intervening years, possibly creating a further shortfall.

Matters are further complicated by the number of amendments the DTI is currently juggling. In addition to mutualisation, the consultation deals with a number of further amendments, some on linked issues such as late payments (replacing the late payment mechanism introduced in April) and the accrual of interest, and others on wholly disparate issues such as a single recycling mechanism for Scotland, Northern Ireland and England & Wales. The desire for a single recycling mechanism is based (just as mutualisation is) on sound principles. However, its proposed introduction poses questions as to whether a supplier default in respect of one of the three buyout funds should trigger mutualisation across the UK or in only the area where it occurred questions that are difficult to answer, given that neither mechanism has yet been introduced. All this change is also against the background of the full-scale review scheduled for 2005-6.

Nevertheless, the Government seems likely to have introduced mutualisation by the beginning of the next obligation period. Should mutualisation be triggered, it may well prove complex, inequitable and difficult to administer. However, it appears to have been preferred on the basis of perhaps its greatest merit: that (fingers crossed) it may never be triggered and market confidence will have been increased at no additional cost to customers.

Key Contact

Derek Goodban, partner, +44 (0)121 685 2710, derek_goodban@wragge.com

This alert may contain information of general interest about current legal issues, but does not give legal advice.

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