Undermining ROCs - shortfalls in the buy-out fund

09.09.03 Share

 

The Renewables Obligation (RO) was introduced in a blaze of publicity in April 2002. It created for the first time a binding obligation on electricity suppliers to obtain a specified proportion of their electricity supplies from renewable sources, and aims to provide a platform for growth in renewable generation and, ultimately, help the Government reach its legally binding Kyoto commitment to reduce greenhouse gas emissions by 20% over 1990 levels by 2010.

However, the predicted £20 million shortfall in the funds to be repaid this year to complying suppliers, caused by the failure of the TXU Europe Group, has undermined the already fragile confidence in the operation of the RO. This lack of confidence risks holding back the development and financing of renewables projects, and puts the Government's target that 10% of the UK's electricity be supplied from renewable sources by 2010 into jeopardy.

The Renewables Obligation

All licensed electricity suppliers are required to comply with the RO and supply an increasing amount of their sales from eligible renewable sources (4.3% in the obligation period 2003/04, rising to 10.4% in 2010/11). The Renewables Obligation Order (ROO) states that each unit (megawatt hour or MWh) of electricity generated from an eligible source will have attached to it a unique renewable obligation certificate (ROC) evidencing that source.

A supplier can comply with the RO in one of two ways (or by a combination of both) - by presenting sufficient ROCs to meet its obligation (either through self generation or by acquiring ROCs from third parties) or by paying to Ofgem an amount, the "buy-out price", for each MWh (currently £30.51) of its obligation for which ROCs are not held.

In order to encourage investment in renewable generation further, the buy-out payments paid by non-compliant suppliers in any obligation period are aggregated to form a "buy-out fund". This fund (together with interest) is paid by Ofgem by way of "recycling benefit" to all suppliers who have submitted ROCs (whether fully compliant or not) in proportion to the number of ROCs presented in the relevant obligation period.

The ROC market

Development in renewable generation is dependent on new entrants into the generation market. In order to facilitate entry, it is essential that external finance for projects is readily available. A key factor in determining the availability of finance for a particular project is its modelled income stream. In constructing that model, the developer and its financiers are likely to make certain assumptions about the level of recycling benefit which will accrue over the life of the project.

There are various offtake pricing structures which enable developers to benefit from the recycling benefit. Most involve a sharing arrangement between developer and supplier with the developer being paid a percentage of the recycling benefit the supplier would receive if the ROCs were submitted to Ofgem.

The developer's percentage under any such sharing arrangement is likely to form a significant part of the project income stream (whilst figures vary, the recycling benefit may constitute up to 20% of the modelled income stream). The risk of a reduction in recycling benefit is therefore borne, at least in part, by the developer and its financiers.

If the basis on which the recycling benefit has historically been modelled proves to be unduly optimistic, this could undermine the financial viability of projects already financed, and the ability of new projects to attract third party funding.

Calculating the buy-out fund

Under article 12 of the ROO, the buy-out fund in relation to a particular obligation period is the aggregate amount received by Ofgem (together with interest) by way of buyout payments under article 7. Importantly, the buy-out fund does not reflect the amount that Ofgem should have received if all non-compliant suppliers had made their buyout payments.

Any shortfall in buyout payments received by Ofgem will, therefore, lead to a shortfall in the buy-out fund and a corresponding reduction in the recycling benefit payable to suppliers. Under a typical offtake arrangement, that will lead to a reduction in the amount paid to the developer by the supplier for benefits accruing from the project. This has clear implications for cash flow and financing.

There are two obvious scenarios in which a shortfall in the buyout fund may arise - a simple failure by a supplier to comply with its obligations to pay the buy-out price, or the inability of a supplier to comply because of insolvency. For example, the recent failure of TXU Europe Group has led to a potential shortfall of £20 million in the 2002/2003 buy-out fund due to be paid out at the end of this year.

While there will always be degree of guesswork involved in predicting the amount of the recycling benefit in any obligation period, it is unlikely that anyone would (or indeed could) have accurately factored in to their financial models the risk of non-payment of the buy-out price by suppliers.

Dealing with a shortfall

The TXU insolvency was not the first and is unlikely to be the last failure of an electricity supplier.

The financial challenges of operating an electricity supply business with small profit margins, high cash flows and little or no infrastructure assets have also been highlighted in the cases of Independent Energy, Enron Direct and Maverick Energy.

However, the ROO spectacularly fails to legislate for the fact that suppliers may not comply with their payment obligations. Whilst Ofgem's only real power that of licence revocation - may incentivise slow paying suppliers and (more importantly) administrators or receivers of insolvent suppliers who wish to keep trading to maximise benefits to meet their payment obligations (in both cases a supply licence being essential to the ongoing business) it is of little use in the case of insolvent supply businesses with no customers or no prospect of continuing to supply.

Against this background, the DTI needs to act quickly to reassure the renewables industry that it is serious about the role renewables have in the UK's future energy mix.

In the case of British Energy and notwithstanding legal challenge, the Government has shown itself willing to use significant amounts of public money to support the electricity sector. If the nuclear industry (which does not appear to form an integral part of the Government's future energy policy) can attract such substantial support, then should the fledgling renewables sector not be entitled to look to the Government for support in the short term, for example by the Government making up the shortfall in the 2002 - 2003 buy-out fund?

The DTI also needs to learn from the lessons of TXU and take steps to increase confidence in the ROO. There are at least two possible approaches:

  • Changes to the ROO to provide a mechanism for any future shortfall to be made up would reassure complying suppliers that their financial interests are being preserved, and incentivise all suppliers to mitigate their exposure to the buy-out price by purchasing ROCs. Shortfalls could be made up from Treasury funds or, possibly more attractively, from suppliers who do not hold sufficient ROCs in the relevant obligation period. The latter approach would have the added benefit of encouraging suppliers to buy ROCs to avoid any risk of having to make a shortfall payment.
  • Other more radical solutions could include changes to the insolvency regime or, if their potential impact on the success of the Government's renewable strategy is such that supply businesses are now seen as meriting sufficient public interest to warrant it, the application of a special administration procedure similar to that being considered for distribution network operators. In either case the intention would be to provide Ofgem with some form of preferred rights in the event of insolvency of a supplier and a shortfall in the buy-out fund.

Conclusion

A shortfall in the buy-out fund could have potentially damaging implications for the expansion of renewable generation in England, Wales and Scotland. Financiers have already expressed concern about the lack of a guaranteed minimum price for renewable output and the possible adverse effects of the review of the ROO that has been promised for 2005/2006.

The DTI has the powers to ensure that the problems highlighted by the TXU insolvency are addressed within the renewables regime. The question is whether or not it has the political will to use them and use them quickly. If it chooses not to, the already fragile confidence in the renewables sector may be further undermined with potentially alarming consequences for Government energy policy and Kyoto commitments

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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