Having discussed proposals for progressing new nuclear in the UK in a previous note, this note further examines UK government plans to include nuclear in the UK’s future energy mix through a relatively novel funding mechanism.
The UK Department for Business, Energy and Industrial Strategy’s (BEIS) Regulated Asset Base (RAB) proposal, published in July 2019, seeks to address the cost of capital – how much it costs to raise the debt and equity needed to fund the project – a factor which some believe could account for as much as half the expense of nuclear new build.
While construction risk will probably be the most politically contentious issue arising from RAB, it should be reasonably simple to settle.
Another contentious point will be raising revenue from suppliers on a mandatory basis.
However, since this is already happening with other RAB projects, the Capacity Market and renewable support schemes (CfD, FiTs, ROCs etc.), it seems harsh to single out nuclear on this basis.
Nuclear detractors argue that there is no need to build new nuclear in the UK.
This is an entirely defensible position, were it not UK government policy to reach “Net Zero” emissions by 2050.
If biomass generation were deployable at much greater scale and if carbon capture, use and storage (CCUS) had progressed beyond pilot/demonstration stage, this would certainly weaken the case for new nuclear capacity.
But unless those technologies make significant breakthroughs in the next 12 months, or the government amends the net zero legislation, nuclear new-build is the only technology that can currently deliver the firm and low-carbon generation needed to meet the UK’s emissions target.
Power supplied from abroad via interconnectors probably cannot be regarded as sufficiently firm, due to its dependency on other economies.
Renewables will make an increasingly important contribution to overall system capacity.
Battery storage and dynamic demand-side response (DSR) will also be important in compensating for the non-dispatchable nature of renewables and allow a move towards smarter networks.
These cannot offer the entire solution, however.
The RAB "risk share" principle: construction cost overrun
The Funding Cap
The RAB consultation floats the idea of the UK government, rather than the developer, underwriting the risk of construction cost overrun "above a remote threshold" – referred to as the "Funding Cap".
The Funding Cap is set following "robust project diligence and global benchmarking", although in reality, that process will be more important in determining the cost (the "Baseline") of the project.
The delta between the Baseline and the Funding Cap would reflect a risk-share between investors and customers, with a certain percentage of spend over the Baseline (but under the Funding Cap) reimbursed through RAB revenue, and the remainder of the cost overrun absorbed by investors.
This risk-share mechanism introduces an additional incentive to deliver the project within budget and the corollary gain-share would apply in relation to project savings.
The particular proportions would be a matter for negotiation.
The government support package
The primary function of the Funding Cap is to deliver a construction cost "risk envelope" for investors.
It determines their level of exposure and allows them to price their investment appropriately.
Above the Funding Cap, the UK government would be contractually required to inject equity, or terminate the project.
The cap has integrity, from an investment perspective, as it is baked into the applicable RAB regime (the "Economic Regulatory Regime"), which is backed by legislation.
BEIS would be the likely counterparty to the investor support package (Government Support Package, or GSP), in the same way the Department for Environment, Food and Rural Affairs (DEFRA) was for London’s super sewer, the Thames Tideway Tunnel (TTT) GSP contracts.
Cost share proposal from BEIS's RAB consultation
This approach can be contrasted with Somerset nuclear project, Hinkley Point C’s (HPC) contract for difference (CfD), where the cost of construction falls entirely on the developer prior to commissioning.
The RAB model achieves two things: First, it opens up the categories of potential investors (specifically pension and insurance funds); and, second, it decreases the overall cost of capital.
This is because "low-risk, low-return" investors can accurately project their investment exposure (limited to the Funding Cap threshold) and both the lower risk profile and the availability of regulation-backed revenue through construction, means the debt and equity will be cheaper.
If construction cost exceeds the Funding Cap, investors may be invited (but not required) to provide further finance, failing which the government is obliged to provide an equity injection and become a shareholder under the GSP.
The government also has the option to "discontinue" the project and compensate investors (referred to as the "discontinuation payment"), which limits the government's own exposure.
This is the same approach taken to the TTT, where the project company can call on a Contingent Equity Support Agreement (CESA) with DEFRA if the project spend exceeds the "Threshold Outturn".
The National Audit Office (NAO) reported that the government's view of the likelihood of a call on the TTT GSP is less than 5% (consistent with the "remote chance" language in the consultation).
This 5% probability is important, for reasons addressed below.
The rest of this note considers a number of factors that suggest setting the Funding Cap (as the proxy for construction risk) is likely to be less difficult than might be assumed.
1. Political consistency
The UK government needs to (quickly) sell the idea of funding nuclear new-build, but is having to do this backwards.
It cannot fund these projects directly (which would probably be the cheapest option) for political reasons, so it is having to inch away from private sector-backed risk to mutualised risk.
A very high price of power was agreed for HPC, as an alternative to an accusation of underwriting construction risk.
For Horizon Nuclear Power’s Wylfa nuclear project in North Wales, a lower strike price, some debt funding and partial equity investment was offered.
With nuclear RAB, a regulated revenue stream from the start of construction is on offer.
But that revenue is coming from customer electricity bills. The government only steps in if the GSP is required (a remote possibility, in principle), but can still establish a regulatory regime so that licenced suppliers are compelled to raise the RAB payments.
So far, so private sector. But the consultation has to sell RAB positively to justify RAB financing against some quite determined opposition.
The key to selling RAB for nuclear is: a) making the case for new build nuclear generally; and b) promoting the success of RAB financing of the quasi-greenfield TTT project (RAB being initially an approach to valuing public assets during privatisation).
The consultation has to tread a careful line between promoting the success of the TTT, while downplaying the similarities of the consultation to that project.
The similarities are not expressly acknowledged in the consultation, probably because the TTT model has already defined a Funding Cap threshold (referred to in the TTT project as the "Threshold Outturn") – i.e., 30% over the Baseline.
2. Picking the winning argument
RAB is being promoted as a solution for funding nuclear new-build and potentially CCUS.
The timing of the consultation clearly has EDF’s Sizewell C (SZC) nuclear project in Suffolk in its sights, as that project will be aiming to take a positive final investment decision (FID) by the end of 2021.
A large part of the business case of SZC is cost reduction over HPC, as it is "next of a kind" rather than "first of a kind" technology.
This is because a large proportion of the design, reactor technology and key contractor involvement essentially replicates HPC, with cost reductions attributed "one-off" HPC costs and lessons learned from HPC's development and construction.
If the combined efficiency of HPC and SZC as joint projects is a key selling point for SZC (and baked into a reduction in the HPC strike price), there is danger of undermining this argument by also insisting on too high a delta between the Baseline and Funding Cap.
It may even make it hard for BEIS to argue for a Funding Cap much above 30% in circumstances where that is more than margin of cost reduction at SZC over HPC.
3. Next of a kind technology
SZC’s "next-of-a-kind" status means there is significant de-risking of both construction risk and performance risk (post-commissioning) in rolling out the same EPR reactor technology and nuclear island design.
Added to this will be the significant lessons learned from HPC in relation to deployment, programme and interface, and the experience of having road-tested key construction and supply contracts.
The greater the similarity between HPC and SZC, the more SZC is de-risked, and the less need to have a significant Funding Cap/Baseline delta.
4. Customers in the spotlight
RAB puts the customer front and centre as, notwithstanding that the obligation to raise and pay the Allowed Revenue falls on suppliers, it is customers who back these costs.
This is similar to the CfD scheme, but in the CfD, revenue only starts to flow after commissioning, not during construction.
While there is some opaqueness in the relationship between CfD funding and payment of the strike price, industry observers will allow no such ambiguity around customers being burdened with the cost of RAB projects.
This means there is additional social and political sensitivity between excess over the Baseline cost that customers will have to pay through RAB and the government (tax payer) having to "bail out" construction cost overruns above the Funding Cap (when the developer's exposure to overspend ceases).In the current climate, investors need to be more sensitive to this when promoting a project that needs broad public support.
They will also be aware that having a very low Funding Cap heightens the risk of political intervention, which adds to the risk-associated costs of the investment.
The UK government will certainly be sensitive to this issue in light of criticism of HPC's strike price and the negative legacy of the now-abandoned private finance initiative (PFI) scheme.
5. Going off balance sheet
A key motivation behind the structure of PFI schemes was to get the funding of large public assets off the government's balance sheet.
This was a concern with the TTT project, and it will remain a concern of the UK Treasury for any RAB new-build nuclear project.
The NAO Report on the TTT project suggested the government thought there was less than a 5% chance of the TTT GSP being called on (although the financial consequences would have been extremely significant if it had been).
The remoteness of government (as opposed to supplier) funding being required is critical to the consideration of balance sheet treatment, in accordance with guidance from the National Office of Statistics.
Prima facie, the same probability would be applied to the RAB model to help determine what a 5% probability level of overspend is, as the trigger for government contribution.
A parallel consideration exists in relation to state aid. The analysis here would probably be that the Allowed Revenue would not be state aid (as it originates from customers), but that GSP funding would be (as it is provided by government).
6. RABble rousing
The points above suggest that setting the Funding Cap may not be as difficult an issue for RAB projects as the consultation implies (or some commentators make out).
There is a more fundamental concern that is presumably already very well understood in well-progressed projects, like SZC.
It is raised in the consultation in the context of setting the Weighted Average Cost of Capital (WACC), which is the authorised return for investors on the capital they provide.
The consultation refers to the possibility of setting the WACC through competition between capital providers, rather than benchmarking.
The TTT project departed from the usual benchmarking approach by running a book building competition, where the marginal bid set the WACC for the construction phase and early operating phase of the project (which, at around 2.5%, was much cheaper than anticipated).
However, SZC will need around five times as much capital as the TTT (c.£16 billion, versus £3 billion).The risk sensitivity of SZC’s investor base may therefore decide the Funding Cap on a similar marginal basis.
This article was written by Hugo Lidbetter, partner and energy and infrastructure specialist at Fieldfisher. For more information on our sector-leading energy expertise, please visit the relevant pages of the Fieldfisher website.
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