The stakes are higher than they seem: the current energy challenge and net zero

It has been an incredibly challenging week in the UK energy sector, and attention has rightly focussed on consumer protection, and indirectly on the state of the energy supply markets. However, it would be a mistake to believe that the ramifications of supplier failure will be limited only to this part of the energy value chain.

There are possible spill-over effects for the wider net zero transition that we could see emerge from this tumultuous period in the supply market, and rather than waiting to think about how to piece back together investor confidence from the attendant rubble of company failure, a focus on how best to maintain investor resilience should be front and centre of the response unfolding right now.

Peaks or troughs, extreme volatility sets nerves on edge

First extremities in commodity prices – whether peaks or troughs – that catch out large numbers of companies in the same sector are obviously unnerving. These are companies who are supposed to have professional expertise in the commodity markets. And when we see large volumes of failures it serves as a sobering reminder of the danger of being exposed to material elements of merchant risk. Certainly, some firms will be doing well from rising volatility and market values, particularly those who came into the market to provide flexibility (more on that later), but once the initial euphoria subsides, they may also be left wondering about how easily extremity could move the other way in an increasingly interconnected and sensitive system.

It also shines a bright light on the weakness of long-term market forecasting tools to capture anything more than general directions and trend-lines of travel. These tools are incredibly useful in setting long term strategies around market fundamentals but less good at capturing drivers of short term cashflow and P&L performance. It reminds people how they can be blind-sided by extraordinary, and relatively short-term deviations to the modelled trend line. This is a problem for any investor – like a pension fund or a debt provider – who wants a relatively stable return and regular repayments of capital. The trouble is these also happen to be the providers of the cheapest forms of capital, and those who have the most money to invest in energy infrastructure.

To protect against this, government needs to continue to work on policy mechanisms that remove volatile commodity risk from the energy investment equation. The CfD has been highly effective in mobilising cheap capital precisely because it takes this risk off the table, as have other mechanisms like the cap and floor for interconnectors. A similar mind-set needs to be brought to bear on how to deliver genuinely investable signals in the short term and long-term flexibility solutions, which recent events show are of paramount importance. In truth, if confidence in merchant models is severely dented by recent events, then this becomes even more important than it already was. The interplay with possible windfall taxes is also pertinent, which we shall address later.

Short-term hiatus often follows

Second, market shocks in adjacent segments of the value chain can lead to hiatus in decision making in closely related projects or businesses. The financial crisis revealed how unexpectedly deep and wide the tentacles of risk can reach into a system once insolvency starts to occur. Mortgages taken out in suburban America brought banks down and starved credit to enterprises across the world. It also revealed how risks can play through and end up causing damage in unexpected places. This prompts everyone about to put capital at risk “on notice”. In the worst case it could lead people to pause whilst risk is crystalised in full across inter-connected systems, and the full value chain impacts are known. It is plausible that right now this very effect is playing out in the energy market, certainly amongst segments that serve and support energy suppliers (like meter providers) and possibly more widely than that. We have also seen before how macro trends can generally weaken credit quality (or perceptions of this) in the PPA markets as well.

To address this, the government could work urgently to investigate the comprehensive impact of the current situation on the wider energy (and wider economic) value chain and publish this analysis, including any mitigating actions to insert firebreaks or ring fences to contain fall-out and risks. This should be an immediate priority. Civil servants are incredibly able and producing such analysis is well within their skillset.

Policy reactions will influence future risk taking in general

Third, how governments and regulators react to global commodity driven events signals how much implied political protection risk-takers will receive in markets exposed to these risks. It is likely that in making capital investments where certain risks are unhedgeable – like taking a view on power prices in two or three decades time given you can’t buy a hedge or find a PPA to cover it off – actors take a view on whether governments would really leave their asset high, dry, and stranded.

If politicians take the view that enterprises should be allowed to fail when exposed to costs outside of their reasonable control, then general faith in “soft political” support starts to be undermined. Governments that wash-hands of their private sector partners can find confidence in them is damaged generally.

To negate this, the government may want to carefully consider whether maintaining the “bad companies fail” general characterisation of the present situation, and a “one-sized” solution is advisable. Arguably a more case-by-case assessment of why failure has happened, and how best to intervene, would show that policymakers appreciate that in a complex market, risk taking, and risk management is also complex. In the financial crisis such an approach was ultimately adopted: some banks failed, some were supported, some saved themselves depending on how they had got to where they were, and their systemic importance.

And catch all windfall taxes could damage sectors we desperately need to thrive

Yesterday we also heard Kwasi Kwarteng does not rule out “windfall taxes” given that energy is a system, with the implication that whilst some are making extraordinary losses, some are also making extraordinary profits. Spain have recently passed a law to recover significant sums from generators who have sold power against the market index price, whilst prices have been above a trigger level, on similar grounds. Substantial caution should be applied to any policy moves in this direction.

Applying such taxes in general creates a very uncertain environment in which investors sense a continuous “sword of Damocles” is hovering over the long neck of their investment horizon. But any policy which applies windfall taxes to physical flexible generation or storage asset owners would be highly dangerous to the long-term investment prospectus in these parts of the market. Investors in these sectors have responded to repeated statements form government about the desire to develop a smart and flexible system. They have been asked to do so on the grounds of exposure to merchant revenues, and that volatility should repay them for the day one risk of doing so. If at the first real sign of getting return on such risk they are taxed heavily, it will be a significant disincentive to follow their money into other assets or technologies and will be viewed as a “broken promise”.

If the prospect of flexible service providers earning market derived prices for delivering on their raison d’etre is politically unpalatable – and that is something that should really be clarified in what we all assumed was a market-based system – then the solution is to introduce policy mechanisms that share risk and reward whilst sending the signal for capital to keep flowing. A CfD, or cap and floor mechanism is tried and tested. Better to look at how these could be adapted to deliver flexibility in future, than tax the flexibility providers who have sunk capital already today.

So what? Well, we need capital to flow

All this matters given net zero is going to require billions of pounds of capital in infrastructure. The success of the UK model to date has been the way that is has encouraged risk-taking, with great policies intelligently leveraging private sector investors in a fashion that fairly shares risks and reward. It hasn’t been all plain sailing but the thriving and dynamic investment world that has developed around energy infrastructure in the UK is testament to its broadly positive effect.

This is a triumph of the last twenty years which should be protected from the vagaries of the next 6 months.

Some of the suggestions we have positioned here are not straightforward, and demand some in depth work. And like gas, time is another scarce commodity given interventions need to happen quickly.

But – like the financial crisis – if all efforts are put into the task, it is possible to deliver a response that could drive better decisions in the short term, whilst mitigating the risk of negative impact on investor sentiment in the long-run. Given net zero is a multi-decade return-on-investment proposition keeping a forensically close eye on the long-term impacts on the holders of capital is seriously important.

It will set the tone for how we progress towards net zero not just for this winter, but for the decades to come.

Related thinking

Energy storage and flexibility

Waiting to connect: the problems and solutions for network connection queues

The number of grid applications has risen significantly in recent years, resulting in increased pressure on the electricity networks to facilitate new connections. In its Energy Security Strategy, the UK government set out ambitions for 95% of electricity to be sourced from low carbon generation by 2030, and for the...

E-mobility and low carbon

2022’s most exciting ‘Charts of the Week’

Some of our team have looked back throughout 2022 and picked their most exciting ‘Chart of the Week’.​Their choices include exploring green tariffs, wholesale gas prices, CfD allocation round 4 and the MHHS Implementation Levy.  It’s My Birthday – Two years of Dynamic Containment Picked by Tom Faulkner, Head of...

Energy storage and flexibility

“Co-location, co-location, co-location”: Benefits and challenges

Key take-aways of the launch event   By Jamie Maule, Dr Matthew Chadwick & Nick Fothergill (Partner – Weightmans LLP) As part of the UK’s transition to net zero, the electricity generation mix needs to evolve, with increasing amounts of renewable capacity required to meet net zero commitments. To maximise...

Low carbon generation

62% of respondents think there is a 2 in 5 chance the GB electricity system will be decarbonised by 2035

Our latest Net zero transition: Future of electricity markets online training course was held on 15 – 17 November, where we asked delegates for their thoughts on several aspects of the future of the GB electricity market. The polls can be seen in our newest REMA portal - a hub...

Energy Market Design

Financing Net Zero: A (revenue) cap on UK merchant financing opportunities?

On 13 October 2022, we hosted the latest instalment of our ‘Financing Net Zero’ webinar series. The session, sponsored by Shoosmiths, focused on opportunities and challenges for merchant financed renewable projects amid the current wholesale price volatility.   In recent years, due to the increasing success-rate and profitability of renewable projects,...

Regulation and policy

Government to consult on the introduction of Cost-Plus-Revenue Limit

The government issued its Energy Prices Bill on 12 October. The bill will put in law a number of the already-announced mechanisms that will be used to support households and businesses this winter including the Energy Price Guarantee and the Energy Bill Relief Scheme. Also announced alongside this is the...

Energy storage and flexibility

From zero to hero: Can CfDs split markets and reduce costs this winter?

Given media comment on the imposition of a revenue cap for low carbon generators instead of migration of existing projects onto a CfD, please find below a blog published by Cornwall Insight three weeks ago. Not only did this note the possibility of the revenue cap being a fall back...

Energy Market Design

How does REMA impact energy generation, flexibility and consumers?

The Review of Electricity Market Arrangements (REMA) is the largest review programme of GB electricity market arrangements for a generation. It comes at a time when European energy markets are suffering extreme turmoil. Depending on the outcome there could be significant implications for generators, flexibility providers, and, indirectly, consumers. REMA...