Route to market for independents

1. Route to market for independents Overview of the evidence to date CLIENT:DECC DATE:11.04.13

2. Contents Agenda Overall objectives and evidence base Key definitions State of the long term PPA market Drivers for PPA market change Evolution under CfDs Emerging conclusions

3. ApproachKey objectives and evidence base Key objectives PPA Market Assessment • Assess the state of the market and establish whether there is evidence to support the assertion that PPA terms are deteriorating for independents Drivers of PPA market change • To the extent that a PPA terms are deteriorating, appraise the evidence presented by stakeholders as to drivers of this market change Evolution under CfDs • Assess how the identified drivers will manifest and evolve in a future market with Contracts for Difference (CfDs) Evidence Base Targeted interviews with stakeholders Call for evidence responses

4. Key definitionsMeaning of “independents” • “…..those renewable projects that are not owned by the six large vertically integrated utilities (VIU) or projects in which those large companies do not have a significant stake.” • Rely on limited-recourse finance to fund the capital costs associated the construction of renewable energy plants • Utility scale projects that fall under the RO projects and therefore do not have a institutionally enshrined route to market (i.e. small scale FIT) • Focus on wind, solar and biomass

5. Key definitionsMeaning of “Bankable PPA” • Material shift in banking requirements following financial crisis, however evidence suggest that there has not been a material change in these requirements over the last 3 years

6. State of the long term PPA marketKey observations and conclusions • General consensus amongst all stakeholders that PPA terms available to independents have materially deteriorated over the last 3 years: Imbalance Risk Discounts • More onerous reporting • Discount re-openers / indexing • Indemnities for imbalance charges • Power – average increase of 5% • LECs – average increase of 4% • ROCs – average increase of 12% Change in Law Risk Floors • Widened definitional scope • Limited carve outs i.e. the floor • Bespoke clauses dealing with specific envisaged circumstances • Limited offtakers willing and able • “Flawed” floors with limited tenor, no indexation, re-openers, stepped Tenor • Reducing tenor available • Increasing focus on short term market Profile Risk • Move from a month ahead to day ahead index • Material loss of value – estimated at [6]% in 2020

7. Drivers for market changeFramework of investigation • What is driving this observed deterioration in the terms on which offtakers are willing to contract for long term renewable power? PPA Demand PPA Supply Availability of Bankable PPAs Has there been a reduction or limitation in the number of potential offtakers willing to enter into long term PPAs? Is there a greater number of independent renewable project developers looking to secure long term PPAs?

8. Drivers for market changeEvidence for increase in demand • There does not seem to be evidence to support the premise that a significant increase in demand for PPAs is driving a deterioration in terms • However, nature of demand for both long and short term PPAs has changed: • Potentially a more lumpy pipeline caused by RO banding uncertainty • There is anecdotal evidence of earlier tendering of PPAs given enhanced development risk owing to route-to-market concerns • An increasingly active short term PPA market driven by: • Old assets rolling off long term contracts • Balance sheet financiers building utility scale projects but looking for short term route to market • Small scale FIT projects opting out of the export tariff for short term PPA positions

9. Drivers for market changePotential drivers of reduced supply • A number of issues highlighted in industry responses that could be causing a deterioration in PPA terms Reduced appetite for renewable power Reluctance to take long term price risk Uncertain long term imbalance costs Balance sheet impact of long term PPAs Increased regulatory uncertainty Barriers to entry preventing effective competition Key drivers Contributory factors

10. Drivers for market changeReduced supply – key drivers Description Driver Reduced appetite for renewable power • Increasing imbalance in the ROC market leaving a number of suppliers potentially long on ROCs against their obligation - reducing the number of offtakers in the market • Of those still with a shortfall, increasingly reliant on the short term market which has emerged in the last 3 years given older plant rolling off long term PPAs and emergence of European utilities using balance sheet finance • Rational contracting strategy that allows supplier to manage the volatility in their obligation owing to changes in the supply base (i.e. sticky vs. non-sticky customers) Balance sheet impact of long term PPAs • Issue of imputed debt, where by the financial risk inherent in a long term PPA is measured by credit rating agencies and consolidated onto a supplier balance sheet • This process is more acute where the supplier is providing a long term price floor • With supplier balance sheets increasingly constrained, the cost and ability of PPA providers to enter into these arrangements has deteriorated [given revised approach by credit rating agencies.]

11. Drivers for market changeReduced supply – key drivers Description Driver Reluctance to take long term price risk • Reluctance by supplier to offer a floor price that allows equity to achieve target leverage due to long term uncertainty in to wholesale electricity prices • This seems to be driven by: • Uncertainty as to long term generation mix and, in particular, the impact that a large penetrations of intermittents and greater integration with the EU might have on the underlying level and volatile of pricing • The unknown impact of the capacity mechanism on energy prices Increased regulatory uncertainty • PPA providers pushing back on the requirement to absorb significant change in law risk. • Progressive process that started with the removal of brown / green bundles, however is now a significant battle ground in negotiations • Caused by significant market change in the GB with the on-going EMR reforms, the launch by Ofgem of the Significant Code Review and the impact of target model compliance (e.g. market splitting)

12. Drivers for market changeReduced supply – contributory factors Description Driver Uncertain long term imbalance costs • Widening discounts and limiting the number of PPA providers willing and unable to price this cost at a viable level for 15 years • Driven by an increased perceived imbalance risk given uncertainty in the nature of the generation mix and how these intermittent volumes will be integrated on the system Barriers to entry preventing effective competition • Stringent banking requirements in relation to an acceptable counterparty capable of supporting long term debt has restricted the number of new entrants that can move in to fill gap left by utilities • Lack of wholesale liquidity risk, especially up the forward curve, restricts ability of new entrants to manage price risk • Concerns over long term ROC liquidity and market power discouraging new entrant aggregators taking a long position on ROCs.

13. Evolution under CfDsWhat risks are the generators left with? Risk - CfD Description Risk - RO Price Risk - Power • Price risk removed with a guaranteed top up payment to fixed strike price against the market reference price Removed Price Risk - ROC Removed • With the move away from the RO, no exposure to ROC price volatility (although largely addressed with headroom) Liquidity Risk - Power Retained • The CfD still requires the generator to sell its power into the market at the market reference price (or better) Liquidity Risk - ROC • Access to subsidy is no longer tied to the ability to find an offtaker for the ROCs Removed Imbalance Risk • Exposed to the imbalance cost associated with different between notified contracted position and delivered output. Retained Change in law • Protection in relation to specific / discriminatory CiLand general CiL that reduce electricity price, however arguably more exposed to general CiL affecting cost base Retained

14. Evolution under CfDsWhy will a generator still require a PPA? Description Issue Cost of accessing the market • Independent generators do not have the energy trading assets, systems or personnel to allow them to trade their generated electricity and interact with SO • For base load CfDs which have to access the forward price this cost increases as the collateral requirements increase Risk of continuing access to the market • “In the absence of a move to an institutionalised guaranteed access to the power market for all generators through, for example, an underlying reform to the electricity market, bankable PPAs will continue to be an absolute requirement of third party finance providers.” Low Carbon Finance Group Ability to manage imbalance risk • Uncertain long term cost of imbalance and as such, notwithstanding the fact that the lenders are no longer exposed to long term price risk, they will require the generator to fix this uncertain cost for at least the tenor of the debt. Change in law exposure • Banks will still probably look for a third party offtaker to provide a level of protection on pricing (i.e. trading / market access costs, imbalance discount) in the event of a general change in law (e.g. imbalance change in law)

15. Evolution under CfDsWhat does this PPA look like?

16. Evolution under CfDsEffect of CfD on key drivers Description Driver Impact Reduced appetite for renewable power • No longer need a supplier who wants the ROCs, however an economic incentive on VIUs to buy renewable power has nevertheless been removed • Theoretical incentive to enter into PPAs with intermittents to hedge a suppliers exposure to the levy however you could do this more easily in DA market • Therefore participation in the long term PPA market will very whether it makes economic sense to do so? Mitigated Balance sheet impact of long term PPAs Potentially Removed • No longer required to provide a long term price guarantee, this should pave the way for a more benign balance sheet treatment. • However treatment by credit rating agencies to be confirmed • Seems that key issue will be the extent of risk transfer - i.e. long term whole sale liquidity risk and scale of imbalance risk

17. Evolution under CfDsEffect of CfD on key drivers Description Driver Impact Reluctance to take long term price risk • Offtakers will not be required to offer any price guarantee as this is transferred to consumers in the CfD • As such this issue should fall away as a reason for not offering PPAs Removed Increased regulatory uncertainty Mitigated • Change in law risk that depresses whole sale electricity price is no longer an issue. • However, imbalance change in law risk in light of uncertain outcome of SCR likely to remain a potential issue in short term • [Unclear how the potential greater exposure of generators to general change of law (as no pass through in the electricity price) will feed through into PPA negotiations]

18. Evolution under CfDsReduced supply – key drivers Description Driver Impact Uncertain long term imbalance costs • Offtakers will still be required price long term imbalance risk over 15 years. Unchanged Barriers to entry preventing effective competition Mitigated • New entrant aggregators no longer required to take a view on their ability to realise fair value for a long ROC position • For an intermittent CfD, liquidity risk is less of an issue for new entrants as not required to manage price risk by hedging along the forward curve • However, there is still the open question as to whether sufficiently creditworthy counterparties will emerge that meet lender requirements.

19. Evolution under CfDsEmerging conclusions • Key barriers potentially removed by CfDs • Potentially more benign balance sheet treatment (although will need to be confirmed) • Requirement to take wholesale electricity price removed • No longer reliant on large supplier to realise value of subsidy potentially opening up market to new entrants • However: • Still require a PPA to manage imbalance risk and provide guaranteed offtake at a fixed discount to the Market Reference Price for 15 years; • Uncertain incentives on VIUs to offer such PPAs without visibility on strike prices • Extent of new entrant aggregators may be limited (at least initially) by: • number of players willing / able to take 15 year imbalance risk at competitive prices; • need to satisfy banks that you are sufficiently insolvency remote to stand behind a 15 year commitment