Energy efficiency and the power sector: USA perspectives on regulation and carbon pricing Thursday 19th March The UK investor perspective John Hargreaves – Indepen Consulting
AGENDA 1 UK context 2 Security of supply 3 Investor perspective 4 Investment in energy efficiency 5 Points for discussion 1
1 UK CONTEXT Challenging times What energy efficiency can do to help 2
Challenging times The UK economy, along with most others is severely challenged in a number of dimensions Those that are relevant to this talk are • The poor state of the economy and its prospects – associated with instability in the capital markets • Increasing concerns about the security of energy supply – particular focus on power and gas • Slow progress in meeting emissions targets – falling behind the previous set not to mention the new ones 3
What energy efficiency can do to help Challenge Potential contribution of energy efficiency Economy ● Contribution Productivity is good for the economy Many efficiency initiatives have a positive NPV Green recovery? Supply ●●● Major contribution security Emissions ●●● Major contribution Among the most cost effective 4
2 SECURITY OF SUPPLY Security is a problem in the UK It is getting worse There are plenty of options The investment required is big 5
Security is a problem in the UK In a paper, dated November 2008*, we concluded that “A generation gap in the UK is likely on unchanged policies. The analysis indicates that with unchanged policies there is likely to be a capacity shortfall in the second half of the next decade and this is so on a range of assumptions The cases we looked at would entail capacity margin lows in the period up to 2020 ranging from +14% to -1% compared with a range from +18% to +26% in the period from 2003 to 2008 and a target planning margin of +20% Since then • some developments have made the security of supply picture, on the whole, less rosy • the investment climate has deteriorated * Energy and climate security - coal and the alternatives to coal in the transition to a low carbon economy by 2020. Paper by Indepen, sponsored by the Ecofin Research Foundation, Nov 2008 6
It is getting worse Adverse - fossil fuel capacity • some LCPD opted out plants will close sooner due to shift to coal as base load and little prospect of life extension of these old plants even with derogations • some opted in plants may close before 2020, timing of new may slip Adverse – renewables • lower carbon and fossil fuel prices are bad for renewable investment • recent evidence that previous assumption on capacity factor was generous Adverse – capital markets Helpful – demand for power • high prices and recession - demand down by between 5 and 10% cf last year No change/adverse – nuclear and CCS • carbon price and fossil fuel prices lower • no change in schedule for old nuclear, new not available in medium term • slower progress on CCS Mixed – policy • helpful - heat and energy efficiency but effects and timing uncertain 7
There are plenty of options Supply side policies to reduce the planning margin by encouraging a net increase in large scale, central generation capacity • building or retention of capacity that is more flexible and better able • to match the profile of demand – oil and gas fired capacity non-generation supply side options - interconnection, grid • intelligence, storage Demand side policies reduce the planning margin by encouraging net reduction in demand – energy efficiency measures e.g. insulation • changing the pattern of’ demand using demand side response • measures, e.g. smart metering – information and control systems – time of day and location tariffs – interruptible contracts – direct load control micro/local generation including waste heat (equivalent to negative • demand) and distributed storage (e.g. electric vehicles) All of these require substantial investment although in some cases the investment will pay back via lower energy bills 8
The investment required is big Since last year central estimates of the likely generation capacity shortfall are now • towards the upper end of the range we found uncertainty about the capacity margin has not diminished • In addition to generation, there will have to be substantial capex in transmission, distribution and supply to provide for infrastructure renewal • network enhancement and connections for distributed generation • gas storage • smart meters and associated systems • energy efficiency and micro-generation • Ernst & Young report for Centrica, February 2009 “UK energy industry will need to invest over £225 billion by 2025 to • meet security and carbon targets” £15bn a year, cf approx £6bn a year (National Accounts Blue Book • sector tables) invested by the utility sector*since 2000 * This includes water at approx £3bn pa 9
3 INVESTOR PERSPECTIVE Financial market conditions – cost and availability of capital Equity • Debt • Bank loans • Other investor considerations – attractiveness and risks of the investment Consequences of market conditions Other investment considerations 10
Financial market conditions We interviewed infrastructure investors in mid January to mid February this year and last and held interview with several energy corporates Since 2008, capital market conditions have deteriorated and by more than investors expected key indicators of credit availability and default rates worse than • expected optimism about a quick end to the credit crisis has evaporated • continuing uncertainty about the depth and duration of recession • continuing sensitivity to bad news • Consider briefly the position in terms of the availability of finance and its cost with respect to equity • debt • bank loans • 11
Equity finance Investors are expecting – cost shocks from refinancing, dividend cuts, rights issues, ownership changes Some are overweight in infrastructure because values have held up Acquisition finance, infrastructure funds and private equity dried up Traditional funding available but cost (driven by the equity risk premium – see chart) higher due to market volatility but the non-availability of debt makes high returns unlikely 50 10% 40 8% ERP (UBS Estimate) (RHS) 30 6% 20 4% 10 2% FTSE 100 Implied Volatility (LHS) 0 0% Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-07 Jul-07 Jan-08 Jul-08 12
Corporate bonds Corporate bond market has re-opened, after closing Autumn 2008, but only for high quality names More fickle market – “early part of year may have been a mini rally” Wider spreads (up to 5 times recent levels) and shorter terms, index linked market closed The chart illustrates the cost of debt in terms of yields on UK utility bonds issued before 2003 5.0 Real Yield to Maturity (%) 4.0 3.0 2.0 NATIONAL GRID ELECTRIC UNITED UTILITIES WATER 1.0 YORKSHIRE WATER THAMES WATER BBB+ NATIONAL GRID 0.0 13 Feb-01 Feb-02 Feb-03 Feb-04 Feb-05 Feb-06 Feb-07 Feb-08 Feb-09
Bank loans Many foreign banks have left the market - impact of weak sterling Remaining banks lack of enthusiasm for lending has led to them requiring Higher pricing, Libor plus 200bp-400bp depending on rating and term • compared with less than 100bp before Higher arrangement fees c100bp vs 25bp 18 months ago and other • fees, e.g. on un-drawn facilities Shorter terms – typically 3 year with steps up to 5 years • Bank lending can be efficient finance but the “cost of carry” is now substantially higher 14
Other investment considerations As well as the usual technical, construction and commercial risks, investors perceive a high level of political and regulatory risk EU political commitment looks weaker in poor economic conditions • risk of stranding – when a new UK administration arrives • lack of clarity and realism about UK emissions targets in transport and • heat may have consequences for power sector partition of market to favour renewables increases risk of • underinvestment elsewhere failure of policy makers to focus on lowest cost solutions will result in • loss of legitimacy Recent rends in the economy and prices have been bad for energy efficiency in the short term global slowdown is depressing fossil fuel prices - clean projects look relatively • less attractive as fuel savings are less valuable – may be short term carbon price – EU ETS targets quantity of carbon, and so its price is uncertain – • lack of credible carbon price is bad for low carbon investments The negative factors may be offset to some degree by diminished supply chain and scarce skills constraints 15
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