Summary

The Government has issued a consultation paper to assess whether the Regulated Asset Base (“RAB”) model for funding nuclear projects would incentivise investment by the private sector into new nuclear projects.

New nuclear forms a key part of the Government’s plans for achieving net zero greenhouse gas emissions in the UK by 2050. Some 20% of our current power needs are already met by nuclear and, with 7 of the UK’s existing 8 nuclear plants due to come off line by 2030, there is an urgent need for new nuclear capacity to maintain and enhance its contribution to the UK’s future energy mix. The Government is willing to support this, but only if (and it is a big “if”) it can be delivered at a competitive price that represents value for money.

This consultation has been anticipated since the announcement in June 2018 by BEIS that it would review the viability of the RAB model. That anticipation has only grown following high profile set-backs such as Hitachi’s announcement in January that it would suspend work on the Wylfa new nuclear project in Anglesey, with widespread speculation that the level of Government funding was a key reason for Hitachi’s decision.

The consultation paper was issued at the start of this week (22 July 2019). It sets out the Government’s proposals, which are based around four key features of a proposed RAB model:

1. Government protection for investors and consumers against specific remote low risk, high impact events through a Government Support Package (“GSP”);
2. Fair sharing of costs and risks between consumers and investors, set out in an Economic Regulatory Regime (“ERR”);
3. An economic regulator to operate the ERR (the “Regulator”); and
4. A route for funds to be raised from energy suppliers to support new nuclear projects, with the amounts set through the ERR for both the construction and revenue phases (the “Revenue Stream”).

The RAB consultation seeks views on the high-level design principles. It is open to stakeholders for a period of 12 weeks, closing on 14 October 2019.

The aspects already grabbing the headlines are that end users will be expected to pay for the costs of new nuclear projects before they are generating electricity and that the Government will take key risks back from the private sector, including for cost overruns. This marks a significant departure from the project finance principles that have underpinned much of the recent private sector investment in UK infrastructure.

We have set out below a brief summary of the What, Why and How as well as highlighting some of the key financial considerations and pressures that these proposals introduce.

WHAT?

The RAB model is a type of economic regulation typically used for monopoly infrastructure, such as water and electricity networks. The relevant company receives a monopoly licence from an economic regulator, with the right to charge a regulated price for provision of the infrastructure in question. An adapted version of the RAB model was developed to enable the delivery and financing of the £4.2bn Thames Tideway Tunnel (“TTT”) sewerage project

For the nuclear RAB, it is proposed that electricity suppliers would be charged as users of the electricity system and would be able to pass these costs onto their consumers, who also use the electricity system. The charges would be set by the Regulator.

WHY?

The key driver for the RAB model is to attract private capital to finance new nuclear projects in the UK, in particular capital held by pension funds and insurers. It is a well-held principle that investors will typically look for a risk-weighted return on their investments, if they are willing to take the risks at all. Underlying this consultation is a perception that the risks associated with nuclear new build have changed recently and that there is better value to be achieved by the Government (and end users) taking some of these risks rather than asking private sector investors to take them and price for them.

New nuclear projects are typically large and complex, with high levels of risk attached to both the delivery and operational phases. Under a more traditional project finance approach – such as the Contract for Difference (“CfD”) model used at Hinkley Point C, for which the Government gave the go-ahead in 2016, these risks are borne by investors (in that case EDF and CGN), who are responsible for financing the cost of construction. The CfD then sets a “strike price” – in effect, a Government-backed price guarantee - to provide long-term price stability once the plant is operational, thus providing some assurance of a return for investors.

The level of risk inherent in new build nuclear, coupled with the (then) unproven European Pressurised Reactor (“EPR”) technology used at Hinkley Point C and the well-publicised problems associated with the delivery of projects in Finland and France, drove the need for a relatively high strike price (£92.50/MWh) in order for EDF to be willing to confirm its investment. Since then, progress on Hinkley Point C and projects using EPR technology elsewhere in the world has encouraged the Government that there may be better value solutions available now. In particular, it is looking at ways to reduce the financing cost of projects, beyond merely driving down the CfD strike price.

HOW?

A nuclear new build project will typically require significant up-front capital expenditure, have a long construction period and a long asset life.

As noted above, the RAB model would initially involve the granting of a licence to a project company, in order to build out the nuclear infrastructure. This licence would be accompanied by a GSP. The GSP would allocate certain construction and operational risks to the Government, specifically high impact, low probability events that the Government considers the private sector unwilling to take at all or to take at a price that represents value for money. The consultation cites the following examples of risks that might be protected by a GSP:

1. Risk of cost overrun above a set threshold;
2. Disruption to debt markets;
3. Uninsurable risks; and
4. Political risks.

The apparent willingness of the Government to take back the risk of cost overruns would be moderated by setting the funding cap at a level that only had a remote chance of being reached. By providing a finite ceiling on the financing requirement, it is hoped that investors will take a more favourable view of their total financing exposure and will, accordingly, be able to offer a lower cost of capital.

However, an element of risk will remain in that the Regulator will have the option to decide whether or not to allow the cost of further financing to be recouped via higher regulated charges. Furthermore, if investors choose not to provide the additional finance required, the Government may elect either to provide finance itself (in return for commensurate ownership and governance rights) or to discontinue the project. Either eventuality could materially alter the risk and return profile for investors. It will be interesting to see whether (and if so how) they are willing to price this level of residual uncertainty.

One specific feature of the RAB model is that it facilitates risk sharing, not only between the Government and investors but with the supply chain. Under a project finance approach, the promoter will typically look to manage risks by transferring them to contractors via robust, fixed price contracts. However, for projects of the scale and complexity of new nuclear, this simply isn’t a viable option. There is very little appetite in the contracting market to accept this level of risk, and it will, at best, demand a hefty price premium for doing so. Moreover, the UK construction industry does not have the balance sheet strength to bear such risks should they materialise. The RAB model allows promoters to adopt a more flexible approach to risk transfer – for example by the use of target cost contracts, as was done on TTT – and to use these as the baseline for the ERR (see further below).

HOW MUCH?

The Regulator would set the prices the project company can charge suppliers (and indirectly end users). This is called the “Allowed Revenue”. The Allowed Revenue will govern the risk share between investors and users of the electricity system. It is expected to be built up from a series of building blocks, potentially including:

1. Return on capital – applied to the adjusted total capex deemed efficient by the Regulator
2. Depreciation – allowing repayment of the initial capital cost during the operational life
3. Operating costs
4. Tax
5. Grid costs
6. Funded decommissioning programme – making allowance for decommissioning and waste management costs
7. Incentives, penalties and other adjustments.

Importantly, the Allowed Revenue will be charged during the construction period, as well as once the plant is operational. This should make the structure more attractive to investors that are seeking steady, predictable cash flows, such as insurers and pension funds. However, this means that end users will be paying for the cost of new nuclear even before the plant is up and running. The Government sees this as an acceptable price to pay for the lower cost of capital that it should deliver, but it clearly carries both economic and political risks which will need to be carefully managed if the proposal is to gain widespread acceptance.

The ERR is likely to be one of the most hotly debated elements of the proposals. This will govern how construction cost overruns will be accounted for and how the project is incentivised to remain efficient. There is a clear link between risk and cost of capital and, although the consultation talks about ensuring an ‘efficient’ cost of capital and achieving ‘best overall value’, there is little detail on how that will be determined. Two potential approaches are outlined:

1. Ex post cost settlement: with the Regulator exercising discretionary powers at regular intervals to assess whether expenditure has been sufficiently ‘efficient’ to be eligible for the RAB; or
2. Ex ante cost settlement: with a total target construction cost used as a baseline for incentivisation and risk sharing.

The ex ante approach was used on TTT and proved highly successful in driving a lower cost of capital, although needless to say it remains to be seen whether it will ultimately deliver value for money for customers. The consultation paper suggests that this is the more likely approach for new build nuclear as well. Whether (as the paper suggests) institutional investors are truly geared up to assess and manage the risk of cost overruns in the much more complex world of new nuclear build remains to be seen. The assumption that the Regulator and Government will be equipped (and resourced) to carry out the necessary risk and value for money assessments before approving a GSP and granting a RAB licence for specific projects also remains to be tested.

REVENUE STREAM DESIGN

The RAB model will require a bespoke revenue stream for funding to flow from suppliers to the project company. The Consultation proposes that the RAB model could achieve its core functions with the following features:

1. during construction, suppliers will pay to the project company a proportion of the Allowed Revenue based on their market share (as the project company is not selling power but needs a revenue stream); and
2. during operation, the project company sells power to the suppliers, whom are again charged their share of the Allowed Revenue, but minus the revenue the project company could have sold the energy for in the wholesale market at a specified reference price.

There are mechanical and administrative issues to be resolved, such as how the reference price is calculated and allocated between suppliers and how the intermediary body is structured and made insolvency-remote. It should be noted that, on TTT, the revenue collection function is handled by Thames Water as a bolt-on to its standard customer billing process, so the issues and complexities associated with the introduction of an intermediary body (including the interaction with other aspects of the wholesale electricity market) do not arise. That said, there are good precedents to draw on from the CfD and Capacity Market models and the Government is not committed to a ‘one-size-fits-all’ approach, accepting that the revenue arrangements may need to be revisited on a project by project basis.

APPROVAL AND VALUE FOR MONEY

Clearly, the Regulator and the Government will need to carry out a robust due diligence process before determining whether to grant a nuclear RAB licence. They will seek to ensure that all of the project risks are fully understood and minimised before doing so.

An important element of the investment “sell” on TTT was the appointment (initially by Thames Water) of a strong and experienced management team, who were then transferred to the Tideway delivery company prior to award of the RAB licence. Their capability and leadership was seen by investors as a critical component of the delivery model. In truth, the level of complexity inherent in a new build nuclear project is much greater than that on TTT, where most of the construction risk (and capex) sat in the three main tunnelling contracts. In our view, getting investors comfortable that the project team is capable of managing the multiple interfaces and delivery risks associated with new nuclear is likely to be one of the key challenges facing those looking to adapt the RAB model for nuclear development.

Another key issue for nuclear new build is obtaining planning approval. Due to their designated national importance, size and complexity, nuclear new build projects need to obtain a Development Consent Order (“DCO”), as well as a Nuclear Site Licence (“NSL”). The DCO process is front-end loaded, particularly in terms of consultation on specific proposals, and requires investment at ‘risk’. The phase of examining the application publicly is also critical, as pressure can be exerted by stakeholders to extract more and more complex and comprehensive mitigation for local communities in particular. The process is legally complex and there needs to be a real focus on promoting a consent that achieves the client’s needs, whilst respecting the interests of local communities and stakeholders. That is a key focus and practical implication of the DCO regime. The process can also be highly political and that needs to be managed within the overall promotion.

Getting the right advice early in the process enables the client to manage these issues and can have significant implications for a project in terms of cost, programme, risk and deliverability as well developing a long lasting and trusting relationship with local communities and stakeholders

Securing the DCO consent in the context of a RAB delivery model brings with it particular requirements in terms of how the DCO responds to the regulatory environment and the client’s proposals and delivery plan. Our team of DCO experts understands this thoroughly, having advised on the DCO for the TTT (which is the only DCO project so far to have taken the RAB route) and on a number of other DCO projects, advising both promoters and regulated clients seeking to raise objections

It should be noted that the obtaining of a RAB licence is separate from the DCO and NSL application processes. However, in practice they will very much need to run in parallel. From an investor perspective, the grant of a DCO and NSL both eliminates several of the key early stage risks to delivery (namely planning, CPO and regulatory approval) and provides certainty to allow the project to proceed with detailed design and logistics planning, thus framing the terms on which the RAB licence is structured and priced. Indeed, it was for this reason that the RAB licence on TTT was not awarded until some months after DCO grant. Equally, as part of the DCO process, the promoter will need to demonstrate that the project is capable of being funded and clearly the ability to secure a RAB licence will be a key element of that.

CONCLUSION

The consultation is a welcome development in the Government’s plans for net zero and comes at the same time as a series of connected consultations, including one on the potential use of the RAB model for Carbon Capture.

The initial reaction from the nuclear industry is likely to be positive, given that it sets out a path for nuclear new build to follow and is designed to reduce the cost of finance. It will be interesting to see how widespread the support is among consumer and the wider energy industry, as well as across the Parliamentary divide. That said, the differences between TTT (the “poster child” for the RAB model) and new build nuclear should not be underestimated, especially given the significantly higher scale and complexity associated with the delivery of new build nuclear projects.