Oral evidence: Investor Confidence in the UK Energy Sector HC 542

Oral evidence, 9 February 2016.

Witnesses

Lilia Stoyanova, Director, Townsend Group, Morgan Angus, Principal, Townsend Group, and Donald MacDonald, Chairman, Institutional Investors Group on Climate Change, gave evidence.

Chair

Can I ask the panel to state their names and organisations for the record, please?

Donald MacDonald

Donald MacDonald. I am the Chair of the Institutional Investors Group on Climate Change.

Lilia Stoyanova

Lila Stoyanova, the Townsend Group.

Morgan Angus

Morgan Angus, the Townsend Group.

Chair

Thank you very much. Donald, you just reminded me, my neighbour is called Neil McNeil, and he was in school with a Donald MacDonald and an Arthur MacArthur as well, so it is not an unusual name at all. The UK, as we know, has fallen from eighth to 11th place, as was said in the previous discussion, in the EY renewable energy country attractiveness index. Broadly speaking, of all the policy announcements, which do you think might have had the biggest impact on investors’ confidence and may have led to that slippage, or may not? Of course you are free to disagree with that.

Donald MacDonald

From the summer onwards there have been changes made, and we understand the reasons for that. But I think that the way that they have been done in a very piecemeal manner has spooked slightly investor confidence. I think that is probably the biggest reason. I do not know the methodology that Ernst and Young used, but my guess would be that it has been a lack of clarity and what appears to be a piecemeal approach to the changes that may have caused some doubt.

Chair

I gave a gloomy opening there, but would it perhaps be fairer to say that the UK’s attractiveness has improved since the Secretary of State’s reset speech?

Donald MacDonald

There are many positive elements in the Secretary of State’s speech, and we welcome many of them, and in fact they are very bold. However, coupled with some of the other changes, the move away from onshore wind and so on, I think there are genuine doubts as to whether or not the UK Government can meet its own targets over the longer term, and could cause problems in terms of energy shortfall and energy security. While there are many strong signals in the Secretary of State’s statement, there are also some rather big issues, and I think there is a lack of clarity as to how we are going to be able to think about how we allocate investment.

Chair

Is it fair to say to say there is a lack of a plan, sometimes I say a lack of a man with a plan, just because it rhymes, in DECC—but it would be more correct to say lack of a woman with a plan in DECC—for the UK energy policy in the future as it goes forward, as the phrase is, at the moment?

Donald MacDonald

Sorry, my hearing is not so good.

Chair

I am wondering if there is a lack of an overall plan, a lack of a person with a plan in DECC. Is that a feeling that you get?

Donald MacDonald

Yes, it does not seem to hang together well, it has been done in a piecemeal manner, and I think the sooner we get together with improvements in terms of trying to give the market some indication as to what the long-term ambitions are, then that will remain. Having said that, I still think the UK remains positive in terms of an attractive market to invest in. The UK probably was best in class when it came to consultation with the market, and with investors, and with the energy industry. What has happened now is we do not seem to have that same sharing of information. That can be improved, and I think improvements in that would be very welcome.

Morgan Angus

I would not say necessarily the lack of a plan, but the lack of how that plan is announced to the market, how transparent that plan is, and how transparent the assumptions and the workings behind that plan are, they are the important things from our point of view.

Chair

Okay. Does the lady have any views on the reset speech and how people felt about that afterwards?

Lilia Stoyanova

Yes. I would like to say that overall investors want a stable, transparent, long-term framework to invest in. What happened last year was that that expectation was disrupted as the announcements of changes to policy started coming in, and that caused a lot of uncertainty and a general feeling of uneasiness as to what the current policy is and what is happening. In addition to that there was the postponing of the CfD auction and a big amount of uncertainty as to the ongoing policy, so not only early closures of the existing policy, but also uncertainty into what is going to come into the future. Those two things combined raised the uncertainty and then caused a lot of doubt about confidence.

Chair

Thank you. Are there any examples that you know about of institutional investors leaving, or putting on hold, or reducing their investment in the UK, or in any way changing their approach to the UK as a result of recent policy changes? Morgan, I can see you are nodding, so I will go to you first.

Morgan Angus

No, absolutely. We invest on behalf of pension funds typically, and we typically have global mandates to invest in infrastructure broadly, so we do not have a specific bucket for UK renewable energy. It is competing against other technologies in the UK, other types of infrastructure in the UK, and other renewable energy in different countries as well. But definitely the way that we approach the UK specifically now has changed in that the bulk of our investing is done via closed-ended fund structures. You had Glennmont on the previous panel; we are invested in their fund, for example. We would not today invest in a 10-year, or 15-year, or 20-year closed-ended fund structure that had a five-year investment period that was just targeting UK renewables, much as we might like to, because there is uncertainty around what they would be investing in and what the terms of those investments might be. We have return targets that we need to hit for our clients as well. That does not mean that we are not investing in the UK. We are, and we have made recent investments into UK onshore wind, for example, but it has been done via co-investments or club structures that have much shorter investment periods, and very specific targets, and much more control for us as investors around where that money will be going and when it will be going in, so that we can have a bit more certainty around what our return profile is likely to be for our clients.

Lilia Stoyanova

Yes. That really targets the window of opportunity created by the expiring of the ROC regime. There are a number of projects that are yet to be built. Our investment currently targets the very short term before this regime closes.

Donald MacDonald

It is fair to say that investors are certainly reviewing their investment plans. I heard what was said on the previous panel about hearsay and so on, but we do know of plans that have investment opportunities that have been scrapped after review. Not many, but we do know of them. Anecdotal, yes, because it is commercially sensitive, but I know of two pension funds, for example, who have done that.

Chair

We all have anecdotes, and as chair of the Committee, months ago—they will remain nameless at the moment—some Americans came to me and said that they were pulling out of a $100 million or $200 million investment in the UK. Is there any figure that we could probably aggregate to give an idea of investment that has been lost, but also investment to be given by the Government? Because some investment might have come in that has not come in, and I think that is the figure we are really about. There is a feeling, and please correct me if I am wrong, that investment has been lost and investment would have happened had these policy announcements not occurred since July. What I am trying to drive at, and I do not know if the answer can ever be found given it is a collection of anecdotes, is roughly how much has been lost?

Donald MacDonald

The assumption you are making is correct, I think there probably has been, but we have not done the work. We have done no work to try to aggregate the total. I think it would be very difficult to do that simply because of the commercial sensitivity. It does not matter whether they are asset owners or fund managers, investors in general will not want to discuss their investment process in public. I do not have a figure for that.

Chair

Do you think it will be something that is found out in the future as we do retrospective year-on-year comparisons, and then we see what the potential drop off was post—

Donald MacDonald

Yes. Bloomberg and other agencies do provide year-on-year comparisons, but of course that is historic information. We will not know that until it is available. On the other hand, there was a drop from, I think, 2012 and that has picked up again. I think that was caused by uncertainty in parts of the European market with retrospective changes to tariffs and so on in Spain and in three or four other countries. There was a drop off in Europe and internationally for a number of reasons last year. The global figures have picked up enormously, but I really would not want to speculate on the total figures for the UK.

James Heappey

We do this inquiry, I think it is a useful inquiry to do, but there is a danger of trying to do it in lab conditions and ignoring that there are plenty of other factors beyond UK Government energy policy that will impact on investor confidence. You just mentioned that. I do not know how we reconcile that in the way that we report, because an impact on the loss of investment will be the Chinese economy. An impact on loss of investment will be general confidence internationally in energy markets full stop. There will be a nervousness starting to emerge over where we will go with our membership of the European Union. All these things run concurrently and will be impacting as well as the explicit policy changes made by DECC.

Donald MacDonald

That is a fair point. But on the other hand, the UK was a market leader and was seen to be a market leader in the area. I am not sure that we are in that position at the moment. I think we can recover that position very easily, but it needs greater consultation with the whole of the investment chain and all of the stakeholders within that, and I think maybe greater clarity over the levy and so on, maybe extending that through to 2025 would give greater clarity. I think what investors are really looking for is simply a glide path. Nobody expects huge subsidies or anything like that on an ongoing basis. But I think what would be helpful would be for DECC to try to provide wherever possible a glide path for what is available, for how much Government support is going to be there, and that gives an improved level of certainty as far as investment decisions are concerned. In the UK the return on renewable investments has been possibly lower, I think, than other countries partly because there has been confidence in the market and confidence in the political consensus supporting that market. There is a little bit of unease at the edges on that, and I think trying to get political consensus, which is really down to you rather than us, would be enormously helpful in trying to build up confidence in the investment process.

Chair

Okay. The final question from me at the moment is how can the UK become more attractive for institutional investors? Could you help us understand the level of detail and in what areas you would particularly like the focus to be on?

Morgan Angus

Yes. Just to echo some of Donald’s thoughts, it is around the transparency, and understanding what is going behind the assumptions that are being made to come up with the Levy Control Framework numbers, and so on, so that when something happens in the market people can understand how that is likely to feed through and start pricing that in way, way, way before any sort of Government announcement is made. It helps people to understand. If people can understand what the ramifications of certain things are then it provides much more stability and clarity. If people are concerned that there are likely to be shocks, even if there are not shocks that has an impact. On the previous panel they were discussing the issues in Spain. They are still way down the list because of things that happened almost 10 years ago. I do not think Spain is likely to do anything like that again, but people are concerned that it might, and that is the issue.

Glyn Davies

This whole collection of questions we have had, there is an interesting aspect of this that I would like you to comment on. We live in a democracy, so we have changes of Government. I would imagine that the investment world, before any election, is looking at the scenarios of different Governments and what they might do. Before the last election it was pretty clear that there was an antipathy to onshore wind in one of the parties. Clearly there were concerns about the Levy Control Framework and whether it might breech the ceiling. I was involved in these discussions myself. When the party that had been saying this becomes the Government, wouldn’t some of these changes have been anticipated in the scenarios that the investment world might have had before the election?

Morgan Angus

At a high level, yes. For us it is difficult because we are one step removed. We are typically investing alongside underlying fund managers or sponsors or developers who will be on that frontline and be thinking about that stuff much more closely. We have a global real-asset mandates so we need to think about the sort of high-level, general policies that are like to happen around the world in all different asset classes. So, yes, there was nervousness around UK onshore wind and that was understood. What was not understood was how quickly that was likely to change and the mechanisms around that were not understood because of the history of that sort of thing not happening.

Lilia Stoyanova

Yes, and I think the other thing is although there are some political underpinnings we would have expected to see a clear economic question or clear justifications and evidence for not supporting cheapest form of energy in the UK, which is onshore wind, and then how that fits within the broader framework of how the UK plans to achieve its 2020 goals; how do we think about decarbonisation generally. So not just one statement here saying, “We are not supporting that form of energy” but that clear justification and evidence and analysis done on how it fits within the overall framework. So it comes back to the communication of it or the process behind not supporting onshore wind for example.

Donald MacDonald

To echo the comments, at a higher level I don’t think this has been a terrible shock. I think there have been one or two surprises; solar and so on. I take your point, we do, fortunately, live in a democracy and it is important that there is clarity of policy but I think the timing, probably the lack of consultation with the stakeholders—I don’t think that helped matters—all of these things do come together and create an atmosphere of trepidation. It won’t stop investments but it may slow down decision making and we know it has probably pulled some investment previously.

Lilia Stoyanova

Another thing to add: I think in the press what we have seen is that the justification for a lot of these policies was affordability—so the overspend of the Levy Control Framework—and minimising consumer bills. We did not see any clarity around how that happens, what the impact on consumer bills would be, whether all the factors that play in to that have been taken into consideration and how the changes that were made would alleviate that. Just one example: it is quite clear of course that if the prices for electricity go down the subsidies or the payment to generators have to increase. However, a consumer bill is composed of more than the payment to support clean energy. I think 35% to 40% of that is just linked to wholesale prices so as wholesale prices go down, consumer bills go down as well. If you are looking at the overall impact, has that been factored into that analysis? That is something that for example we are thinking through and it was not quite clear from our perspective whether all these elements had been taken into account.

Morgan Angus

It may be that they have but it has not been communicated effectively.

Chair

Thank you. We will cover that, and indeed the LCF as well, later.

James Heappey

What do you see as the role for the institutional investors in the UK energy structure?

Morgan Angus

I think institutional investors should be the primary source of equity capital for the UK energy infrastructure market. Certainly it makes a lot of sense when you look at the cash flow profile of a lot of infrastructure projects and sectors and match that to pension funds’ liabilities. It is a good fit. Certainly a number of the larger pension funds at least, we have seen good evidence of them becoming heavily involved in the sector, including our clients and I do think that should be the case. Pension funds and insurance companies should be the backbone of the equity investment into the sector.

James Heappey

Nods of agreement from the rest of the panel. We will move on.

Donald MacDonald

Can I just make the point, though, that the institutional investors, most of our members for example, will invest right across the whole range of energy from oil, gas and coal right through to the renewables areas. We all have a fiduciary responsibility to our members. So what we are seeing is a move away from coal, for example, and a move towards cleaner technologies, including intermediate technologies like gas and so on, as a move towards a lower carbon society, plus big investments in renewables and we do that through equity holdings in listed companies; we do it through private equity holdings; we do it through joint ownership in some cases of windfarms. We also do it through the credit market so we will provide the finance for corporate bonds for example. So right the way through the entire energy market we have a pretty critical role, I think, at every stage of that and some of us will provide the finance for project build and things like that. Institutionals tend to go for more mature infrastructure rather than the high-risk front-end element; project capital and things like that.

James Heappey

I was going to ask you about that right now. The project pipeline: my understanding is that institutional investors will tend to be towards right-hand end, the construction, operation end of it. Were you just suggesting that indirectly there is money that originates from you that makes it into the left-hand end of the pipeline as well?

Donald MacDonald

Yes, Pension funds and insurance companies are now becoming more used to the area and they are now starting, in a small way, to take some of the build risk on, for example. I don’t want to go into particular details because again it is commercially sensitive for the players involved but there is a capacity to do that. By and large the high risk stuff is taken on at the front end by project capital and high-risk private equity and they have investors who are prepared to take that level of risk. It is not a problem because although it is a relatively short-term investment what they do is they will run the project, do the construction, sell to institutionals and then take that money and move on to do other projects. So it is a very efficient use of capital. The institutional investors will then hold the windfarm or whatever project it is for a pretty long period and so there is an issue of illiquidity for pension funds because if we are going to buy into a long-term project clearly we need to have long-term confidence that that is going to provide a return for pensions, in our case, as a pension fund trustee. So it is really getting the mix right and understanding what role each player has in the investment chain. That is a very important point.

James Heappey

Thank you. Lilia, you look like you were about to speak as Donald spoke. Did you have anything to add to that?

Lilia Stoyanova

No. A very similar view.

Morgan Angus

I was going to say that every pension fund is different. There are very few pension funds that have a specific bucket or target allocation for UK energy within their mix of investments. They will typically have 40% equities, 40% fixed income, 20% alternatives, let’s say, and within alternatives maybe 10% private equity and hedge funds and 10% real assets. Then within their real assets maybe it might break down as far as 5% to infrastructure but it is unlikely to break down much further than that and that infrastructure could be UK energy or German energy; it could be US roads; it could be anything in the infrastructure space.

James Heappey

Well that is interesting, Angus—Morgan, sorry.

Morgan Angus

That’s all right. Everybody gets it wrong. Don’t worry.

James Heappey

Forgive me. Your appetite for investment as institutional investors in the energy market, is it the same as it would be in other infrastructure markets? You mentioned US roads there.

Morgan Angus

Yes.

James Heappey

What it would be useful to understand is we are going to try to make an analysis of the impact of UK Government energy policy on investor confidence in the energy industry. Are we able to make a comparison between people’s willingness to invest in energy and their willingness to invest in other things because you applied the same primacies to both, or is there something very different about the way you invest in different types of infrastructure?

Morgan Angus

The same macro parameters are applied to both. We look at everything on its own merits. But also each of our clients has a specific target they want to hit in terms of return and they also have a specific requirement in terms of the level of risk they are willing to take on. I guess what you want to get to is a point where the UK energy environment is so stable that there is a separate carve out for UK energy within a pension fund, let’s say, and they say they want to put 2% of the pension fund into UK energy projects and they will do it just for the operational phase, let’s say, and they know they are only going to get a 4% or 5% return but that is okay for that little part of the bucket. The issue is that when you are looking at as we are in the grand scheme of things and looking at the mix of all the different types of things we can invest in then it needs to stack up against those things.

Donald MacDonald

I entirely agree, but I think there is one significant difference about investment in the energy area and that is the issue of carbon and the move towards a low-carbon economy. Investors, particularly those involved in the IIGCC, including the Environment Agency pension plan, I think are becoming increasingly aware of the risks associated with carbon fuels, particularly obviously coal but also oil and the volatility of that market. The whole concept of stranded assets has become largely accepted I think now within the markets. So the institutional investors are looking towards low-carbon investments as a means of hedging against the risks of their carbon investments. So while there is a gradual process of moving away from carbon-based investments toward renewables the renewables are seen as a hedge against potential losses elsewhere. That to me is the only difference between the energy market and some of the others.

James Heappey

The premise of some of the briefing we have had for today’s session is that it is relatively binary. If you are not investing in UK energy infrastructure you will be investing in the energy infrastructure elsewhere. But that is a false premise because it may be that you are investing in UK railway instead of UK energy. Can you give me a sense of if the pipeline for energy projects does start to dry up in a way that it becomes unattractive to you as institutional investors, what are the other areas in which you would invest? What are similar investments in other sectors?

Morgan Angus

Again, it is very client specific. I mentioned the Environment Agency pension fund, which is one of our clients. For them a lot of what we do is UK renewable energy investing and if it is not UK renewable energy the bulk of it is likely to be in other countries’ renewable energy. The alternatives for them are anything else that is not high carbon. So they won’t invest in roads; they won’t invest in airports; things like that, which make up quite a large part of the overall infrastructure market. So that particular client’s market is more constrained but then they can invest in telecommunications, low-carbon transport, rail for example, other things like that, and social infrastructure, schools and hospitals.

James Heappey

What sort of volume of investment per annum—wet finger in the air—has that sort of responsible tie to it? What proportion of investment is just, “We want a rate of return; we don’t care what it is in”; what proportion is, “It needs to be in particular area because we need to feel good about where we spend our money”?

Morgan Angus

Investors are generally becoming more conscious and a lot of pension fund investors especially have a certain ESG overlay on their investment programmes more generally. In the real asset space it is, I guess, easier to see concrete evidence of that and really influence—

James Heappey

So globally we are talking about huge amounts of money, trillions of dollars, that are in funds that are intended to go towards specifically green energy or just sort of “do no evil” to quote people?

Donald MacDonald

I would not put it in trillions but certainly hundreds of billions every year go straight into renewables. I think it is about $270 to $300 billion last year.

James Heappey

That money therefore by default is going to go somewhere—

Donald MacDonald

Oh, yes.

James Heappey

—and if it is not being invested in the UK; it is invested in renewables elsewhere.

Donald MacDonald

Absolutely. But even in Europe there is a lot of interest for example in the EU club plan and specifically in the proposals by Commissioner Sefcovic for greater interconnection of electricity and gas in continental Europe because of energy security and also because that will improve the efficiency of the renewables sector through greater interconnection. That it is going to need some heavyweight finance. There is a lot of interest within the pension funds to see how this is going to be rolled out because we know that the Commission will use public money but try to heavily leverage and get large-scale private investment. There is a lot of interest and there will not be a lack of investable opportunities but it would be a great loss to the UK if we gave up some of our potential investment in the UK. That would be a shame.

James Heappey

This will be a matter of political perspective, frankly. I am starting to conclude that Government policy has redirected your focus—you may or may not want that to have happened—but there are still lots of opportunities within the UK to invest in the decarbonisation agenda, be it in interconnection, be it in electrification of the railways, be it in offshore wind, be it in new nuclear. Lilia, you are interjecting helpfully.

Lilia Stoyanova

No, I would not concur with that because what is the detail available today? What you are talking about here does not exist really. So let’s take it one by one. First, nuclear I think is out of reach for most institutional investors. That is not something that they will invest in. It is much higher risk. If you look at offshore wind, we have heard from the Government that this is an area they would like to support; however the parameters of that support are not clear. There is no clarity on timing, on quantity of support, on how many projects can get off the ground. So there really is not a clear view there either. In terms of interconnections, there are a few projects ongoing but this is by far not something that is out there and available for investment. There are a few big projects, but same thing. There are a few groups investing in them. So if you look at the smaller to mid-size market where more institutional are likely to play there is not that much to invest in.

Donald MacDonald

If I could just make the point though that there are other indirect investments in things like energy efficiency that we will undertake through property portfolios for example. In London my own pension fund is a major player in the King’s Cross redevelopment in which energy and water efficiency have been integral from the very first day, long before planning permission was granted. So there is a lot of positive investment being made by institutions in a way that is not necessarily to do with energy generation but it is to do with the better use of the energy that has been generated. There is a lot of stuff going on and the level of investment is quite high and that will continue but our focus here really is on the generation issues.

Morgan Angus

We are also investing in energy efficiency as well but again it is quite difficult to find people—and it all comes down to partners and managers that you would trust to execute a strategy over a multiple-year timeframe—to do that. So we have invested in energy efficiency but the rate of deployment has been fairly slow and it has been difficult. The projects tend to be very small so to aggregate that to a fund-level investment takes a lot of time and has probably been much harder than those people have expected. That is the main issue; finding those partners. The problem is that when there is a lack of confidence in the system and you start to lose that early-stage development then that is when those quality partners just say, “If we can’t do it in the UK we will do it somewhere else” and then later down the line when the fund managers are looking to partner with someone they do not have those quality partners. The risks within a project are not just the macro-level risks, obviously. There is a level of detail that you need to go into and multiple risks, even from site to site, that need to be taken into account. If those quality partners are not there and maybe some of those other risks become higher and it becomes less investable generally from an institutional point of view.

Chair

I like the sound of positive investment. I need to find some institutional investors to invest in an interconnection to the Outer Hebrides or indeed maybe interisland tunnels, if you know anybody who is interested in infrastructure.

Donald MacDonald

I agree, because there is still that big diesel standby generator.

Chair

Indeed.

Dr Poulter

There is an implicit conflict, or is it a trade-off, between keeping energy prices low in the short term and investing for the future or investing to save, if you like, in the energy market. There is an impact on the costs to consumers. Can you explain about how costs to consumers could be affected if we don’t invest in the energy market and just generally in the energy sector now?

Donald MacDonald

Looking at it from a higher level, if the UK does not meet its 2025 to 30 targets—there has been a lot of speculation just this week in The Financial Times and elsewhere about consultants who believe there is going to be a major energy shortfall—I think under those conditions, with the provision of diesel generators and so on and with an overall shortfall in production, the wholesale prices of electricity will rise significantly and that will have, I submit, a detrimental knock-on effect. Therefore what we would argue is that it is better to continue now with a higher level of investment in renewables, which will help to meet our own renewables targets, help to meet the targets we have agreed to with the EU and now with the COP 21 Paris agreement and so on, but we also need to keep investing in order to provide our own energy security. It is not just a question of the windfarms. We haven’t had a strong signal for example as to how we are going to deal with the shortfall through improved gas generation. There is a whole range of issues that we could be looking at. Both Government and investors should be looking at a menu of opportunities to ensure that we are able to maintain our energy security in the UK. That is a very important issue.

Dr Poulter

You have picked out the key issue of energy security. I also want to talk about what the effect on consumer prices would be if we do not invest or see investment in the energy sector.

Donald MacDonald

The longer we put off investment in long-term generation then the costs for short-term solutions will be much higher. That is the reality for energy, as it is for most other industries.

Morgan Angus

It is not exactly clear what that feed-through effect is. Obviously at the moment fossil fuel prices are incredibly low so that is presumably lowering the wholesale price. The renewable part of the consumer’s bill is only 20%-odd, let’s say, but also the renewables themselves will lower wholesale prices over time. If wholesale prices are coming down anyway because of fossil fuels, should we be reinvesting that difference in things that will lower the price longer term? I think that makes total sense.

Dr Poulter

Donald, you told us that Government intervention lowers the cost of capital. Can you take us through that in more detail?

Donald MacDonald

Without having clear plans, without having a clear pipeline, without having the mechanisms of the levy understood on a longer-term basis, then the cost of capital will increase because of the uncertainty. If the perceived risks become higher then the cost of capital will increase and that ultimately will be fed through to the wholesale prices.

Lilia Stoyanova

An example of that, if you look at Germany for example, which is probably the country in Europe with the lowest cost of capital, institutional investors are willing to invest at mid-single-digit figures. The reason for that is obviously the clarity of the framework, the long-term nature of it—there have been no back and forths; no changes—in fact changes were built in to the system to adjust gradually over time so that when the cost of technology went down the level of support would go down as well, and of course the nature of the system as well, where institutional investors lacked exposure to power prices. All that taken together led to the fact that in Germany is by far the lowest cost of capital.

Dr Poulter

Government policy, Government intervention, the actions of Government, can affect the risk premium. Can you talk us through that with perhaps some examples like the very good one you just gave from Germany of how that could play out?

Donald MacDonald

By and large anticipated returns in the UK are not spectacular but historically they have been regarded as being pretty secure and there has been a good forward understanding of where the industry and Government policy is likely to take us. If we lose that confidence in general political policy cohesion and stability then the risk issue, the appetite for risk, will change and the cost of the risk will change. It could well mean that the appetite of some investors who are already in the area may diminish because they are looking, as Mr Heappey said, at the right-hand end of the scale. So they may want to move further down that line, which would not be in anybody’s interest quite frankly. It will shove up the prices.

Morgan Angus

It is very difficult to quantify.

Chair

It is interesting, the point you were making there, Donald MacDonald, on Government intervention lowering the cost of capital. It just shows what many economists will say the Government is a big player in the market; a huge player in the economy. But someone else in Government says to us it is about the cost of bills and they are quite focused about keeping the costs down for bill payers. A criticism I have for that stems from studying engineering many years ago, you can argue that water is liquid until you bellyflop; you can argue that glass is a solid until it is in the fine old English cathedrals and it has actually flowed over a thousand years; it is liquid, not solid. The point you were making about costs then and investment, the focus on keeping costs down, what Government does not say is there is a time link to that. You can keep costs down today but that is at the expense of costs tomorrow. I am putting that hypothesis out there. Would you agree or disagree with that? Feel free to shoot me down.

Donald MacDonald

Consumer costs are going to be critical. It goes back to the point I think we made earlier on; the longer we delay investing in the longer term the costs of dealing with short-term problems will increase.

Chair

I think I agree with you and I definitely think that the communication from Government about this is that they see investment today as a cost.

Donald MacDonald

Yes.

Chair

I disagree with them. I don’t think it should be seen as a cost today. It is an investment for tomorrow. But if you want to drive your investment on money you are putting in today, it is quite tempting to reduce that, to reduce today’s costs, but today’s costs are part of tomorrow’s investment, which will then reduce tomorrow’s—

Donald MacDonald

Absolutely. You are investing for the long term. These are long-term projects. There is absolutely no doubt about it. What is seen as a cost should actually be seen as an investment opportunity. There will be a return for the nation, in our opinion, because public support, private capital getting involved with the support of Government, will give long-term benefit and better price stability for the wholesale, and ultimately the retail, market.

Chair

Before I move to the Levy Control Framework, which I want to touch on, strategically there is an argument I have seen about the Government and its undermining of support for renewables over the last few months. It touches on the point you made earlier; just a brief remark about wider energy security that you said was in The Financial Times. Having attacked, if you like, onshore wind; having attacked solar, and now with the uncertainty there is now around Hinkley C, it may be that the Government, some would argue, have lost twice over. They are either not going to get Hinkley or they are going to get a more expensive Hinkley. One of the reasons might be playing into that energy security you were saying, but they have played a card already that has shown a lack of support for renewables and if you are a Hinkley investor you know they have already closed an avenue down and you could potentially cynically say, “We can drive more money out of the UK Government for this”. Is that an argument you would disagree with, or agree with?

Donald MacDonald

Let’s put it this way, since the announcement was made, and it is 35 years of RPI—CPI or RPI; I think it was RPI—linked, the cost of Hinkley now would be running at £96 per megawatt hour. Is that correct? Thereabouts.

Chair

£92.50, I think.

Donald MacDonald

If you put in the RPI multiplier effect it would take that I think to around £96. From memory the last auctions—there were three, was it three, big auctions, last year—for onshore wind were running between something like £79 and £82. I wouldn’t want to speculate on the reasons behind all of that—that would not really be my role in this—but I think quite clearly there has been a strategic shift away from what is becoming a very cheap and long-term provider of energy to this country. There are issues, which we all know about, of intermittency and so on and there are ways of overcoming that through greater interconnection, as the Grid already manages, through gas, where you can turn up and turn down the generating capacity, and that can operate efficiently. I think it would be wrong for me to speculate about the Hinkley thing, the pricing mechanism and why we got there. From a purely personal point of view we do not have any position on this. We are not pro-nuclear and we are not anti-nuclear. It is up to each individual investor. We are certainly not anti-nuclear. As a body we do not take a position on wind as against solar as against nuclear. They are all low-carbon technologies as far as we are concerned. But, as we know from the press reports, there are still significant issues as to whether it is ever going to go into operation. The longer we delay using our investment opportunities for the renewables sector, then the more likely we are to have energy shortfall and quite significant changes in the pricing structure.

Chair

Thank you. I am going to move us onto the Levy Control Framework now. To what extent do you feel policy mechanisms, such as the Levy Control Framework, influence institutional investors in your investment decisions?

Donald MacDonald

Hugely.

Chair

Hugely. Thank you. That is brief and to the point.

Morgan Angus

It clearly does have a big impact. As we said earlier, it is around the lack of transparency about how those figures are arrived at, what feeds into them, what the assumptions are that go into making those up and how they change over time. The latest numbers are a couple of years out of date. Fossil fuel prices have come down massively in that period of time and so if you reset it now, what would it be? It is difficult to understand exactly how that mechanism works.

Chair

You obviously want a high level of detail in the LCF and we have heard some criticisms that there is no clearly defined plan for how changes to policy were made and there is an overspend in the LCF. Is that something that concerns you?

Morgan Angus

Absolutely, and for the same reasons as the previous panel said. We are looking at investments over 20 years and we are looking at making commitments to those investments that will last multiple years as well. Obviously there are retrospective changes and also future changes. Notwithstanding the LEC thing, which obviously some people think is retrospective and some people do not, I think we are relatively comfortable that the UK Government is not going to make massive retrospective changes to policy so we can be fairly confident and that is the reason why we are still pursuing the investments in UK onshore wind that are closing now because we are confident that those will be fine for the 20-year PPA that will be in place, but by the same degree we need to make investment decisions, to go into funds for example, that are going to invest over five years and if we are not clear exactly where they are going to be investing it is much harder for us to make that decision.

Chair

Do you think there is a structural problem, or an underlying foundational problem, with the LCF in that the LCF is being paid for by bill payers and that leaves it open to political attack—back to the previous point about investment; from evidence we had from E.ON that attacked its structure and said it should be funded from general taxation, which would be a lot less regressive, would be progressive, rather than the way the LCF currently is structured—because it enables the politician to turn round and say, “This is about costs”—of course we know what they mean about costs, it is immediate costs not future costs—and that therefore has an impact on what should be happening strategically when somebody can use something short and tactical like that against it.

Morgan Angus

We probably do not think about it at that level, to be honest, but yes I agree, generally speaking, that it probably would have less of an impact if it was funded like that.

Lilia Stoyanova

I think it would help if it was clear what the LCF stands for. What is it trying to achieve? How does it fit within the overall framework of reaching the 2020 goals? We are talking about overspending but it is not quite clear on what basis. When originally the £7.6 billion in 2020 was set it was a few years ago when the power prices were at a different level. So if you are looking at overspending from the perspective of the consumer and the consumer bills, you have to compare like with like. It is not quite clear how that is used and what it stands for.

Chair

When you have a panel and the voice of that panel is that they unclear about the LCF what chance do the general public and everybody else have with understanding the Levy Control Framework. Donald MacDonald?

Donald MacDonald

I would not claim to understand the mechanisms because it is not transparent. However, the good point about it is it does give an approximate indication as to the pipeline for the future. So from IIGCC’s point of view probably the best reform we could make to the LCF would be to try to extend the period through to 2025. To me, or to our members, that is probably the most important change we could make because it is actually helpful.

Chair

A hobby horse of mine is the effect of the LCF on wholesale prices. We know of course that fossil fuels have affected wholesale prices but we know that the LCF has enabled renewables to come on, to be there, which has had an impact on wholesale prices. Do you have any feeling as to a positive role the LCF has played? In some ways it can be argued that the LCF is cutting its own throat because as it has passed the LCF’s lowest wholesale prices today perhaps that puts greater demand on the LCF, combined with the fossil fuel drop, on further top up to agreed prices.

Lilia Stoyanova

Do you mean what the overall impact would be? Or just in view of what—

Chair

If there had been no work in the past from the LCF, where would wholesale prices be today; if that had not enabled the building of renewables?

Lilia Stoyanova

It depends. I have not seen any work, any analysis, done on that. It is difficult but if you just look at purely what the consumer bill is comprised of, that is roughly 35% to 40% linked to wholesale prices and about, I think, 15% to 20% linked to supporting, or paying for, renewable energy, supporting green generation.

Chair

When you say that would you say that renewable energy has sent wholesale prices up or down?

Lilia Stoyanova

Renewable energy should be decreasing prices because it is an upfront investment with a zero marginal cost of production. So if you have a generator with a zero marginal cost of production that should have a negative impact on prices. I don’t know what the exact magnitude is.

Chair

I think that is the problem, we don’t know the exact magnitude but we can see that renewables have had an effect on bringing down wholesale prices. A final point I want to raise in this area. We talked about subsidies. We have had a complaint that the UK Government was on a glide path, in the last six months it went on a different glide path, maybe went on a free fall some might argue; some might not. Could you give us an example that you know of from other countries of a particularly well-managed glide path out of subsidies?

Donald MacDonald

Every country is very different and takes a different approach. Countries that are able to plan for capacity or for budgeting I think are in a stronger position. For example the expansion corridor that operates in Germany seems to work well. I don’t want to get drawn into all the policy decisions that have been taken in Germany but the expansion corridor for various types of technology seems to have operated well. That could be worth looking at. The important point really is to try to have planned budgets and planned capacity, and countries that do that I think are in a stronger position than those who do not.

Chair

So you think Germany is a good example. Anybody else you would say?

Lilia Stoyanova

I would probably add South Africa to that. It is quite interesting. If you look at South Africa five years it was at the bottom of the RECAI index. Today it is just below the UK, or just above the UK in fact.

Morgan Angus

It is just below. I think it is ninth, isn’t it? UK is 11th.

Lilia Stoyanova

Could be.

Chair

It has improved a lot in the last five years?

Lilia Stoyanova

The point there is I think it was four or five years ago they implemented this renewable energy programme with competitive auctions. Since then they have had very clear auctions every year. If you look at what happened with the price of generation—it was built into these auctions—for wind I think it was a decrease of 40% and for solar it was a decrease of more than 60% over these four years. So anecdotally from people who are involved in that sector, while in the first auction cost of equity was in the mid-to-high teens, last year’s auction it was high single digit. So there was a massive drop in the cost of capital because of the certainty and transparency of the framework. Of course it also had to do with the structure of how it was done but it is definitely something worth looking into.

Chair

Thank you very much. Time is running out so I will take in James Heappey for the final area.

James Heappey

It really comes down to one question. We were talking about the long-term vision. While much of it has been covered already, do you have any final thoughts on what the Government should do to provide long-term clarity and specifically what it should do to encourage institutional investors?

Morgan Angus

It has all been said. Stable, transparent, long-term strategy that makes it clear to investors how those changes to policy will be made is the key for me.

Lilia Stoyanova

So clarity: how much generation is likely to be supported and what type of generation, if that is different? In the context of the Levy Control Framework, what would that cover? Would that include renewables? So clarity on what the support would be for and how that would be done; and the timing of that as well.

Donald MacDonald

Two practical suggestions. On the LCF, again putting the point made earlier, have that extended through to 2025. Also I think it would be greatly appreciated if the Government could provide more clarity as to how they intend to proceed with the Contracts for Difference over the coming period. That would be extremely helpful for long-term investors.

Chair

Thank you very much. Thank you, Committee, and thank you, panel especially, for your time this morning. Greatly appreciated. Oral evidence: Investor Confidence in the UK Energy Sector, HC 542 4