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Nuclear may be needed for a cleaner future

The ever-increasing political focus on carbon emissions, climate change and energy efficiency is having a major effect on the shape and direction of the power sector in the UK. Wind-power capacity is growing, but nuclear generation may yet make a comeback, writes Alex Msimang, partner, Vinson & Elkins RLLP

AS WORLD leaders gathered in Scotland for last month's G8 summit, climate change was at the top of their agenda. In the UK, this political emphasis is not new. Tony Blair, the UK prime minister, sees climate change as "probably – long-term – the single most important issue we face as a global community".

To comply with its obligations under the Kyoto Protocol, the UK government set a target for 10% of the country's electricity to be generated from renewable sources by the end of April 2011. It has aspirations to reach 20% by 2020 and it estimates that meeting the 2011 target could reduce annual carbon emissions by 2.5m tonnes. Meanwhile, the overall European Union target is even higher, at 22% by April 2011.

However, some question whether these targets are achievable. For many years, renewable energy projects in the UK were very small in scale and the industry was seen as dominated by a small number of optimistic enthusiasts. In 2000, when the government first announced its policy on renewables, only around 2.8% of the country's electricity was produced from renewable sources. The UK continues to lag behind other European countries in the scale of its wind-power capacity, with around 1.04 gigawatts (GW) of installed wind capacity, compared with over 16 GW in Germany, 8 GW in Spain and 3 GW in Denmark.

The UK may be about to start catching up, however. Significant additions to the country's wind-power capacity are being added onshore and offshore. In June, the country's most powerful onshore wind farm – the Cefn Croes onshore plant in Wales – was commissioned. Yet although the plant will have 39 turbines, a planned generating capacity of 58.5 megawatts (MW) and the ability to supply 42,000 homes, generation on this scale is still small by comparison with coal, gas and nuclear plants.

But much larger projects are also going ahead. Also in June, Shell, E.On and Core – a joint venture between the UK's Farm Energy and Denmark's Energi E2 – submitted a joint application for government consent for the London Array offshore wind farm, having already been awarded an option to lease the project's site in the Thames Estuary from the Crown Estate. The London Array project could be the world's largest offshore wind farm. Plans are for up to 270 turbines with a total generating capacity of up to 1 GW – enough to supply over 0.75 million homes. This project alone could reduce carbon emissions by 1.9m tonnes a year and could account for up to 10% of the government's renewables target for 2011.

There are, however, many obstacles confronting the developers of renewables projects. In the UK, the consenting and permitting process for offshore wind farms remains complex and uncertain. Development of an offshore wind farm typically entails applications to the Crown Estate and to various UK government departments under the Electricity Act 1989, the Coast Protection Act 1949 (in relation to marine works), the Food and Environment Protection Act 1985 (in order to place materials at sea), as well as numerous other applications relating, for example, to shipping, fishing rights, low-flying military aircraft and the laying of onshore cables. With effect from 1 March 2005, the UK consenting arrangements for offshore wind farms have been clarified slightly by the provisions of the Energy Act 2004, but the process remains complex and time-consuming.

Even when the permitting process has been completed, there is not yet a widely available supply of limited-recourse bank finance to fund project construction. There are a number of reasons for this. For example, in some quarters there are lingering concerns about the long-term reliability of the technology for offshore projects. Some potential lenders are yet to be satisfied that the turbines will safely withstand exposure to saltwater and to the sometimes harsh extremes of the offshore UK climate, at least for a long enough period to repay substantial project debt.

Many banks also continue to fret about the long-term economic viability of renewables projects in the UK. The economics of a UK renewables project are largely underpinned by the Renewables Obligation, a legal requirement for each electricity supplier to obtain from renewable sources a certain percentage (5.5% from 1 April 2005, rising to 15.4% in 2015/16) of all electricity supplied. Ofgem, the UK gas and electricity regulator, issues Renewables Obligation Certificates (ROCs) to renewable generators – one ROC for each MW hour (MWh) of electricity generated. ROCs are then sold to electricity suppliers, either together with or separately from the electricity.

Every year, electricity suppliers must produce evidence of their compliance with the Renewables Obligation. Evidence of compliance can take the form of ROCs purchased by the supplier or, to supplement any shortfall in the number of ROCs acquired, the supplier can pay the statutory buy-out price. In relation to the year from 1 April 2005 to 31 March 2006 the buy-out price is set at £32.33/MWh ($56/MWh) and this price is escalated annually in accordance with the retail prices index. If a supplier fails to meet the Renewables Obligation, either by presenting ROCs or by paying the buy-out price, it is exposed to financial penalties imposed by Ofgem.

Amounts paid by suppliers that do not meet the Renewables Obligation by means of ROCs, and that, therefore, pay the buy-out price are accumulated in a buy-out fund. Cash from the buy-out fund is recycled back to the suppliers on which the Renewables Obligation falls and payments from the fund are made to those suppliers in proportion to the ROCs they have presented. This recycling of the fund acts as an incentive on suppliers to seek ROCs from renewable generators rather than simply to pay the buy-out price.

Market prices for ROCs have, at times, been well above the buy-out price (at prices of around £45 each) because suppliers presenting ROCs (but not those simply paying the buy-out price) receive payments from the buy-out fund.

The Climate Change Levy

It is also worth considering the UK Climate Change Levy. Broadly, by reason of the levy, industrial and commercial customers must pay an extra 0.43 pence/kilowatt hour (KWh) for electricity they purchase. But electricity produced from many renewable sources is exempt from the levy. In a similar way to ROCs, levy-exemption certificates (LECs) are issued to renewable generators and LECs may then be sold to the electricity suppliers to which the generators sell their output.

Given the level of the ROC buy-out price and also the value of the Climate Change Levy exemption, ROCs and LECs comprise a fundamental part of the economics of any renewables project. ROCs and LECs are artificially created mechanisms that could, in theory, be unwound by any government. Past UK governments have been prepared to take steps that, at least in the short term, have been detrimental to new power projects and could do so again in future. Even without adverse government intervention it will be apparent that, as renewable generation increases, so the supply of ROCs and LECs will rise. Basic economic theory suggests that, as the supply increases, so the price of ROCs and LECs, and their value to generators, will fall. These risk factors have contributed to the reluctance of some developers, and their potential lenders, to become involved in the UK renewables market.

While the renewable power sector is expanding across the UK and the rest of Europe, interest is also reviving in fossil-fuelled generation. Forward power prices have recovered from some of the depths that were seen following implementation of the UK's new electricity trading arrangements in 2001 and future capacity margins appear set to shrink as nuclear stations are retired. Conventional generators are, however, seeing a steady increase in the price of fuels for generation.

Between the end of the first quarter of 2004 and the end of first-quarter 2005, the price of coal for UK power stations increased by 25.5%, while the price of gas has risen by 31.1%. Over the same period, the cost of oil has increased by 39.6%. Regardless of these fuel-price rises, the spark-spread for generators is improving on the basis of improved power prices and conventional generation is looking attractive again. Until very recently, the development of new gas-fired generating capacity in the UK seemed almost unthinkable, yet already in 2005 the Department of Trade and Industry (DTI) has received consent applications for at least 2.6 GW of new gas-fired generating capacity.

M&A upsurge

Interest in conventional UK power generation has also resulted in an increase in mergers and acquisitions activity in the sector. In April, NRG, El Paso and Indeck Energy sold the 400 MW Enfield gas-fired plant in North London to E.On UK for $210m. In May, the 1.2 GW Saltend gas-fired plant was sold by Calpine to International Power and Mitsui for nearly $1bn.

The UK coal sector, widely thought of as declining in favour of cleaner fuels, is also making a comeback. According to June 2005 figures produced by the DTI, the quantity of coal used for UK power generation in first-quarter 2005 increased by more than 6% from the same period in 2004. The renewed interest in coal has led to some significant asset sales in the UK coal business. Scottish and Southern Energy bought nearly 4 GW of coal-fired plant at Ferrybridge and Fiddler's Ferry from AEP in the second half of last year.

The other component of the UK power portfolio is nuclear generation. Around 23% of the country's electricity is generated by 12 nuclear plants, but, on the basis of asset-life expectations, only three of these are projected to remain operational by 2020. To replace the large amount of generating capacity that will be lost it is estimated that the UK would need eight to 10 new nuclear plants at an estimated cost of more than £8bn.

Nuclear option is open

For years, perceived health, environmental and cost concerns have kept nuclear expansion firmly off the political agenda. But, since the re-election of Blair's government in May, that situation may be changing. In June, in the build-up to the G8 talks, the prime minister said it would not be "responsible" to refuse to look at the issue of new nuclear power. The DTI says the nuclear option is being kept open and a number of nuclear developers and construction firms are gearing up to respond to any government initiative to stimulate growth in the sector.

It is also possible that the UK position may be influenced by US thinking on this issue. Recent US opinion polls suggest that public support for continued use of nuclear energy stands at 70%, with a majority of respondents supporting newbuild projects.

Although it is growing rapidly in the UK, doubts remain over the ability of wind power to help the country meet its long-term Kyoto and EU commitments. As a result, there is a real possibility that the UK government will pursue the development of more nuclear plants as a means to address the country's growing need for emissions-free electricity.

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