If the UK is to meet its binding target under the Renewable Energy Directive of 15% of total energy consumption from renewable sources by 2020, as much as 30-40% of the UK’s electricity will need to be generated from renewable sources by that year. Offshore wind is expected to make a significant contribution to meeting these targets, with 33GW of capacity predicted by 2020. As the technologies develop in the coming years, marine and tidal projects are also expected to play an increasingly significant role. Under Rounds 1 and 2 of offshore development, the developer has been responsible for consenting, licensing, constructing and maintaining all of the grid connection assets up to the onshore substation. Consequently, developers have had to meet all of the costs of making the grid connection at the outset. If the project was being developed onshore, much of the connection infrastructure would be installed and maintained by the transmission licensees (or the distribution network operators) with much of the costs being recovered through ongoing network charges.
The lack of a clear regulatory regime and the unattractiveness of front-loaded grid connection costs are deficiencies that the government has sought to address by designing a new offshore regulatory regime. The new regime, consulted on since 2005, is currently being introduced.
Key Features of the New Regime
The principal features of the new regime are as follows:
- transmitting electricity offshore at 132kV and above will be a prohibited activity without a licence;
- National Grid Electricity Transmission Ltd (NGET) will be responsible for operating and co-ordinating both onshore and offshore grid connections;
- through a competitive tender process, companies will bid for an open-ended licence to be the Offshore Transmission Network Owner (OFTO) of particular offshore networks;
- OFTOs will be entitled to earn a regulated rate of return on the costs of building and operating these networks for a period of 20 years, such costs ultimately being recovered from generators via NGET; and
- the new regime will be implemented through amendments to the existing system of licences, codes and agreements that govern onshore electricity transmission.
The government has favoured the introduction of competition to the offshore transmission market, on the basis that this will encourage new entrants to enter the industry, provide more scope for innovation and allow a longer-term and lighter-touch regulatory regime.
Which generating stations will be affected?
Under Rounds 1 and 2, 29 generating stations have been granted site leases. Some of the projects that have already been built and are operating (for example North Hoyle, Scroby Sands and Kentish Flats) are connected to the onshore distribution system via 33kV cables. These offshore connections are low voltage and, along with any future projects connecting at low voltage, will not fall under the offshore transmission regime. However, any other projects with connections at 132kV or more (expected to include most of the Round 2 and Round 3 developments) will be high voltage and covered by the new regime.
In the near future, while most wave and tidal devices are likely to connect via low-voltage cables, these generating stations will also be subject to the new regime if connections are made at 132kV or more.
Legal and Regulatory Framework
When certain provisions in the Energy Act 2004 (the 2004 Act) are brought into effect next year, all offshore connections at 132kV or more in the Renewable Energy Zone (designated pursuant to s84 of the 2004 Act) and in the territorial sea adjacent to the UK will require a licence or an exemption.
Pursuant to powers in the 2004 Act that have just taken effect, a new form of transmission licence will be created for OFTOs. This will contain standard conditions applicable to all OFTOs and special conditions covering issues such as geographical scope, performance incentives and revenue recovery.
It will be a standard condition of each OFTO licence that the relevant industry codes are complied with. These will include the Grid Code, the Security and Quality of Supply Standard (GBSQSS) and the System Operator/Transmission Owner Code (STC). The latter will set out the key relationship between the OFTO and NGET (as the GB System Operator) and the rights and obligations of each in respect of the transmission services provided.
The implementation and management of the new regime will be the responsibility of the Gas and Electricity Markets Authority, acting through the Office of the Gas and Electricity Markets. In this article the term ‘Ofgem’ has been used to describe both organisations.
The new regime requires that licensed OFTOs will build and operate the offshore transmission networks. However, the new regime will cover all offshore generation projects, including those that have already been built or consented. The new system therefore needs to ensure that those projects that are already operating (or will come into operation shortly after the new regime takes effect), will have transferred their transmission assets to a licensed OFTO before the prohibition on transmitting electricity offshore at more than 132kV without a licence takes effect.
To deal with this issue, there will be two types of tender process: the transitional regime, which applies to those projects that have achieved a prescribed stage of development by certain dates, and the enduring regime that will apply to those projects that have not.
Transitional Regime
Which projects will qualify?
A developer must satisfy various pre-conditions for the project to become a ‘qualifying project’ for the transitional regime. Essentially, a project must have secured construction and grid connection agreements, obtained property rights, environmental and planning consents, and secured sufficient financing to construct the wind farm.
The transitional regime will have two tender rounds. To fall within the first round, a project must have satisfied these conditions before the ‘Go Active’ date of 19 June 2009. To fall within the second round of the transitional regime, it must have satisfied the conditions before the ‘Go Live’ date (currently expected to be June 2010). The first transitional tender round is due to commence shortly after Go Active and the second will commence shortly after Go Live. Those projects that are in the course of development but have not satisfied the pre-conditions by the Go Live date will be dealt with under the enduring regime.
There will be some flexibility on these requirements in limited circumstances if developers can show they have used reasonable endeavours to meet all of the criteria before the relevant dates. However, the requirement for a consent under s36 of the Electricity Act 1989 (the 1989 Act) a licence under the Food and Environment Protection Act 1985, and a Crown Estate lease, will not be waived. There are additional criteria that a qualifying project must also satisfy before the tender itself can actually take place.
Transitional tender process
The tender process itself is prescribed in the Electricity (Competitive Tenders for Offshore Transmission Licences) Regulations 2009. (See adjacent diagram)
What if no suitable OFTO can be appointed?
Where an initial or relaunched transitional tender process fails to receive significant market interest, Ofgem would then consider the appointment of an ‘OFTO of last resort’ for the transmission assets, by using the Secretary of State’s powers under s90 of the 2004 Act.
Before using these powers, Ofgem will contact all licensed transmission owners to seek their proposal for taking on the assets, to establish which licensee is best placed to take on the asset, before issuing a formal direction to that company. No direction can be made where it will ‘materially constrain’ a transmission owner’s activities and obligations.
The OFTO of last resort mechanism will only apply to transitional projects and as an option for Ofgem where there is an abandonment of transmission assets by an OFTO. The OFTO of last resort mechanism will not be applied to failed competitive processes in enduring tender rounds on the basis that the failure of an enduring tender process may demonstrate that the market does not see an economic case for investment. Developers will therefore be nervous that their project could be sunk if no bidders are attracted to bid for the OFTO licence, particularly in view of the costs that will have been incurred by the developer up to the point of the tender.
Can the developer apply to be the OFTO?
The third package of legislation on EU gas and electricity markets at the EU Energy Council meeting on 10 October 2008 will, when implemented, require that the OFTO is a ring-fenced company with no interest in generation, supply, distribution or other onshore transmission networks. These unbundling requirements are anticipated to be implemented in the UK by the end of 2012.
Until that point, it will be permissible for generators to bid to become OFTOs and to own, operate and maintain transmission assets. Ofgem will therefore allow generators to bid to become OFTOs in the initial tender rounds on the understanding that any successful bidders will have to fully comply with the ‘unbundling’ requirements when these come into effect. This may mean that some developers would subsequently have to divest themselves of the transmission assets (or alternatively their generation assets).
The extent to which affiliates of the developer (and joint ventures involving those affiliates) will be entitled to be involved will depend upon the final wording of the directive agreed, although it will depend whether, as a matter of law, one of the entities is able to exercise control over the other.
Transfer process
Ofgem has produced a model Sale and Purchase Agreement (SPA), which is intended to be used to define the terms for the transfer of the transmission assets and associated rights and liabilities to the newly licensed OFTO. This is expected to facilitate successful commercial negotiations and minimise the need for parties to seek the use of statutory transfer powers now provided for in Schedule 2A of the 1989 Act. These powers will nevertheless be available should the tender be frustrated by stalled negotiations. It remains to be seen to what extent the parties will seek to vary the terms of the model SPA.
Costs recovery
Developers will be keen to ensure that they are fully compensated for the significant costs incurred by them in designing and constructing transmission assets. Similarly, bidders will need to factor in the cost and efficiency of the system when compiling their bids and will want to avoid being overcharged for a system that does not work efficiently. To provide a degree of certainty, for transitional projects, Ofgem has guaranteed that developers will receive the greater of:
a) 75% of Ofgem’s (advance) regulated asset value estimate; or
b) 100% of the efficient economic cost actually incurred.
Developers and bidders alike will understandably be concerned as to what Ofgem will regard as ‘economic’ and ‘efficient’. It remains to be seen whether developers will be compensated for the costs of installing assets that are more secure than is strictly required by the GBSQSS.
Enduring Regime
Tender process
The same basic principles for running tenders in the transitional regime will apply to the enduring regime, with some adjustments to reflect the fact that OFTOs will be required to design and construct the transmission infrastructure, as well as maintain it in accordance with the licence.
Enduring regime tenders will be run in annual rounds so that all projects that have obtained an agreement for lease from the Crown Estate and entered into a bilateral connection agreement with NGET by a specified date each year will be eligible for inclusion in the tender round.
At the invitation to tender stage, bidders will therefore have to give detailed proposals for providing transmission services, including their technical proposal for the design of the network, as well as their firm bid revenue stream for the 20-year period. A key selection criteria will be the amount of energy losses that would result from the proposed network.
The preferred bidder will have to demonstrate that it has the necessary funding in place, as well as the relevant contracts for the design, build, operation and maintenance of the network. The OFTO is also required to provide security cover to ensure that construction of the transmission assets is completed.
Where pre-construction development work (eg obtaining consents and leases, seabed surveys etc) has already been carried out by the developer prior to the award of the licence, the OFTO will be required to refund the ‘efficient’ (as determined by Ofgem) cost of this to the developer and subsequently recover this amount through its regulated revenue stream. Ofgem’s interpretation of ‘efficient’ will be closely monitored by developers and bidders alike.
Grid connection timing issues
Co-ordinating the connection applications process with the OFTO tender process will be a delicate exercise for developers. Before a tender can take place, a developer will need to approach NGET for an initial connection offer, without any details of the design or cost of the necessary transmission infrastructure, or whether it would be preferable to connect the infrastructure to the onshore distribution system or transmission system.
Once a preferred bidder has been identified, it will liaise with NGET to finalise the overall connection design and enter into a Transmission Owner Construction Agreement (TOCA) with NGET for the construction of the offshore transmission assets. NGET will use this TOCA to develop a revised connection offer, which it will forward to the developer for acceptance. The preferred bidder will only be granted the OFTO licence after this varied connection offer has been signed by the developer. It therefore remains to be seen whether developers will try to use this opportunity to veto the OFTO selection.
OFTO revenue stream
The licence will entitle the OFTO to a regulated revenue stream (as set by the outcome of the tender process) for a period of 20 years, subject to review at pre-defined intervals and certain pre-defined adjustments for known but unpredictable costs.
The OFTO’s annual revenue, received from NGET, will be based on asset availability rather than utilisation. Where OFTOs fail to meet performance targets for availability, they will be penalised through a reduction in their regulated revenue stream, subject to a 10% annual cap on revenue exposure. To encourage adequate performance towards the end of the revenue stream, OFTOs will be required to post a performance bond with a suitable third party.
At the end of the 20-year period, the OFTO assets would be treated as fully depreciated and the revenues to the OFTO would cease. The ongoing regulation of the transmission assets will be decided by Ofgem based on the demand for the assets at that time. Many people have argued that the period should be longer on the basis that any ageing turbines are likely to be replaced and will still require connection to shore at a regulated price.
In such a heavily regulated and monopolised industry, the new offshore regime represents a novel opportunity for businesses to enter the electricity transmission market. The key issue for all potential bidders will be understanding the risks that they are being required to price out through the 20-year regulated revenue stream and quantifying these accurately so as to ensure a healthy (but competitive) level of profit. It will inevitably be difficult for OFTOs to make a realistic estimate of design, construction, 20-year operation, and maintenance and decommissioning costs. The competitive tender process will not provide best value for consumers if revenue proposals are over inflated to account for high risk and uncertainty. A sufficient number of competing bidders will therefore be vital.
Ofgem’s costs
The developer will be required to underwrite Ofgem’s costs of the tender process. Fees will be charged to the developer and to the bidders at various stages of the tender process. Ofgem has estimated that its costs of running each tender during the transitional phase will be approximately £560,000. External advisers will undoubtedly be required by Ofgem to help run the tender exercises and indeed financial advisers have already been appointed.
Conclusion
There are many factors that will dictate whether the anticipated stream of offshore wind projects will come to fruition as hoped, particularly in the current economic climate where all investment opportunities are being treated with great caution. The comprehensiveness of the consultation process in relation to the new transmission regime means that many of the concerns of prospective developers and OFTOs have been addressed. However, several significant risks and uncertainties remain, including:
- whether the ongoing review of the framework for access to the GB transmission system might fundamentally change existing transmission access rights and charging;
- whether, in view of the approach of having a separate tender process for each wind farm instead of an ‘exclusive multi-zone approach’, there will be sufficient co-ordination between projects to ensure the most efficient and economic grid infrastructure design possible; and
- whether OFTOs will be appointed at a sufficiently early stage under the enduring regime to be able to meet intended timescales, particularly in view of the limited number of participants in the supply chain and commitments that may have been pledged through the formation of consortia for the Round 3 bidding process.
Time will tell whether, in light of the remaining uncertainties and the high costs of bidding for an offshore transmission licence, a sufficient number of prospective OFTOs will have the confidence to participate in the tender process to make the system work. The experience of developers and bidders during the transitional tender rounds will undoubtedly be crucial to the success of the new regime and will be monitored closely by all.
By James Phillips, senior associate, Burges Salmon LLP. E-mail: james.phillips@burges-salmon.com.
