Neil Cornelius makes the case for a nuclear power generator with regulated returns.
The current contract for a differences-based business model for funding new nuclear power plants in the UK unnecessarily increases the cost of power for customers.
However, switching to a regulated returns (RAB) model could significantly reduce the cost of nuclear without exposing electricity customers to excessive risk.
Currently, the UK uses a contract for differences (CfD) model for the build of new nuclear power plants. This is a 35year contract (from the start of operation) which is intended to fix the revenue per unit of generation at a pre-agreed level, known as the strike price, and in the case of the Hinkley Point nuclear plant, is agreed at £92.50/MWh.
The CfD sets out the conditions under which any revision of the strike price will be allowed and how that will be done.
However, there are a number of weaknesses with this model in terms of getting the best deal for electricity consumers in the UK:
Firstly, the CfD approach allocates most of the construction cost overrun risk to the project owners. Although this may appear to be sensible, the scale of potential liabilities relative to company balance sheets severely limits the number of companies able to participate and creates a risk perception that feeds into the required return. The recent financial stress placed on Areva and Toshiba by nuclear contracts will only amplify this issue.
As a result, the cost to consumers will significantly increase due to a combination of cost contingencies and increased returns required by investors.
The risks from regulatory change are high for nuclear power due to the length of its construction and operating periods.
While the current CfD terms provide some protection against these risks, it’s down to potential investors to decide whether specific clauses go far enough and provide sufficient protection against the range of uncertainties that can be imagined over a 35-year contract term and, importantly, those that currently cannot be imagined given the pace of change in the UK electricity sector.
The capital requirements and the timescales for construction and operation of nuclear plants are key drivers when it comes to the cost of nuclear electricity. The most competitive financing cost for major projects is generally achieved where the risk profile of an investment matches the requirements of a large and liquid pool of investors.
Other low carbon electricity options have seen financing costs reduce sharply, as with pension funds – and their huge investment pots – becoming more comfortable with the risks involved. However, under the CfD model, nuclear is a long way away from a risk profile that lends itself to competitive financing.
In fact, the CfD risk allocation is significantly narrowing the pool of potential investors into new nuclear projects, as it forces these investors to “bet the farm” in terms of the scale of their risk liability, in addition to making them accept regulatory risks that are both very hard to bind and only partially within the control of the UK government.
Unsurprisingly, the investment return that the investors need to be paid reflects these risks. The challenge to the use of CfDs is that the risks may be greater from a private investor’s perspective than from those of the government or electricity customers, and therefore allocating these risks to the nuclear investor through the CfD model leads to a worse deal overall.
A RAB model for nuclear power
There are numerous infrastructure companies in the UK with regulated returns, most notably, gas, and electricity networks and water companies.
The two standard elements of the Regulated Asset Base (RAB) model are the ability to recover efficiently incurred costs from customers and a defined incentive structure.
When recovering costs from the consumer, different mechanisms are used to set the efficient cost level, including benchmarking, market testing and uncertainty mechanisms to pick up actual costs where efficient costs can’t be estimated through alternative approaches. In addition to this, a defined incentive structure shares cost savings where these are achieved and enables the regulated company’s investors to benefit from outperformance on various measures of the company’s activities (or outputs in RIIO parlance).
This type of commercial structure could easily be applied to new nuclear projects. Build costs for different parts of the overall construction effort would be fixed where possible; other component parts would have cost recovery with material incentives for cost control but not at a level that threatens the commercial viability of the contractors.
Furthermore, changes in regulation would be dealt with in a rolling assessment of efficient costs; and rights to recover an allowed revenue would remove any artificial risks in the CfD structure associated with changes to the operation of the electricity market.
In its most recent price control review, the National Grid had a WACC (blended overall financing cost of equity and debt) of approximately 4.5% in real terms.
Since then, investment returns have fallen and Ofwat expects that the WACC of UK regulated water companies will start with a ‘2’ in real terms for the price control period starting in 2019. An appropriate WACC for nuclear investment would depend on the construction and performance incentives placed on the investor. However, it is likely that the WACC would be significantly lower than under the current CfD model, in which case the costs of future nuclear power would be much closer to those of offshore wind.
Taking into account the system benefits of nuclear versus wind, particularly as the wind fleet grows and cannibalization becomes more of an issue, this suggests that nuclear, under a regulated model, would be a very competitive part of the future power system. In addition, the reduced WACC also dampens the effect of cost-overruns and construction delays because the cost of financing-sunk investment would be lower.
In conclusion, under the CfD model currently used by nuclear, the large burden of risk limits the build to a handful of investors with increased costs for the consumer from the point of operation. However, nuclear could learn from other large infrastructure sectors, switch to regulated returns and take advantage of the competitive financing and increased savings at a lower cost to the consumer.