UK Energy Prices Bill: A windfall tax for low carbon generation?

In Europe, the price of electricity is generally determined by the “pay-as-clear principle” under which generators are paid for their generation at the cost of the last unit required to meet demand. The immediate problem for European policy makers that all energy markets in Europe are facing is that they were designed for a world in which generation was more centralised and gas was cheap – on an average day in the UK, gas accounts for just over 40% of generation supplied to the national grid, yet the price of gas dictates the price all generators receive. 

There are therefore four conclusions that governments have reached. First, that generators reliant on gas as a fuel cannot do much about reducing their costs of generation; secondly, that generators not reliant on gas (nuclear, biomass, solar, wind and hydroelectric) may be receiving payments well in excess of their costs of generation (and in excess of what they ever expected to receive); thirdly, as a result of European governments deciding to provide untargeted support to consumers and businesses for the increase in gas prices, they are also providing (indirectly) support to generators that do not “need” that help; and, finally, that some energy market redesign is needed to address the consequences to those markets of the invasion of Ukraine (as well as facilitating the transition to net zero).

The UK government’s response to the above conclusions can be seen in the Energy Prices Bill, which was published on 12 October 2022 (the Bill). The concern many of our energy clients will have is that enactment of the Bill could result in an outcome by which carefully structured contractual arrangements, painstakingly negotiated in the context of long term investments, are overridden by a change in law. This could trigger serious consequences not only for the UK government’s net zero commitments but also investor appetite for UK government risk more generally. 

The Bill, if passed, will put into law a number of measures aimed to provide assistance to UK consumers and businesses with their energy bills over the coming months, some of which have been previously announced by the government such as the Energy Price Guarantee (for domestic consumers) and the Energy Bill Relief Scheme (for non-domestic consumers, including businesses). 

Cost-Plus Revenue Limit

More importantly for present purposes, the Bill makes provision for the government’s intention to introduce a Cost-Plus Revenue Limit that would effectively impose an upper limit on the revenue being received by certain low-carbon generators. This measure applies in England and Wales only at this stage but the government has stated that it is liaising with the Scottish government to confirm whether the measure will extend to Scotland.

Whilst being labelled as a de facto “windfall tax” by many in the media, the government has sought to distinguish its proposals from a more traditional “windfall tax” by stating that the cap will apply to “excess revenues” relevant generators are receiving, as opposed to all profits (although, for many, particularly generators that have entered into long term hedges, this distinction potentially makes the position worse rather than better for them). 

As part of its justification for the new measure, the government highlights the fact that the UK wholesale price is set by the most expensive form of generation required to meet demand (currently gas-fired generation), the cost of which is abnormally high due to Russia’s invasion of Ukraine, and which is significantly higher than the day to day operating cost of low-carbon forms of generation.

Whilst the precise workings of the Cost-Plus Revenue Limit (including its scope and the level of the cap) remain subject to future consultation, the Bill provides the statutory powers for the Secretary of State to impose payment obligations on specified generators for the purpose of funding (via electricity suppliers) reductions in prices for electricity consumers. A side-effect of the Secretary of State having these powers means that they are, in principle, more susceptible to legal challenge by way of judicial review than if they were set out in the Bill (an Act of Parliament) itself. 

It is expected that the mechanism will be forward-looking (not applied retrospectively) and take effect from the beginning of next year. It would last for no more than five years (though this period is extendable). The revenue cap is expected to apply to low-carbon generators not currently benefiting from a Contract for Difference (CfD) (for the obvious reason that under CfDs payments above the CfD strike price are returned to the public sector), although generators with a CfD might still be included within its scope where CfD payments have not yet started (that is, to catch generators who have, in accordance with the agreed contractual terms, delayed triggering the start date of their CfD to benefit, for a limited period, from higher prices).

The Bill benefits from a fast-track legislative process under which all stages of the Bill in Commons are to be considered on Monday 17 October 2022. Once all stages of both Houses have been passed, the Bill will put into law the legislative framework for the Cost-Plus Revenue Limit, but the key details of its application (including its scope and the level of the cap) will nevertheless remain subject to the consultation (which the government has stated will be launched shortly).

Generators and investors in the sector really need clarity on the proposals sooner rather than later. This will allow them to consider the extent to which the new law will prejudice their contractual rights and trigger claims (as they have done in other European countries, for example, in Spain).

In 2013-2014, Spain introduced a number of legislative measures, which radically changed the remunerative framework for renewables generators. A large number of investors brought claims under the Energy Charter Treaty (ECT), alleging among other things that Spain breached its obligation to provide fair and equitable treatment (FET) to investors by reneging on its guarantee of fixed payments for an installation’s operating life, and by entirely revoking and altering the regulatory framework. To date, 27 claimants have succeeded in their ECT claims (8 of whom were represented by Allen & Overy). 

The level of the cap and the methodology that underpins that cap will clearly be important as that will dictate the fairness of the approach and degree of prejudice suffered by investors and generators. The EU has recently, under a similar policy, introduced a revenue cap for renewables generators of EUR 180/MWh. There has been speculation in the press that the limit imposed in the UK might be lower, and the government has reportedly said that it would take into account pre-crisis expectations for wholesale prices in determining what a reasonable upper estimate might be. Any significant deviation from the EU limit will be met with scrutiny from investors who may be positioned to make direct comparisons between the UK and EU low-carbon generation investment landscapes.

Equally important will be to take into account generators that have hedged their positions at lower than market prices in such a way that they (or their wider corporate groups) are not receiving excess revenues in the nature of those the government is aiming to target.

Getting these points wrong could hinder investment in the UK renewables sector (which would clearly run against wider political goals and the achievement of UK net zero ambitions). Unlike the recent Energy Profits Levy on UK oil and gas companies, this arrangement is not coupled with any additional investment incentives.

A failure here may also lead to claims under the ECT. The renewables cap is the latest in a series of changes to the remuneration of renewables generators, primarily in the European Union, which are already leading to claims being brought against the States concerned. For example, following the likes of Spain and Italy, France is now facing its first ECT claim after it cut tariffs to solar producers in 2020. Investors whose revenues are severely impacted by the proposed Bill will immediately consider whether they may have a claim under the ECT.

An investor may be able to claim that in passing the Bill into law, the UK breached its obligation to provide FET to investors. The likely success of any claim will depend on how the Cost-Plus Revenue Limit is structured, as well as (potentially) the extent to which stakeholders are involved in consultations on the measures. An investor may be able to argue one or all of the following  (once the government has made its approach clear):

• that the cap is not a proportionate response to the energy crisis;
• that the government has acted unreasonably in introducing the Cost-Plus Revenue Limit;
• that the investor had a legitimate expectation, when it made its investment (and managed all the risks of developing that asset), that the generator would be remunerated for its production in a specific manner; and/or
• that in introducing the Bill, the government is in breach of its obligation to provide a stable legal framework for renewable energy investments.

By way of example, generators benefitting from the renewables obligation will have expected to receive both: (i) the market price; and (ii) the price for selling their ROCs for the electricity they produce (they will continue to receive ROCs as the intention is only to normalise for wholesale market changes), and will have assessed the risks of their investment and returns they were likely to make on that basis. If the market price were to be effectively capped, investors may have a claim that the UK is unfairly targeting them for a crisis that is not of their making, and changing the legislative framework to which they reasonably believed they were entitled for a long-term period, at great cost to the investor.  Such a claim could come under the FET standard in the ECT.

By contrast, if – when the final details are ascertained – the Bill targets only “windfall profits” made as a result of temporary and disproportionate increases in gas prices due to the situation in Ukraine, and the understanding is that when gas prices are lower, any caps will be lifted, an investor would have much weaker grounds for an ECT claim.

The courts have already been willing to hold  the UK government to account on its declared “green” credentials and pathway to net zero. The government has recently accepted that a revised Net Zero Strategy must be published following a court ruling that it did not comply with the Climate Change Act. The government has, in the context of the Bill, reiterated its continuing support for investment into the UK renewables sector, which, if the approach in the Bill sets the template for future legislation, can only be seen as conditional and qualified.

Contracts for Difference

Another important aspect of the Bill is that it provides the legislative powers for the Secretary of State to consider running a CfD process for existing generators from next year. 

The backdrop to the current proposal in the form of the Cost-Plus Revenue Limit is that the government initially appeared to recognise that the fairest approach was to discuss with the generators and investors it is now targeting, how to achieve a balanced approach to address the short term pricing impact (for example by agreeing a lower price but contracting for a longer term with those generators). It has now become clear that the government was not capable, in the time it had, of striking a deal with low carbon generators to enter into long-term fixed-price contracts in time for this coming winter.

Although the government is pushing ahead with its plans to cap revenues of generators, it is nevertheless laying the framework for long-term agreements to be available for eligible existing generators should that become a viable option (and, depending on where the revenue limit is set, this may become a more attractive option for generators and investors).

REMA

As stated above, few would disagree that a redesign of the electricity markets in Europe will be one outcome of the current energy crisis. The UK manifestation of that is the Review of Electricity Market Arrangements (REMA), on which the initial consultation has recently closed. 

Whilst REMA has a broad remit and intends to address the fitness for purpose of the GB power market over the medium to long-term, one notable point consulted on was the potential for a split wholesale market, under which renewables prices could be decoupled from thermal plant.

Next steps

The Bill will likely be passed into law very quickly, but this does not provide details of the level or scope of the payments which will be levied. The government’s consultation on the regulations determining these is awaited shortly, but we would hope that that any decision would be sensitive to hedged positions of generators and treating generators and investors fairly so that investment momentum can be maintained. Generators and investors will need to be in a position to respond swiftly.

If you would like to discuss any of the matters raised in this article, please get in touch with any the related contacts listed, or your usual Allen & Overy contact.