Low Carbon Windfall Tax Take 2: The Electricity Generator Levy

The structure of European energy markets – where the marginal cost of the most expensive form of generation needed to meet demand sets the market price – means that high gas prices have created additional profits for some forms of generation as compared to those generators that have to buy fossil fuels to generate electricity.  Whilst the substantial redesign of the GB power market promised by REMA (on which consultation closed last month) will aim, in part, to address the consequences to the market of significant external shocks such as that caused by the invasion of Ukraine, the redesign and its implementation are not straightforward and so will inevitably take some time.  In the meantime, the Government has formed the view that low carbon generators should contribute some of their additional revenues to public finances and support households and businesses through the current cost of living crisis.   The Generator Levy is expected to raise approximately £14 billion for the public sector over its life.

The Generator Levy is to replace the Cost-Plus Revenue Limit (envisaged by the prior Government as an effective cap on the revenues of certain low carbon generation) which was contemplated by the Energy Prices Act, which passed into law last month – see our previous commentary on this here.

Scope and mechanics

The Generator Levy is described as a temporary measure that will apply to generation between 1 January 2023 and 31 March 2028, irrespective of when sales contracts were entered into. 

The Generator Levy will be applied to corporate groups generating electricity in the UK from renewable, nuclear and biomass sources.  It will not apply to pumped hydro or battery storage and will not include revenue from the sale of ROCs or from capacity market payments.

“Extraordinary profits” are defined as receipts (not profit) from electricity sold above £75/MWh (on the basis of aggregate revenue that a generator group makes in the relevant period from in-scope generation at an average output price above £75/MWh).  Nothing has yet been said about indexation of this threshold.     

Average receipts per (accounting) period therefore need to be above £75/MWh to trigger the levy.  The Government has stated that it considers that there should be an allowance made for balancing and financial hedging costs (although details are not yet available), but otherwise this is structured as a tax on revenue, and not profit.  If unfairness to generators is to be minimised, the language will need to be carefully crafted to not unfairly penalise groups’ hedging or trading strategies.

The tax will be limited to generators whose in-scope generation output exceeds 100GWh across the relevant period and will then only apply to such “extraordinary profits” to the extent exceeding £10 million.

Similarly to the existing Energy Profits Levy applicable to oil and gas producers (the scope and duration of which are to be extended as part of the same package of measures), the Generator Levy will be administered through the corporate tax system – the levy is charged to a company as if the amount thereof were an amount of corporation tax chargeable to it.  The relevant period for calculation will be aligned to the accounting period of the company responsible for administering the levy for the group. 

Consolidated corporate groups

The Generator Levy therefore considers corporate groups on a consolidated basis.  This is a significant change from the approach of the Energy Prices Act, which focussed on the individual generator (which might not have been realising the market price due to hedging arrangements).  This change in approach adds a level of complexity that will need careful consideration to ensure that it works without unintended consequences.

Where a group’s generation output is sold to third parties, the revenue measure will be the revenue received from the third party by the relevant group member (irrespective of whether ultimately sold by the generator).  The treatment of intra-group consumption will need to be considered. 

For energy companies that span generation and supply, revenues with regards to the end supply to consumers will need to identify the relevant components of those receipts.  Clearly any misalignment between the entity responsible for the tax and the recipient of the revenue raises the prospect of cash flow issues for generators.  There may also be temporal misalignments, depending on when revenues are recognised.  We anticipate difficult questions around when the group monetises the power – for example, a group should not be permitted to exchange in-scope power with another group at sub-market prices, to keep the “realised prices” for their own generation down.

It is recognised that there may need to be special consideration for generation joint ventures (particularly where output is sold to stakeholders) – again, careful language will be needed here to get this to work as intended.

Groups with different minority investors in their generation assets may also face issues in allocating the tax.

The Generator Levy will not apply to electricity generated outside the UK and imported (but it will apply to electricity generated in the UK and exported).             

CfDs

It is stated that the Generator Levy will not apply to electricity that is “generated under a Contract for Difference” (where the generator pays back to the public sector generation revenues above the applicable Strike Price). 

This formulation may imply that generation by holders of CfDs prior to the Start Date thereunder will be subject to the tax, which may raise some interesting debate around the scope of the Change in Law and Generation Tax protections in the CfD.

The proposed exemption for CfDs may be a further encouragement for generators to enter into the “Pot Zero” CfDs contemplated under the Energy Prices Act.

Scope for challenge

A side-effect of the measure being structured as a tax under an Act of Parliament itself means that it will, in principle, be less susceptible to challenge by way of judicial review than if the Secretary of State were exercising powers granted to it.  This may also have a bearing on any potential claims under the Energy Charter Treaty.

Continued investment in the sector

The Government expresses the hope that the “temporary and proportionate” levy is not expected to harm long-term investment due to it applying to only a portion of additional returns, and electricity generators still being able to write off investment against corporation tax.  This remains to be seen.  Critics will argue that the impact on cash flows itself may hinder appetite for reinvestment.  Unlike the Energy Profits Levy, where oil and gas producers may benefit from specific tax relief for reinvestment into the sector, there is no specific relief offered from the Generator Levy for reinvestment into new projects.

As we have noted previously, investors positioned to make comparisons between the UK and EU investment landscapes for low carbon generation will note that the EU’s incumbent revenue cap for renewable generation (which applies as an effective cap, rather than a levy on excess revenues) is set at EUR 180/MWh.  This will doubtless be contrasted unfavourably with the much lower level at which the Generator Levy starts to apply.

Treasury has not provided detailed rationale behind the £75/MWh threshold beyond stating that the level is considerably higher than the average wholesale electricity price in the decade up to 2021.  The Energy Prices Act did not state the threshold – it was to be left to delegated legislation.

Next steps

The detail of the Generator Levy will be set out in the Finance Bill.  A draft of the relevant legislation is expected in mid-December.

Generators will want to carefully review the position set out in the draft legislation when it is published.

The Treasury has stated it will reach out to relevant generators to discuss the implementation of the Generator Levy, although discussions on previous approaches to this issue have already been reported as having taken place.  Given the draft legislation is expected to be published in a matter of weeks, generators will need to react quickly.