Political risk is alive and kicking and nowhere more so than within the UK electricity sector – a sector that, incidentally, needs to attract billions of pounds of new investment if secure supplies of low carbon and affordable, predictable power are to be delivered into the future.
Unfortunately, despite the fact that achieving these aims is in the best interests of the UK economy, regulatory uncertainty in this industry runs the risk of undermining confidence to such an extent that it has the potential to deprive the sector of this essential investment. Last week for example, the Government demonstrated a willingness to change its mind again on important subsidy issues in this industry, with no prior warning but with profound consequences for public listed companies and their shareholders.
On this occasion, the Department of Energy & Climate Change (DECC) surprised the market and the industry by issuing a consultation on changes to the grandfathering policy for future biomass co-firing and conversion projects under the Renewables Obligation. Coming out of the blue, this single announcement caused a fall of almost 10% in the share price of Drax, a company in which we are invested that is transforming itself from being a coal-fired power generator to one predominantly fuelled by biomass, a process that has cost its shareholders £700 million in capital investment.
The consultation from DECC is highly frustrating, given that its own analysis suggests that every tonne of carbon saved by biomass conversion costs the taxpayer £60 compared to the £200 per tonne cost of offshore wind carbon mitigation.
For a sector characterised by large capital investments with long payback periods, it is worrying that DECC feels that it has carte blanche to amend existing policy in the name of budget management. The consultation issued last Friday is the first time that DECC has exercised this right. In so doing, it gave no obvious consideration to the fact that final investment decisions may already have been taken by companies and capital may have already been committed.
This looks much more like a move motivated to suit political imperatives (such as the current ministerial love affair with offshore wind) and it ignores the clear economic benefits of biomass conversion over other renewables. From an environmental perspective too, the benefits are clear. Drax has been carbon footprinting its biomass supply chain for over seven years and the results, which demonstrate material life-cycle carbon savings versus coal (typically above 80%), should silence the environmentalist sceptics.
The electricity industry has for too long been the victim of a misguided, short-term and politically inspired policy mess. The Government has to be held to account for its policy decisions. As long as it (and its predecessors) believes that it can arbitrarily move goal posts in this way, without appropriate economic justification, the more likely it will be that the industry will continue to shun the necessary investment in electricity generation infrastructure that the economy so clearly needs.
I believe that it won’t be long before the profound economic implications of this shambolic mess become very evident. The current reserve margin for next winter already looks so low that it is hard to measure. The consequences for the economy of this policy failure will therefore become all too clear on some cold, still winter’s day in the not too distant future. The capacity market auction recently conducted by DECC does nothing to change this dynamic, in my view.
Nevertheless, Drax’s underlying investment case to become a predominantly biomass-fired generator remains secure, despite potential changes to the regulatory regime. Biomass conversion projects such as Drax are helping the UK to meet its legally binding carbon reduction targets in a cost-effective manner, while ensuring security of supply. No other renewable generation technology offers these combined benefits. For these reasons, we believe Drax remains a strategically important asset in the UK electricity sector and are confident of its ability to generate attractive returns for shareholders in the future.