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Doom and gloom from analysts -- Renewables Obligation as yet holds too many risks says industry

As the UK's new renewable energy support system -- the Renewables Obligation -- comes into force, industry analysts are warning that high levels of uncertainty associated with the obligation will increase the costs and difficulties of financing projects. A severe shortage of renewable energy capacity means that electricity retailers, known as suppliers in Britain, will, in aggregate, fall 40% short of meeting the specified 3% of their power sales from renewables generation. Out of 9.4 TWh -- representing the total size of the 3% obligation -- a shortfall of some 3.7 TWh is predicted.

From April 1, 2002 all electricity suppliers in Britain are required to buy a percentage of their power from renewable sources, starting at 3% for year 2002-03, rising to 10.4% in 2010. They can meet their obligation by buying renewables obligation certificates (ROCs) either directly from renewables generators, or from a third party, such as a trader. Suppliers who are unable to buy enough ROCs will have to pay a penalty of £30/MWh to "buy out" of their obligation. As an added incentive to meet the obligation, the buy out money will then be shared between compliant suppliers. The expected shortfall for the first year will leave around £113 million to be recycled between compliant suppliers.

Minister disagrees

At a financing seminar organised by the Renewable Power Association last month, energy minister Brian Wilson claimed the renewables obligation will be "cost effective." Financial analysts disagree. Much of their unease centres on the future values of ROCs and the value of the buy out money -- termed the "smearback". These are unknown quantities, they fear. The only published prices for renewable power under the new regime come from an auction of non-fossil fuel obligation (NFFO) capacity in February where prices averaged £64.40/MWh. These prices, however, were for short term contracts of only six months. Longer term contracts will be priced lower.

The NFFO system had many shortcomings, but banks were happier to lend against the security of the 15 year index linked NFFO power purchase agreement (PPA) with a solid counter party in the shape of the Non-Fossil Purchasing Agency. By contrast, the credit worthiness of present day counter parties -- the suppliers -- adds its own element of risk. Michael Starmer-Smith of Deutsch Bank points out that due to the fragmentation in the electricity supply industry and over capacity in the electricity market, the credit ratings of some suppliers are on the decline. The recent demise of a couple of electricity retailers, such as Independent Energy, makes banks nervous about lending to projects, even with a long-term PPA.

BANKS WARY

John Wood from Norton Rose energy and projects group also takes a gloomy view. What developers want, he says, are long term contracts, and cheap, non-recourse finance. Today, banks are wary of a whole basket of risks including the new electricity trading arrangements (NETA) which penalise non-firm power such as wind, operating risks -- such as the lightning strike which recently broke the rotor on an offshore wind turbine at Blyth -- the possibilities for government to change the rules (he points to experience in the UK with Railtrack, which shows the dangers of political meddling), and credit risk (Enron is an example). Meantime, the site permitting process is still an imponderable under the British planning system, he says. These uncertainties all have to be factored into the cost of borrowing.

This all means that banks are more likely to favour a lower gearing of 60% debt rather than the 80% or higher that some projects enjoyed under the NFFO. As the cost of borrowing rises, there is a consensus that smaller renewable developers will be squeezed as the new market is tilted in favour of "the big boys" -- particularly vertically integrated electricity companies that can finance projects off-balance sheet, but that can also award long term contracts to their renewable development arms.

Many involved in renewables financing point out that 2010 -- the government's 10% renewables target date -- is not far away. To develop a viable renewables industry it is important for the UK's renewables targets to continue rising beyond this date to give suppliers and developers confidence that the momentum will be sustained.

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