the value of subsidies and their insurability
Introduction – government subsidies becoming increasingly popular worldwide Global energy usage is predicted to rise between 25% and 35% by 2040, due to the ever-increasing population and higher global GDP1. Projections show that renewable energy sources must increase in order for countries to meet their COP 21 and individual low carbon electricity generation targets2.
With this in mind, governmental energy subsidies have become increasingly popular in recent years, stimulating and stabilising investment in developing technologies with an estimated US$40 billion currently being spent on subsidies globally each year. In the US for example, $18.4 billion was spent on energy subsidies in 2016, of which US$11 billion was awarded to renewable energy sources. Contract for Differences – how it works The UK in particular has used subsidies as a method of bringing forward the investment needed to sustainably deliver its target of 20% renewable energy by 2020, and 80% carbon reduction by 20503. For instance, the UK established the Low Carbon Contracts Company (LCCC) as the government-owned counterparty to Contract for Differences (CFD) – a private law contract between a low carbon electricity generator and the LCCC that essentially pays the difference between:
Though the revenue generated from the electricity will be sold to the National Grid as usual, if the market reference price falls below the strike price, the LCCC will top up the payment to reach the strike price. Conversely, the generator must pay any revenue received above the strike price if the market reference is higher. Traditional renewable technologies, such as solar PV and onshore wind, have been restricted from entering the CFD process since the auctions started in 2015, with preference being given to less established technologies such as offshore wind and dedicated biomass.
Result 1 – reduced exposure to price volatility In regards to the value of energy subsidies such as the CFD incentive, it is argued that this finance support mechanism reduces generators’ exposure to volatile wholesale prices by ensuring the bankability of a project’s revenue, by pre-agreeing a fixed price for the duration of the contract.
Meanwhile, in doing so consumers are also awarded a level of protection in terms of electricity price fluctuations.
Result 2 – the industry grows still further The clear, stable and predictable revenue streams have undeniably helped the Renewable Energy industry thrive, particularly providing Offshore Wind developers with access to a huge pool of capital.
But is it still necessary? However, with the cost of this capital falling consistently and wholesale pricing playing a growing role, the question can be asked as to whether the same level of support that CFDs provide is still necessary within the industry. Moreover, the rationale for subsidies used to be centred round the fact that the investment needed to develop a renewable energy project was not financially feasible if the remuneration was subject to the standard market price.
However, the drop in supply chain cost and the uptake in production have left many with the opinion that seems to have coalesced around the need for a change in the current process. Spain, for example, took this opinion into action when it awarded 8.7 GW of renewables in 2017 - none of which will necessarily receive any government subsidies.5
Government protection measures Additionally, the value of the energy subsidy mechanism has previously encountered other issues centred round the protection measures in place for changes to the relevant country’s legal system. In the UK, the LCCC provides the developer with the security of either party having limited termination rights, as well as having provisions in place to protect the value of the CFD to developers, should any change in legislation occur.
Political risk vulnerability: an example from Spain However other countries have arguably less sophisticated processes, which can leave the developers vulnerable to political risks. Using Spain as an example, the approval of the Royal Decree 661/2007 brought about a guaranteed profitability to both domestic and foreign investors in renewables, causing a ‘photovoltaic boom’ to take place in a matter of months. This huge success was far higher than the Spanish government anticipated, and unfortunately led to the need for remuneration cuts and maximum production hours being put in place – a change that a stipulation in the current legislation allowed for. This development, together with the introduction of a 7% electricity generation tax, undoubtedly caused significant losses to the sector and arguably more so to the investors who no longer possessed a guaranteed profit.
Subsequently, these cuts in renewables incentives led to over 40 different investors filing claims against the Spanish Government to the International Centre for Settlement of Investment Disputes, arguing that they had violated Article 10 of the Energy Charter Treaty by depriving the plaintiffs of fair and equitable treatment6. Although to date they have tended to rule in the plaintiffs favour (currently two arbitral awards have been won by Spain, four to the various plaintiffs), the fact still remains that not knowing the security of your investment, despite signing a contract to determine specifically that, is hardly an attractive feature of a subsidy in the eyes of a developer. In addition, as investors that continue to choose subsidies have to hedge against potential future losses of income due to regulatory uncertainty, the price of the projects themselves are likely to increase as a result – a factor that almost goes against the aim of a subsidy in the first place.
The value of political risk insurance and other risk mitigation measures With governments potentially having the power to eliminate a favourable regulatory regime and replace it with a less favourable one that affects the developers pre-agreed investment, it appears renewable energy projects are particularly exposed to changes in law and an additional form of financial guarantee may be deemed necessary. Political risk insurance, bilateral investment treaties and stabilisation clauses are potential mechanisms to be explored.
Indeed, the World Bank’s Multilateral Investment Guarantee Agency (MIGA) provided political risk insurance to the shareholders loans to the 47 MW Rajamandala Hydropower Project in Indonesia in 2014, which provides coverage against the risks of transfer restriction, expropriation, war and civil disturbance, and breach of contract7. Alternatively, the renewables feed-in tariff in Ukraine is an example of stabilisation clause providing an indemnification to investors as a result in the change to the law. Though these mechanisms can raise challenges in themselves, such as limited coverage, ambiguous policy language, and expensive and complex application processes, the question remains as to whether these processes are growing to be significantly important for developers in a subsidy contract.
Is the current subsidy process fit for purpose? To summarise, though the value of subsidies in the growth of the renewable energy market has been undeniably successful, industry changes now raise the question as to whether the current process is fit for purpose. Are renewable energy generators transitioning away from subsidies into a more merchant risk future? Furthermore, is the financial guarantee of a subsidy proving to be stable enough for investors, or should we consider it necessary that political risk insurance is provided in parallel?
Here in the UK, the Department of Business, Energy and Industrial Strategy (BEIS) estimates that investment of around £100 billion is required in electricity generation and transmission in the UK in this decade alone, and we need to ensure investors have security in the mechanisms in place to provide profitable, yet affordable, sustainable electricity8.
Conclusion – the challenge for the insurance community Be that as it may, the ability to trade this macro political risk for loss of anticipated subsidies following a change in legislation with the insurance markets is still frustrated by insurers’ lack of appetite, potential aggregation of exposure and inability to broadly deliver long term insurance policies which provide equivalent certainty. It is therefore critical for risk intermediaries to challenge insurers to deliver innovative, long term non-cancellable products which can respond to loss of subsidy or other financial support mechanism where delays are achieved resulting from physical loss or damage triggers.
Kelsie Makepeace is a Graduate Trainee currently working in the Renewable Energy division at Willis Towers Watson in London.
1 https://cdn.exxonmobil.com/~/media/global/files/outlook-for-energy/2016/2016-outlook-for-energy.pdf 2 Maloney, B., 2018. Renewable Energy Subsidies - Yes or No? Available at: https://www.forbes.com/sites/uhenergy/2018/03/23/renewable-energy-subsidies-yes-or-no/#1b80b68e6e23 3 LCCC, 2016. Contracts for Difference (CFD) Booklet 2016/17: Overview of the CFD mechanism and Delivery Partners. Available at: https://www.lowcarboncontracts.uk/sites/default/files/CFD%20Booklet%202016-17.pdf 4 LCCC, 2016. Contracts for Difference (CFD) Booklet 2016/17: Overview of the CFD mechanism and Delivery Partners. Available at: https://www.lowcarboncontracts.uk/sites/default/files/CFD%20Booklet%202016-17.pdf 5 https://www.windpowerengineering.com/ business-news-projects/business-issues/end-subsidies-spain- beginning-new-era-renewables/ 6 2014. THE ENERGY CHARTER TREATY (WITH INCORPORATED TRADE AMENDMENT) and Related Documents. Available at: http://www.europarl.europa.eu/meetdocs/2014_2019/documents/itre/dv/energy_charter_/energy_charter_en.pdf 7 MIGA, 2014. Rajamandala Hydropower Project. Available at: https://www.miga.org/project/rajamandala-hydropower-project 8 Maloney, B., 2018. Renewable Energy Subsidies - Yes Or No?. [Online] Available at: https://www.forbes.com/sites/uhenergy/2018/03/23/renewable-energy-subsidies-yes-or-no/
