The more I hear about the imminent agreement between the UK government and EDF Energy over the guaranteed price of electricity from their planned new Hinkley Point C nuclear power plant, the more controversial the deal seems to be.
Here I’m going to briefly consider what the fuss is about and then unpick how this power plant is going to be paid for – both upfront and refunding its upfront costs.
On Monday I had a lively Twitter debate with Steve Hawkes of The Daily Telegraph and Mike Rigby, an independent county councillor in Somerset where the plant would be built. Both men agreed that it would be fairer to fund the investment through taxation (which would hit the richest the most) than through a guaranteed price (the so-called “contract for difference”), under which any difference between the wholesale market price of power and the guaranteed price will be topped up from an increase in bills. This guaranteed price is expected to be paid for 35 years.
This seems interesting to me because it goes against the prevailing orthodoxy that the private sector should be allowed to provide utilities and invest in infrastructure from its own profits, where possible; an orthodoxy supported by UK governments for over 30 years.
So why is it necessary to have a guaranteed price which, if recent press reports are correct, would be nearly 47 per cent more than the wholesale price at the moment? The simple answer is that the figure doing the rounds for a new nuclear price – £93 per megawatt hour – is in the region of 10 per cent more than the cost per MWh of producing that power from a new nuclear power plant*, and EDF Energy wants a 10 per cent return on its investment. That is far from unusual for an equity investor in an infrastructure project, in fact it’s on the low side.
But underneath that, what is driving the cost of getting a new nuclear power plant built? I will try to explain.
1. Capital structure
The government expects** that the first new nuclear plant in the UK will be funded on a corporate finance basis, i.e. the companies investing in it will provide equity (their own money) and borrow debt on their own balance sheets in order to pay the upfront cost of getting the plant built.
Debt is senior to equity in the payment waterfall (don’t ask me why but that’s what the pecking order of who gets paid is called), so if the project’s financial return is affected by problems during construction or operation, the shareholders, including EDF, will take a hit before the debt investors do. On a £14 billion project, you can expect at least 20 per cent, or £2.8 billion, to be contributed by shareholders. Because that’s quite a lot of equity for an infrastructure project (technically, ‘a hell of a lot’), some of it will almost certainly actually be debt, in the form of ‘equity bridge loans’ borrowed by the shareholders and repaid relatively quickly compared to the main senior debt.
And those equity bridge loans will generate interest as well as dividends for the shareholder, driving up the revenue the project needs to make to generate targeted returns.
Most of the senior debt – the stuff that isn’t equity or anything like it – will be covered by a UK government guarantee, so that even if the project can’t pay bank its lenders, the government will step in and make the payments. This guarantee comes with a fee to be charged at a market rate, but should overall reduce the cost of the debt by reducing the risk it won’t get repaid. However, the guarantee will only cover £10 billion of the estimated £14 billion cost. Depending on the final capital structure, that could be all the senior debt or most of it, an probably none of the equity/quasi-equity.
2. Risk profile
So not all of the project costs are guaranteed to be repaid. What are the risks that could damage the project and risk that repayment? It’s crucial to understand this, because (of course) the higher the risk an investor is taking, the higher the return they expect on their investment. Which in this case means, the higher the unit price of energy EDF asks for. Under corporate finance, even with that guarantee, EDF could be directly on the hook for over £1 billion of investment – even if there are other shareholders – which could be a big hole in its balance sheet if it doesn’t get it back. That means high risk, and high returns expected.
There’s construction risk: there could be faults in the design or problems could crop up during construction. EDF could try to pass the risk of this happening on to its construction contractors and suppliers, but that would drive up the price of its contracts.
Then there’s technology risk. No nuclear reactor has been built in this country before using the European pressurised water technology EDF has in mind, and the last project EDF tried building with it – Flamanville 3 in France – is behind schedule and more than twice over budget. In fact, as of now, no EPR reactor is in operation yet; they’re still under construction. So it’s not a proven technology and there’s a very real risk it could cost more and take longer than expected.
This risk is related to the first of a kind premium which the government recognises in its cost estimates for various types of power (see here). First infrastructure projects of their kind in a given country always take a little more cost and effort than subsequent ones. Future new nuclear projects are expected to be cheaper.
Then there are operation and maintenance risks. No doubt modern nuclear plants are very safe, but in a worst-case scenario the reactors could be shut down for months, or for good, if inadequate operation and/or maintenance caused a critical failure. Those worst-case scenarios will be factored in to the financing package.
Finally there are ‘soft’ risks: environmental, political, insurance premium and regulatory risk. For example, if the plant causes unexpected pollution, it could have to be shut down. Or a new government could introduce new legislation which impacted on the plant’s financial returns, or try to amend the contract for difference. Government can, if it wants to, offer to take on some or all of these risks. If not, that means more risk passed on to EDF and co, and more cost.
So that is how a unit price which could easily translate into the shareholders of Hinkley Point C being paid over £2 billion a year for 35 years could be perceived as quite reasonable in the circumstances. A unit price of about £93 is more than what the government wanted, but also less than the £95-100 EDF wanted and what some industry participants told market data service ICIS was financially viable.
If EDF does get a 10 per cent return on its investment, that will be rather low considering the perceived risk of building the first new nuclear power plant of its kind in the UK. That is not to say that this is the best way to pay for it; in fact I speculatively suggested a different way below. But it does explain how the mechanics work.
*Based on Department of Energy and Climate Change figures for a first-of-a-kind (in this country) nuclear plant using European pressurised reactor technology, on which development (the steps before construction) begin in 2012. For Hinkley Point C, the power station in question, those are the correct assumptions.
**see page 13 here.