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The Most Innovative Law Firm in Europe
Onshore Transmission – “The Opportunity”
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IntroductionWelcome to this seminar hosted by Pinsent Masons, Centrus Advisors and Jacobs to discuss the infrastructure investment opportunity which is created by Ofgem’s announced plans to create competitively appointed transmission owners (or “CATOs”) to design, build and operate selected electricity transmission assets in Great Britain. Ofgem is currently consulting on proposed arrangements to introduce onshore tenders and is planning for the first tenders in 2017, with notice of projects to be tendered from the middle of 2016.
Size of the Opportunity
As ever, this is the real challenge because it is sensitive for the existing TOs which will potentially lose the investment opportunity and no party is currently certain which projects will finally meet the criteria. At the time of the RIIO T1 settlement in 2013, the principle was set that projects deemed Strategic Wider Works (or “SWW” projects) COULD be subject to third party delivery where it was in the interests of consumers. A wider remit is planned for the next price control period from 2021. The 2013 factsheet on SWWs identified twelve possible projects, ten of which were in Scotland with one inter-connecting Scotland and England. Two of those projects listed, Caithness and Moray and the Kintyre project have since been subject to Needs Case applications to Ofgem identifying the projects capital values at £1-1.4bn and £200m respectively. National Grid Transmission’s RIIO-T1 had SWW projects accounting for just £1.3bn (in 2009/10 prices), but this excluded projects under £500m. Either way, the evidence suggests that the potential size of the competitive investment is likely to be significantly bigger than the £2bn plus offshore transmission market has yielded to date, with Ofgem’s informal estimate being £1-1.5bn of projects per annum in RIIO T1.
Criteria
In high level terms, the criteria that has been set for investments in overhead line, cable or substation to be considered for tender are that they are:
New and Separable – meaning greenfield assets or replacement assets where the ownership boundaries can be clearly delineated in industry codes and standards.
High Value – meaning a minimum capital value of at least £100m.
There has been a lively debate between TOs and other experts regarding whether complete electrical separation is necessary or not, even though most agree that it is desirable for clear accountability in operations. There has also been a proposal that existing assets may be transferred to a CATO where this makes operational logic for the benefit of the overall scheme.
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Pinsent Masons | Onshore Transmission – “The Opportunity”
Different tender modelsTwo models have been proposed by OFGEM as to how and when they will run tendering, an early and a late CATO build with the key differences being that the System Operator (“SO”) or Transmission Operator (“TO”) would complete preliminary works (including environmental assessment impacts, high level asset design and securing planning consent). Unlike the generator build OFTO model, both ONTO models assume that the CATO will construct as well as operate and maintain the asset.
The implications for prospective bidders are much longer lead times before operational cashflows begin, and a need for asset and detailed design and construction management skills in the consortium. Balancing that, Ofgem are informally signalling that only late CATO builds are likely in RIIO T1.
Structure of regulation and revenues
Ofgem have proposed that CATOs bid to receive 25 year fixed annual revenues which will cover required capex, opex and financing costs (bid as indexed or not) with a sharing of any benefits of any debt refinancing. To incentivise delivery of assets on time, these revenues will only commence on their availability for use although for projects where construction is in excess of five years, this may be amended. Ofgem’s initial view is that like the OFTOs, the CATO’s annual revenue at risk from underperformance should be capped at 10%.
Summary
The high investment needed in the GB electricity transmission network to support changing generation sources, patterns, and locations is driving the desire by Ofgem to encourage competitively tendered investment delivery. The ONTO opportunity is real and is now with information regarding the first tender expected in the next 6 months. It has parallels with the OFTO processes but we think the drivers to tendering success are likely to be different.
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Key Technical, Financial & Legal ConsiderationsCharacteristic CATO OFTO Conclusion
Project Size £100m+ Round 1: Sub £100m
Round 2: £250m+
The minimum size proposed is based on a cost benefit analysis. This size may be on the small side for equity.
Term Construction (c.3 years) + 25 years’ operating period.
20 years’ operating period. A revenue stream of 25 years including a build period of 5 years should allow sufficient sources of long dated finance to be tapped.
Scope of responsibilities
Model is based on Design, Construct, Own and Operate.
Additionally with the potential on Early Tender to develop the design solution and achieve consents.
Whilst the OFTO regime includes both Generator and OFTO build options, the only model operated so far is the Generator build. Thus restricting the OFTO activity to:
•Asset transfer
•Own
•Operate.
CATO organisations/partners will require a very different mix of capabilities.
Nature of Assets Assets are likely to be mainly conventional onshore assets, including OHL, cables, substations, HVDC etc.
Submarine cables may be included for bootstrap type projects.
Assets exclude OHL and are mainly Offshore substations and subsea cables plus the onshore substation assets. For Crown Estate R3 projects HVDC technology will be involved.
CATO organisations/partners will require a very different mix of capabilities.
Engineering Capability Fundamental part of the process to design solutions, detail design and construct/commission.
Other than during due diligence the emphasis is on operation.
For the CATO process engineering capability is critical.
Bid terms For late CATO, the following will be bid firm: equity return, debt cost and gearing, capex, opex and some design – fixed for 7-9 months pre financial close.
For early CATO, equity return, gearing level, development costs including design and planning are to be fixed while debt costs, capex and opex will be indicative only – final debt cost to be fixed at financial close through a debt funding competition.
All financing (equity return, debt and gearing) as well as operating costs are included in firm bid.
For late CATO, there will be no opportunity for sharing factors for costs that Ofgem believes should be fixed and subject to competitive tender pressures. However, limited reopeners to be allowed for costs beyond bidders’ control.
In early CATO, given the time period between bid submission and receiving all consents only those ‘near term’ costs not subject to uncertainty need to be firm.
In both cases, the Ofgem process for signing off costs will need to be priced by equity over the whole project life.
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Pinsent Masons | Onshore Transmission –” The Opportunity”
Characteristic CATO OFTO Conclusion
Bid Resources Potentially a large number of projects requiring significant tendering resources.
Relatively few projects which have been well distributed over time.
Availability and management of resources will be critical for CATO bidders.
Competition New players plus the incumbents, including the existing contractors who could be potential competitors as well as partners.
Very similar organisations set up specifically for the OFTO business.
There will be many more CATO projects but the competition is likely to be more intense.
Revenue Stream In late CATO there will be a bid for one revenue stream to cover capex and opex that will be paid post construction.
In early CATO there will be two revenue streams to bid for – one for preliminary works and one construction and ops, with the latter paid only with assets are available for use.
Bid for single revenue stream when capex already known.
Due to the long time period between the bid and the start of construction for early CATO, it is believed that it should not have to carry development costs for that period.
The second revenue stream will be finalised only at the final checkpoint when costs and debt pricing are finalised.
Ofgem process for final sign off likely will impact equity risk.
Revenue at Risk Up to 10% of revenue per annum at risk due to underperformance based on availability, may also allow further incentive eg. related to energy supply.
Up to 10% of revenue per annum at risk due to underperformance based on availability, rewards of up to 5% allowed if availability target exceeded.
Final revenue incentives for outperformance remain to be determined.
Technical Risk Mainly onshore but design and construction risk.
Normally assets already designed and built, so risk is predominantly Technical Due Diligence, but involving higher risks associated with offshore/subsea equipment.
Very different risk profile, but level of risk will be project dependent. Other than Planning/Consent the CATO risks would generally be considered as lower.
Additional Capex Revenue adjustment mechanism will allow for additional investment in upgrades or new extensions over term
OFTO can reject additional capex exceeding 10% of the transfer value.
Ofgem process for signing off changes could be a major issue for debt financing/ratings.
Payment for existing assets / development costs
To be decided if existing assets will need to be paid for on transfer from incumbent for late CATO. Equivalent costs in the form of development costs prior to FC in early CATO will be paid for through an early revenue stream.
Transfer value of asset to be bid on – this will include known development and capex costs of incumbent subject to an efficiency assessment by Ofgem.
Too early to determine final position. However, any of these pre-financial close costs to be funded by the OFTO contractor up-front will impact the finance required and bidder’s return profile.
Legal regime The regime draws from the regulatory framework implemented for OFTOs, specifically OFTO-build which is, as yet, untested.
Success of OFTO as a new investment asset class is due in part to the robust regulatory framework which gives certainty that revenue is stable and downside is limited.
There is no reason to believe that the CATO regulatory regime will be any less robust than the OFTO regime.
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Residual Asset Value It is proposed that CATO assets will be depreciated over 45 years in line with onshore transmission generally. However the revenue term is 25 years. The regulatory regime will need to give sufficient comfort to the market about treatment of the residual asset value, e.g. the framework for making any residual asset value payments etc.
Depreciation is perhaps less of an issue offshore, given that the tender revenue stream is tied to the life of the generation capacity.
Ofgem will need to provide further clarity in relation to the residual asset value arrangements.
Bidding structures Similar considerations which apply to OFTO bidders will apply to CATO bidders.
We have seen incorporated and unincorporated structures to ensure that the right mix of skills (technical and financial) are available to bidders.
Characteristic CATO OFTO Conclusion
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Pinsent Masons | Onshore Transmission –” The Opportunity”
Michael WatsonPartnerFinance & Projects T: +44 (0)131 777 7071E: [email protected]
Pinsent Masons LLP
Centrus Advisors LLP
Jacobs Leigh Fisher
Geoff KnightPartnerT: +44 (0)20 3397 7693E: [email protected]
Murdo MacleanPartnerFinance & Projects T: +44 (0)20 7054 2581E: [email protected]
Jason MurphyManaging Director, Centrus Advisors LimitedT: +353 (0)1 669 4656E: [email protected]
Jeremy ChangLegal DirectorFinance & Projects T: +44 (0)20 7054 2647E: [email protected]
Fiona O’DriscollDirectorT: +353 (0)1 237 4678E: [email protected]
Chris JonesTechnical DirectorNetworksT: +44 (0)191 211 3879E: [email protected]
Martin RobinsonDirectorT: +44 (0)20 7420 2852E: [email protected]
Key Contacts
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