Sometimes it pays to keep things simple. The proposal to cap renewables companies’ UK revenues looks set to be a mess.
Liz Truss’s government is ideologically opposed to imposing anything that is obviously a windfall tax (notwithstanding that It’s kept the extra levy on North Sea oil and gas production imposed in May). So a cap on renewables companies’ revenues won’t be labelled as a windfall tax — much like the one being introduced in the EU. And, unlike traditional windfall taxes, it won’t be a retrospective tax on profits.
That’s where the problems start. The best thing for the industry overall would arguably have been for those on the type of old-style subsidised contracts — that can attract politically problematic windfalls — to have voluntarily exchanged the benefit of sky-high prices now for long-term fixed-price contracts offering greater certainty. My colleague Helen Thomas argued as much last month.
It would have had some complications, but there are clear benefits from lower financing costs over projects’ lifetimes. Analysis by Aurora Energy Research in September put the potential savings for generators from cheaper finance at between £2.5bn and £3.3bn.
That isn’t where we’ve ended up. The issue with that kind of contract switch is that it would be hard to implement for the coming winter. It is not difficult to see how that might be a problem for a government that has landed itself with a very large bill to support both households and businesses in the cold season and needs to be seen to be doing something — not least because it now has to demonstrate its fiscal credibility to the markets before the end of the month.
It’s also easy enough to see how it might result in the less than optimal design of a new tax for the industry, whatever it is called. And a revenue cap is less than optimal.
The first problem with a revenue cap is that generators aren’t necessarily the ones reaping the benefits of high prices right now. Many have hedged their production for this winter and next. Lots of those hedges — particularly the ones for this winter — will have been struck at prices which are far below the prevailing spot price in the markets.
In one situation the government ignores those hedges and bases the cap on what generators might theoretically have received. Generators end up out of pocket, but the government raises a decent amount of revenue. Alternatively the government takes account of hedges, discovers that lots of generators aren’t in fact receiving large windfalls on their output this year, and ends up raising rather less revenue than it anticipates.
The thing that has really spooked the industry is the potential level of the UK cap — originally rumoured to be £50 to £60 per megawatt hour when wholesale prices are above £400. The EU has set its cap at €180.
A cap at £50-60/MWh might make sense if it was being offered in exchange for the long-term. As a revenue cap, analysts at Jefferies labelled it “punitive”, distorting both markets and incentives to invest.
It is clearly possible to overstate the risks to investment from introducing a revenue cap: no one is going to have drawn up investment plans on the basis that they’ll be receiving £300/MWh-plus. There should be a level below this at which it is possible to cap revenues without damaging the attractiveness of investment which is, after all, central to net zero plans. Embarrassingly for the UK government, it might be easiest to assume that the best level is the one the EU has picked and work back from that.
Still, whereas a traditional windfall tax on profits might have come with carve-outs for certain types of investment — as the North Sea oil and gas levy did — capping revenues doesn’t offer that kind of nuance.
Ideally the government would still pursue a scheme to shift the old-style renewables projects on to longer-term fixed-price contracts even if it can’t be done immediately. There will be those who don’t wish to participate because their projects have shorter remaining life expectancies and aren’t worried about fixing for the long term. And the benefits are likely to dwindle the longer it takes to organise a switch to long-term fixed-price contracts, since the gains will be lower when the price is lower. But at least it would avoid a similar windfall issue arising again.
In the meantime, the renewables industry may wish it was getting a classic windfall tax much more like the oil and gas industry.