ADE Briefing Note

DRAFT Consultation response | CfD Fuelled Technologies 20 December 2016

About the ADE The Association for Decentralised Energy (ADE) welcomes the opportunity to respond to the BEIS consultation on selective overcompensation in the Capacity Market.

The ADE is the UK’s leading decentralised energy advocate, focused on creating a more cost effective, efficient and user-orientated energy system. The ADE has more than 100 members active across a range of technologies, and they include both the providers and the users of energy. Our members have particular expertise in combined heat and power, district heating networks and demand side energy services, including demand response and storage. Response to questions Question 1: How should the CFD scheme treat biomass conversion in future? Please provide evidence supporting your suggestions and set out what you think the impact of these would be.

The ADE has no view on biomass conversion specifically, but notes that support for biomass should depend on its ability to deliver carbon savings at good value for consumers and taxpayers.

Question 2: What are the expected heat vs power outputs for geothermal projects in the UK? Will geothermal projects be developed on a power-led basis? What difference do these factors make to project capital, operating and financing costs and technical parameters? For guidance in answering this question, please benchmark your views against the BEIS levelised cost results and underpinning assumptions for geothermal CHP in Annex 1 and Annex 3 respectively of the Generation Costs Report and in chapter 17 of the Arup report.

The ADE has no comment on geothermal technology costs.

However, we would note that investors in geothermal energy generation would likely see heat revenue as higher risk than power revenue, as heat revenue can fall out if network connections www.theade.co.uk

of 7 DRAFT Consultation response | CfD Fuelled Technologies 20 December 2016 are lost. The higher risk profile of heat revenue and RHI subsidy compared with the CfD subsidy makes it more likely for projects to be power-led.

Question 3: What factors will affect cost reduction potential for the fuelled technologies from 2020-2030? Please provide evidence to support your assessment. Please describe any barriers to these cost reductions taking effect and be specific about the technology and fuel type you are referring to.

For biomass and EfW CHP, we do not expect to see significant reductions in the capital costs of projects in the coming years. This is because the underlying capital costs which make up these technologies are largely well-known.

We see opportunities for reduced financing costs as these projects become more common. Several large-scale bioenergy projects have recently faced significant technical challenges, which will raise the cost of capital for future projects.

We also see opportunities for reduced financing costs for renewable CHP schemes providing heat into networks, which have a lower risk profile than industrial heat projects (as industrial heat demand has a higher risk of reducing demand/closing).

Reductions in biomass CHP financing costs can have quite a significant impact on overall plant costs. Large, industrial heat projects are either financed by the industrial manufacturer, who often requires IRRs of between 20 to 25%. In contrast, third-party financing and building of these sites can secure them at a lower IRR, although their ability to do so is highly dependent on the third-party’s ability to offset the risk of heat demand falling away.

The inability of the Contract for Difference scheme to guarantee payment for the non-good quality biomass power, even if the heat demand closes, makes biomass CHP projects uninvestable for debt investors. For equity investors, the cost of capital would rise significantly, as these investors must price in the risk that the entire biomass CHP asset will have to be written off in the event of the heat demand closing.

Similarly, the inability for the RHI to date to provide a commitment of the RHI tariff level a plant will receive when it commissions prevents this revenue from being ‘banked’ as part of the business case. A biomass CHP plant will take at least two years to move from financial investment decision to commissioning, during which time the RHI tariff could degress or close completely. This uncertainty means biomass CHP plant often must secure debt investors against the ‘worst case’ business plan, with no RHI revenue, reducing the value of the subsidy as value for money funding, securing additionality.

Finally, we see opportunities for fuel supply costs to be controlled and potentially lowered through increased growth of local biofuel supply chains.

Question 4: What changes could be made to the CFD scheme to drive more cost effective decarbonisation of electricity generation or improve its ‘carbon cost effectiveness’? Please www.theade.co.uk

of 7 DRAFT Consultation response | CfD Fuelled Technologies 20 December 2016 provide any evidence you have on how the different fuelled technologies compare (with each other and with other renewables) in this respect.

We would support an increased focus on improving the efficiency of bioenergy energy generation, including setting minimum heat efficiency requirements for new biomass and EfW CHP generation.

We would also support increasing the GHG requirements for bioenergy fuels. Currently bioenergy fuels are …

Question 5: What factors do you think Government should take into account in considering the interaction between the CFD scheme and support for decarbonisation of heat?

The benefits of biomass CHP The loss of biomass CHP participation is that BEIS loses a key cost-effective decarbonisation tool. We are aware of internal BEIS analysis which found that biomass CHP saved carbon at lower cost compared to other forms of renewables, and that CHP support could be better decarbonisation value than even low-cost offshore wind.

Lower carbon fuel. Large-scale biomass energy generation tend to use imported wood pellets, which have carbon content of TK. In contrast, smaller-scale biomass CHP wood fuel, because it can be sourced locally, can have carbon content of TK. This difference represents a carbon saving of nearly TK times for every unit of fuel.

Less fuel used. By generating heat and power simultaneously, biomass CHP can reduce fuel usage to secure the same level of energy production if it was generated separately. This saving is called the primary energy saving. As Government recognises, whatever the fuel source, CHP is the most efficient way to use it, when ensuring that CHP are delivering a minimum 10% primary energy saving as required under CHPQA. With a 10% primary energy saving, that reduces fuel use by 10%, and reduces the carbon content of the energy generated by 10%.

Contributing to industrial decarbonisation. Industrial sites in the refining, food and drink, chemicals, and paper sectors require medium temperature steam, which is between 400 and 800 degrees Celsius. Heat pumps and solar thermal are not able to generate these temperatures, and electricity is too costly, leaving coal, natural gas or bioenergy able to deliver these temperatures. The industrial decarbonisation roadmaps showcase the important role that biomass heat generation needs to play in industrial heat decarbonisation. CHP is already being used in more than 375 industrial sites, providing efficiency benefits and lower cost electricity production for those sites, and the best use of limited biomass fuel is in high- efficiency CHP.

Security of supply.

AUCTION RESTULS

Why the CfD in uninvestable for biomass CHP www.theade.co.uk

of 7 DRAFT Consultation response | CfD Fuelled Technologies 20 December 2016 Combined heat and power produces both heat and electricity. It has up to 10 times the capital cost of a heat-only boiler, but by producing high-value electricity in addition to lower-value heat, the project is able to deliver sufficient returns to pay back the higher capital cost.

The electricity revenue is even more important if the heat demand is lost, such as when a heat customer closes their site. When this occurs, the site may look to secure alternative neighbouring heat demands, but this is rarely possible due to the limits of transporting heat over long distances. If an alternative heat demand cannot be secured, the CHP is converted into a ‘peaking plant’, focussed on delivering peak services in the electricity market. This arrangement still results in substantial financial downside for the investor, and will likely include a substantial write down, but the plant is able to continue earning revenue and make debt payments.

However, this arrangement is not possible for a biomass CHP plant, due to the significantly higher costs of biomass fuel. For a biomass CHP to receive support under the CfD, biomass CHP plants need to maintain their CHPQA certification annually, with support only paid on the proportion of their metered electrical output assessed by the CHPQA to be Qualifying Power Output (QPO).

The effect of this approach for biomass CHP is that plants which lose their heat demand stand to lose not only income from lost heat sales and the Renewable Heat Incentive (RHI), but also all of their support under CfDs as their ‘Good Quality’ electricity falls to zero. The CfD’s provision to allow a plant to receive CfD revenue for up to 5 years after losing its Good Quality status is insufficient certainty for investors in this marketplace.

Once the five year window ends, the loss of heat revenue and RHI revenue for a biomass CHP project reduces returns to the point where the plant, without continued CfD support, cannot continue to make debt payments. The potential additional loss of the CfD revenue puts the entire investment capital from debt investors at risk. Debt investors, including John Laing and the Green Investment Bank, have advised they will not back any biomass CHP project under these conditions. The five-year safeguard does not provide debt investors any protection for the final 10 years of the contract, and debt investors will only consider the worst-case scenario.

The additional complication of having to participate in two different subsidy schemes simultaneously makes the projects additionally uninvestable. An investor currently has to bid into the CfD allocation round without being able to lock in their RHI tariff. This makes it very difficult to know the value of their heat, and therefore the most economic bid price in the auction. If the investor assumes too little RHI revenue, they will either lose the allocation round, or receive a higher price than necessary reducing value for money; if they assume too much RHI revenue, the investment and CfD commitment would be at risk.

The RHI tariff guarantee is a welcome improvement, allowing an investor to lock in the rRHI tariff at financial close. However, the tariff guarantee now due to start in April 2017, but does not allow a plant to commission after December 2019. This date is one year before the earliest CfD delivery year in the 2017 CfD allocation round. This timing difference means that no www.theade.co.uk

of 7 DRAFT Consultation response | CfD Fuelled Technologies 20 December 2016 project can know the level of RHI revenue they will receive when they commission their plant, and therefore makes it impossible for an investor to include the RHI value in their investment case and their CfD bid.

Impacts of policy design on CHP efficiency A combination of three factors has resulted in current renewable support regime securing insufficiently low heat to power ratios to ensure value for money in exchange for the relatively higher tariffs than power-only plant.

The lack of ability for a plant to secure a guarantee on the tariff it will receive from the RHI at financial close, has meant generators must base their investment case on power production and electricity subsidy. The result of this uncertainty is that projects are a much sounder investment case when based on electricity under the Renewables Obligation.

The risk that the entire CfD will be removed if a biomass CHP plant loses its heat demand discourages investors from considering high-heat demand projects. The higher the heat demand, the more risk to project viability if that heat demand closes. This has also meant that only the most secure heat demands, such as new build fish farms or greenhouses, are seen as sufficient for investors. An industrial heat demand, which may close due to market pressures, would be viewed as unworkable under the current CfD framework since.

Insufficiently strong CHP Quality Assurance scores encourage high power-led CHP plant. In 2013, the CHPQA was changed to ensure that all plant achieve at least 10% heat efficiency and 10% primary energy savings, in addition to a minimum overall efficiency of 35%. In 2016, the CHPQA was reformed again to reflect the significant improvements in electrical efficiency from large biomass power generators.

Proposed changes to increase CHP efficiency We would propose three steps to increase CHP efficiency:

Further review current biomass CHP technology to ensure the CHPQA formulae are securing sufficient fuel savings to achieve value for money. This could include a minimum heat demand requirement, which is already implicitly included in the CHPQA formulae, but could be explicitly stated in the document.

Set an electrical capacity limit for biomass CHP. We recommend the cap be set at 50 MW, which is the maximum size for a non-licensed generator. Larger biomass generation sites are often able to secure CHPQA Good Quality status with a relatively small heat demand, and due to their large size, are rarely sited in locations where they can supply heat to industrial, business and heat network customers.

Require a due diligence process for biomass CHP to ensure that new schemes have met a number of key tests, including securing a long-term heat contract with a customer. The detail for what such a scheme would include is set out below.

Proposed changes to secure investment To make biomass CHP investable, it will require one of the following three potential steps: www.theade.co.uk

of 7 DRAFT Consultation response | CfD Fuelled Technologies 20 December 2016 1. Allow non-Good Quality CHP to receive CfDs for the full 15 years We recognise that this approach creates a risk the CfD will be used to support biomass power only projects in cases where the heat demand has closed. However we see this risk as manageable, with limited impact on CfD value for money, by implementing an accreditation system to ensure only the best-quality CHP projects, with committed heat demand contracts, are accepted into the scheme.

Under this proposed approach, BEIS would accept the risk that if the biomass CHP plant ceases to provide heat, such as, but not limited to, when a heat off-taker moves or closes, then the CfD remains in place and subsidy is being paid to power-only biomass with no heat off-take.

There are two questions which the due diligence process would need to answer in a clear and objective manner to reduce risk for BEIS of biomass-only projects coming forward.

 Is the heat off-take a stable and financially viable counterparty?

 Does the generator have a genuine, commercial opportunity and are they committed to meeting the proposed heat demand (e.g. a gaming test)?

The criteria to meet these tests could include:

 CHPQA certification, which includes engineering reports substantiating the viability of the heat offtake proposals;

 Type of heat demand and evidence of its eligibility according to CfD requirements

 Evidence that heat demand exists currently and has existed for a minimum of X years; or, Proof of Final Investment Decision for investment that will deliver future heat demand

 Heat purchase agreement, which includes:

1. A take or pay agreement, a take in priority to another 3rd party agreement or early termination agreement is in place

2. The cost of terminating the agreement early includes a financial penalty equivalent to X% of the total contract

3. The cost of terminating includes recompense for installation and CAPEX costs of original heat infrastructure

 Third-party assessment of heat offtaker financial viability

2. Implement a Government-backed insurance scheme for heat demand Across a diversified portfolio of CHP projects, there is a low risk of heat demand loss. Analysis undertaken by then-DECC, using CHPQA data, showed that there were relatively few losses of heat demand over the last 20 years.

However, these incidents resulted in significant financial harm to the individual investing companies. This individual risk makes it challenging for investors on a project by project basis.

www.theade.co.uk

of 7 DRAFT Consultation response | CfD Fuelled Technologies 20 December 2016 This market failure could be addressed by putting in place a Government-backed insurance scheme, which could make debt investors whole in the rare case of a heat demand closure or significant reduction. Such an approach could be provided by a private sector provider, who deliver due diligence assessments of schemes in line with the process outlined above.

3. Implement a new support mechanism for bioenergy CHP A challenge for BEIS is that the Contract for Differences programme is only interested in delivering low-carbon electricity, and is not incentivised to use its funding to support other key Government priorities, including renewable heat, heat network, and industrial energy decarbonisation and competitiveness, all priorities which could be supported through bioenergy CHP.

Until there is strategic direction within BEIS to ensure the CfD scheme helps to support these wider BEIS priorities, it will be difficult to deliver the changes necessary to achieve successful biomass CHP investment.

One option is to create a new mechanism which would specifically support bioenergy CHP. This mechanism would have to deliver two key principles:

 It should ensure that debt investors remain whole, or have alternative revenue recovery options, in the event of heat demand closure.

 It should encourage only high-efficiency CHP projects.

We could see merit in considering combinations of grant funding for the upfront capital cost and a per MWh payment to cover the additional bioenergy fuel costs.

Question 6: How can the Government use the CFD scheme to promote the development of innovative ACT projects which will help develop a circular economy using waste as a fuel? Please provide evidence for or against making changes to the support of ACT and set out what you think the impact of making these changes would be.

The ADE has no comment.

For further information please contact: Jonathan Graham Head of Policy Association for Decentralised Energy Tel: +44 (0) 20 3031 8740 [email protected]

www.theade.co.uk