The (strike) price is right: EU State aid approval of new biomass plant supported by UK government

Written on 8 Jan 2016

Overview

In December 2015, the European Commission (the Commission) approved, under EU State aid rules, the UK government’s support for the conversion of the Lynemouth coal power plant in Northumberland to operate on biomass (wood pellets).

The UK government support will come in the form of a Contract for Difference (CfD), which will fix a “strike price” (£105/MWh) for the electricity. This guarantees that the generator of the plant will earn money from selling its electricity into the market until 2027. When the average wholesale price is below the strike price, the generator will receive a top-up payment (conversely the generator will make a balancing payment to the government when the wholesale price exceeds the strike price).

Following an in-depth investigation, the Commission is satisfied that the terms and conditions of this support will not amount to overcompensation. The Commission also looked into the question of whether the global wood pellets market would be distorted as a result of this project, but concluded any such distortions were outweighed by the project’s contribution to the European renewable energy and CO2 emissions reductions targets.

This decision follows the Commission’s recent approval of the CfD/strike price arrangements for Hinkley Point C in Somerset. Although this is a fact-specific area of law, these decisions indicate that national governments will continue to be given the benefit of the doubt in making future projections about energy demand, provided that they are supporting projects that are aligned with the EU’s wider objectives of increasing renewable/low carbon energy sources and enhancing the EU’s energy self-sufficiency, particularly given the uncertain geo-political climate.

State aid in a nutshell

Broadly, the State aid rules prohibit public support which confers a competitive advantage to a particular company, or group of companies, if it has the potential to distort competition in the EU unless that support either:

  • is notified to, and approved by, the Commission, or
  • fits within one of the existing block exemptions.

CfDs and State aid

As summarised above, in the case of the Lynemouth project, the support takes the form of a CfD, an initiative to support low-carbon energy generation by guaranteeing the price the generator will receive for the energy it produces (the “strike price”). Under CfDs the generator sells the energy on the open wholesale market. Where the market price is below the strike price the UK government will “top-up” the generator’s revenues to the value of the strike price.

CfDs were developed as part of the UK government’s Energy Market Reform (EMR), a package aimed at replacing the UK’s aging energy infrastructure, as a tool to drive investment in low-carbon energy generation projects by offering revenue certainty to low-carbon generators. CfDs may constitute State aid if they provide a selective advantage (a guaranteed price) to low-carbon generators and have the potential to distort competition in the markets for energy generation, as well as neighbouring markets such as coal, wood pellets and other key inputs for the energy generation process.

The Lynemouth decision

Since CfDs do not fit into any of the recognised block exemption regulations, the UK government was required to notify the Lynemouth CfD to the Commission for prior assessment and approval.

Generally, the Commission will approve support with environmental objectives such as promotion of low-carbon energy generation provided that:

  • on balance, those objectives outweigh any anti-competitive effects (the balancing test); and
  • the support goes no further than necessary to achieve the low-carbon objective (the proportionality test).

In applying these tests to the Lynemouth project, the Commission identified two key competition concerns and took the decision, back in February 2015, to open an in-depth investigation. The concerns were that:

  • the CfD mechanisms might lead to overcompensation to the generator. In particular, the Commission was concerned that the parties’ estimates regarding key cost parameters, including the load factor of the plant (i.e. the actual electricity produced in a year compared to the maximum possible), its efficiency and the cost of wood pellets, were too conservative; and
  • given the size of the Lynemouth plant, significant volumes of wood pellets would have to be imported which could have disproportionate distortive effects in the wood pellet markets.

Twelve months on from the initial notification, and after considerable analysis and investigation, the Commission has announced that it is satisfied that the Lynemouth CfD satisfies both the balancing and proportionality tests and is, therefore, compatible with the EU State aid rules.

Looking forward

As mentioned above, CfDs are a new initiative and so the Lynemouth decision is one of the first, and much anticipated, rulings on the compatibility of CfDs with the EU State aid rules. The UK government predicts that £100 billion of capital investment will be required by 2020 to meet the objects under its EMR programme, which is likely to involve further rounds of CfDs. Indeed, on 6 January 2016, the Commission announced a new in-depth investigation into a CfD to support the conversion of a Drax coal plant to operate on biomass in the UK, raising substantially the same competition concerns as in the Lynemouth decision.

The Lynemouth decision therefore has significant implications for low carbon energy generation projects not only in the UK, but potentially across the EU.

Companies hoping to secure CfDs would be well-advised to take heed of this emerging pattern, by ensuring that State aid notifications for CfDs are supported by water-tight financials on cost parameters. Generators can expect the Commission vigorously to test these projections with third parties and experts from within the industry, particularly if the CfDs have been awarded without going through a competitive tender process. 

Companies should also be mindful of the timescales involved in securing clearance. The Lynemouth decision took twelve months to clearance, plus several months of pre-notification dialogue with the Commission. Accordingly, sufficient time to secure regulatory clearance should be built in to all project plans which involve an element of public support or subsidy that may require the Commission’s approval.