Flexible Generation and the UK Funding Landscape

John McNair: Hello I'm John McNair, Inspiratia's Head of Content and welcome to another podcast from Inspiratia, this time on the topic of Flexible Generation and the UK Funding landscape.

John: Flexible energy generation will play a crucial role in balancing a system with increasing amounts of intermittent renewable power. But the role of battery storage and gas peakers will require a substantial amount of capital and, as it stands, only a few market players have got their heads around the complex revenue streams that come with these technologies. Most of the assets today are being funded with development equity, but structures involving asset finance or alternative lenders are emerging and there will inevitably be project finance opportunities at the more contracted end of the market. To discuss this client funding landscape with me today I'm delighted to be joined by Gareth Baker who's a partner at Gowling WLG and Tom Williams who's a partner at Downing.

John: Well good morning to you both. Gareth, perhaps if I start off with you. Just interested in how you would characterise the funding landscape for flexible generation to date and, secondly, how does that compare to, for instance, the early days of solar and wind in the UK.

Gareth Baker: Thanks, John. So, for stand-alone assets, which is the majority of what we see, as opposed to co-location, I would divide the market into two. Battery storage is still challenging, has been for some time. What I believe is behind that, from what I'm seeing is that as an asset class we're still in relatively early days and different types of capital are trying to work out the opportunity and how they can anticipate in that opportunity having regard to their need for a particular return profile and their appetite for risk. Peakers, in particular, gas peakers, we've seen a great deal of continued interest and activity in development opportunities and if anything we saw a spike in the instructions come through whilst the capacity market was at a stand still. And, perhaps that was because of a belief in the opportunity and that that market would come back and of course that has proven to be correct, as we've seen very recently. If I was to compare it with solar and wind I would aw that it is certainly different. The activity that we were advising on, particularly in 2013 through to 2016 was either supply chain activity in the form of JVs where perhaps panel suppliers, or turbine suppliers wanted to help create the route to market for their kit. Or a deeper pool of capital that was attracted by a mix of a straightforward subsidy regime and merchant power but that subsidy regime smoothing any concerns around merchant power that they might have.

John: Ok, thanks Gareth. And then, Tom, coming to you now. Gareth briefly touched upon the capacity market there. As an investor that would seem to perhaps form one strand of a revenue stream. I mean, how do you approach these more distributed assets, if they have perhaps uncontracted revenues, or several different revenue streams?

Tom Williams: Well, first of all, thanks very much for having me here. I think this is definitely my format, as my wife said to me this morning. I have a face for radio, so, I'm not quite sure how to take that. How do we take these unprotected elements? Well, look, I think it's very simple. We adopt the same methodology that we adopt for all of our other assets and it's very straightforward. There are a variety of different streams of analysis. The most relevant to these assets is the NR assisted revenue which we will break out into its constituent parts. You know, we first assess each revenue stream to determine whether fixed or variable and what level of operational risk is associated with delivering that revenue stream. There are a lot of further levels of detail like nature of variability, you know. Variability has many forms. The thing that is interesting and challenging about these assets is that the variability of revenue is linked to volatility, rather than long term considerations affecting baseline pricing. So it is a very different scenario. You know, if we go back to what Gareth was saying about the differences between the early days of solar and today. I think there are more differences than similarities. Despite the fact that many of the original solar developers are the guys that are playing in this market and I think fundamentally that comes down to the nature of the revenues of the asset. I think in the solar days it was very clear that these, once built, as long as they were built to a certain standard and they had the requisite documentation around them, they were clearly an investable asset and there was no question about that. I don't think they were debt fundable when you started, but it was clear from where the wind market was, that it was going to be that way. So really the focus was on building a high quality asset. I think in FlexGen constructing the asset and developing the asset is probably even simpler than solar, so the focus for me is really on who is going to own those assets and where the natural home for those assets is, after it has been bought and once it's operational.

John: OK, and I think we will perhaps come onto who the ultimate owners of these assets will be in a moment. But first I wanted to kind of pick up on the first part of your answer there. So, and I suppose the background to this is Downing closed a fund in this area at the start of this year. And you mentioned that you treat these assets much the same as many others, but I'm just interested to hear whether your LPs look at it in the same way as perhaps other renewable generation asset, and if not, how do you kind of communicate the more complex economics behind these assets to them?

Tom: I think the short answer is that the investors absolutely don't see these as similar to core renewables, and I think rightly so. I think you absolutely need to communicate the differences between the revenue streams and the nature of the risks associated with these assets. As I said, I think the simple answer is that it isn't as straightforward as core renewables. The revenue stack is much more subtle, it's much more complex. The way that we articulate investments in this asset class is to, first of all, start with the macro picture and I think the macro picture is undeniable. There is going to be a need for greater flexibility in the UK's energy markets and when you look at the policy statements that all of the parties have announced in this area, it's clear that the need for that flexibility is going to be unprecedented. People just simply don't know what technology is going to fill the gap. They know it looks something like a peaker, or something like a battery, or a combination of the two, but deploying that on the scale that people think is going to be necessary is going to be very very challenging. What does that do? That creates opportunity. So, having settled on the macro picture, then I think you start to look at the revenues of the assets. And as I alluded to earlier, these are layers of revenues and these revenues at different levels have different levels of risk associated with them and are increasingly complex and increasingly hard to understand and quantify as we move up the stack. So you can start with a capacity market contract which doesn't take a great deal of understanding, and doesn't have a great deal of operational risk associated with it, and then you can move through that into day ahead trading, intra-day trading, different types of intra-day trading, with greater and greater degrees of uncertainty, lower and lower capture rates and more and more complex discussions about how you capture value in those markets. What we are trying to do is work with people on the Offtake side to simplify that story and we have spent a huge amount of time and effort over the past, about 18 months now, trying to work up different solutions with different market participants to be able to persuade them that it's appropriate for them to take risk on the other side of the asset, on the Offtake side, and then consequently, de-risk the investment for our investors.

John: Ok. Gareth, if we go on to talk about the development side of things and the equity behind that, I mean, in your experience, for platforms currently rolling out, either pipelines and batteries, or gas peakers, and you know, the circumstances may be different, as you mentioned, for both those assets. What sort of development equity do you see as most liquid right now?

Gareth: Sure. Well, I would agree that again we see different things for batteries and peakers. I just want to first of all echo a comment that Tom made about the macro need because anyone investing in this space - do they have an inherent belief in the value of storage and the need for capacity as we move to more intermittency, and therefore do they believe in the sector opportunity? I think that's just so fundamental really to anyone who's investing. You talked about the most liquid. I would change that to are available. Because, in my experience, we aren't seeing lots of different options such that clients who are seeking equity are able to market a proposition and then perhaps use competitive tension in order to get certainty of pricing. There is definitely capital out there looking to invest. Whether that capital is well matched to the opportunity is a theme in this sub-sector, as I'm sure it is in others as well. Nonetheless, certainly in battery storage we've seen some great businesses where they've gone through founder equity, they've gone through friends and family and they're approaching that place where larger players are looking at them, perhaps I would describe it as "core plus" money. And they will take some development risk, maybe that's to secure a pipeline or maybe there's an institution or a strategic investor who will come along. The other thing that we've seen a little bit of which we didn't see in solar and wind, is actually the off-taker looking at coming in a bit earlier. Perhaps they want to learn, perhaps they want to secure route to market opportunities for themselves and exit later, so we're seeing that. I think the final thing I would say is under solar and wind, because of the subsidy regime, any tax incentives on the way in were quickly quashed. Certainly for the type of equity coming in at early stage, there are some incentives available, EIS type arrangements, and that's can help facilitate a certain type of capital into this sector early on and that will be a motivating factor for some people who are prepared to take that kind of risk on the opportunity at the early stage.

John: Ok. Tom, from your side of the fence, kids are here, but what kind of development equity do you see out there? And picking up on Gareth's statement about there being very little competitive tension, perhaps, is that what you're seeing?

Tom: I think last year was a funny year, or this year just gone. Our experience of the market was that developers have been developing these projects and, as is necessary, they forecast a recycling of equity in order to fund future development activity. There are very very few developers that are indefinitely funded. With the suspension of the capacity markets, what happened was, yes there was activity, but I'm not sure that it was the kind of activity that necessarily those developers wanted to see. Because I think it was more around a need for replacement working capital in lieu of a normal development cycle and a sale of fully developed projects. What we saw was projects changing hand at significant discounts to what had been achieved before. So, we did see and we were quite active in that market. And so that was quite a good period for us. The reason then I suppose why we were deploying capital into the space at the time was we did have a view on the fundamentals of what was required. We had a view on whether we thought the capacity markets would be reinstated - it was more based on a fundamental belief of the necessity for flexible generation. The specifics of whether the capacity market was perhaps over supplied and perhaps over procured I think are playing out in what we saw in pricing this year and where we are seeing it in terms of the market itself and how the market volatility responded to the suspension of the capacity market. But also then in our view on where future options are going to come out. And in our view that created an opportunity that was here and now in terms of projects which had CM16 contracts, CM15 contracts, that were obviously cleared at attractive levels. And so the nature of our investment has been both in a secondary market, and it has also been in green field development, and it has also been actually further back than that into the provision of working capital to certain of our development partners. So we've straddled, if you like, the capital spectrum. I think that does differentiate Downing in the market because we have different pots of capital from different types of investors, whose money that we manage, that have specific risk requirements and they are very distinct from one another. So we were able to put appropriate capital to work and appropriate risk weighted opportunities. I think where other people are struggling a bit is that the asset class falls perhaps not quite in an infrastructure bucket, you might squeeze it into your core plus intra bucket once it's operational, but then before that "operational" in this world - there's not much of a difference between construction and operation in terms of the risk that you're taking and the view that people take and so really then it's about going further back and helping those projects be realised, which is more of a working capital at play, and that's where I think that most people who are in that infrastructure investments base, struggle. They struggle to have significant amounts of capital, or it's strategically a mandate issue. And so, as a consequence, I think it has been very difficult for people to find ways of deploying capital into the market. The people that you see that are doing that is the people who have decided that this is a certain long term sector for them, they've built up platforms and operational capabilities and then they have really pursued development activity right the way through. And what they're doing is they are taking relatively conservative views on revenues and they're trying to squeeze every possible cost they can out of the development and construction cycle so that they can get acceptable returns from taking a more conservative view of those uncertain revenues in the future.

John: Ok. And out of all this in mind, looking to the debt side now, I mean, we've seen a few instances in the battery storage sector of debt playing a part. I mean I'm just keen to hear your view Tom on how much more of a part does debt need to play, if at all it does?

Tom: I think the problem that you have is that, I strongly suspect, that the projects that have been debt funded have been funded off the back of legacy FFR contracts, where there has been a long term revenue stream associated with the asset. As we're all aware, those are just not available any more and there is a very significant level of uncertainty at the moment about whether anything will replace those contracts in terms of ancillary services and I wouldn't be investing on a case now that those contracts will be there in the future for any significant period of time. So, I think that where that leads you to is, well what are you funding going forward and where can I get my certainty of revenue from? You know, it's possible for capacity market contracts for storage and we have looked at those ourselves but I think the main answer is actually what we've been focusing on heavily which is a credit worthy off-taker that provides a level of certainty within the revenue structure. Now there are a variety of different ways of doing that and a variety of different durations that are possible, but we are making significant inroads into floor style structures, where you just have a certain portion of revenues for, what is now actually medium term, so we're seeing that. Originally we were at three years. We're kind of past five and into seven. You will not have the 15 years that you'd like and you'd like to be amortising significant amounts of debt over, but it is making strides in the right direction and we think there is still some way to go.

John: Ok. And Gareth I'm just keen to hear your view on what you're seeing out there and looking at, I suppose, bank debt playing a role in this sector and how will that, you know coming up against the reality of the revenues on offer? But also perhaps we can explore asset finance and what role that's playing, and other kind of alternative non-bank lenders.

Gareth: So in terms of bank finance, first of all, mainstream PF, there's been an inherent believe that project finance will move because it inevitably has to move into this sector and I'm just not seeing that at all right now for some of the reasons that we've talked about here, and that Tom has already set out. Maybe as the visibility on revenue and floor pricing etc develops that will change, but I'm just not seeing that happening at all. We are seeing activity from some of the asset finance houses who will look at anything that has some sort of revenue stream that they can back and they are picking different elements of that revenue stream and are able to finance perhaps on a shorter term arrangement, whether that's FFR, EFR, or something else, they are interested in doing that. And we've seen publicised interest from some of the alternative lenders, the likes of Gravis Capital have done some work in this space as well. I think the other bit that people are struggling with as well as the revenue visibility is what is my asset life going to be like? What's the residual value and that is uncertain. Costs are coming down, not at the rate that we saw in the supply chain for solar and wind. Have we reached the point now where they are going to drop further dramatically - well we don't know that and also are we at the point where there's going to be significant step change in terms of the technology to make the earlier asset redundant and have no useful life - that's another risk that lenders are struggling with. That's all in battery storage, in terms of peakers. Certainly I would concur with the comments earlier that capacity market and other revenue streams, banks are just more comfortable with that. What we are seeing is development platforms are gradually refinancing, perhaps some assets and some PF style lending into corporate lends as they grow and commission more, particularly when they get to that 100 to 150 megawatt number.

John: Ok. If we now perhaps move onto the M&A side of things. Tom, firstly, I think it's good to touch upon Downing's recent divestment of Pivot Pal to EDF Renewables and I'm just interested to hear you4r view and what EDF's interest in assets like that, you know, that Pivot Pal are developing, and what it says about the motivations of groups like that in this area. And also you know that deal had an easy charging component, or possibility to it, so how big a part does that play, versus the batteries themselves?

Tom: Well, first of all, I'm not entirely sure I can speak to EDF's renewables strategy, but you know, what does it say? I think EDF's appetite in Pivot is good proof of our market view on the need for flexible generation going forwards so I think it's a sort of ringing endorsement of the sector and a great signal to market and investors as it shows, our view is shared by others who have a great deal of experience in the energy markets. So I think mainstream utilities taking up some of these opportunities is great. We were obviously really delighted. There were a variety of other people interested in Pivot and that spanned out across the investor universe, from infrastructure investors right the way through to utilities. So it was one of those assets that did have a wide range of appeal. And I think the EB charging element did play a part in that, you know that it is a very topical discussion and it's a very topical sector. And there is obviously a huge opportunity with the way that the Pivot business is structured and the way that their connections are arranged for power. Making power available for charging is one of the biggest challenges that faces that sector at the moment. So, yes - did it play a part on that? I'm sure that it did.

John: Ok. So, Gareth, Tom right at the top of the recording mentioned you know, or raised the point of who will be the natural owners of these assets? And he's obviously described utilities there and also mentioned infrastructure investors, there's also oil majors and other types of strategics. I mean obviously perhaps it's difficult perhaps to say right now and put a finger on one of them, but how do you see the ownership going in this market over the next few years?

Gareth: As you say, it's a guessing game and I haven't bought the crystal ball with me today but I'll have a go. I mean first of all it's important to emphasise that some of the market making that happens or that is happening will naturally create preconceived exit points that will also need to happen, so I mentioned Off-take is taking an interest earlier, for example we advised Statcraft on the Sotera deal and that's one of those one where they've provided a route to market and they aren't going to want to be in there forever. Tom touched on types of capital and timeline and the horizon. Inevitably there is capital in there that isn't patient, isn't long term, it wasn't raised in order to be that kind of capital, so I think I can predict that there will be activity. Who are the long term natural owners? I suspect we will see some investors like we did in solar and wind where there will be consolidation. I think there will be funds that do that. If you look at the existing renewable owners they face an interesting challenge in that they've been very successful in consolidating subsidised wind and solar and very successful at raising funds but they are running out of things to buy and therefore diversification is necessary and that will either be geographical or that will be technological and they will look at things which are complementary and closer to what they can do. So I think we will see, and it will be interesting to look at, the way in which funds are going out and perhaps having a more flexible mandate to look at more and I continue to be surprised at what I see as ostensibly pension fund money and infrastructure money looking at having some small participation at the very early development end because they want to see and experience what it's like and also maybe that can secure a long term opportunity for them. But there's still a lot of capital that needs to be put to work and it isn't going to earn the returns that are needed in cash or bonds or any other thing like that given the low interest rates at the moment.

John: And finally Tom, your thoughts on that?

Tom: It's interesting. There's certainly a place for flexible generation in a diversified portfolio, that's for certain. And actually I believe that that maybe one of the ways of securing more favourable off-take arrangements, is to actually start taking on more of the balancing risk yourself, and selling forward your portfolio as a whole. Nobody's really doing that at the moment but it's a very interesting discussion, it's one we've been looking at for some time. It is clearly in the off-taker's interest to be able to procure that as a whole and I think continuing on that theme there's clearly a place for this within a utility's books to again manage imbalance, and there are again discussions that we're having about how we can help with our assets, make some of our off-takers more competitive in their markets and their supply markets. So there is some way to go there but there is a natural home of those assets within the utility envelope. What's really interesting is that we're seeing interest in this sector from a very wide range of foreign entities, specifically oil and gas and utilities who (a) want to learn from the UK's experience of the energy transition - I recently spoke at a conference in Japan. Japan is interesting because it has very similar characteristic to the UK in terms of it's an island, it's quite a developed economy, but it's at the start of its energy transition, and so you have very large vertically integrated utilities who feel that their core business at different points in the chain is under threat and the evolution of the energy markets, the evolution of technology and the move to a more - through the energy transition - is something that is causing them to take a great deal of attention about what's going on elsewhere in the world and what's really interesting is that they seem to be focusing most of their attention on the UK on the market that they see as having made the greatest strides in their energy transition. That's not to say it's been painless or we're even vaguely where we need to be, but it is interesting and it's seeing capital being attracted form those different markets to learn, to make solid investments, and then to take that learning back into domestic markets. So, rather like Gareth's response, I think, I'm not entirely sure where this all ends up and in those hands these end up. I suspect it's going to be a combination, and I expect that over time that will evolve and I expect that returns will prove out and people will get increasingly comfortable with volatility and increasingly comfortable with people's ability to forecast volatility and to capture value in volatility. And at some point there will become an accepted view that it is considered to be a lower risk than today. How far that goes and how rapidly that market matures will determine in whose hands these assets lie.

John: Well, that will be no doubt very interesting to keep track of that market as it develops. I think we'll leave it there for today. So, Gareth, Tom, thank you very much.