What is the background for the current discussion around renationalisation of the energy sector?

The Labour party, under its current leadership, has expressed taking key infrastructure back into public ownership. Rail and water are in its sights, but the first detailed policy paper to be issued relates to the energy sector, and more specifically the energy networks in mainland Great Britain.

The recently launched paper ‘Bringing Energy Home‘ sets out how the high voltage electricity and high pressure gas networks and the lower voltage electricity and lower pressure gas networks will be transferred into a new regulatory and ownership framework which will include a National Energy Agency, Regional Energy Agencies, Municipal Energy Agencies and Local Energy Communities.

What are the main arguments for and against the renationalisation of the energy sector?

Labour’s principal argument runs thus:

‘public ownership of transmission and distribution networks will deliver better value for the public, accelerate and coordinate the investments needed to roll out renewable and low carbon energy, provide democratic control over nationally strategic infrastructure and ensure decentralisation occurs equitably’.

Labour believes that since privatisation the owners of the networks have made ‘huge profit margins’, have overcharged customers by billions of pounds and have failed to invest enough to facilitate the transition to renewable energy.

The proposals tabled so far are very high level, so it is difficult to tell how, or if, they would work in practice (particularly as existing privately owned supply and generating businesses are not mentioned). So far, the main thrust of the arguments against the nationalisation plan have been around the valuation of the companies that would be nationalised and Labour’s plans to pay less than market value to existing shareholders.

National Grid are strongly opposed to nationalisation and have indicated they would take legal action to avoid it. What are the reasons behind their stance? And what legal actions could the National Grid take?

In the immediate aftermath of Labour’s launch of its nationalisation policy, shares in National Grid and SSE (which owns part of the Scottish electricity transmission system) fell sharply in value and National Grid warned that any attempt to pay less than market value for its shares would result in significant legal challenges from investors. National Grid also stated that, in its view, the shift to green energy would be hindered by the plans, and costs to consumers would ultimately increase.

The proposed change in ownership would require primary legislation, which once passed into law is, by definition, legal. Challenges are therefore unlikely against the decision of a sovereign parliament to change the ownership of the networks. Instead, previous owners and investors may to bring challenges against the valuation and compensation that any future Labour government puts in place. Claims may be brought because Labour has stated that the nationalisation of Northern Rock provides a precedent which allows Parliament to set the value of the business, with further deductions to be made for pensions fund deficits, asset stripping since privatisation, state subsidies since privatisation, the state of repair of the assets and stranded assets. Following this precedent could however be challenged on the grounds that Northern Rock was insolvent with a market value no higher than zero at the point when it was taken back into public ownership, whereas, by Labour’s own admission, the network businesses are anything but bust.

There are potentially several ways in which a claim could arise, under bilateral investment treaties, the Energy Charter Treaty or an interference with property claim under the ECHR.

How has the wider energy industry reacted to Labour’s proposal?

The Confederation of British Industry believes that Labour’s renationalisation plans would cause ‘profound harm’—damaging consumers whose pensions are invested in the utility companies, reducing investment and harming the improvements in network resilience that have been delivered since privatisation. The Energy Network Association, which represents the distribution businesses, perhaps unsurprisingly, feels that the proposals will not deliver Labour’s objectives and will be extremely costly to the public at large. Renewable UK described the plans as a ‘costly and complex option, when we also need to speed up the decarbonisation of our economy’. The Britain’s General Union (GMB) Union on the other hand have welcomed Labour’s ‘big and bold’ policy.

What form could the process of renationalisation take?

The proposals are based on a ‘nested system, that combines decentralisation and local participation with central authorities’. Decisions are to be taken ‘as closely as possible to citizens and communities, with central authorities performing tasks not deliverable to more local levels’.

A newly established National Energy Agency (NEA) will provide overall strategic guidance for the energy transition. It is described as being set up on the existing institutional base of the National Grid, as an independent, statutory Non-Departmental Public body, under the sponsorship of the Department for Business, Energy and Industrial Strategy. On day one after renationalisation, the NEA will own Great Britain’s electricity transmission infrastructure, the assets and workforce of the gas transportation companies will gradually transfer to the NEA over time, merging gas and electricity networks. Regional Energy Agencies (REAs) will own the distribution networks, and each will be established on the institutional basis of the current electricity Distribution Network Operators. Municipal Energy Agencies (MEAs) will be established where local authorities wish to ‘accelerate the energy transition locally’. REAs will be required to devolve ownership of distribution networks to MEAs where the relevant local authority can demonstrate the capability to run those networks. The scale of an MEA runs from a rural parish council, right up to a large metropolitan city. Finally, Local Energy Communities (LECs) will be established as vertically integrated bodies that can engage in supply, distribution, and generation of energy at a micro level. Potential issues with EU regulations on unbundling (whereby the owner of a natural monopoly such as a distribution network cannot also own generating or supply businesses) are not addressed. Brexit aside, would an LEC be required to allow a local MEA to use its distribution network, in competition to its own generation or supply activities? This is one of many questions that the renationalisation proposals have yet to expound.

The mechanics of transferring the assets would be undertaken in two stages—first an Act of Parliament would establish the various bodies and transfer the assets, second the former owners would be compensated through a bond issue by HM Treasury. The bond issue is stated to be cost neutral to the public purse as a liability (the bond) is exchanged for a profitable asset (the nationalised companies). Ofgem employees would be transferred to the NEA, the staff of the nationalised companies would transfer to the NEA under Transfer of Undertakings (Protection of Employment) Regulations 2006, SI 2006/246 and the posts of senior executives ‘will be re-advertised on dramatically reduced salaries, capped by Labour’s 20:1 pay ratio policy’. No mention is made of rights of the senior executives under SI 2006/246.

What would happen to the private energy companies?

The companies which currently own the transmission, gas transportation and distribution assets will cease to exist once the Act of Parliament is passed. What is not clear is what would happen to the other companies in the energy sector. There is no talk of dismantling any of the other components of the current arrangements, so it is not immediately obvious what the relationships between the newly created bodies and the generators and suppliers already operating in the market would be. A particularly surprising omission is any discussion of public service obligations—which obligation currently rests with the larger energy suppliers (by virtue of the standard licence conditions), or how security and continuity of supply would be guaranteed. LECs, for example, would need access to the necessary assets and liquidity to be able to guarantee supply where their own generation assets are unavailable, which could have significant cost implications. Who would step in to provide supply if an LEC could not? And how would any entity stepping-in be paid?

It is fair to say that there needs to be a lot more detail on how the proposed arrangements would fit into the current framework. The energy system is complicated and changing one part of it without taking a thorough look at the whole risks causing more problems than it solves.

Interviewed by Aslak Ringhus.

The views expressed by our Legal Analysis interviewees are not necessarily those of the proprietor.

Original news

The Capacity Market has operated efficiently in its first five years, review concludes, LNB News 31/07/2019 98.

The Department for Business, Energy & Industrial Strategy (BEIS) has published a review of the CM’s first five years of operation, 2014–19. The review assesses the scheme to be working well and no major changes have been proposed. However, BEIS intends to continue to make incremental changes to the CM, on the basis of its operation and the responses to BEIS’ call for evidence.

What is the background to this report?

The government issued a call for evidence on the Great Britain Capacity Market and Emissions Performance Standards in August 2018 and published the responses in March 2019. The report also comes at the end of the first year of capacity being delivered under the full CM mechanism. There have been a number of recent changes to the CM framework, both to refine and develop the CM and to manage the ongoing standstill of the market following the annulment of its state aid clearance in November 2018.

Given the complexity of the CM framework, it is not surprising that the background and context of the report isn’t straightforward. At its core, the report on the five-year review has been published by the government with four aims in mind. These include:

• satisfying the government’s obligations under the Capacity Market Rules and SI 2014/2043
• forming the basis of a wider report that the government is obliged to lay before Parliament under the Energy Act 2013 (EA 2013), and
• satisfying the terms of the original state aid clearance of the CM, even though that clearance has now been annulled

EA 2013, SI 2014/2043, and the Capacity Market Rules are broadly aligned in requiring the government to assess whether the objectives of the relevant aspects of the CM are being achieved, whether those objectives are still appropriate and, if so, whether they could be achieved with less regulation or in a less burdensome way. It is therefore understandable that the government has sought to achieve this via a single review.

The government has also dealt with the questions of whether the CM is still required—it quickly concluded yes – and the next steps needed to develop and assess the CM over the coming years.

What are the key findings to come out of the report?

The report concludes that the CM is meeting its central objectives and says the mechanism in its current form is necessary for maintaining security of electricity supply in a cost-effective way. The government continues to believe that the security of the country’s electricity supply would be unacceptably uncertain in the coming years without the financial support provided via the CM.

This is particularly so, given the closure of old coal and nuclear generation during the 2020s. The report also re-emphasises that the government remains wedded to the CM as the appropriate mechanism for providing the market with this ‘missing money’. It discounts a move away from a CM to, for example, the strategic reserve approach seen elsewhere. The report also resists adding other core objectives to the CM, noting that issues such as decarbonisation of electricity generation should be achieved and protected through external regulations or policy.

The report does, however, conclude that the government will evaluate a number of potential changes to the CM, so it can meet its objectives more effectively. These act as a useful pathfinder for the likely future direction of the CM.

What do you expect to see coming up for consultation in the future?

The report notes that a level playing field between technologies, so that their contribution to security of supply is fairly taken into account, is important. In light of this, the report suggests that the government will review a number of changes across the themes of security of supply, cost-effectiveness, and the avoidance of unintended consequences.

These include consulting on the general simplification of de-rating—the level of reliability the mechanism attributes to each technology type—in late 2019. To date, the approach has evolved in a piecemeal fashion across different technologies. There is also the potential removal of the 2 megawatt (MW) minimum capacity threshold to reflect the trend for smaller generation and demand side response (DSR) and the move towards electricity trading in smaller MW increments.

The government will also consider whether to build on the work already done to allow more renewable technologies to participate in the CM. This could be done by providing a de-rating factor and a more sophisticated approach to connection capacity that allows for renewable ‘hybrid’ projects—where renewable generation is coupled with other technologies, most notably storage—to participate in the CM as one project.

There will also be a further examination of the potential for ‘battery augmentation’—enhancements made to battery storage projects during the course of their lifetime—to be acknowledged or provided for within the CM mechanism.

Perhaps most significantly in this levelling of the playing field section of the report, the government notes areas of specific interest around DSR, such as the one-year limit for capacity agreements. While it is minded to maintain the limit, it acknowledges some in the industry have argued for change and it promises to engage with them over the agreement lengths.

On interconnection, the report notes the upcoming and important move to allow foreign plants to participate directly in the CM as required by virtue of Regulation (EU) 2019/943, the Recast Electricity Regulation. At present, foreign capacity can only be caught via the participation of electricity interconnectors.

While the report does not highlight this, it is worth noting that the relevant provision of the Recast Electricity Regulation applies from 1 January 2020. Therefore, in the event of a no-deal Brexit before this date, the European Union (Withdrawal) Act 2018 means this requirement would not become retained EU law in the UK and so the obligation to implement it may not arise. However, clearly this is both subject to the timing of Brexit and to any agreements reached between the UK and the EU in respect of the EU internal energy market more generally.

In addition, the report discusses the need to ensure the CM supports the necessary investment in reliable capacity. One of the striking features of the CM to date has been the relatively small volumes of new build/refurbishing generation that has won support, as a result of the low clearing prices.

While the report commits to reviewing the potential for ‘split auctions’—whereby new build capacity participates in a different auction to existing capacity—it appears to suggest the government is at present comfortable with a single auction and with maintaining capacity agreements at the same length. Though not directly linked to the CM—which is a mechanism for the procurement of capacity rather than system services—the recent power cut may, among a number of questions, heighten focus on the types of technology on our system and, in particular, their ability to respond quickly to stabilise the frequency on the system. It will be interesting to see whether this has any impact on the relatively technology agnostic approach of the CM.

However, with a view to ensuring reliable delivery of capacity, the report suggests termination fees will be simplified, with the potential for partial termination introduced, while penalties for non-delivery of capacity during times of system stress will be strengthened.

When it comes to cost-effectiveness, the report suggests the government will be mindful of avoiding over-procurement, given the impact this can have on costs to the consumer and will reassess the way in which the volume of capacity to be procured is calculated.

In the section on avoiding unintended consequences, the report reiterates that, while the primary role of the CM is not to drive decarbonisation, it should be consistent with decarbonisation policies and not prejudice them. Examples are given of moves already made to avoid such inconsistences/unintended consequences, such as the recent introduction of a carbon emissions limit for new plant pursuant to the Recast Electricity Regulation, with a consultation on carbon emissions limits for existing and refurbishing plant launched in tandem with the report. Going forward, the report notes that at present government is particularly mindful that:

• small capacity is not exposed to EU-ETS carbon costs
• the Carbon Capture and Readiness (CCR) requirement (under the Carbon Capture Readiness (Electricity Generating Stations) Regulations 2013, SI 2013/2696) only applies to large plant, and
• behind the meter generation acting as DSR may not be subject to emissions controls. Therefore, the industry can expect to see action on this, if distortions to the CM are precipitated

Is five years the right time scale to judge how the market is developing?

Clearly, five years is a relatively lengthy period, particularly given the speed of evolution of the electricity market. However, given the need to build investor confidence in any mechanism like the CM, as a general rule stability rather than constant wholesale review is to be encouraged. There is also the need for a balance between ongoing reassessment on the one hand and having a sufficient body of data for such reassessment to be meaningful on the other hand. In terms of capacity delivery, the CM has only just got going—and indeed this has been put on hold as a result of the State aid standstill—therefore a review any earlier may well have been premature. It is also worth noting that the five yearly review process does not prevent, and markedly has not prevented, earlier changes being made to the CM mechanism by government and Ofgem when deemed appropriate.

Were there any surprises arising out of the report?

As noted above, the report is primarily a review of the CM to date and a pathfinder for possible future changes, rather than purporting to decide or implement changes. In this context, the report provides a reasonably comprehensive review of the key issues and features noted in respect of the CM to date.

The role and success of different technology classes in the CM has prompted debate for some time—among others the low clearing prices leading to little new build/refurbished capacity being supported, the place of DSR, and the position of interconnection. All of these areas are considered in some detail, but, for the relevant parts of industry there may be disappointment that more fundamental changes have not been signalled.

Relatively few pages are explicitly dedicated to the ongoing standstill of the CM following its state aid clearance being annulled. However, for the industry, this standstill remains a primary issue, with progress on new state aid clearance being achieved a key area of concern and interest.

What, if any, changes to the CM are to be made following the report?

While the report does not implement changes, it does signal possible changes across a wide range of areas. These include a consultation on emissions limits for existing and refurbishing capacity and a consultation before the end of the year on issues such as strengthening the penalty regime.

Interviewed by Grania Langdon-Down.

The views expressed by our Legal Analysis interviewees are not necessarily those of the proprietor.

Original news

Water industry must ‘up its game’ against climate change, politics and pollution, LNB News 14/05/2019 81

Sir James Bevan, Chief Executive of the Environment Agency, has named politics, operations and climate change as the ‘three big challenges’ for the future for water. Speaking at the Water Industry Forum, Bevan said that ‘we have to crack all three if the sector, and the country, is to thrive’. He urges companies to first and foremost address pollution, water leaks, drought and long-term approaches to climate change as a good place to start.

What are the key arguments for and against nationalising the water industry?

The most frequent arguments heard in favour of nationalisation are performance and payment-based. Namely some people hold the view that excessive returns have been made in the water sector, but that necessary investment has not been made sufficient to curb service failure and leakage.

It’s worth exploring each of those in turn.

In terms of payment, the amount water companies are allowed to charge is determined by the water regulator, Ofwat. Regulatory settlements determine what water companies will deliver for customers and what charges can be made. Water companies take performance and financing risk. The settlement regime works both ways—companies can achieve benefits if their costs are lower than the charges determined by Ofwat but can lose out if their costs exceed amounts set by Ofwat.

There are competing claims as to whether bills would be cheaper under a privatised or nationalised model. A figure often stated is that household water bills have risen by 40% since 1989. This rise is correct as expressed in real terms between 1989 and 2014/15. However, stating this position alone is slightly simplistic. A National Audit Office report from 2015 shows that the majority of this rise happened between 1990 and 1995 when privatised water was in its infancy. Bills fell in real terms between 2009/10 and 2014/15 and at the 2014 price review Ofwat determined that average bills should fall by 5% in real terms between 2014-15 and 2019-20. The counterfactual of what bills would be in a nationalised water scenario is difficult to establish.

In terms of performance, it is frequently stated that private water companies underperform. Underperformance can come in many forms—including loss of pressure, interruptions in supply, or leakage:

• loss of pressure—the NAO reported that the proportion of properties at risk of low pressure fell from 1.33% between 1990 and 1995, to 0.01% in 2009-10
• water supply—Water UK reported in 2018 that customers are now five times less likely to have interrupted water supplies since privatisation
• leakage—leakage figures for 2017–18 showed that, on average, 9.3 cubic metres of water were leaked per kilometre of water pipe per day. This seems high but in reality the picture is somewhat complex. In August 2018, BBC Reality Check reported that leakages in England and Wales fell 38%—so more than a third—from their peak (it was reported to be about 5 billion litres per day in the early 1990s)

This is not to say that performance is perfect. There are obviously some instances where underperformance has arisen and been widely reported in respect of privatised water companies—most recently Southern Water was fined £126m following failures in the operation of its sewage treatment sites and for misreporting its performance. Ofwat’s investigation and the scale of the fine demonstrates that the role of the regulator is performing as it is supposed to.

In the recent price review, where Ofwat set prices and targets for the next five years through to 2025, Ofwat set significant targets for leakage, pollution and a requirement for a 12% reduction in average household bills before inflation. Targets for leakage and pollution will become more prevalent in future years reflecting the priority of the climate change agenda. It is difficult to know exactly how a nationalised water industry would compare.

WaterUK’s recent survey revealed a big drop in support for nationalisation in consumers. How have water companies managed to create such trust from their customers? Please include specific events and instances where necessary.

It is difficult to say what shapes public opinion in respect of matters such as those in the survey. However, I have worked with a number of water companies over the years and each of them place a premium on communication with their customers.

What has been the impact of Labour’s leaked briefing paper (in which it proposes to buy back the water industry from private companies for £20bn) on the water industry?

It is difficult to say what the impact of any leaked document is. However, it is less difficult to consider some of the challenges if nationalisation of the water industry were to take place.

One challenge is the means by which nationalisation would be undertaken. I would expect an Act of Parliament to be passed that would pass equity and (in some cases) debt of the relevant companies to publicly owned entities. This approach has been used before. Such legislation would also set out relevant transition arrangements as well as the powers and scope of the new entities that would run our water networks. However, another approach may be an asset transfer or a part nationalisation where the government may purchase part of the relevant company. Some participants in the water industry have complex structures and so any approach that involved the transfer of equity and/or debt would need to consider the scope of what was being nationalised.

There is a huge challenge regarding the amount of compensation that should be paid for any company to be nationalised. I would expect this to be determined by Parliament, but figures reported in the press range from £86bn to as low as £15bn. There are a number of options as to how a government may go about valuing a water company—this could be done on the basis of the companies’ regulated asset bases (RAB)—this is a maintained notional regulatory value of the relevant company based on value of past investment and values determined as at privatisation. However, water companies currently trade and are sold on the basis of a mark-up against RAB.

Whatever approach is taken in respect of nationalisation, it is likely to be controversial and is likely to attract challenge. There are a number of options for challenging nationalisation, including:

• Article 1 Protocol 1 of the European Convention on Human Rights (ECHR)—as enacted under the Human Rights Act 1998—generally allows people to peaceful enjoyment of their property. While it does allow people to be deprived of property, such deprivation is subject to restricted conditions. The ECHR may enable a challenge where owners consider they have been deprived of their assets at an undervalue. Such a claim was unsuccessfully used by shareholders in respect of R (on the applications of SRM Global Master Fund LP and others) v Commissioners of Her Majesty’s Treasury, [2009] EWHC 227 (Admin), [2009] All ER (D) 139 (Feb) where the court noted a margin of appreciation given to the legislature in this regard. While nationalising a business in failure is not the same as nationalising a healthy water company, it is an illuminating case
• claims of public misfeasance may also be considered. Misfeasance in public office is an action against a holder of public office. It is available where a public officer exercises their powers in bad faith. The bar for using this action is exceptionally high and while shareholders of Railtrack sought to use this action in respect of the nationalisation of Railtrack (in Winsor v Special Railway Administrators of Railtrack Plc, [2002] EWCA Civ 955, [2002] All ER (D) 152 (Jul)) that was very case specific—it is unlikely to be the optimal means of challenge
• challenges may also be brought by investors based in overseas jurisdictions who may have rights under various bilateral investment treaties and free trade agreements with the UK. Many such treaties contain obligations regarding compensation upon expropriation

Why is the industry discussing it now?

The discussion regarding nationalisation stems from the political agenda and this seems to be the main cause for the discussion.

However, one interesting feature of the discussion to date is that—while the established regulatory system in the water industry is the subject of discussion for reform—it is being considered as a potential exemplar and a successor to Public Private Partnership or Public Finance Initiative 2 (PF2) contracts in the wider governmental sphere. As part of the on-going Infrastructure Finance Review consultation—the Infrastructure and Projects Authority is currently considering a number of options to replace PF2 and one such option being discussed is the use of a model akin to that used in regulated water and regulated electricity—namely an approach designed on the basis of a RAB. The UK government has also begun a consultation exploring use of this approach in respect of the nuclear industry.

A further interesting aspect of the discussion is that Ofwat (and indeed Ofgem in respect of electricity transmission) are increasingly trying to establish competition within areas that are historically regulated monopolies. Nowhere is this more apparent than in respect of Ofwat’s new flagship approach of direct procurement for customers. Under this policy, water companies will be required to procure a competitively appointed provider to design, build, operate and maintain major infrastructure assets. The competitively appointed entity will also be responsible for financing the project—as opposed to such financing being undertaken by the water company and returns being set by Ofwat. To date much of the discussion on nationalisation has been focussed on the water companies themselves but nationalisation may also present challenges for policies such as direct procurement.

How likely is renationalisation of the water industry? Why/why not?

This depends on a number of political realities. However, it seems likely that should a Labour government be appointed they would implement the policies which they have proposed. This includes nationalisation of the water industry.

Interviewed by Samantha Gilbert.

The views expressed by our Legal Analysis interviewees are not necessarily those of the proprietor.