Public energy company: outline business case

6 Financial Case

6.1 Introduction

This Financial Case examines the benefits and costs of the shortlisted preferred solution. The basis for calculating these benefits is a series of metrics, which result from the commercial structure of the Project and how it is funded. These include the Internal Rate of Return, Net Present Value and overall benefit of the Project.

Initially this section details the approaches and assumptions implemented in respect of the Financial Model, to enable an understanding and comparison between the two alternative sets of assumptions applied (the 'Acquisition' model and the 'Retention' model – discussed in more detail below), with optimistic and pessimistic criteria applied to these assumptions in order to assess the resilience of the Project. We have also prepared a 'Counterfactual' model, which assesses the cost to customers of the Public Energy Company against a 'business as usual' position to assess if the Public Energy Company can present an attractive proposition to attract consumers.

For the avoidance of doubt, we present two key options throughout this section, the Acquisition Model and the Retention Model for the White Label Supply option. Each of these two core scenarios has the same underpinning of assumptions, with the following exception:

Table 40 - Core scenarios

Retention Model

The Retention Model assumes that, once a customer has switched to the Public Energy Company, that the White Label Supplier the Public Energy Company is partnered with pays a monthly retention fee for each month that the customer remains with the Public Energy Company. This is assumed to be £1 / meter / month (so the supply company pays the energy company £2 a month for a customer on a dual fuel tariff).

Acquisition Model

The Acquisition Model, in contrast, assumes a £25 upfront payment by the energy supplier to the Public Energy Company for each new customer that switches to the company. There are no follow-on payments from the energy supplier to the Public Energy Company – this approach therefore improves the upfront cash position, but requires the consistent identification of new customers for the network.

This section is structured under the following headings:

• Programme
• Approach to calculating the Financial Outputs
• Modelled scenarios
• Tax assumptions (excluding VAT)
• VAT assumptions
• Indexation applied
• Capital Costs
• Counterfactual – this set out the financial benefit of doing the Project as compared to business as usual, or the 'do nothing' scenario.
• State Aid considerations
• Optimism Bias
• Accounting Treatment of the Public Energy Company
• Confirmation of the preferred option

Information on and the assumptions behind operating costs, revenues and the funding structure of the Public Energy Company can be found at Appendix E.

6.2 Programme

The table below describes the timeframe applicable to the creation and set-up of the Public Energy Company. It should be noted that these timescales are estimates, but are considered to be appropriate and deliverable within the constraint of the targeted Public Energy Company operational date. The timings should be viewed as flexible to reflect future developments and information. The timelines will need to be updated accordingly as the timelines for procurement and a date for the operation start of the Project becomes clearer. Given the relatively simple nature of the Public Energy Company, there is also a potential for the timeline to be brought forwards to bring the Project to an operational state more quickly.

Additionally, there is an acknowledgement that the Project is unlikely to be in a position to move straight into the commercialisation and procurement phase from the completion of the OBC. The OBC is expected to go to an iterative stage while the agreed form of involvement from Local Authorities is refined. This is an essential stage as Local Authority involvement is considered to be crucial to the next stage of the Project.

The cash flows for the Public Energy Company have been considered over a period of 10 years from the point of operation. The Financial Model has the capability to assess the Project over a shorter or longer timeframe, if required.

Table 41 - Project timetable

Preparation/Procurement	Operation
Start Date	Start Date
September 2019 – March 2021	Financial year commencing April 2021

Once the Public Energy Company is operational, we have modelled the income and expenditure of the company over an initial 10-year period, with a predicted annual customer growth informing the level of income and costs of the Public Energy Company. Under the core scenarios, the customer projections are as follows. Also assumed within the customer numbers is an annual 10% customer 'churn' (none in year 1), so that not only are new additions to the network accounted for, but assumptions are also made for those customers switching to another supplier. The customer numbers have been based on advisors' knowledge of the market and proven trends (discussed in more detail at Appendix E). The impact on the customer numbers is demonstrated in the table below.

Table 42 - Customer numbers

Year	Opening customer numbers	New customers in year	Assumed customer churn	Closing customer numbers
2021 / 22	-	50,000	-	50,000
2022 / 23	50,000	40,000	(6,879)	83,121
2023 / 24	83,121	40,000	(10,047)	113,074
2024 / 25	113,074	45,000	(13,168)	144,906
2025 / 26	144,906	45,000	(16,209)	173,697
2026 / 27	173,697	45,000	(18,960)	199,737
2027 / 28	199,737	45,000	(21,448)	223,289
2028 / 29	223,289	50,000	(23,957)	249,332
2029 / 30	249,332	50,000	(26,445)	272,887
2030 / 31	272,887	50,000	(28,695)	294,192

Note: As both customer additions and customer churn is calculated on a monthly basis, customer losses vary from month to month (although as customer numbers are projected to increase, so too does the number of customers departing the Public Energy Company).

6.3 Approach to calculating financial outputs

The Financial Model was developed to project the Cash Flows (including developing an income statement and balance sheet), using various financing and financial assumptions.

The outputs of the cost model are the calculation of the annual operational income and expenditure flows. The various outflows include:

• Customer projections
• Revenue streams
• Public Energy company set-up costs
• Ongoing operational costs
• Customer acquisition costs

The purpose of the Financial Model is to give an indication of the financial viability of the Project using a set of assumptions about the revenues and costs of the Project, including the impact of applying a commercial structure that includes (where appropriate) tax and financing costs. Sensitivity analysis has also been undertaken on both the Retention and the Acquisition Models to explore the effects of changes to key assumptions within the Financial Model. The model produces a pre-tax Project IRR (i.e. excluding the impact of tax and financing assumptions). In addition, it calculated a Projected Investor IRR, based on the assumed levels of equity and debt invested into the Public Energy Company. While it is appreciated that the Public Energy Company is not being developed for the purposes for being a profit generating entity (as surplus cash flows are intended to be used to address fuel poverty concerns in Scotland), it provides a good indication of the performance and profitability (and therefore resource generating capability) of the Public Energy Company. The Investor IRR assesses the value of the returns of the Project, taking in to account all tax implications, debt and / or equity paid in to the Public Energy Company by an Investor, interest received on any debt, and dividends received (which it is assumed would be used to fund fuel poverty targeting activities).

The Financial Modelling assesses the investments needed and the potential returns for each of those investors, having incorporated the tax and any debt financing costs assumed for the relevant scenario. The development of the Cost Model into a Financial Model has:

• Enabled the identification of the optimum Public Energy Company set-up and subsequently stress-tested the key variables.
• Allowed for the review of alternative funding mechanisms for the Public Energy Company prior to finalizing this through Commercialisation.

6.4 Modelled scenarios

As noted above, the Financial Model has been used to calculate the core Retention and Acquisition Models. A number of sensitivities have also been modelled to assess the impact upon these scenarios. These are detailed in the table below.

Table 43 - Project sensitivities

Scenario	Description	Details Acquisition Model
1 / 2	Core Scenarios	As noted in the Introduction, two 'Core' scenarios have been prepared – the Retention Model and the Acquisition Model The Retention Model assumes a monthly payment from the White Label energy supplier for each customer served by the Public Energy Company. The key assumptions supporting this scenario are documented throughout this Financial Case. The Acquisition Model assumes a one-off payment from the White Label energy supplier for each customer that switches to the Public Energy Company. The key assumptions supporting this scenario are documented throughout this Financial Case.
Scenario variations
3	Blended	Under this scenario, a blending of the retention and acquisition model is presented, with income received from the energy supplier for each new customer meter joining the company received both an upfront one-off payment of £12.50 (in the same manner as the acquisition model), but also an ongoing retention payment of £0.50 per month (in the manner of the retention model)
4 / 5	Optimistic	The optimistic scenario uses a similar set off assumptions to the Core scenario, however assumptions regarding revenue levels and customer take-up are improved, and projections of cost are reduced, in order to show how the Public Energy Company could develop under favourable circumstances
6 / 7	Pessimistic	The pessimistic scenario uses a similar set off assumptions to the Core scenario, however assumptions regarding revenue levels and customer take-up are reduced, and projections of cost are increased, in order to give an indication of how the Public Energy Company may perform if projections are not as positive as those anticipated under the Core scenario.
Funding sensitivities
8 / 9	Equity funding	The Core Scenarios assume that the working capital required to fund the development of the Project is made in the form of a revolving loan facility. Under these scenarios this is replaced with a contribution in the form of equity, repaid to the Investor at the end of the Project.
10 / 11	Grant for set-up costs	The Core Scenario assume that the working capital required to fund the development of the Project is made in the form of a 10-year annuity loan facility. Under these scenarios this remains true, however the set-up costs of c.£250k of establishing the company are provided in the form of a grant to the Public Energy Company to reduce the need for debt funding.
12 / 13	Increased interest charge	The Core Scenarios apply an interest rate to debt provided from investors at a rate of 5.09% (refer to Section 6.14 for details). Under these scenarios an interest rate of 11.09% is charged, should the Public Energy Company be identified as a 'high-risk' investment. Again, Section 6.14 explains the reasoning for this.
Pricing sensitivity
14 / 15 / 16 / 17	Revenues + / -	Under these scenarios, the revenue assumptions used in Optimistic and Pessimistic scenarios replace those used in the Core assumptions, to assess the impact of improved/worsened revenue negotiations, without the other variations seen in the Optimistic/Pessimistic Cases
18 / 19 / 20 / 21	Costs + / -	Under these scenarios, the cost assumptions used in Optimistic and Pessimistic scenarios replace those used in the Core assumptions, to assess the impact of improved/worsened costs occurred, without the other variations seen in the Optimistic/Pessimistic Cases

The scenarios modelled are driven to an extent by the number of customers signed up to the network, as this drives both the revenues received, and influences the costs of the Public Energy Company, through the acquisition costs incurred in gaining new customers.

The projected customer sign-ups under the Core, Optimistic and Pessimistic scenarios is presented in the table below.

Table 44 - Projected customer assumptions

Year	Core scenario – new sign ups	Optimistic scenario – new sign ups	Pessimistic scenario – new sign ups
2021 / 22	50,000	65,000	40,000
2022 / 23	40,000	50,000	30,000
2023 / 24	40,000	50,000	30,000
2024 / 25	45,000	55,000	35,000
2025 / 26	45,000	55,000	35,000
2026 / 27	45,000	55,000	35,000
2027 / 28	45,000	55,000	35,000
2028 / 29	50,000	60,000	40,000
2029 / 30	50,000	60,000	40,000
2030 / 31	50,000	60,000	40,000
Annual customer drop-off (y2 onwards)	10%	8%	15%

6.5 Taxation

Corporation tax

Included within the Financial Modelling performed are various high-level tax assumptions, in order to provide an indication of the likely taxation costs incurred by the Project entity in operation. It should be noted that the intention is for the Public Energy Company to be a not-for-profit entity, that will also explore the possibility for establishing as a charitable entity in order to obviate the need to pay corporation tax. However, for completeness and as this cannot be confirmed at this time, we have assumed that the Public Energy Company is exposed to corporation tax at 17%.

As the Project progresses into the commercialisation phase, further specialist taxation advice will be required, to ensure key areas around taxation are addressed appropriately.

Value Added Tax (VAT)

VAT is assumed in the Financial Modelling at the standard rate of 20%.

Whilst the supply of fuel and power for domestic use is subject to VAT at the reduced rate, this is where the supply is being made to the end consumer. In the structure being appraised this supply is being made by the White Label Supplier. The White Label Supplier holds the contracts with the end consumers and invoices these people directly. As such, it will be for the White Label Supplier to confirm the VAT liability of its various supplies.

The supplies being made by the Public Energy Company are those of an intermediary or agent, and the "customer" of the PEC is the WLS. The PEC will receive payment from White Label Supplier for administering and marketing the scheme and manage the ongoing arrangement. The activities of the PEC should therefore all be subject to VAT at the standard rate. This is turn should allow the PEC to recover VAT in full on the costs it incurs.

Costs of the Public Energy Company are therefore modelled at the standard rate of 20%, with the exception of staff costs and their associated overheads, which are assumed not to attract VAT. No assumptions around changes of VAT rates in future have been included. The Financial Model has been prepared on an annual basis. Therefore, with respect to timings and receipts of payments of cash to or from HMRC, these have been assumed to occur on a quarterly basis throughout the financial year, in April, July, October and January in each year. For the Commercialisation stage of the Project, it is recommended that the VAT assumptions are revisited and the Financial Model be developed further as required to project VAT cash flow timings in accordance with expectations.

From the perspective of consumers who purchase energy from the White Label energy supplier, under the guise of the Public Energy Company, they will incur VAT at the reduced rate of 5% for home energy.

For the avoidance of doubt, the assumption has been made that the set-up costs of the Public Energy Company have been incurred within the commercial vehicle – and that costs incurred before the Public Energy Company is operational are exposed to VAT as described above and recoverable accordingly. This too should be revisited as an assumption as the Project develops.

6.6 Indexation

The application of a commercial structure to the Financial Modelling includes assumptions around Real increases and general inflation. Also included are the financing costs of the Public Energy Company.

The Financial Model uses a price base date of 1 April 2019.

Table 45 - Indexation assumptions

Index	Assumed to be	Applied to
RPIx	Based on Office for Budget Responsibilities Projections to 31 March 2024, then 2.5% after this date	All items not specified below
BEIS Electricity trend (residential)	Based on UK Government Energy & Emissions Projections – Reference Scenario + RPIx	Revenues received in relation to electricity customers
BEIS Natural gas trend	Based on UK Government Energy & Emissions Projections – Reference Scenario + RPIx	Revenues received in relation to gas customers

6.7 Discounting

In line with HMT Green Book, the Net Present Value calculation uses discounting at a rate of 3.5% on real (unindexed) values to represent social time preference for years to 1 to 30, and 3% thereafter. The discount rate is multiplied by the RPI applied in a given year in order to calculate the discount rate to be applied to the nominal values.

The discount rates are applied to calculate the Net Present Value to consider the prospective value of a Project over its life. The Financial Model has been prepared for a ten-year operations period.

6.8 Capital costs

As noted throughout the Economic Case and the Commercial Case, the Company structure for the Public Energy Company is very 'thin'. Acting as it does, effectively as an entity engaged in focused marketing activity, with a limited level of administrative activity, it is not anticipated that there are any capital costs required for the company. No assumptions have been made for any capital costs in the Public Energy Company.

6.9 Financial results

The tables in this section describe various financial metrics of the Retention and Acquisition Core scenarios, the pessimistic and optimistic scenarios, and sensitivities tested:

• Project IRR (pre-tax) – This is the returns of the Project before the impact of Corporation Tax and debt servicing costs
• Investor IRR – This is the returns of the Project for Scottish Government based on the funding solution adopted
• Scottish Government NPV – This is the Net Present Value of the Project to Scottish Government based on the funding solution adopted
• Scottish Government Payback Period – this is the period of time required to reach a break-even point, based on the funding solution adopted

Values reported have been calculated over a 10-year operational period and use a Real discount rate of 3.5%, multiplied by the RPIx value.

It is acknowledged that Scottish Government is not developing the Public Energy Company for the purpose of 'generating returns' – however the returns provided from the Public Energy Company can be used for the purposes of funding projects aimed at reducing fuel poverty. As such a more positive IRR position provides an indication of greater surpluses that could be utilised to fund fuel poverty reduction programmes.

6.10 Core Scenarios

The table below shows the results of the Retention and Acquisition Models.

Table 46 – Returns of the Core scenarios

Scenario	Project IRR (pre-tax) %	Investor IRR %	Investor NPV £000s	Investor payback period (years) (nominal)	Initial Investment required £000s	Dividends paid by Public Energy Company £000s
Scenario 1 – Retention Model Core scenario	61.2%	34.5%	12,086	6	2,914	22,540
Scenario 2 – Acquisition Model Core scenario	141.8%	62.7%	3,251	3	297	5,597

It should be noted that the IRR figures for Investors include the impact of the return on money lent to the Public Energy Company at a State aid compliant rate (assumed to be 5.09%), with the remainder being a reflection of the dividends the Public Energy Company is able to pay which, it is assumed, would be used to address fuel poverty issues in Scotland. The right-hand column in the table above shows the dividends forecast to be paid under each scenario over the ten-year operating period.

This table shows the positive returns of the Core scenarios, with payback periods under the two approaches of 6 years for the Retention Model and 3 years for Acquisition Model. The length of time required for the payback period reflects the up-front investment required to ensure the Public Energy Company has sufficient resources to operate without requiring a further working capital loan. The Scottish Government in these scenarios is 'remunerated' in two ways – being through the payment of interest on debt lent to the Public Energy Company and through the receipt of dividends. These dividends could be utilised for pursuing fuel poverty addressing initiatives by Scottish Government. The figures below demonstrate the cashflow and returns profiles of the Public Energy Company under the two Core Scenarios.

Table 47 - Income & Expenditure summary - Retention Model

Year	20-21	21/22	22/23	23/24	24/25	25/26	26/27	27/28	28/29	29/30	30/31
	£000	£000	£000	£000	£000	£000	£000	£000	£000	£000	£000
Revenues	-	633	1,551	2,328	3,147	4,519	5,512	5,726	7,070	8,161	8,594
Opex	(261)	(2,072)	(1,668)	(1,664)	(1,821)	(1,820)	(1,821)	(1,830)	(2,020)	(2,026)	(2,041)
EBIT	(261)	(1,439)	(117)	664	1,326	2,699	3,691	3,896	5,051	6,135	6,553
Net financing costs	(131)	(124)	(117)	(105)	(88)	(66)	(48)	(33)	(15)	(3)	13
Net tax charge	71	281	42	(101)	(223)	(474)	(656)	(695)	(906)	(1,105)	(1,182)
Net Income	(322)	(1,282)	(192)	458	1,015	2,160	2,987	3,168	4,129	5,033	5,385

Table 48 - Income & Expenditure summary – Acquisition Model

Year	20-21	21/22	22/23	23/24	24/25	25/26	26/27	27/28	28/29	29/30	30/31
	£000	£000	£000	£000	£000	£000	£000	£000	£000	£000	£000
Revenues	-	2,434	1,895	1,948	2,260	2,636	2,748	2,524	3,100	3,241	3,146
Opex	(261)	(2,072)	(1,668)	(1,664)	(1,821)	(1,820)	(1,821)	(1,830)	(2,020)	(2,026)	(2,041)
EBIT	(261)	362	227	284	438	816	927	694	1,080	1,215	1,105
Net financing costs	(14)	(13)	(10)	(9)	(8)	(5)	(4)	(3)	(0)	2	2
Net tax charge	49	(63)	(39)	(49)	(78)	(146)	(166)	(124)	(194)	(219)	(199)
Net Income	(225)	287	177	225	353	665	757	567	885	998	908

Table 49 – Funding position for investor - Retention Model

Year	20-21	21/22	22/23	23/24	24/25	25/26	26/27	27/28	28/29	29/30	30/31
	£000	£000	£000	£000	£000	£000	£000	£000	£000	£000	£000
Loan drawdown	(2,913)	-	-	-	-	-	-	-	-	-	-
Interest received	143	131	118	105	91	77	61	45	28	10	-
Loan repayment	229	241	254	267	281	296	311	327	344	362	-
Dividends	-	-	-	-	-	1,838	2,987	3,168	4,129	4,033	5,385
Annual position	(2,541)	372	372	372	372	2,210	3,359	3,540	4.501	4,405	5,385
Cumulative position	(2,541)	(2,169)	(1,797)	(1,425)	(1,053)	1,157	4,516	8,056	12,557	16,962	22,347

Table 50 – Funding position for investor - Acquisition Model

Year	20-21	21/22	22/23	23/24	24/25	25/26	26/27	27/28	28/29	29/30	30/31
	£000	£000	£000	£000	£000	£000	£000	£000	£000	£000	£000
Loan drawdown	(297)	-	-	-	-	-	-	-	-	-	-
Interest received	15	13	12	11	9	8	6	5	3	1	-
Loan repayment	23	25	26	27	29	30	32	33	35	37	-
Dividends	-	61	177	225	353	665	757	567	885	998	908
Annual position	(259)	99	215	263	391	703	795	605	923	1,036	908
Cumulative position	(259)	(160)	55	318	709	1,412	2,207	2,812	3,735	4,771	5,679

From these, it can be seen that the Public Energy Company is capable of generating an annual surplus of cash flows while still meeting its debt obligations – particularly in the instance of the Retention Model which is positioned to generate significant dividends.

Net cash position

An important consideration for Scottish Government is to understand the net cash requirements placed on it in order to invest in the Public Energy Company. The figures below reflect the net cash position from the perspective of Scottish Government; this includes all cash demands placed on Scottish Government and all receipts from the Public Energy Company. It is shown on a cumulative basis.

These figures show that the breakeven point for the Public Energy Company is around the year ending 31 March 2026 under the Retention Model and 31 March 2023 under the Acquisition Model. After this date, based on the assumptions used in the Core scenarios, the Public Energy Company is generating sufficient revenues in comparison to its costs to operate on a self-sufficient basis. However, it should be noted that there is a potential 'shelf life' for an Acquisition Model – as if company ceases to attract new customers, the Public Energy Company will no longer be viable.

6.11 Alternative scenarios and sensitivities

The alternative scenarios and sensitivities are displayed below. These reflect the optimistic and pessimistic scenarios, alternative funding structures, and sensitivities performed on revenues and costs of the Public Energy Company.

Table 51 - Results of alternative scenarios and sensitivities

Scenario	Project IRR (Pre-tax) %	Investor IRR %	Investor NPV £000s	Investor payback period (years) (nominal)	Investor funding provided £000s	Interest paid on debt £000s	Dividends received £000s
Scenario 3 – Blended Model	71.9%	41.4%	7,727	6	1,205	338	14,152
Scenario 4 – Retention Model – Optimistic Case	117.5%	60.4%	23,000	4	1,489	418	41,115
Scenario 5 – Acquisition Model – Optimistic Case	1062.9%	220.2%	10,359	2	210	59	16,573
Scenario 6 – Retention Model – Pessimistic Case	25.0%	12.1%	2,249	8	6,980	1,962	5,435
Scenario 7 – Acquisition Model – Pessimistic Case	0.0%	5.2%	(364)	8	5,202	1,447	-
Scenario 8 – Retention Model – Equity funding	61.2%	35.5%	11,890	6	1,852	-	23,231
Scenario 9 – Acquisition Model – Equity funding	141.7%	61.0%	3,206	3	260	-	5,670
Scenario 10 – Retention Model – Grant funding for set-up costs	61.2%	36.9%	12,313	6	2,475	695	22,841
Scenario 11 – Acquisition Model – Grant funding for set-up costs	141.8%	684.1%	3,497	2	6	1	5,869
Scenario 12 – Retention Model – increased interest charge	61.2%	32.9%	12,169	6	3,647	2,437	21,213
Scenario 13 – Acquisition Model – increased interest charge	141.7%	62.1%	3,260	3	308	205	5,498
Scenario 12 – Retention Model – Revenues + 10%	69.7%	39.1%	14,383	6	2,551	717	26,496
Scenario 13 – Acquisition Model – Revenues +10%	320.6%	105.0%	5,943	2	295	83	9,859
Scenario 14 – Retention Model – Revenues -10%	44.0%	23.9%	7,416	7	4,136	1,162	14,498
Scenario 15 – Acquisition Model – Revenues -10%	28.3%	10.7%	386	8	1,748	491	1,014
Scenario 16 – Retention Model – Costs +10%	45.6%	25.7%	8,633	7	4,148	1,166	16,618
Scenario 17 – Acquisition Model – Costs +10%	44.0%	24.1%	1,389	7	798	224	2,674
Scenario 18 – Retention Model – Costs -10%	91.6%	49.9%	15,431	5	1,513	425	27,966
Scenario 19 – Acquisition Model – Costs -10%	482.4%	132.6%	5,165	2	210	59	8,413

Scenario 3: The blended scenario presents the advantages of both the Retention and Acquisition Models, while minimising the shortcomings of each approach. Under this option, the company receives both an upfront acquisition fee and an ongoing monthly retention fee. This reduces the amount of upfront funding required (as the acquisition approach allows the company to operate profitably from midway through its second year of operation, while also assisting in providing longer term security to the company in the form of the ongoing retention payments, which are (once a critical mass of customers have been received) sufficient to allow the company to continue to operate profitably).

Scenario 4: When the Retention Model is modelled using optimistic sensitivities, the Project IRR increases by 56.3% to 117.5%. This is due to an increase in revenue and customer numbers, together with a reduction In costs. This demonstrates a scenario whereby the Public Energy Company is operating under favourable conditions, both in terms of additional revenue and reduced costs. Investor IRR also improves and the payback period for Investors reduces by 2 years.

Scenario 5: Similarly, when the Acquisition Model is considered under optimistic conditions, the Project IRR increases by 921.1% to 1,062.9%. Again, this is due to additional customer uptake numbers and reduced costs for the Public Energy Company. The Investor Payback Period drops from 3 to 2 years under the optimistic sensitivity analysis for the Acquisition Model.

Scenario 6: Under pessimistic circumstances, the Retention Model's Project IRR drops by 36.2% to 25%. This is due to a drop in the anticipated customer numbers and therefore revenue. Projected costs are also increased which increases the Investor Payback period by from 6 to 8 years and also reduces Investor IRR.

Scenario 7: As above, when modelled under pessimistic circumstances, the Acquisition Model Project IRR drops in this case to 0%. Investor returns drop by 57.5% to 5.2% and there are no dividends to investors. This is due to the combined impact of a reduction in revenue and an increase in costs. Under this set of assumptions the business would not be sustainable as it would require additional funding to maintain its operating position, as it would not be generating sufficient revenue to cover its operating and financial cost base.

Scenario 8: Under this scenario, the Project IRR stays the same as the Scenario 1 – Retention Model as there is no change to revenue and costs assumed however there is a change in the form of the investment the investors put into the Project. Under this option there are no significant variances in IRRs to Scenario 1 however, Investor returns does increase by 1% to 35.5% and dividends increase by £691,000 to £23,231,000. The initial investment required is also lower by £1.06m. This is due to the repayment to investors being at the end of the Project as opposed to being in the form of a loan paid over the duration of the Project. The time value of money there makes this NPV and IRR to investors drop.

Scenario 9: Similarly, there are no changes to the assumed revenue and costs under this scenario therefore the Project IRR stays the same as Scenario 2. However, Investor IRR drops, by 1.7% to 61.0%. However, dividends paid out increased marginally. This is due to the repayment to investors being at the end of the Project as opposed to being in the form of a loan paid over the duration of the Project. The time value of money there makes this NPV and IRR to investors drop.

Scenario 10: Under this model, there are no changes to assumed revenue or costs therefore the Project IRR stays the same as Scenario 1. However, the Investor IRR increases by 2.4% to 36.9% as a result of the returns of the Project being the same, but a lower level of investment required due to the grant received.

Scenario 11: As with scenario 10, there are no changes to the Project IRR, which is agnostic to funding source. However, the Investor IRR increases as a result of the returns of the Project being the same, but a lower level of investment required due to the grant received.

Scenario 12: Under this scenario the interest charged on debt provided by the Investors to the Public Energy Company is increased to 11.09%, to reflect a likely 'maximum' level of interest that could be assessed as commercial (refer to Section 6.14 for details). The change in the interest rate increases the level of funding initially required, as the Public Energy Company has been modelled to require no further drawdowns of debt beyond its initial funding requirement, and therefore needs a greater level of funds to cover early year debt and interest repayments. However, the NPV and overall returns are not significantly negatively impacted, as both interest and dividends return to the investor.

Scenario 13: Scenario 13 sees a similar outcome to that seen under Scenario 12.

Scenario 14: Under this scenario the Project IRR increases by 8.5% to 69.7% due to an increase in revenues. There is no corresponding increase in costs so the Project IRR and Investor IRR both increase. This scenario assumes the Public Energy Company is operating under favourable conditions.

Scenario 15: As above, under this scenario the Project IRR increases by 178.8% to 320.6% due to an increase in revenues. Again, there is no corresponding increase in costs so the Project IRR and Investor IRR both increase. The significant increase in Project IRR compared to scenario 11 is due to income streams under the Acquisition Model being recurring and this causes any changes to the assumptions revenue in this model to have more of an impact. This scenario assumes the Public Energy Company is operating under favourable conditions.

Scenario 16: Under this scenario the Project IRR decreases by 17.2% to 44% due to a drop in revenues. There is no corresponding increase in costs so the Project IRR and Investor IRR both decrease. Investor IRR drops by 10.6% to 23.9% and due to the drop in revenue and thus surplus funds, the payback period increases to 7 years. This scenario considers a more pessimistic view on revenue, if the entity were not to achieve the revenue figures as anticipated by scenario 1.

Scenario 17: Under this scenario the Project IRR decreases by 52.0% to 10.7% due to a drop in revenues. There is no corresponding increase in costs so the Project IRR and Investor IRR both decrease. As per before, any changes sensitivities applied to the Acquisition Model have a significantly larger impact on the Project's returns due to the annual pattern of income for each customer. The changes are therefore impacted by a multiplied effect. The payback period under this scenario, compared to scenario 2, increases from 3 years to 8 years.

Scenario 18: Under this scenario, there is an increase in anticipated costs by 10%, with no assumed increase in revenue. The Project IRR therefore drops by 15.6% to 45.6%. This scenario takes a more pessimistic view on assumed costs and allows for costs to be 10% higher than modelled in scenario 1. As a result, Investor IRR also drops by 8.8% to 25.7%.

Scenario 19: As above, this scenario assumes costs are 10% higher than modelled under scenario 2. This results in a drop in Project IRR from 141.8% to 44%.

Scenario 20: Under this scenario, Project IRR increases by 30.4% due to a reduction in anticipated costs with no change to projected revenue. The overall returns of the Project are therefore higher and investors are paid back sooner, with a payback period of 5 years as opposed to 6. Investor IRR also increases by 15.4% to 49.9%.

Scenario 21: As above, under this scenario Project IRR increases by 340.6% to 482.4%. Again, this is due to the drop in costs with no corresponding drop in revenue which results in higher returns and less outgoings. Investors are paid back in 2 years as opposed to 3 as is in scenario 2.

6.12 Counterfactual – 'Business as Usual'

In addition to the modelled Public Energy Company scenario, we have prepared a Counterfactual scenario. This considers the activities of the Public Energy Company vs. the Business as Usual or 'No Change' option. It should be noted that Scottish Government will - under a 'no change' scenario - incur no costs and generate no surpluses, this is a straightforward calculation.

Table 52 - Financial Benefit of Retention Model

Description	Real £000s	NPV £000s
Net interest generated under the Public Energy Company (Retention Model)	810	624
Net dividends generated under the Public Energy Company (Retention Model)	22,540	12,290
Total benefit	23,350	12,915
Net cash generated under a Business as Usual position	-	-
Benefit to Scottish Government of the Public Energy Company (Retention Model)	23,350	12,915

Table 53 - Financial Benefit of Acquisition Model

Description	Real £000s	NPV £000s
Net interest generated under the Public Energy Company (Retention Model)	83	64
Net dividends generated under the Public Energy Company (Retention Model)	5,597	3,272
Total benefit	5,680	3,336
Net cash generated under a Business as Usual position	-	-
Benefit to Scottish Government of the Public Energy Company (Retention Model)	5,680	3,336

In addition, the Counterfactual also considers whether the beneficiaries of the Public Energy Company – in this case the domestic customers who sign up to the network, are in a financially improved position as a result of choosing to switch to the Public Energy Company. In order to do this, we have made the following assumptions:

• The same customer cohort is used as for the Public Energy Company
• A 'Business as Usual dual fuel tariff of £94.97 is compared against an implied weighted average tariff for the Public Energy Company of £90.28
• A 'Business as Usual single fuel tariff of £50.33 is compared against an implied weighted average tariff for the Public Energy Company of £48.25
• VAT of 5% is applied
• Tariffs are indexed on the BEIS Electricity (residential) trend

The above reflects (pre-indexation), an annual saving of £58.97 for a dual customer or £26.21 for a single fuel customer. It is not possible at this time to calculate exactly how many individuals this might help to lift out of fuel poverty. As the Project develops to Full Business Case and the tariff can be determined with more certainty, further work should be undertaken to determine how many this assists in lifting out of fuel poverty, while also bearing in mind the additional benefits gained from the money that can be reinvested in to fuel poverty tackling measures.

This results in the following position for customers of the Public Energy Company. As the customers are not impacted on the Public Energy Company being under either a retention or acquisition model, the results are the same regardless of the approach Scottish Government adopts.

Table 54 - Results of the Counterfactual

Description	NPV £000s
Dual Fuel customer costs in Public Energy Company	1,039,888
Single meter customer costs in Public Energy Company	244,467
Total customer costs in Public Energy Company	1,284,354
Dual Fuel customer costs under Business as Usual	1,093,839
Single meter customer costs under Business as Usual	255,022
Total customer costs under Business as Usual	1,348,861
Financial benefit of Public Energy Company to domestic energy customers	64,506

The above calculations demonstrate that there is a potential significant overall financial benefit for the domestic customers switching to the offering made by the Public Energy Company. The values included in both the Public Energy Company scenarios and the Counterfactual scenario are based upon the commercial assumptions. Assumptions made are based on 'best estimates' and knowledge of the market. It is recognised that these are high level assumptions and, as assumptions, for example around customer numbers, are projected into the future, these become less and less certain.

6.13 Sources of funding

The Scottish Government, as a central government body, has access to money from a variety of sources, collectively called the Scottish Consolidated Fund, derived from the following sources:

• Block grant from the UK Government
• EU funds
• Scottish income tax
• Non-domestic rates
• Devolved taxes
• Borrowing

The Scottish Government borrowing would be accessed from the national Loans Fund and the term would be flexible within three to five years at the discretion of Scottish Ministers.

Scottish Local Authorities also has access to funding from the following primary sources:

• Block grant (c.85% of net revenue expenditure, comprised of General Revenue Grant, Non-Domestic Rates Income, and Specific Revenue Grant
• Local taxation (e.g. council tax)
• Borrowing

Scottish Local Authority borrowing is primarily driven around borrowing for capital projects – which is not applicable to the proposed Public Energy Company. However, in certain circumstances Local Authorities may be given a consent to borrow for revenue costs – however this is only possible with the agreement of the UK Government.

Based on the above, it is likely that funding for the Public Energy Company will need to be made from existing reserves. From a financial perspective, Scottish Government and any involved Local Authorities will need to consider the opportunity cost of any investment made in the Public Energy Company – i.e. what else the revenue could be utilised for, and whether that would represent a more appropriate use of resources or offer better returns.

For the purposes of funding the Public Energy Company in the financial model, we have assumed 100% of the funding will come from the public sector, without confirming the explicit source. As such, it is essential that State Aid requirements are considered, as these can impose a floor on the interest rates that can be charged.

6.14 State Aid - Interest rate charged in the Financial Model

To calculate the required rate to meet State aid requirements, reference was made to the European Commission Interest Base Rates^[30] to identify the effective interest rate for the most recent period. At the date of preparation of the Financial Model, this interest rate was set at 1.09%. Then, via reference to State aid requirements and exemptions^[31], a margin of 400 basis points was applied – the minimum margin required for lending to an entity with no trading history and therefore considered to be higher risk (which would apply to the Public Energy Company as a new entity – regardless of the ultimate ownership of the company. This sets a minimum interest rate for lending from a public sector entity to an arm's length company (although still owned by the public sector) of 5.09%. As a result, a lending rate of 5.09% was set for all scenarios in which lending is provided by the public sector (with the exception of Scenarios 12 and 13).

For the purpose of the Financial Modelling, the decision has been taken to assume lending is made on an arm's length basis – hence the calculation of 5.09% described. We are not aware of the General Block Exemption Regulations (GBER) providing an allowance for the anticipated activities of the Public Energy Company – particularly at its outset in the form of a White Label energy company, however we recommend specific legal advice is obtained to support this assertion.

In the Core scenarios in the Financial Model, the Public EnerStagy Company is assumed to require an injection of debt for all set up and initial operating expenditure requirements, which then has an interest rate applied at 5.09%. This is then repaid to the public sector using a revolving loan facility, in order to maximise the use of available cash and reduce the interest burden on the Public Energy Company.

Under Scenarios 12 and 13 we have applied an interest rate assumption of 11.09% to debt provided to the Public Energy Company. This is to reflect the greatest potential margin identified in reference to State Aid requirements and exemptions, to demonstrate that even under this more onerous interest burden, the Public Energy Company is still, under the Core Scenarios, able to meet its debt obligations.

Both the 5.09% and 11.09% rates are intended as proxies for the actual interest rates that the initial investors would charge and reflects a rate that is likely to be State aid compliant and appropriate for the completion of the Outline Business Case. We would anticipate that as the Project moves to Full Business Case, more rigorous analysis could determine the definitive figure to charge the Public Energy Company and that appropriate legal advice would be obtained to ensure compliance with State aid obligations.

6.15 Optimism bias

In preparing an OBC, it is important to incorporate the impact of optimism bias, to help assess the level of uncertainty over Project costs. Optimism Bias reflects the demonstrated and systematic tendency for Project appraisers to be overly optimistic when considering Project benefits and costs.

Key areas to consider relating to Optimism Bias are:

• Capital Expenditure Optimism Bias
• Operating Expenditure Optimism Bias
• Confirmation of the Preferred Delivery Option

To address this tendency, it is important to make explicit adjustments and thus determine a suitably optimism bias-adjusted outcome. These adjustments will have the effect of increasing the cost estimates, decreasing the projected benefits and extending the timescales over which the costs and benefits are assumed to accrue, compared to the initial unadjusted estimates.

As there are no forecast capital expenditure requirements for the Public Energy Company, no adjustments have been made for optimism bias in the Financial Model.

The principles in Annex 4 of the Green Book and in the HMT supplementary guidance should be applied with proportionate effort in a manner that suits the circumstances. Wherever possible, the relevant adjustments should reflect local experience in preference to use of the HMT generic figures. They should be based on data from past Projects or similar Projects elsewhere and adjusted for the unique characteristics of the Project in hand. When such information is not available, it is encouraged to collect data to inform estimates of optimism, and in the meantime use the best available data.

It is important to be satisfied that the adjustments made are realistic and justifiable inn relation to local experience. They should represent a meaningful effort to improve the quality of assumptions rather than arbitrary percentage adjustments.

Consideration of optimism bias to date has been based on the sensitivity testing performed to demonstrate the robustness of the Public Energy Company to these variables. Similarly, the base data prepared through the initial modelling undertaken by Cornwall-Insight is based upon the collection of local data and an understanding of the energy market to reduce the impact of Optimism Bias on the Project. Where various possibilities have presented themselves optimism bias has been reduced through the use of prudent and realistic estimates of obtainable costs and revenues. These have been stress tested further through the application of the 'Optimistic' and 'Pessimistic' scenarios calculated and through the further sensitivities conducted. The sensitivity testing section of this Financial Case demonstrates the level of resilience of the Public Energy Company.

Further work to quantify the potential optimism bias should be undertaken through the commercialisation phase, once further details of the commercial arrangements are understood.

6.16 Accounting treatment

The modelled commercial option represents a Public Energy Company as a private company limited by shares, with the shares owned by interest Public Sector parties. It is therefore a Public Sector-controlled subsidiary.

Subsidiary companies are defined as organisations that the Shareholder controls by having power over the organisation, exposure or rights to variable returns from its investment and the ability to use its power over the organisation to affect the amount of the return.

6.17 Confirmation of the Preferred Delivery Option decision

In reaching the preferred solution decision, a prudent approach has been taken to the assumptions adopted. For example, an over enthusiastic expectation of the achievable level of customer numbers has not been considered to be applied.

The Core scenarios are considered to represent financially beneficial positions, which generate a sufficient level of income to repay the debt injected to the Public Energy Company and also to generate a modest surplus for use in addressing fuel poverty. This provides an opportunity for the Public Energy Company to establish itself and become a 'known brand' in the marketplace, under Public Sector control, allowing the Public Sector investors to work in unison to lead the decision-making process around future company direction and strategy.

In summary, the preferred financial solution for the Public Energy Company is:

• 100% public sector owned, with the flexibility to allow public sector partners to have an appropriate level of involvement
• Public sector funding is assumed to be provided in the form of a revolving loan facility. 100% of all funding requirements are provided from the public sector.
• The maximum debt required, based on the core assumptions, is incurred in the year to March 2021 and reaches a maximum level of £2.9m under the Retention Model, or £0.3m under the Retention Model.
• Public sector sponsors are currently determining their relative share of this investment.
• Surpluses generated will be paid out of the Public Energy Company and used to fund programmes designed to help reduce fuel poverty in Scotland.
• The proposal has the flexibility to allow for either the Retention or the Acquisition model of generating revenues – this will be refined through discussions with the market in the commercialisation phase of the Project.

This generates the returns as set out in the table below.

Table 55 – Returns of the Core scenarios

Scenario	Project IRR (pre-tax) %	Investor IRR %	Investor NPV £000s	Investor payback period (years) (nominal)	Initial Investment required £000s	Dividends paid by Public Energy Company £000s
Scenario 1 – Retention Model Core scenario	61.19%	34.45%	12,086	6	2,914	22,540
Scenario 2 – Acquisition Model Core scenario	141.75%	62.73%	3,251	3	297	5,597

6.17.1 Summary - Public Energy Company vs. Counterfactual financial benefit

We have calculated the benefit to key stakeholders and customers in the Public Energy Company on an NPV basis over the Project life and compared to a 'Business as Usual' scenario over the same timeframe.

Table 56 - Financial Benefit of Retention Model for the Public Sector

Description	Real £000s	NPV £000s
Net interest generated under the Public Energy Company (Retention Model)	810	624
Net dividends generated under the Public Energy Company (Retention Model)	22,540	12,290
Total benefit	23,350	12,915
Net cash generated under a Business as Usual position	-	-
Benefit to Scottish Government of the Public Energy Company (Retention Model)	23,350	12,915

Table 57 - Financial Benefit of Acquisition Model for the Public Sector

Description	Real £000s	NPV £000s
Net interest generated under the Public Energy Company (Acquisition Model)	83	64
Net dividends generated under the Public Energy Company (Acquisition Model)	5,597	3,272
Total benefit	5,680	3,336
Net cash generated under a Business as Usual position	-	-
Benefit to Scottish Government of the Public Energy Company (Acquisition Model)	5,680	3,336

Table 58 - Results of the Counterfactual from the perspective of customers

Description	NPV £000s
Dual Fuel customer costs in Public Energy Company	1,039,888
Single meter customer costs in Public Energy Company	244,467
Total customer costs in Public Energy Company	1,284,354
Dual Fuel customer costs under Business as Usual	1,093,839
Single meter customer costs under Business as Usual	255,022
Total customer costs under Business as Usual	1,348,861
Financial benefit of Public Energy Company to domestic energy customers	64,506

The above calculations demonstrate that there is an overall financial benefit for the domestic customers switching to the offering to market made by the Public Energy Company.