Small-scale hydro plant and machinery review: report

Annex C: Required Changes To The Plant & Machinery Order – View From The Small-Scale Hydro Sector

Introduction

1. This paper has been prepared by Kenny Hunter of Hunter Hydro Services, on behalf of the small-scale hydro sector in Scotland, to provide a basis for discussion at the second meeting of the Tretton Review Group, established by the Scottish Government to carry out the fast track review of the Plant & Machinery Order as it applies to small-scale hydro-electricity schemes.

2. The aim of the paper is to inform the group of the hydro sector's current understanding of how rating applies to small-scale hydro, the sector's view of the inherent flaws in the current legislation and methodology, the economics of small hydro development and the sector's proposals to revise the Plant & Machinery Order.

Proposed changes to the Plant & Machinery Order

3. The proposal from the small-scale hydro sector (schemes of up to 5MW capacity) is that all physical infrastructure, including all items of plant and machinery associated with such scheme extending from where the water is extracted from the water course to where it is returned, should be exempt from rates. For clarification, this will include the intakes, the penstock, the power house, equipment linking the scheme to the grid and all access tracks and bridges that support the safe operation and maintenance of the scheme.

4. With all the infrastructure being classed as non-rateable, assessors will be able to draw upon the rental evidence provided for the 2017 Revaluation by hydro operators to calculate Rateable Values. We would expect this to produce rateable values of approximately 10% of gross turnover.

5. At this stage we are seeking support in principle from the Tretton Review. It is appreciated that there will be wording challenges, with concerns about the prospect of other sectors seeking to take advantage of any revised wording and concerns around state aid consequences of the wording being overly specific regarding small-scale hydro.

The components of a small-scale hydro scheme

Rating issues for small-scale hydro

6. The Plant & Machinery Order currently decrees that the substantial majority of a small-scale hydro scheme is deemed to be rateable. This statement is supported by the attached document detailing the conclusions of the Valuation Appeals Committee on 28 October 2013. Alastair Kirkwood has confirmed that this represents an accurate view of the current interpretation of the Plant & Machinery Order.

7. Without any discretionary adjustment by the assessors, small hydro schemes would be at least 90% rateable – with the only exempt elements being the screen at the intake along with various electrical items in and around the power house, notably the transformer, switchgear, distribution board and control panel.

8. In such circumstances, to establish a hypothetical rent, it would be assumed that the landlord has >90% 'ownership' of the scheme.

Worked examples to illustrate impact of current PMO wording

9. The following worked examples are designed to illustrate the valuations that result from applying The Plant & Machinery Order through the Receipts and Expenditure valuation method to small-scale hydro schemes.

10. In the first example, the valuation is based upon rateable classification as decreed by the Plant and Machinery Order with no discretionary intervention by the assessors, i.e. hydro schemes are deemed to be 90% rateable.

11. The second example reflects the approach taken by Scottish assessors during the 2017 Revaluation, with a discretionary adjustment of the rateable component (or landlord's share) to 55% for depreciation purposes and 60.2% for allocation of the Divisible Balance.

12. The purpose of this exercise is to demonstrate two points:

• The Plant and Machinery Order as it stands, does not produce valuations for small-scale hydro that are fit for purpose

• The arbitrary adjustments made by the Scottish assessors are insufficient to produce a fair outcome in terms of small-scale hydro scheme valuations

Example 1: No discretionary adjustment by assessors

13. A 500-kilowatt scheme will typically generate 1,500,000 kWh per annum and produce gross income in the region of £325,000.

14. Applying the Receipts and Expenditure method and adjusting for a 90% landlord ownership level (based on rateable classification) the hypothetical rent/RV would be £145,172.

15. On this basis, assuming a poundage rate of 50p, the rates payable will be £71,085 – which when added to the rental, amounts to £213,150, i.e. 65.6% of gross turnover.

Application of rateable classification as per the PMO (Receipts & Expenditure method)

Scheme size	500 kilowatts
Annual generation	1,500,000 kilowatt hours
Gross income	£325,000
Operational costs	£75,000
Net turnover	£250,000
Tenant allowance for depreciation (10%*£2,450,000/30)	£8,167
Divisible balance	£241,833
Landlord/tenant split	90/10
Tenant share	£24,183
Amount available for rent and rates	£217,650
Rent/Rateable Value (@66.7% of amount available)	£145,172
Rates payable	£72,586
Rates payable as % of gross turnover	22.3%

16. But the assessors do make a discretionary adjustment, reducing the rateable component to 55%. This is understood to be in line with the approach taken by the VOA in England, with the intention being that the two approaches are harmonised. This split is used when calculating depreciation.

17. A further adjustment is then made by the assessors to reflect the associated risk, which creates the c.60/40 split between landlord share and tenant's share as applied by Scottish assessors in their application of the Receipts and Expenditure method when allocating the divisible balance.

18. The Rateable Value produced by Scottish assessors using the Receipts and Expenditure Method of Valuation, as it was applied for the 2017 Revaluation, would produce a Rateable Value of £85,717 – equivalent to 26.4% of gross turnover, as illustrated below;

Approach applied by Scottish assessors for 2017 Revaluation (Receipts & Expenditure method)

Scheme size	500 kilowatts
Annual generation	1,500,000 kilowatt hours
Gross income	£325,000
Operational costs	£75,000
Net turnover	£250,000
Tenant allowance for depreciation (45%*£2,450,000/30)	£39,057
Divisible balance	£210,943
Landlord/tenant split	60.2/39.8
Tenant share (39.8%)	£83,955
Amount available for rent and rates	£126,988
Rent/Rateable Value (@66.7% of amount available)	£85,717
Rates payable	£42,858
Rates payable as % of gross turnover	13.2%

19. If assessors are going to make arbitrary adjustments, why not reflect the real arrangements that apply rather than a hypothetical construct that does not exist?

The Wood Committee 1999

20. Extract from recommendations:

21. Electricity Generation. Under Class 1 of the existing regulations most of the plant and machinery used in the electricity generating industry would be rateable. The Committee considered that Class 1 of the regulations was devised to bring into rating plant which generated power for use in some other trade or process which was the principal business activity of the ratepayer. However, in the case of the power generators, the manufacture and supply of power was the very business which they carried on. Therefore, they recommended that a 'tools of the trade' exemption should apply to generating plant and machinery belonging to the power generators, although such plant which was in the nature of a building or structure and fell within Class 4 should continue to be rated.

22. To what extent should the Tretton Review be bound by the earlier work of the Wood Committee?

23. If we do feel such a need, why is this separate review taking place?

24. The 1999 Wood Committee sought to keep rates bills down, through 'tools of the trade' exemptions, for electricity generation destined for the grid. With 90% + of the average hydro scheme currently being rateable under the Plant & Machinery Order, it is surely inappropriate to use the Wood Committee as a start point or even as a point of reference for the Tretton Review.

25. The composition of hydro schemes, with a very large civil engineering component and a relatively small share of the cost attributable to electro-mechanical plant, results in them singularly failing to benefit from the 'tools of the trade' exemption for electricity generators, as defined by the Wood Committee.

26. There needs to be a different approach to the rating of hydro schemes.

27. This is likely to involve treating those buildings and structures that appear to be the 'sacred cows' of rating, as tools of the trade, and therefore exempt from rating, so far as hydro schemes are involved. On the basis that we will require to deviate from long established rating precedent to reach a fair outcome for small-scale hydro, it is hard to see why any physical element of a hydro scheme should not be exempt from rating.

The economics of small-scale hydro

28. The predominant model throughout the FIT period has been for small hydro schemes to be funded by non-recourse/unsecured bank debt. Repayment terms are between 12 and 15 years and the rate of interest is between 7% and 12%. For the purposes of this example it is assumed that the scheme is funded with 20% equity and 80% debt.

29. The 500 kW scheme referred to throughout this paper will typically cost £2.5 million to construct. Annual finance repayments are likely to be in the region of £225,000.

30. Operational costs have historically been between 10% and 15% of gross revenues, albeit this % falls for larger schemes as some of the costs are fixed, regardless of scheme size. This figure excludes rent and rates. Allowing for rent at 10% and rates at 5% of gross revenues, the overall operational costs amount to between 25% and 30% of costs (£80,000 - £100,000).

Scheme size	500 kilowatts
Annual generation	1,500,000 kilowatt hours
Gross income	£325,000
Operational costs (excluding rent & rates) @ 12.5% of t/o	£40,625
Rent @ 10% of turnover	£32,500
Rates @ 5% of turnover	£16,250
Net income	£236,125
Debt repayments (£2,000,000 @ 8%)	£225,000
Net profit/available cash (year 1)	£11,125

31. The above example would leave approximately £11,000 after finance costs and operational costs, but quite possibly less than that or even a negative figure depending on generation output over the year and the prospect of unforeseen costs.

32. These figures may cause one to question why schemes proceed, however the situation will improve over time thanks to the fact that the Feed in Tariff element of the income stream is index linked in accordance with RPI. This progressively creates a degree of financial 'breathing space', however, for most schemes, the first 5 years produce little, if any profit.

33. The main profit years for hydro schemes are between years 15 and 20, when the loans are paid off, but Feed in Tariffs remain in force. Beyond year 20, income is based solely on the sale of electricity in the market, with gross revenues typically falling by between 70% and 80%. For this reason, it is essential that an interim Revaluation takes place for each scheme when its FIT eligibility ends.

34. When the financial models were being prepared for the schemes that have been built in recent years, the small hydro sector was benefitting from 100% relief from business rates. It was recognised that this was a temporary arrangement and consequently most financial models, if not all, would include a line for business rates. The broad assumption applied was that business rates would amount to approximately 5% of turnover – partly on the basis that rateable values would be aligned to rents.

Impact of 2017 Revaluation on new hydro development

35. The 2017 Revaluation saw Rateable Values for small-scale hydro schemes increase to an average level of 24% of turnover. Applying a poundage rate of 50p, this resulted in rates payable equating to 12% of gross turnover on average.

36. Returning to the worked example used throughout this paper, that would add £22,750 of costs. As has been demonstrated, the economics cannot accommodate such extra costs, particularly during the early years of operation. Consequently, many of the schemes that were in the development pipeline at the time of the Revaluation, were put on hold. The intervention of the Scottish Government with the 60% relief scheme has allowed development activity to re-commence, however it should be noted that developers remain concerned by what they perceive to be the temporary nature of reliefs.

Impact of 2017 Revaluation on existing schemes

37. The introduction of the 'capped increase' relief scheme in 2017/18 and more importantly, the 60% relief scheme as from April 2018, has protected most schemes below 5MW from the full impact of the 2017 Revaluation. Had the Scottish Government not made these interventions, many schemes would have been unable to continue trading.

What is a fair level of rates?

38. On the SAA website the role of the assessor is said to be "to balance the interests of individual ratepayers against those of others, in terms of valuation levels.". This balancing of interests would, to a reasonable person, equate to the principle of fairness.

39. In the meeting with the Finance Minister in July 2017, Mr Mackay asked his official what % of turnover small businesses typically paid in rates. The answer given was 'between 3% and 4%'.

40. The view of the hydro sector is that rates payable should not exceed 5% of average gross turnover.