Small-scale hydro plant and machinery review: report

Outline Economics of Renewable Energy Generation and Government Incentives

10. Unlike traditional forms of electricity generation based upon thermal combustion, low carbon sources of electricity are characterised by relatively low operating costs with significant upfront capital build costs. In the case of hydro, the ARUP report^[3] used to inform decisions on Feed in Tariff (FIT) levels suggested capital build cost of around £2.5-£4.1 million per Megawatt (MW), while the Scottish Assessors Association (SAA) practice note assumes a cost of £4.9 million per MW. Meanwhile the marginal operating cost of generating each additional unit of electricity is minimal.

11. Similarly, while traditional thermal generation (including low carbon sources such as biomass) typically involves a conscious decision whether to generate electricity or not (based in part on the price achievable), renewable electricity essentially generates by default when the weather conditions are right with no relationship with the electricity price.

12. This high capital cost and inability to respond to market price signals undermines the investment case for low carbon generation sources. In response, successive UK Governments have sought to incentivise renewable (and latterly low carbon) generation through subsidy mechanisms known as the Renewable Obligation Certificate (ROC), the Feed-in-Tariff (FIT) and now the Contracts for Difference Feed in Tariff (CfD).

13. The ROC system involved an obligation being placed on electricity suppliers to source an increasing volume of electricity from renewable sources. Qualifying Renewable generators are awarded a fixed number of certificates for each unit of generation which, when redeemed to suppliers, operated to provide renewable generators with a form of generic subsidy over and above the prevailing electricity price. The FIT system was introduced on 1 April 2010 and effectively removed any market price volatility by providing an inflation adjusted (indexed linked) fixed price per unit of generation. The CfD system is a complex derivation of the FIT system which protects public finances at times of high wholesale electricity costs. In all three cases, the costs of the support mechanisms are effectively funded through a levy on suppliers which are passed on to consumers.

14. The level of subsidy offered to each technology was based upon a 'Levelised Cost of Energy' calculation. A levelised cost approach compares the average lifetime generation cost of all forms of generation taking into account the different build and operating costs of different technologies. This estimate is then adjusted to reflect a technology specific hurdle rate^[4] and the capacity required to meet the UK's renewable energy targets to determine the level of subsidy to be offered.

15. The UK Government's levelised cost calculations do not take any account of the non-domestic rates liability as part of the operating cost assessment^[5]. As a consequence, the group discussed the omission of non-domestic rates from the subsidy calculation, which effectively means that the stated "hurdle" rates may not actually be delivered by the policy.

16. These subsidy regimes are currently exempt from State Aid considerations as 'notified schemes' under the General Block Exemption Regulations. However, any decisions to supplement the level of subsidy, for example to correct for any perceived errors in subsidy levels, would be considered a State Aid intervention.

17. The levels of support available through the ROC and FIT regime are outlined in the Valuation of Conventional Hydro Generators Practice Note attached at Annex E.

18. In addition to the financial subsidy per unit generated, in some cases the rateable occupier may also benefit from the savings associated with using the electricity being generated.

19. Due to greater than anticipated uptake of the Feed in Tariff - primarily solar photovoltaic installations - the UK Government introduced a Levy Control Framework in March 2011 to help mitigate the impact on consumer bills. Following a review of the support mechanisms in 2015, the UK Government decided that expenditure on new tariffs would cease in March 2019. The review of the Feed in Tariffs^[6] was not published until 17 December 2015 and therefore was not applicable as at 1April 2015, which was the tone date for the 2017 Revaluation.