Hurdle Rates and the Cost of Capital for Financing Electricity Generation in the UK

Wed Nov 09 10:42:00 EST 2016
By Dr. Richard Hern, Daniel Radov, Alon Carmel, Marija Spasovska, and Jinzi Guo

A team led by NERA Managing Director Dr. Richard Hern, Director Daniel Radov, and Senior Consultant Alon Carmel and including NERA Consultant Marija Spasovska and Economic Analyst Jinzi Guo, prepared a major study in 2015 for the UK Department for Energy and Climate Change (DECC, now known as the Department for Business, Energy and Industrial Strategy, or BEIS) on the cost of capital and hurdle rates for investors in electricity generation assets. BEIS published on 9 November 2016 the announcement of the next Contract for Differences (CfD) auction round, a consultation on closing coal by 2025, and the background reports (including the NERA study, “Electricity Generation Costs and Hurdle Rates Lot 1: Hurdle Rates update for Generation Technologies”, along with peer reviews).

The cost of capital is a significant part of the investment cost for power generation assets. This study formed part of the UK government’s evidence base on the levelized cost of energy (LCOE) of different technologies, including renewable energy technologies, such as offshore wind, onshore wind, solar, and biomass; other low-carbon technologies, such as nuclear and carbon capture and storage (CCS); and fossil fuel generation, such as gas and coal. NERA assessed the impact of different risks and the subsidy regime on the cost of capital for investors in such assets. The study reviewed and analyzed several sources of evidence, including surveying and interviewing investors across the industry, modelling the potential returns for projects, and assessing observed market returns offered by new financial structures, such as renewable electricity yieldcos. NERA considered the required rates of return (IRRs) or hurdle rates at the project appraisal stage but also discussed how the cost of capital evolves over the stages of the project development cycle, and the impact of specific risks, such as allocation risk, as well as construction, development, and policy risk.

The analysis for the report was carried out during spring 2015. Between the time the analysis was undertaken and the date of publication, there have been several significant developments affecting the UK electricity sector, including the changes in July 2015 to the Climate Change Levy (CCL) tax regime and the removal of exemptions for renewable energy, the early closure of the Renewable Obligation (RO) scheme to certain technologies, and the referendum vote to leave the European Union. The analysis does not reflect the possible impacts of these developments on the cost of capital for electricity generation.