What the electricity generator levy means for the renewables community in the UK

As part of its #autumnstatement on 17 November 2022, the #uk government issued an ‘Electricity generator levy – Technical note’ (the Note) to expand on the policy behind the Chancellor’s announcement in Parliament that electricity generators will be charged a new and temporary 45% levy on “Exceptional Generation Receipts” (the Levy).

The Levy had been rumoured for some time and follows the energy profits levy targeted at oil and gas companies benefitting from recent high commodities prices.

This article aims to explain who the Levy is intended to apply to, how it is to be calculated, our views on its impact on the #renewables investment community and finally our recommendations.

Who does the Levy apply to?

The Levy will apply to corporate groups or standalone companies that undertake electricity generation in the UK from nuclear, renewable and biomass sources, and are either connected to a national grid or a local distribution network.

Key exclusions would therefore comprise:

• Electricity generated under a Contract for Difference with Low Carbon Contracts Company Ltd - this is in line with the intention of the Levy to control exceptional generation receipts. Where the market price is above the strike price under a Contract for Difference, the generator is required to pay the difference to Low Carbon Contracts Company Ltd. We trust legislation will clarify that electricity generated under investment contracts is also excluded;
• Groups (see further below on this term) which generate 100 GWhs per annum or less from in-scope generation assets;
• Revenue from the sale of Renewables Obligations Certificates or capacity market payments;
• Gas generators, pumped storage hydroelectricity and battery storage technologies – the government clearly wishes to promote these technologies which, by the nature of their business models, aim to profit at times of low electricity supply and higher wholesale prices; and
• Electricity generated from coal or oil - the rationale being that these generators have seen fuel price volatility and service a unique function to ensure security of supply to the UK market.

How is the Levy calculated?

The Levy will be at a flat rate of 45% on Exceptional Generation Receipts, calculated pursuant to the following formula:

Exceptional Generation Receipts = Generation Receipts less (Electricity Generation x Benchmark Price) less Allowance

where:

• Generation Receipts means total receipts of a group from in-scope UK electricity generation
• Electricity Generation means electricity generated in the UK from in-scope generation, measured in in MWh
• Benchmark Price means ￡75 per MWh, with the portion of a generator’s earnings below this level not being subject to the Levy
• Allowance means ￡10m per annum for the group

The Levy will be chargeable on generation from 1 January 2023 until 31 March 2028. It does not appear that any of the figures will be adjusted to inflation, notwithstanding the current inflationary context. The Note mentions that the Benchmark Price has been deliberately set at a level which allows for some input cost inflation. Nevertheless, in a market where the price contracted under many corporate PPAs is either subject to a pre-agreed annual rate of increase of between 2-3%, or where the price is subject to adjustment in line with RPI or CPI (albeit typically subject to an annual cap of around the same level), the level of the Benchmark Price needs to be borne in mind by generators when pricing their PPAs, even if the initial price struck falls below this threshold.

The Levy will be calculated by aggregating Exceptional Generation Receipts across all in-scope generation of a taxpaying group. Notably, the Levy will not be deductible from the profits subject to Corporation Tax, to remove any tax benefit resulting from payment of the Levy.?

What type of revenue will be captured?

Revenue generated from the output of in-scope generation facilities under a physically settled PPA (with the exception of on-site PPAs), route to market agreements, long forward contracts and trading on the day-ahead and intra day-ahead markets will all count towards the calculation of Generation Receipts for a group. The wholesale component of the revenue arising from the sale of power to a downstream UK supply business that then generates revenue from onwards selling to an end consumer will also be captured. There is also no distinction made between revenue arising from power sold within the UK or exported abroad and both will be captured in the calculation.

Unlike the energy profits levy, there is no allowance for alternative/renewables investments. There is only a de minimis allowance of ￡10m per year. The Levy is also applied against Generation Receipts, not the profits of the group, meaning the government has assumed low marginal costs for in-scope generation and accordingly assessed Generation Receipts above the Benchmark Price constitute extraordinary earnings worthy of levying.

There is acknowledgement in the Note that the calculation of Generation Receipts should take account of or be adjusted for:

• revenue from accepted balancing market offers
• the net impact of imbalance settlement
• gains and losses on financial derivatives used to hedge output and/or group trading relating to output e.g., buying back electricity in the market at a higher or lower price than output was previously sold. This would therefore suggest that net revenue generated under financially settled PPAs (other than those contracted under the government’s Contracts for Difference scheme) would also count towards revenue for the purposes of calculating Generation Receipts
• any substantial increase in fuel costs to generate which is expected to persist

The details of how these adjustments will operate appear still to be worked through. It is also not clear whether revenue generated by the sale of REGOs is intended to be captured, but the assumption is that it would be.

The overall design of the Levy is somewhat different to the existing energy profits levy, which is calculated in a similar way to the Ring Fence Corporation Tax and Supplementary Charge.

The Levy is intended to apply to in-scope generation activity of a corporate “group”. Further detail is not provided in the Note, but a group for tax purposes typically comprises a holding company and entities which it controls, so there is currently some uncertainty as to how a corporate with a minority interest in one or more generators will apply the Levy. The government has recognised that the treatment of JVs will need further consideration with the Levy being designed to cover electricity generated through JVs. This is a key piece of uncertainty given the scale of many renewables projects has meant diverse shareholdings in generators.

What is the impact on renewables community?

The quantum of the Levy (45%) as well as the term of 63 months will be met with surprise and disappointment by the renewables investment community. The community will also find it difficult to reconcile the Levy with the ‘super-deductions’ style investment allowance that oil and gas producers benefit from under the energy profits levy.

At a time of rising borrowing costs, rising input costs and continued supply chain difficulties, developers and investors will now see the Levy as another challenge to their returns and investment models, from a renewables investment market that had been seen as world leading. We understand the UK government had been unsuccessfully attempting over the past months to persuade generators to voluntarily move to the government’s Contracts for Difference scheme, so this could be interpreted as a strong signal to those calling the government’s bluff. ?The M&A market is likely to see at least a temporary cooling for in-scope electricity generators, given the drag on IRR that the Levy will imply, depending on the project and application of the Levy. Without seeing draft legislation, it is difficult for investors to accurately value generation assets with any precision.

The sigh of relief coming from those holding Contracts for Difference will be matched with a groan of frustration from developers and investors who have been strengthening the UK’s journey towards merchant and off-site corporate PPA-backed revenue streams. They will feel their innovation to move the cost of the UK’s renewables buildout away from billpayers has been penalised rather than rewarded.

Investors will be surprised that a 63-month application period for the Levy has been described as ‘temporary’ and would hope that either through a rapid improvement in economic conditions or a change of approach following the next election, the Levy is reconsidered in order to increase the investment appetite required to meet the UK’s net zero commitments. ?The irony of this Levy being introduced in the same week as #cop27 cannot be ignored.

Our recommendations

We recommend generators, investors and lenders consider the following actions:

• respond to HM Treasury with their views on the proposal as soon as possible, noting that draft legislation is to be published in mid-December 2022;
• consider how the Levy might apply in the context of their particular group arrangements, including JVs, and whether any representations should be made to HM Treasury in this regard;
• make submissions on the ambit of exceptional costs that should be taken into account to reduce Exceptional Generation Receipts; and
• in respect of projects already subject to contracted PPAs (other than on-site PPAs, those participating in the government’s Contracts for Difference scheme or those benefitting from the other exemptions mentioned above), review the change in law provisions (in particular whether changes in tax are expressly declared not to constitute a change in law, which is sometimes the case) to establish how this change could impact the existing balance of risk and reward between the parties. In particular, it should be established whether a change in price under the PPA is allowed to rebalance the negative impact of a change in law, to the extent required, noting that corporate PPAs entered into prior to the last twelve months did on occasion prohibit amendments to the price or settlement mechanics as a result of a change in law. In the past twelve months, carve outs prohibiting amendments to the price following a qualifying change in law have undoubtedly become less common.

Our tax and energy experts are available to explore with you how the Levy could apply to your investments, and the means to influence the final form of legislation.?

For more information please contact: Natasha Luther-Jones , Ben Brown , Bruce Chen and Jennifer Keogh .