Infrastructure funds are excited about investing in interconnectors to the UK. Yet given Brexit, competition for energy supply and merchant risk, is it a good investment?
The UK’s desire to source a sizeable chunk of its energy needs via new transmission links with neighbouring countries has created a large potential investment opportunity in the coming years.
The country currently has four interconnectors in operation with a combined transmission capacity of 4.2GW. They include a National Grid-RTE link with France (2GW), Mutual Energy’s Moyle link with Northern Ireland (500MW), National Grid and Tennet’s BritNed link with the Netherlands (1GW), and EirGrid’s EastWest link with Ireland (500MW).
However, this could potentially quadruple to 16 links and close to 20GW of capacity if all planned links are realised by 2023.
Full deployment will require over GBP 10bn of capex investment, with costs ranging from around GBP 500,000 per MW to over GBP 1m per MW, depending on the length of the lines being developed, sector sources said.
Their rationale is simple. With the UK facing a looming supply shortage as baseload energy generators go offline, new nuclear continuing to face delays, and a growing portfolio of intermittent renewable energy plants, there is a strong investment case for importing cheaper, surplus energy from European markets.
Their development also plays into the concept of an integrated European grid, whereby each country’s security of supply can be enhanced by being able to easily tap into other countries’ energy sources.
UK government support
The UK’s willingness to embrace interconnectors is demonstrated by regulator Ofgem’s launching of cap and floor support in 2014 to help create the right environment for investment in the sector.
Under the mechanism, interconnectors can register for a cap and floor price at which they would supply energy over a 25-year period – if the market price falls below the floor the owners are remunerated via an addition to consumer bills, if it rises above the cap they pay the difference back to National Grid.
In 2015, Ofgem granted in principal support cap and floor support to an initial five projects: the 1.4GW NSL link to Norway (which is being developed by National Grid and Statnett); the 1.4GW FAB Link to France (Transmission Investment and RTE), the 1GW IFA 2 link, also to France (National Grid and RTE), the Viking Link to Denmark (National Grid and Energinet 1GW) and Greenlink to Ireland (Element Power 500MW).
In June this year, the sector received a further boost when Ofgem announced it was “minded to” award cap-and floor support to GridLink, NeuConnect and North Connect (each 1.4GW), which would connect to France, Germany and Norway respectively.
The UK will clearly benefit from the existence of the interconnectors. NorthConnect would allow the UK to tap into excess hydro power from Norway, for example, while NeuConnect can take energy from Germany’s growing fleet of offshore wind farms in the North Sea.
Germany’s offshore wind energy may eventually be transmitted to southern Germany but is currently prevented from doing so due to grid constraints. Grid operator Bundesnetzagentur must instead pay compensation to owners of the wind farms for curtailing generation. Unsurprisingly, it is said to be very supportive of the NeuConnect link.
Interconnectors with France meanwhile, such as FAB Link and Grid Link, would gain access to energy generated by the country’s large nuclear fleet.
In addition, there will also sometimes be a market for selling energy back the other way, as evidenced when France had to import from the UK last winter after temporary shut-downs at a number of its nuclear plants.
Ofgem’s cap-and-floor mechanism has been attractive enough to draw in infrastructure investors including Meridiam (NeuConnect), iCON Infrastructure (GridLink), and Amber Infrastructure-backed Transmission Investments (FAB Link) even though these projects are up to six years away from completion.
Fund involvement at such an early stage shows a solid appetite for development risk, as final permits and regulatory agreements will still need to be negotiated.
“People are taking quite a bit of development risk, there’s no question about that, so the industry is hoping for low teen net IRRs,” said one source active in the space.
FAB Link, one of the first batch of cap-and-floor projects, is not expected to make a final investment decision until Q1 2018, for example, as this ties in with an anticipated verdict on its planning application to lay cables over the island of Alderney. It will also be subject to a final project assessment from Ofgem around the same time. Commissioning is targeted for 2021.
The group mandated RBC at the start of 2017 to assist in future financing arrangements, although a formal process seeking third-party equity has not yet launched, it is understood.
iCON’s GridLink project, being developed alongside Elan Energy, is scheduled to be operational in 2022, while Meridiam and Frontier Power and Greenage Power-backed NeuConnect is even further away from realisation, with financial close on the project not anticipated until 2020, and commissioning in 2023.
Links are also fundamentally merchant, despite having the guarantee of a floor price for any energy they sell.
“This is because they have to auction their capacity – under a number of different routes – to get their revenues,” one sector player said. This includes both selling into the grid, and on a bilateral basis to specific corporate customers.
The Brexit vote in 2016 has created unwelcome complexities largely because it is not yet know whether the UK will remain in the EU’s Internal Energy Market (IEM), a system that allows for efficient energy trading between countries.
Despite this stakeholders are optimistic fundamental drivers will remain, namely the arbitrage revenue on offer, with sellers securing a market for surplus energy and buyers selling on at a mark-up into the UK market.
Ofgem’s regulatory support creates the possibility for sponsors to tap project finance, as lenders should be able to structure deals against the floor price.
“Everyone will then look to see if they can convince lenders to lend more than that based on projections of the revenue above the floor, and other sources of revenue – like the capacity market, and auxiliary grid services,” one sector source said, conceding that conservative 60% gearing was most likely.
Other interconnectors – such as Grupo Eurotunnel’s GW ElecLink scheme, and the 2GW Aquind project, both with France – have opted to exempt themselves from cap-and-floor support and are taking full price risk.
This will allow them to keep all of their profits, although they are also exposed to substantial risks if energy prices go against them, meaning securing project finance will be a challenge.
ElecLink is a prime example.
Hybrid infrastructure-private equity investor Star Capital acquired a 51% stake in the link in 2011 as part of a JV with Grupo Eurotunnel, and attempted to raise debt to back its interest.
Yet despite successfully taking the project through various phases of development, the investor sold on its stake to its co-investor in 2016 without concluding financing.
The 2GW Aquind scheme, meanwhile, which is backed by Ukrainian-born businessman Alexander Temerko and has earmarked a 2021 connection date, has also opted for exemption from cap-and-floor support.
A spokesperson for Aquind declined to comment on when a capital raise for the GBP 1.1bn project would kick off, saying only that “the team have already seen interest from private international investors and are confident about being able to raise the necessary funding”.
One potential risk to interconnectors’ success could come from rival schemes.
While NeuConnect is currently the sole interconnector being planned with Germany, for example, four such links are on the cards with France.
This cluster of projects means there is a risk that not all links will be able to auction out to their full capacity, although sector sources say there is enough demand for everyone.
There is also a potential concern that over time energy prices across Europe will level out, eroding a business case which relies on arbitrage, although cap and floor projects argue that they are protected from this by the 25-year tenor of the agreement with Ofgem.
For projects outside of this support mechanism – such as Eleclink and Aquind – this could be more of a concern, although there is also an opportunity in selling energy back the other way.
Regardless, investors’ willingness to get involved in cap and floor schemes, years ahead of project completion, shows they firmly believe in the sector.