The government’s proposal to lift the restrictions on the ownership of onshore transmission assets and open up the market to competitively appointed transmission owners (CATOs) has sparked significant interest from funders, investors, developers, supply chain providers and incumbent transmission and distribution system operators. The government is keen to capitalise on the momentum and success of the offshore transmission owner (OFTO) regime and industry seems equally keen to apply expertise developed offshore to onshore network expansion.
Assets tendered as CATOs must be “new, separable and high-value”. During the current RIIO-T1 price control period (which applies until the end of March 2021), only projects that are “strategic wider works will be tendered”, and initially the ‘late CATO’ model will be the one that is deployed.
As the government evaluates responses to its recent consultation and works to flesh out the detail, its initial proposals for the programme already present opportunities and challenges. Advance thinking and strategy around some of these potential legal and structural pinch points will better inform industry’s dialogue with government as the regime evolves and enable a smoother and more successful rollout of the programme.
Competitive tender process
The principal rationale for CATOs is that by having an open competitive tender, transmission assets will be delivered at a lower cost and represent better value for money. To ensure this is achieved, a clear, certain tender process that maximises the number of participants is crucial. One of the first challenges for potential CATOs will be to successfully navigate this competitive framework.
On the available information, the tender process for the ‘late CATO’ model is likely to be through the OJEU (Official Journal of the European Union) process, and it will take between 18 and 24 months, depending on the size and complexity of the asset. There will be four stages to the tender process:
- Enhanced pre-qualification (3-6 months).
- Invitation to tender – bidders’ response (6-8 months).
- Invitation to tender – evaluation (3-4 months).
- Preferred bidder stage (6 months).
Participants will be required to:
- include detailed design work;
- have undertaken supply chain engagement for construction and operations and maintenance;
- present fixed price bids with only a limited number of cost reopeners; and
- nominate the proportion of the total revenue stream that will be indexed.
Clearly, prospective participants will have to invest significant time, energy and money in the tender process, although it is likely that only a successful CATO will recover its bid costs. Ofgem has indicated that it is considering extending bid cost protection to the full range of bidders, although they note that this may only apply where project need is still in question when the invitation to tender (ITT) commences.
No doubt Ofgem will have to consider bid cost recovery carefully for the ‘early CATO’ model as well, on the basis that it has a much later final tender checkpoint where project need is decided.
Some bidders may have more experience of the OJEU process than others. A limited track record with competitive procurement is likely to complicate the tender process for such bidders when they consider early projects and they may need additional time to build up the required skills and support.
For any bidder, early engagement with consortium members (including funders) and the supply chain will be necessary. Early engagement of the supply chain will be particularly important when there is a limited number of participants or lead times are lengthy.
Finally, to ensure the process is truly competitive and the best value for the asset is obtained, it is essential that the final tender process is clear, certain, minimises costs of tendering and takes account of any knowledge held by incumbent transmission owners or the system operator.
Preliminary works Under the ‘late CATO’ model, initial solution designs, studies, surveys and planning consent will be undertaken by the system operator or possibly the incumbent transmission owner. It is also possible that the CATO will have to reimburse the system operator or incumbent for such work.
This creates two challenges for prospective CATOs. First, if any issues with the preliminary works are identified during the tender process, the government must decide when those issues will be dealt with. Based on the timetables provided by Ofgem, the planning application, its examination and decision will occur concurrently with some, if not most, of the tender process. The consultation includes at least three different proposals on the timing of the ITT versus the preliminary works, but the earliest option could result in planning consent being granted just before the preferred bidder stage – or later, if there are delays in the planning process.
Given that the outcomes of various preliminary works – including conditions on planning consent – will set the parameters for a tender, if the information is provided later it will be harder to provide certain bids.
A potential CATO may have to prepare its tender (or at least start the tender process) without knowing the conditions of any planning consent. Although the tender process may permit issues that have cost implications to be reopened, it is likely that there will be pressure to minimise this, either directly by reopener issues or indirectly through the pressure of participating in a competitive bidding process.
Given the need for transmission assets in the UK and concerns about security of supply, it is understood that some overlap between the preliminary works and the tender process is essential to ensure assets are brought online as quickly as possible. However, this will have to be balanced with CATOs’ need to have enough information to submit meaningful bids.
A potential CATO may have to prepare its tender without knowing the conditions of any planning consent.
Second, the consultation is clear that the system operator and transmission owner will not have any significant liability to the successful CATO for any mistakes or defects in relation to the initial solution designs, studies, and surveys and planning consent.
Ofgem’s preference is to rely on incentivising the system operator or operator to deliver the preliminary works on time and to a high standard through a combination of cost-recovery provisions under their licences and, potentially, a one-off ‘success fee’. Where issues with those works do arise, the consultation is scant on detail but suggests that CATOs may have the benefit of a licence mechanism that compensates them for related ‘economic’ and ‘efficient’ costs.
The workings of this licensing mechanism must be robust, not just for prospective participants but for their funders and investors. Under a traditional project finance structure, studies, design and surveys are often outsourced to a third party, but developers and investors typically have a contractual relationship with the third party and often the benefit of indemnities under a contract and the third party’s professional indemnity insurance.
Similarly, when developers and investors acquire a project before construction they would expect to rely on due diligence, warranties and indemnities provided by the vendor, together with an assignment of any recourse to third parties carrying out the development work – under contract or otherwise.
The licensing mechanism must replicate this cost-recovery position as closely as possible, particularly if Ofgem decides that CATOs will pay (and potentially arrange funding for) the transfer of the preliminary works themselves.
The risk will be further mitigated by prospective participants’ due diligence on the preliminary works during the tender process. However, if this information, combined with the cost-recovery provisions in the licence, is not sufficient, any residual risk may have to be priced into the potential CATO’s bid.
As a final note on the preliminary works, Ofgem must finalise its proposals on how they will be transferred to or shared with successful CATOs and at what price. It is minded to use ‘fair value’ as a benchmark and to include asset transfer or sharing mechanics in the ITT. However, given the issue of timing of finalising preliminary works, prospective participants will need early warning of transfer and pricing arrangements to prepare sensible bids.
There is always a significant risk during the construction of an infrastructure asset. Costs are incurred, no revenue is being generated and there is no asset to generate that revenue. The issue is who should bear the construction risk – and in both CATO models the consultation indicates that most or all will be borne by the successful CATO. Timelines for building CATO assets are long – Ofgem estimates construction periods of 36 months or more, particularly where nuclear assets are involved. And under the ‘late CATO’ model as currently proposed, the successful CATO will not receive any payments until construction is complete.
This will affect the structure and financing of a CATO. Prospective participants, whether they are developers, investors or funders, must consider their appetite for construction risk. From the perspective of an investor or funder, construction risk will affect the terms, structure and availability of financing.
This appetite for construction risk will vary depending on the nature of the asset being tendered. If it involves established technology (such as HVAC), a wider range of financing options will be available. If the asset involves less established technology (such as HVDC), bank financing is more likely to be the only type available before completion, with the possibility of a capital markets refinancing after delivery.
It will also rely on the risk allocation adopted by Ofgem for the construction period. Risks will have to be allocated to parties that are best able to manage them to make CATOs bankable. Treatment of delays will be of interest, particularly in light of the interface with the wider electricity network and the policy importance of having infrastructure completed on time. Ofgem suggests that CATOs should be appropriately incentivised by:
- their revenue stream commencing on completion;
- finance monitoring, similar to that imposed currently on transmission owners;
- Ofgem’s ability to replace the CATO if it is unable to continue its obligations during construction or operation, through a ‘CATO of last resort’ mechanism.
However, delays and related consequences for CATOs are still in flux until the programme is finalised. CATOs will have to consider these measures and how they interface with other contracts.
Level playing field
The government says the CATO opportunity is intended to attract a wide pool of prospective participants to ensure competitive pressure. However, there are some potential barriers to entry that Ofgem should consider and mitigate to maximise bids.
Regulations CATOs will operate in a heavily regulated environment. The current regulatory framework for the electricity industry in general and transmission operators in particular is complex. Unless participants have been involved with the OFTO regime or have run another licensed business in the utility sector, operating a CATO within this environment will likely pose a number of challenges for them. These include:
- participating in a ring-fenced business;
- being required to hold a licence and the consequences of that, including penalties for breach of a licence condition;
- complying with various codes and industry agreements;
- conflicts of interest.
If a CATO is to be considered a bankable project, it will be essential to address the real or perceived competitive advantage that a CATO may have when it includes the system operator or a transmission owner. Ofgem has acknowledged this and is still considering appropriate solutions.
Operations, maintenance and system support
Ofgem is keen to ensure that new assets are appropriately operated and maintained by the successful CATO, given their obvious importance to the workings of the overall network. It views the CATO licence as the principal means for regulating the CATO’s activities and ensuring that it meets expectations, but is also considering the addition of a performance-based availability incentive. However, the final scheme will have to acknowledge that some elements of the CATO’s performance of its obligations will be contingent on interfaces with, and support from, the broader electricity network.
As an example, incumbent operators often establish a maintenance and depot network for their own works. Will the cost to CATOs of setting up such depots and networks independently be prohibitive, preventing potential participants from bidding, or act as a competitive advantage for existing operators? Regulation and licensing may be an appropriate way to resolve this problem – incumbent operators could be required to make their depots available in accordance with a regulated timeframe and tariff.
To the extent that such issues affect asset availability there could be financial consequences for successful CATOs. There is little information in the consultation about what an availability incentive might look like – although Ofgem has indicated that at least 10% of a CATO’s revenue stream could be at risk for under-performance.
The OFTO regime has provided the building blocks for the proposed CATO programme, but location is a key difference. CATOs will be onshore and, importantly, be closer to populated areas and interface with more participants in the electricity market. This has the potential to create a more complicated and vocal stakeholder matrix. This challenge is likely to increase if the tendered asset includes any nuclear infrastructure, which Ofgem has indicated is a possibility.
It is true that the CATO will not be engaging with stakeholders during the planning process, but this presents its own complication. A CATO’s ability to manage and engage with stakeholders (landowners, for example) will be further complicated because the CATO is not starting with a clean slate. The planning consent processes and engagement throughout the preliminary designs will not be managed by the CATO but by the entity undertaking these works (the system operator or incumbent owner).
Complex stakeholder management is an issue that is present in much of the infrastructure sector and there are many tools to help CATOs, but some participants (such as sponsor entities and construction companies) will be more familiar with it than others. The key point is that it is more of an issue than for OFTOs, and should be assessed early to allow for early engagement and management.
It is a tenet of the CATO models that an asset be separable (that it must be possible to delineate clear ownership boundaries) but that electrical separability is not required. CATOs will be operating within the transmission system and wider electricity network. To ensure continuity and stability of the network, interfaces between the various transmission assets and other components of the electricity network, including generators and DNOs, must be clearly defined and recorded. This will include determining liability to other parties in situations of asset failure. As the number of CATOs multiplies, this could become more and more complex.
Handback provisions There will be a high residual value in the asset at the conclusion of the 25-year fixed revenue stream. The life of assets being tendered could be up to 45 years. This is different from OFTOs, where the life of the asset generally matched the revenue period. How the asset is dealt with at this point will be of particular importance, and CATOs must ensure this is clearly agreed and documented.
CATOs present an exciting opportunity for different participants in the electricity sector in general and transmission assets specifically. Potential participants should consider their position on the above issues now so they have time to resolve any issues.
Is your project suitable for competitive tender?
The government, through Ofgem, initially published a consultation letter on 29 May 2015 to establish the criteria for projects to be eligible for competitive tendering. That consultation closed on 10 July 2015. This established the approach taken as to the meaning of ‘new, separable and high-value’: assets qualifying for tender must be greenfield assets or entire replacement of existing assets, have clear ownership boundaries (but without the need for electrical separability) and have capex in excess of £100m.
A full consultation, closing on 11 January 2016, received 37 responses and covered issues such as identifying projects for tender, the difference between the proposed early and late development model CATOs, the structure and approach to remuneration and managing potential conflicts of interest. Ofgem is expected to respond in the first half of 2016.
On 21 January the Department of Energy and Climate Change published draft legislation for the CATO regime and on 4 May, the House of Commons Energy and Climate Change Committee published its pre-legislative scrutiny report of the draft legislation. The draft legislation does not answer any of the questions raised in this article. The highlights of the draft legislation are that it:
- introduces the idea of competitive tenders for onshore transmission licences, with the details of the process to be set out in regulations;
- makes it clear that Ofgem’s costs associated with the tender may be recovered as set out in regulation; and
- sets out the idea of transmission of last resort.
The report by the House of Commons Energy and Climate Change Committee recommends that a number of issues are clarified before the legislation proceeds. They include the process of determining whether or how to tender, which has to be finalised. It also asks for clarification on how the risk of delay will be mitigated. Ofgem wants to be in a position to run the first onshore transmission tender in 2017.
This blog post was first published in New Power, June 2016.