Out-Law / Your Daily Need-To-Know

The regulator is currently consulting on its proposed arrangements, which would allow it to appoint 'competitively appointed transmission owners' (CATOs) to design, build and operate new, high-value assets in Great Britain (GB). It is planning to issue its first tenders in 2017, with notice of projects to be tendered published from the middle of 2016.

We recently discussed the opportunities (8-page / 1.6MB PDF) at an event with financial advisors Centrus Advisors and technical advisors Jacobs.

Although it is not yet clear which projects will meet the criteria for competitive tendering, the evidence suggests that the potential size of the market is likely to be significantly bigger than the £2 billion-plus offshore transmission market has yielded to date. Ofgem has informally estimated that it will award between £1bn and £1.5bn worth of projects each year until the current performance-based price control mechanism period ends in 2021.

Ofgem's desire to encourage competitively tendered investment delivery is clearly driven by the considerable investment GB's electricity transmission network needs to support changing generation sources, patterns and locations. The onshore transmission owner (ONTO) opportunity is real; and, with information regarding the first tender expected in the next six months, is now.

Criteria

In very general terms, the criteria that Ofgem has set before investment in overhead lines, cables or substations will be considered for tender are that they are:

• new and separable; meaning greenfield assets or replacement assets where the ownership boundaries can be clearly delineated in industry codes and standards;
• high value; meaning a minimum capital value of at least £100 million.

There has been lively debate between transmission operators and other industry experts regarding whether complete electrical separation will be necessary or not, even though most agree that it will be desirable for clear accountability in operations. There has also been a proposal that existing assets may be transferred to a CATO where this makes operational logic for the benefit of the overall scheme.

Different tender models

Ofgem has proposed two different models covering how and when they will run tendering. These are an 'early' and a 'late' CATO build, with the main difference being that the system operator (SO) or transmission operator (TO) would complete preliminary works including environmental impact assessments, high level asset design and securing planning consent. Unlike the generator-build OFTO model currently in use for offshore transmission assets, both ONTO models assume that the CATO will construct as well as operate and maintain the assets.

The 'early' build model would have significant implications for prospective bidders; including much longer lead times before operational cash flows would begin; and a need for the project consortium to include asset and detailed design and construction management skills. However, Ofgem has informally signalled that only 'late' CATO builds are likely before the end of the current price control period.

Regulation and revenue

Ofgem has proposed that CATOs bid to receive 25-year fixed annual revenues which would cover required capital expenditure, operational expenditure and financing costs, with a sharing of the benefit of any debt refinancing.

To incentivise delivery of assets on time, revenue payments would only begin once the assets are available for use. However, this may be amended for projects that are expected to take longer than five years to build. Ofgem's initial view is that annual revenue at risk from underperformance should be capped at 10%, as is the case for offshore transmission operators.

Technical, financial and legal considerations

Although there are clear parallels between the planned CATO regime and the existing competitive offshore transmission owners (OFTO) regime, the drivers to tendering success are likely to be different.

Project size

Ofgem is proposing a minimum capital value of £100m for CATO projects, based on a cost-benefit analysis. This size may be on the small side for equity. OFTO tendering round 1 projects were valued below £100m, while round 2 projects were over £250m.

Term

OFTOs are appointed over a 20-year operating period. CATOs will be appointed for both the construction and a 25-year operating period. A revenue stream of 25 years, including a build period of up to give years, should allow sufficient sources of long-dated finance to be tapped.

Scope of responsibilities

While the OFTO regime includes both generator and OFTO build options, the only model operated so far is the generator build. OFTO activity has therefore so far been limited to 'asset transfer, own, operate'.

CATOs will require a very different mix of capabilities. The model is based on 'design, construct, own, operate', while early tender CATOs may also be required to develop the design solution and achieve consents.

Nature of assets

CATO assets are likely to include mainly conventional onshore assets including overhead lines, cables, substations, high-voltage direct current (HVDC) transmission systems, etc. Submarine cables may be included for bootstrap-type projects.

OFTO assets exclude overhead lines and are mainly offshore substations and subsea cables, plus the onshore substation assets. For Crown Estate R3 projects, HVDC technology will be involved.

Engineering capability

Other than during due diligence, engineering capability is less relevant for OFTO projects where the emphasis is on operation.

For the CATO process, however, engineering capability will be a critical part of the process to design solutions, detail design and construct/commission.

Bid terms

All OFTO financing, including equity return, debt and gearing, as well as operating costs are included in the firm bid.

For CATO projects, the position is more complicated and will depend on whether the project is early or late:

• late CATO: fixed equity return, debt cost and gearing, capital expenditure, operational expenditure and some design - fixed for 7-9 months pre-financial close. No opportunity for sharing factors for costs that Ofgem believes should be fixed and subject to competitive tender pressures; limited reopeners allowed for costs beyond bidders' control;
• early CATO: fixed equity return, gearing level, development costs including design and planning; indicative debt costs, capital and operational expenditure. Final debt cost will be fixed at financial close through a debt funding competition. Given the time period between bid submission and receiving all consents, only those 'near term' costs not subject to uncertainty need to be firm.

In both cases, the Ofgem process for signing off costs will need to be priced by equity over the whole project life.

Bid resources

Due to its nature, the OFTO regime applies to relatively few projects which have been well-distributed over time. The CATO regime, on the other hand, could potentially apply to a large number of projects requiring significant tendering resources. Availability and management of resources will therefore be critical for CATO bidders.

Competition

Where OFTOs tend to be similar organisations set up specifically for the OFTO business, the CATO regime is likely to attract new players along with the incumbents - including the existing contractors, who could be potential competitors as well as partners. So although there will be many more CATO projects, competition for them is likely to be more intense.

Revenue stream

OFTOs bid for a single revenue stream, where capital expenditure is already known. Revenue streams for CATOs will depend on the procurement model used:

• late CATO: one revenue stream to cover capital and operational expenditure, that will be paid post-construction;
• early CATO: two revenue streams, one for preliminary works and one for construction and operation. The latter will be paid only when assets are available for use.

Due to the long time period between the bid and the start of construction for early CATO projects, the CATO is not expected to have to carry development costs for that period. The second revenue stream will be finalised only at the final checkpoint, once costs and debt pricing are finalised.

Revenue at risk

OFTOs risk up to 10% of revenue per annum for underperformance based on availability, with rewards of up to 5% allowed if the availability target is exceeded. Similar revenue at risk is planned under the CATO regime, but final revenue incentives for outperformance remain to be determined.

Technical risk

CATOs would generally be considered lower risk than OFTOs, other than during the planning and consent process. OFTO assets are normally already designed and built, but carry the higher risks associated with offshore and subsea equipment.

Additional capital expenditure

OFTOs are permitted to reject additional capital expenditure exceeding 10% of the transfer value. CATOs will be subject to a revenue adjustment mechanism, allowing for additional investment in upgrades or new extensions over the 25-year term. However, Ofgem's process for signing off changes could be a major issue for debt financing and ratings.

Payment for existing assets/development costs

Under the OFTO regime, the transfer value of the asset to be bid on will include known development costs and the capital costs of the incumbent, subject to an efficiency assessment by Ofgem.

It is too early to establish the implications of these costs for CATOs. Ofgem has not yet decided whether existing assets will need to be paid for on transfer from incumbent for late CATO projects. Equivalent costs in the form of development costs prior to financial close in early CATO will be paid for through an early revenue stream.

Legal regime

The success of OFTO as a new investment class has been due in part to Ofgem's robust regulatory framework, which gives certainty that revenue is stable and has limited downsides.

The CATO regime draws from the regulatory framework implemented for OFTOs – specifically 'OFTO-build' which is, as yet, untested. However, there is no reason to believe that the CATO regulatory regime will be any less robust than the OFTO regime.

Residual asset value

It is proposed that CATO assets will be depreciated over 45 years in line with onshore transmission generally. However, the revenue term is 25 years. Ofgem will need to provide further clarity to the market about how residual asset value will be treated - for example, the framework for making any residual asset value payments.

Depreciation is perhaps less of an issue offshore, given that the tender revenue stream is tied to the life of the generation capacity.

Bidding structures

For OFTO, we have seen incorporated and unincorporated structures to ensure the right mix of skills - both technical and financial - are available to bidders. Similar considerations are likely to apply to CATO bidders.

Michael Watson is a project finance expert at Pinsent Masons, the law firm behind Out-Law.com.