Financing the electricity system: Part 2 Hotel California and the cost of reform

Many people are inclined to check their wallets when encountering politicians promising to reduce the cost of living or offering other handouts. Recognising this scepticism, politicians like to claim that they have prepared a “fully costed” assessment of whatever is being proposed. This is dangerous at the best of times, and especially so when they rely on the “garbage in, garbage out” models that underpin official fiscal forecasts. Hence, the current Chancellor, after claiming that no major adjustments to tax rates would be required to meet the fiscal targets in her October 2024 Budget, is now faced with the need to break her party’s pre-election promises by implementing a major tax hike.

The need to reconcile caution with a desire to promote the potential benefits of a major shift in policy is particularly important in presenting the case for reversing the UK’s Net Zero policies. After all, the current Secretary of State for the Department of Energy Security and Net Zero (DESNZ) has repeatedly claimed, both before the last election and in announcing new policies, that his Government’s policies will reduce the average household energy bill by at least £300. This is a nicely ambiguous claim, since it does not rule out offsetting increases in other prices and taxes. Still, on reasonable assumptions there is no prospect that the policies announced so far will achieve the claimed outcome, so the claim if likely to join the long list of political promises that were not - and could not be - delivered.

The potential cost of reversing Net Zero policies has been increased greatly over time by Governments adopting the Hotel California approach to the promotion of renewables – you can check in but you cannot check out. In part, this is a consequence of focusing on forms of generation with high capital costs, negligible operating costs and intermittent output. Risk averse merchant generators will not choose such technologies as the risk of not covering their capital costs is too high when market prices are set either by marginal operating costs or imports. Hence, the government has offered various price top-ups underpinned by subsidised grid connections and (in effect) guaranteed dispatch.

To reinforce these incentives, the contracts offered have been extended in length and revised to include increasingly strong provisions to provide compensation in the event of “adverse” changes in law. In addition, the UK was, until April 2025, a member of the Energy Charter Treaty (ECT) which includes clauses designed to protect foreign investors and their investments against risks including expropriation, nationalisation, and breach of contract. Under the terms of the ECT, the UK’s obligations with respect to the protection of foreign investors continue for 20 years after the UK left the ECT in 2025.

The key provision is Clause 10 whose text is as follows:

(1) Each Contracting Party shall, in accordance with the provisions of this Treaty, encourage and create stable, equitable, favourable and transparent conditions for Investors of other Contracting Parties to make Investments in its Area. Such conditions shall include a commitment to accord at all times to Investments of Investors of other Contracting Parties fair and equitable treatment. Such Investments shall also enjoy the most constant protection and security and no Contracting Party shall in any way impair by unreasonable or discriminatory measures their management, maintenance, use, enjoyment or disposal. In no case shall such Investments be accorded treatment less favourable than that required by international law, including treaty obligations. Each Contracting Party shall observe any obligations it has entered into with an Investor or an Investment of an Investor of any other Contracting Party.

(2) Each Contracting Party shall endeavour to accord to Investors of other Contracting Parties, as regards the Making of Investments in its Area, the Treatment described in paragraph (3).

(3) For the purposes of this Article, “Treatment” means treatment accorded by a Contracting Party which is no less favourable than that which it accords to its own Investors or to Investors of any other Contracting Party or any third state, whichever is the most favourable.

This clause is usually referred to as a guarantee of “fair and equitable treatment”. As written and originally understood, the clause was intended as an obligation to ensure that foreign investors should not be treated less favourably than domestic investors with respect to legal and regulatory policy. However, in the manner of other international agreements, arbitration tribunals have extended that interpretation to cover adverse legal and regulatory changes of any kind, not just those which discriminate against foreign investors. In practice, this gives foreign investors rights that are superior to domestic investors, who cannot rely on its provisions. Further, it creates an unholy mess when both foreign and domestic investors own shares in domestic holding companies or special purpose vehicles.

As an illustration, the ECT has provided the basis for many arbitration cases filed by foreign investors against the Spanish Government in relation to the Spanish renewables saga. These cases were prompted by Spanish decisions between 2010 and 2014 to limit or revoke subsidies and special privileges for renewable generation following the impact of the Eurozone financial crisis on Spain’s economy. Many of these cases were based on what was referred to as “legitimate expectations of the stability or consistency of the legal and regulatory framework”. These cases have tended to revolve around two questions:

· Did the government make a specific commitment to the investor concerning the nature and level of subsidies? In the case of CfD contracts, there is little doubt that the UK government has made such commitments to the CfD counterparties and their investors.

· If no specific commitment to investors has been made, is the legal or regulatory change one that deprives investors who invested in reliance on the legal or regulatory regime of (a part of) their investment’s value? This has been construed to apply to any changes in government incentives that have a “disproportionate” effect on the returns earned by foreign investors.

Arbitration tribunals dealing with such cases face a dilemma. They recognise that the second question might effectively preclude any change in regulation or incentives applied to existing as well as future investments. Nonetheless, many tribunals have been willing to adopt either (a) a generous interpretation of the phrase “specific commitment” to cover any reference to existing regulations and incentives in official correspondence, or (b) the view that any change in incentives had a “disproportionate” impact on investors.

Such an expansive interpretation of the ECT could have large implications for the cost of reforming Net Zero policies. Consider an example that is quite distinct from subsidy arrangements. The costs of system balancing and the capacity market have grown rapidly over the last decade and are likely to grow even faster in future. In my assessment of the costs of the current government’s Clean Power 2030 I estimated that these items alone would increase from a total of about £4 billion in 2024 to about £15 billion in the Clean Power 2030 scenario. The costs are recovered by a levy per MWh on energy suppliers that is passed on to electricity consumers with a predicted average levy in 2030 of about £44 per MWh at 2024 prices.

It should also be noted that the structure of charges to cover balancing costs was changed in 2023-24. Up until then the costs were calculated on a half-hourly basis and were split between electricity generators and electricity consumers. The change in 2023-24 transferred all the costs to electricity consumers and the costs were averaged quarterly. This was a deliberate effort to benefit renewable generation as well as to obfuscate the extent to which the increase in intermittent renewable generation was increasing the costs borne by consumers.

On any reasonable economic analysis more than 90% of the costs of system balancing and the capacity market are directly linked to the role and impact of intermittent renewable generators in meeting electricity demand. Thus, the logical and economically appropriate way of recovering these costs would be to impose an appropriate combination of levies on renewable output and renewable capacity. It would not be especially difficult to calculate such levies. Making such a change would be a reasonable and quick way of ensuring that system costs are borne by the parties which give rise to the costs. Any renewable generator that is willing to commit to providing firm dispatchable power would be exempt.

Now, imagine the response of foreign investors in wind and solar generators to such a regulatory change. Based on the Spanish example, it is likely that they would submit many claims for compensation to arbitration tribunals on the grounds of violation of the ECT’s provisions concerning fair and equitable treatment. This would have nothing to do with discrimination against foreign investors but would be based on the argument that the ECT protects them against any adverse – even though efficient - regulatory changes.

Take this one step further. Such claims would be an open invitation to some politicians to campaign against international agreements and judges on the basis that such claims seek to force the government to increase electricity prices for consumers by about 20% to protect largely EU investors in renewable generation under a treaty that we left years previously. While the facts are considerably more complicated than that, the furore would be enormous but mostly unhelpful in the longer term.

Since 10 EU countries have withdrawn from the ECT since 2015 – including Spain – for various reasons, it is clear there is widespread unhappiness with the language and interpretation of the Treaty. Usually, the reason given is that the Treaty penalises green climate action, but that is just spin aimed at gullible defenders of international agreements. The substantive issue is that the Treaty’s provisions, as currently interpreted, protects the status quo from significant changes in policy and regulation, whether to promote renewable energy or to reverse such policies.

For these reasons, any Government with a serious intention to reverse Net Zero policies and to modify the treatment of renewable energy in the UK electricity market should consider revoking or limiting the commitment to implement arbitration awards for 20 years following withdrawal from the ECT. The original intention to ensure fair and equal treatment of foreign investors relative to domestic investors remains valid. However, all major EU countries have concluded that the expanded interpretation of the ECT’s provisions give greater rights to foreign investors than to domestic investors in respect of any changes in legal and regulatory arrangements. Enacting legislation that bars UK courts from enforcing ECT arbitration judgements on any grounds other than equal treatment of foreign and domestic investors would not only be reasonable but essential to permit a new government to change the direction of energy policy.

Of course, there will be complaints from the usual suspects about joining the Russians in refusing to accept ECT arbitration judgements. Still, this cannot be a good reason for accepting the drift in the interpretation of the Treaty by lawyers and arbitration tribunals that has vastly changed its nature and implications for domestic policy.

The alternative approach would be to follow a strategy that game theory economists call “tit for tat” (for obvious reasons). In that case, the government implements the change and offers modest compensation to all (not just foreign) investors affected. Eligibility for compensation would come with a condition that the investor foregoes any right to seek compensation under the ECT. Any foreign investors who choose to forego such compensation and to pursue compensation under the ECT will be warned that (a) such cases will be resisted by the UK Government by all possible means, and (b) the investor, including any affiliated parties, will be blacklisted from any involvement the UK’s energy sector for a lengthy period – perhaps 20 years. Anyone who argues that retaliation is improper in this context is just naïve.

The residual burden in 2030 of policies affecting the electricity system to promote Net Zero will be very large. Changes such as abolishing the Emissions Trading System or accelerating the phase-out of the Renewables Obligation (due to disappear by 2037 anyway) will only have a small impact on the total cost falling on electricity consumers. To do more will require radical changes that are likely to prompt claims for large amounts of compensation under the current Hotel California system of contracts and legal assumptions.

Any politician thinking of making real reductions in the costs of Net Zero must recognise and prepare for the need to adopt a harsh approach to those who benefit from the existing arrangements. Tinkering at the margins is just playacting. It is not yet clear that those who claim they want to change course really understand the challenges that they will face. To return to my initial point. Promises to reduce energy costs by abandoning Net Zero will simply lead to both disappointment and further loss of trust in politicians, unless the steps required to make a real difference are full understood. It is not the numbers that matter but a clear understanding and commitment to do whatever is necessary to change course.