COMMISSION DECISION. of

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1 EUROPEAN COMMISSION Brussels, C(2014) 5475 final COMMISSION DECISION of on the exemption of ElecLink Limited under Article 17 of Regulation (EC) No. 714/2009 for an electricity interconnector between France and Great Britain Only the English and French texts are authentic EN EN

2 COMMISSION DECISION of on the exemption of ElecLink Limited under Article 17 of Regulation (EC) No. 714/2009 for an electricity interconnector between France and Great Britain Only the English and French texts are authentic THE EUROPEAN COMMISSION, Having regard to the Treaty on the Functioning of the European Union, Having regard to Regulation (EC) No 714/2009 on conditions for access to the network for cross-border exchanges in electricity 1, and in particular, Article 17 thereof, Whereas: (1) Article 17 of Regulation (EC) No 714/2009 of 13 July 2009 on conditions for access to the network for cross-border exchanges in electricity (hereinafter the Electricity Regulation") provides the possibility for Member State authorities to exempt new electricity interconnectors from Article 16(6) of the Electricity Regulation and Articles 9, 32 and 37(6) and (10) of Directive 2009/72/EC concerning common rules for the internal market in electricity (hereinafter the "Electricity Directive") 2 provided certain conditions are fulfilled. (2) Article 17(7) of the Electricity Regulation provides for the Commission to be notified of the decision by the national authorities on an exemption request and its Article 17(8) provides for the Commission to approve the exemption or to take a decision requesting the notifying bodies to amend or withdraw the decision to grant an exemption. 1. Procedure (3) On 11 September 2013, Eleclink Limited submitted its request for exemption to the French Energy Regulator, Commission de Régulation de l'energie, (hereinafter "CRE") and on 18 September 2013 to the British Energy Regulator, the Gas and Electricity Markets Authority (hereinafter "Ofgem") in accordance with Article 17 of the Electricity Regulation. (4) CRE and Ofgem undertook a joint public consultation between 28 November 2013 and 3 January (5) Based on their assessment of the exemption application and the results of the consultation, Ofgem and CRE developed a "Joint opinion of the Commission de régulation de l'énergie (France) and the Gas and Electricity Markets Authority (Great Britain) on Eleclink's exemption request under Article 17 of the Electricity Regulation for an electricity interconnector between France and Great Britain" (hereinafter "Joint Opinion") setting out the exemption decisions applying to their respective jurisdictions. 1 2 OJ L 211, p. 15. OJ L 211, p. 55. EN 2 EN

3 (6) Both the French Exemption Decision and the British Exemption Decision (hereafter referred to as "Exemption Decisions") were notified to the Commission on 20 March 2014, together with the Joint Opinion (which forms an integral part of the Exemption Decisions). (7) On 3 April 2014, the Commission published a notice on its website 3 informing the public of the notification and inviting third parties to send their observation by 22 April The Commission has received no observations from third parties. (8) On 5 May 2014, the Commission services addressed to CRE and Ofgem a request for additional information, in order to allow for a full assessment of the Exemption Decisions. This information was provided on 26 May The request triggered the extension of the deadline for the treatment of the case by a period of two months, until 28 July 2014, as provided for in Article 17(8) of the Electricity Regulation. (9) On 23 April 2014 and 5 June 2014, the Commission services met with Eleclink. Eleclink provided additional information at this meeting and subsequently. (10) On 2 July 2014, the Commission services met with the relevant national regulatory authorities (hereinafter "NRAs" or "Regulatory Authorities" or "Authorities"), CRE and Ofgem. 2. Description of the project and modalities of the exemption request (11) ElecLink is an interconnector linking the Great Britain and French markets through the Channel Tunnel (hereinafter the "Project"). The project is being developed by ElecLink Limited Shareholders in ElecLink Limited (12) According to the information provided by ElecLink Limited in its exemption application, it is owned 51% by STAR Capital and 49% by Groupe Eurotunnel (together the Shareholders ). The information provided indicates that: STAR Capital is a private equity fund 4. STAR Capital has in excess of 1bn of funds managed and/or advised by STAR Capital Partners Limited, a company incorporated in England (registered number ). STAR Capital s investors are a broad mix of pension funds, insurance companies, fund of funds and family offices. Groupe Eurotunnel manages and operates the Channel Tunnel through the Concession Agreement which lasts until The company has four businesses: (i) Infrastructure manager for operators of rail services (e.g. Eurostar); (ii) Transport operator through its own shuttles that carry cars, coaches and trucks; (iii) Rail freight services provider since November 2007 and (iv) Cross-Channel ferry services, My Ferry Link, since Groupe Eurotunnel is listed on the Paris stock exchange; its ordinary shares are fully distributed between individuals, custodians and institutions. Neither STAR Capital nor Groupe Eurotunnel has any direct or indirect links to energy producers or suppliers, except in their capacity as consumers Technical and operational description A full list of STAR Capital s investments can be found at its website EN 3 EN

4 (13) The ElecLink project consists of twin HVDC cables in the 51 km Channel Tunnel. This will result in a capacity for ElecLink of 1000 MW (1050MW with estimated losses of the link enabling a transfer capacity of 1000MW). ElecLink Limited s application states this limitation is based on initial technical advice to ensure compliance with temperature and space constraints within the Tunnel and available grid capacity in Q This limitation is also based on the ElecLink Limited s connection agreements with the respective transmission system operators (hereinafter "TSOs") of France Réseau de Transport de l Electricité (hereinafter RTE ) and of Great Britain National Grid Electricity Transmission (hereinafter NGET ), included in the exemption application. According to this information, grid constraints both in Great Britain and in France limit the maximum capacity available. (14) ElecLink Limited plans to subcontract the construction of the Project through one or more construction contracts with suitably qualified contractors following a competitive tendering process. ElecLink Limited has agreed a framework for access to the Channel Tunnel with Groupe Eurotunnel for the construction period. (15) ElecLink will connect with the national grids, respectively, of France at Les Mandarins substation and of the UK at Sellindge substation. In this respect, ElecLink Limited has entered into agreements with RTE and NGET for the withdrawal and injection of 1000MW at Les Mandarins and Sellindge 400kV substations, respectively, expected to be operational from Q The connections are non-firm until planned reinforcements are carried out. (16) ElecLink Limited states that it intends to undertake (or sub-contract) all activities associated with the operation including its physical operation, maintenance, capacity allocation, client relations, balancing management in conjunction with TSOs, and accounting and information systems. (17) ElecLink is a project of common interest within the North Seas Offshore Grid corridor Financial and commercial operations (18) ElecLink Limited s exemption application estimated its capital (construction) costs to be approximately [BUSINESS SECRET] million 6. ElecLink Limited estimated its operational costs to be approximately [BUSINESS SECRET]. However, in both cases the final costs depend on negotiations with contractors and suppliers, and recently ElecLink Limited has indicated that the initial offers were higher than the estimates submitted as part of their application. (19) ElecLink Limited plans to use project finance to support this project based on approximately [BUSINESS SECRET] leverage. Loan arrangements are not yet in place. The project finance structure is expected to include debt covering the greater proportion of the total Project's costs. These debts are to be amortised over a period of 5 6 Commission Delegated Regulation (EU) No 1391/2013 of 14 October 2013 amending Regulation (EU) No 347/2013 of the European Parliament and of the Council on guidelines for trans-european energy infrastructure as regards the Union list of projects of common interest, OJ L 349, , p , project ElecLink costs and revenues and associated modelling [BUSINESS SECRET]. The estimates are based on the information provided in the exemption request. The Commission notes that at the later stage of the exemption review (on 16 June 2014), ElecLink Limited provided new estimates [BUSINESS SECRET]. EN 4 EN

5 20 years. The entire project will be amortised over 25 years. ElecLink Limited s application states that the final terms of the financing structure will be dependent on the long-term contracts negotiated post-receipt of the exemptions requested. (20) ElecLink Limited indicates that it expects the project to produce an internal rate of return of [BUSINESS SECRET], and has a target return on equity of [BUSINESS SECRET], based on [BUSINESS SECRET] leverage. (21) ElecLink Limited proposes to sell 80% of the capacity through long term contracts which will underwrite loan agreements and to sell 20% through short term contracts. (22) ElecLink Limited sets out that it will sell a mix of contract types and durations and that they are targeting a portfolio of contracts up to 20 years in duration, with an average duration of 15 years. (23) ElecLink Limited does not give details on proposed capacity allocation methods or contracts in the application for an exemption. (24) ElecLink Limited indicates that they will engage a third party to run the capacity allocation process ElecLink Limited s proposed limitations on allocation of capacity (25) ElecLink Limited proposes that the long term contracts will be subject to use-it-orsell-it arrangements. This will be facilitated by ElecLink Limited s commitment to implement secondary trading arrangements. (26) ElecLink Limited commits to putting in place restrictions on the percentage of longterm capacity rights a potentially dominant player could acquire and, to the extent it is within their control, preventing such a dominant player from acquiring additional capacity on the secondary market. This is specified as ensuring that dominant parties may not own more than 50% of total ElecLink import capacity rights from Great Britain to France. 3. Description of the notified decision (27) In their Joint Opinion notified to the Commission, the NRAs set out their decision to grant an Exemption to ElecLink in their respective jurisdictions for 25 years from the date that the interconnector commences commercial operation subject to conditions. (28) The effect of these conditions is that ElecLink has a partial exemption from normal third party access rules for 20 years, and a partial exemption from normal congestion revenue rules for a period of 25 years. ElecLink is also exempted from the obligation to implement full ownership unbundling, but is instead required to implement the independent transmission operator model Use of congestion revenues (29) In relation to the application for an exemption from Article 16(6) (i.e. use of congestion revenues) of the Electricity Regulation, the notified exemption decision states: "ElecLink is partly exempted from Article 16(6) of the Regulation. ElecLink is required to comply with the conditions imposed by the NRAs which are set out in part [H] of this Exemption Decision." (30) Part H states: "ElecLink must comply with the following profit sharing mechanism: EN 5 EN

6 If, over the exemption period, the present value of profits, discounted at a nominal rate of [BUSINESS SECRET], is positive, 50 % of these profits shall be transferred to the regulated National Electricity Transmission System Operators (NETSOs) NGET and RTE in accordance with the provisions of Article 16(6) of the Regulation;[ ]" 3.2. Unbundling (31) In relation to the application for an exemption from Article 9 (ownership unbundling) of the Electricity Directive, the notified exemption decision states: "ElecLink is partly exempted from Article 9 of the Directive. ElecLink shall comply with the conditions imposed by the NRAs which are set out in part [I] of this Exemption Decision." (32) Part I reads "ElecLink shall comply with the specific terms and conditions of an amended OU model detailed below: (a) (b) ElecLink is exempt from Article 9 of the Directive to the extent that: i ii For the assessment of Article 9, undertakings that are directly or indirectly controlled by Star Capital will not be taken into account, provided that these undertakings are not of a size materially different to the size of typical investments made by Star Capital according to ElecLink s exemption application 7. As a consequence, Star Capital will be allowed to make investments in generation or supply activities providing this condition is met; and For the assessment of point (b) (i) of paragraph 1 of Article 9, the same person or persons are authorized to directly or indirectly exercise control over an undertaking performing any of the functions of generation or supply and to exercise any right over ElecLink, so long as any right over ElecLink does not constitute direct or indirect control. Because of the investment opportunities in generation or supply allowed by the above conditions, ElecLink shall also comply with all conditions set out in chapter V of Directive 2009/72/EC (ITO model) with the exception of Article 22 of the Directive. [ ]" 3.3. Third party access (long term contracts) (33) In relation to Article 32 of the Electricity Directive (third party access), the notified exemption decision states: "ElecLink is partly exempted from Article 32 of the Directive for multi-year capacity allocated through an Open Season. ElecLink shall comply with the conditions imposed by the NRAs " (34) The additional conditions specified by the NRAs include: 7 According to the exemption application, ElecLink Limited states that Star Capital is looking for the opportunity to invest in capital-intensive corporate activity that has an enterprise value in the range of 100 million to 500 million. In addition, ElecLink Limited states that any investment would be separate from ElecLink and would not result in discrimination in respect of the operation or conflict of interest given the likely value and nature of the participation in such activities and the likely size and market share of any such generation and/or supply activities. EN 6 EN

7 General conditions for capacity allocation (Open Season and other capacity) (35) ElecLink Limited is required to implement use-it-or-sell-it provisions on all capacity sold. ElecLink Limited is required to participate in market coupling. ElecLink Limited will transfer remaining capacity after the Intraday allocation available to the National Electricity Transmission System Operators (NGET and RTE) for balancing purposes Multi-annual basis through an open season process (long term contracts) (36) Up to 80% of capacity may be allocated on a multi-annual basis through an open season process. Over the whole exemption period, the present value of discounted revenues from capacity allocated through multi-year products may not exceed a maximum amount expressed in M 2016 discounted at the nominal rate of [BUSINESS SECRET]. [BUSINESS SECRET]. Additionally, an open season process cannot be operated if the revenue sharing arrangements had been activated in the preceding year Open Season approval process for capacity allocated under long term contracts (37) For the up to 80% of capacity which may be allocated through an open season, NRAs will approve, and may require modification to, ElecLink s Access Rules and Charging Methodology/Tariffs. ElecLink Limited is required to organize a public consultation on the proposed rules before submitting them for NRA approval. No products are to be allocated for more than 20 years, and no contracts are to extend beyond the 20 th year after commissioning. The average contract length may not exceed 15 years. (38) A range of products of different lengths is to be offered, including products with duration equal to or shorter than 5 years. Eligibility conditions must allow smaller players to be eligible at least for smaller and/or shorter capacity products. When multiyear products allocated through an Open Season reach the same timeframe as regulated long-term products they are to comply with the same conditions as regulated long-term products. (39) The results of the Open Season are to be made public and include at least the name of the capacity holder as well as volume, duration and price Other capacity (40) For all capacity not allocated on a multi-annual basis through an open season process, the approval process of the Access Rules and Charging Methodology/Tariffs must comply with relevant national and European requirements for the approval of terms of access to interconnectors both in France and Great Britain. That is, this capacity is subject to all normal regulatory rules Limit of long term products allocated to undertakings (41) For long term products allocated through the Open Season, ElecLink must ensure that no entity holds more than 40% of the total capacity of the interconnection (400 MW) in either direction. (42) If an entity holds more than a 40% market share in a relevant geographic market, it shall not hold, at any time, more than 20% of the total capacity of the interconnector (i.e. max. 200 MW) in the direction of the import to this market Scope of exemption (43) The NRAs specifically state that no exemption is given for any other aspects/parts of applicable current and future national and/or European law, in particular paragraphs 6 EN 7 EN

8 and 10 of Article 37 of the Electricity Directive. This means that allocation rules including rules both for an Open Season and the remaining capacity are subject to regulatory approval by the NRAs. (44) They also specify that no exemption is given from Article 32 of the Electricity Directive for capacity that is not allocated through an Open Season. This means that ElecLink is required to comply with all relevant, current and future provisions of national and European legislation in respect of the remaining capacity Validity (45) The notified Exemption Decisions expire if either two years after the date the Exemption Decision is adopted or amended by the Commission the construction of the Interconnector has not started or the Interconnector has not become operational after five years. However, the notified Exemption Decisions also state that they continue to apply if the Commission decides, pursuant to subparagraph 5 of paragraph 8 of Article 17 of the Electricity Regulation that any delay is due to major obstacles beyond the control of ElecLink. 4. Assessment of conformity with the criteria set out in Article 17 of the Electricity Regulation 4.1. Article 17(1)(a): the investment must enhance competition in electricity supply Need for additional interconnection (46) Additional interconnection between Great Britain and Central Western Europe is undoubtedly needed. The UK as a whole falls short of the 10% interconnection target established by the European Council in The need for additional interconnection is clearly set out in ENTSO-E s 2012 Ten Year Network Development Plan 8, and the studies submitted by ElecLink Limited (undertaken by Redpoint), as part of their exemption application, show that the optimal total interconnection capacity between France and Great Britain in addition to the capacity of existing IFA and BritNed interconnectors as well as the planned IFA-2 and Nemo interconnectors is in excess of 5 GW. (47) France too stands to benefit from additional capacity. According to the report Crossborder electricity exchanges: Use and management of interconnections in 2012 by CRE 9, the average capacity available to the market in 2012 was 8 GW for import and 12 GW for export (these commercial quantities are below the physical capacity of the lines) Ensuring new investments in interconnectors enhances competition (48) While investment in new infrastructure is likely to entail positive effects on competition through increased capacity and a greater scope for cross border competition, an exemption can counteract these positive effects. This is because access to the exempted infrastructure is restricted, which is in turn likely to restrict CRE writes that: It is clear that exchanges through French interconnections have a high value and the existing interconnections are not sufficient to meet all market player s demand for cross-border exchanges. Investments are therefore required to increase physical interconnection capacities ; implementing more efficient mechanisms tailored to generators and consumers requirements is also needed to improve capacities use. EN 8 EN

9 competition, in particular if the capacity is held by players with a significant degree of market power. Where dominant undertakings can become indirect beneficiaries of an exemption by securing capacity, a positive competition assessment is unlikely in the absence of conditions that effectively address the competition concerns. (49) In particular, long term contracts have the potential to facilitate the foreclosure of the market and act as a barrier to entry. In the case of electricity interconnection, long term contracts are of potential concern because interconnection is an important route to market for new players trying to compete in neighbouring jurisdictions, particularly where wholesale markets are illiquid. (50) Therefore, a requirement to reserve capacity for short-term contracts to enable the development of a spot market and hence facilitate competition and entry of new players is necessary. It may have been considered that a reservation of capacity for short-term trading is not fixed as a pre-defined percentage, but could be based on the respective market demand for short-term capacities indicated in a market demand evaluation. However, also the defined quota for short term contracts is efficient and facilitating a solution of potential competition concerns Competition on French and British markets (51) Concerns about effective access to the market apply to both of the national markets in question. (52) The French power generation market is highly concentrated. The market share of the largest generator in the country, EDF, is of 86% 11. Its market share for total installed capacity was 73% in The other generators have a market share between 1 and 7%, GDF-Suez having the biggest share (7%), due to its hydropower plants. The wholesale market in France has low liquidity; with the majority (87% in 2012) of trading taking place over-the-counter (OTC). Market concentration is very high also at retail level with only 8% 12 of consumers served by alternative suppliers to EDF, the dominant incumbent. However, for big industrial consumers (annual consumption higher than 7 GWh), EDF's market share has decreased from 55% in 2012 to 51% in (53) In the UK, the market shares of the six largest suppliers in the supply of domestic electricity range between 11 and 25%. The six largest electricity suppliers directly own around 70% of generation capacity and all but one own capacity equivalent to their domestic supply needs. 13 Likewise, in the UK, around 85% of power was OTC traded in 2012 (down from 95% in 2011). (54) Lack of liquidity in the markets has been a concern for some time, and as a result Ofgem initiated its liquidity project to ensure that the wholesale electricity market supports effective competition. Ofgem is concerned that poor liquidity in the wholesale electricity market is posing a barrier to effective competition and in 2014 intervened in the market to improve liquidity by requiring companies to follow a set of Supplier Market Access rules when trading with small independent suppliers imposing a market making obligation on the six largest vertically integrated Eurostat : CRE, 2012 National Report to the European Commission, National%20Reporting%202013/NR_En/C13_NR_France_Summary-EN.pdf. Ofgem, Office of Fair Trading, Competition and Markets Authority State of the Market Assessment EN 9 EN

10 companies (i.e. with generation and supply arms) 14. On 26 June 2014 Ofgem decided to refer the retail energy market to the Competition and Markets Authority for investigation. 15 (55) The London Economics report on Impact on Competition and social welfare of the proposed ElecLink interconnector between Great Britain and France also indicated that a single player had the ability to exercise market power, based on the Residual Supply Index, for flows in both directions on the ElecLink interconnector National regulatory authority restrictions on long term contracts (56) The NRAs impose a number of conditions, beyond those proposed by ElecLink Limited in their application, on the allocation of capacity by ElecLink in order not to undermine competition and minimize potential adverse effects on the British and French markets Capacity caps (57) First of all, to avoid that any holder of capacity could exercise market power, the proportion of the total capacity of the ElecLink interconnector in either direction which may be held by a single entity is capped at 40%, reduced to 20% if the entity holds a market share of over 40% in the destination market. (58) In practical terms, this has the effect of capping the long term contracts which EDF may hold for imports to France at 200MW, ensuring that the remaining 800 MW is available to competitors. In the UK context, this ensures that capacity is available to a mix of suppliers, and that no single supplier is able to secure the majority of the new interconnection capacity under long term contracts Long term products transparency (59) The NRAs require that the results of the Open Season are made public and include at least the name of the capacity holder as well as volume, duration and price, in order to enhance the transparency of the market and therefore competition Long term contracts duration and allocation (60) The NRAs restrict how long term contracts can be allocated in several important ways. Firstly, in addition to retaining the average and maximum durations of 15 and 20 years, respectively, proposed by ElecLink Limited in their application, they specifically require that contracts of shorter duration are offered, of at least 5 years. Furthermore additional conditions are provided to allow smaller players to be eligible at least for smaller and/or shorter capacity products Ofgem November Wholesale power market liquidity: statutory consultation on the 'Secure and Promote' licence condition condition.pdf Wholesale power market liquidity: decision letter 23 January Ofgem s final decision can be found at: London Economics report on Impact on Competition and social welfare of the proposed ElecLink interconnector between Great Britain and France, part of the Exemption application. EN 10 EN

11 (61) These provisions are enforceable by the NRAs, as ElecLink Limited is obliged to consult them on its access rules and as the open season allocation procedure for the long term products is subject to approval by the NRAs Commission assessment of the competition criterion (62) Article 17 of the Electricity Regulation requires that the investment must enhance competition in electricity supply and that the exemption is not detrimental to competition. While these two requirements are not identical, they imply that the project must be pro-competitive and thus create benefits for consumers. (63) In the Commission staff working document on new Infrastructure Exemption (SEC(2009)642 final) 17, the Commission Services examined a number of potential remedies to address competition concerns where exemptions were being granted. These include inter alia restrictions on the total capacity being held by individual entities or requirements to ensure a mix of short and long term products to be offered to the market. The Commission has actually included such obligations and restrictions in previous exemption decisions 18. (64) The restrictions proposed by the NRAs on the proportion of capacity held by a single entity limit the risk of one company booking the entire capacity of the interconnector. The NRAs also require additional limitations for companies with above 40% market share in securing access to the capacity of the interconnector. These restrictions serve to mitigate against the potential of dominant undertakings using access to an interconnector benefitting from an exemption in order to exercise market power. (65) Reservation of capacity for short-term trading is ideally not fixed as a pre-defined percentage but instead based on the respective market demand for short-term capacities indicated in a market demand evaluation. In this case no such evaluation has yet taken place. The Commission notes the requirement that products are offered with duration equal to or shorter than 5 years. The Commission also considers it appropriate both that ElecLink Limited is required to hold a consultation on its proposed access rules and that those access rules are then subject to regulatory approval. NRAs will therefore be able to ensure that the share of shorter term products allocated through the Open Season process reflects the needs of the market as expressed in the market testing. The Commission considers this to be an important element of the notified decision. (66) The Commission considers that these conditions, combined with the restriction on average and maximum duration of long term contracts, sufficiently mitigate the concerns about the effect of the allocation of long term contracts on the positive benefits of the interconnectors on competition. (67) The Commission also welcomes the proposed requirements relating the transparency of the allocation of long term contracts. However, the Commission also notes that this should only be implemented insofar as it does not itself create concerns about ensuring effective competition Commission staff working document on Article 22 of Directive 2003/55/EC concerning common rules for the internal market in natural gas and Article 7 of Regulation (EC) No 1228/2003 on conditions for access to the network for cross-border exchanges in electricity SEC(2009)642 final This has applied across all classes of exemptions, including gas interconnectors (e.g. Nabucco, TAP) and LNG terminals (e.g. Shannon LNG). EN 11 EN

12 (68) On the basis of the above and subject to the implementation of the requirements set out in the joint opinion, the Commission concludes the investment would enhance competition Article 17(1)(b): the level of risk attached to the investment is such that the investment would not take place unless an exemption is granted. (69) ElecLink Limited make the case in their application that this project is to be financed using project finance, whereby long term contracts will underwrite loan agreements specific to this particular project. Their application sets out that these long term capacity agreements require an exemption from the application of the regulated capacity allocation framework (including the potential for future changes to the regulatory regime) on the one hand, and that the risks associated with operating outside the normal regulatory framework justify an exemption from the provisions of Article 16(6) of the Electricity Regulation on the use of congestion revenues on the other. (70) In support of their application, ElecLink Limited submitted financial projections based on modelling undertaken by Redpoint Energy. This is set out in Exhibits C and E of the application in particular. (71) The NRAs commissioned additional analysis from London Economics set out in the report Impact on Competition and social welfare of the proposed ElecLink interconnector between Great Britain and France. Section 3 of this report is entitled Revenue and RiskAnalysis, and examines the projections provided by ElecLink Project finance (72) At section of their application ElecLink Limited explains their need to use project finance on the following basis: "ElecLink will be underpinned by a group of agreements and contracts between lenders, Shareholders, EPC contractors and other interested parties. This creates a business organisation that will issue a finite amount of debt on inception; will operate ElecLink as its sole business; and will ask that lenders look only to the Project to generate cash flow as the sole source of principal, interest payments and collateral We will sell long-term interconnector capacity contracts to generate a stream of predictable cashflows. An exemption from the provisions of Articles 32 and 37(6) and (10) of the Third Package Electricity Directive removes the risk of tariffs and terms and conditions for access being set by and potentially changed year on year and will allow us to demonstrate to lenders the stability of such cashflows despite a changing regulatory environment over the course of the exemption period." (73) ElecLink Limited therefore requests to be able to sell up to 80% of the capacity under long term contracts outside the normal regulatory framework in order to be able to secure sufficient revenues to underwrite their debt. They based the need for 80% coverage on their initial discussions with financiers and the experience of the shareholders, their assessment of likely revenues and the resulting interest cover. The application proposed that contracts would be of varying duration, on average 15 years and not longer than 20 years. (74) London Economics assessed the basis for the request. They state that they consider [BUSINESS SECRET] gearing, as set out in the ElecLink Limited financial EN 12 EN

13 projections, not excessive, and that achieving project finance would involve conservative assumptions on revenue. London Economics concluded that the requirement of 80% LT contract cover is within the norms of our experience for project financing and levels of gearing up to [BUSINESS SECRET] given the revenue, cost and modelling predictions of ElecLink the 80% would fall if higher revenues were achieved on LT contract sales especially Revenue streams central scenario (75) ElecLink Limited s expected returns according to the documentation submitted with their application amount to an Internal Rate of Return (IRR) [BUSINESS SECRET] (nominal pretax). The rate of return for equity is set at [BUSINESS SECRET]. By comparison Ofgem and CRE informed the Commission that the weighted average cost of capital (WACC) allowed for the national TSOs was 4.55% ('vanilla') 19 for the next eight years in Great Britain and 7.25% (nominal pre-tax) for the next four years in France. This means there is approximately a [BUSINESS SECRET]% point ([BUSINESS SECRET] basis point) additional return for the project compared to what might be expected under a regulated regime. The higher returns are justified by ElecLink Limited on the basis of the different risks faced by ElecLink compared to a national TSO supported by regulated tariffs. (76) The returns submitted by ElecLink Limited are based on forward sales of [BUSINESS SECRET] of capacity at a capacity price of [BUSINESS SECRET] over the 25 year exemption period, with the remaining [BUSINESS SECRET] being auctioned on the short term market for the congestion value. Short term revenues are based on modelling and inflation-indexed. (77) The long term contract revenue of [BUSINESS SECRET] value was estimated based on a [BUSINESS SECRET] discount to the [BUSINESS SECRET] IFA prices Risks to projected revenue streams (78) The Commission considers that the higher revenues could only be justified based on a different risk profile of the project compared to what would normally be allowed under the regulated regime. (79) In the case of this particular investment, there are a number of reasons revenues could differ from those projected: Construction and operational risk (80) Incurred capital costs or operational costs could be higher or lower than those projected. In relation to capital costs, ElecLink Limited, in their application, argues that there are significant complexities to building an interconnector using the existing tunnels, relating to safety, access rights etc. (81) As part of their application, ElecLink Limited indicated that they are carrying out specific studies on the impact of operating an interconnector as part of a railway infrastructure. These include in particular the need to ensure that electro-magnetic fields or heat generation from the interconnector do not have a negative impact on other equipment, including safety in the tunnel. ElecLink's exposure to outage risk is potentially enhanced by its specific operating environment as there may be factors which create outages in the Tunnel which are outside ElecLink Limited's control. 19 Different models of calculating WACC covering different periods are applied in the UK and in France. The UK WACC was calculated as combination of pre-tax cost of debt and post-tax cost of equity ('vanilla'), while in France the WACC was calculated as nominal pre-tax. EN 13 EN

14 (82) Moreover, because this project is first of a kind, it is possible that realised construction costs will be higher. The submitted application projected costs of approximately 400 million. Information submitted by ElecLink Limited to the Commission during the consideration of the draft decisions by the NRAs 20, suggested that the submissions by contractors at the first stage of the procurement process were up [BUSINESS SECRET] higher. However, the Commission notes that the actual agreed price is still a matter for negotiation between ElecLink Limited and its contractors (including on how issues relating to risk associated with the operation of the tunnel are treated). (83) The connection of ElecLink into the onshore networks of Great Britain and France will not be firm until NGET and RTE complete reinforcement work Market risk long term contracts (84) The modalities according to which long term contracts are to be allocated are not elaborated in the exemption application submitted by ElecLink Limited. According to the decision taken by the NRAs, the procedures will be subject to regulatory approval. (85) The financial projections provided by ElecLink Limited are based on assumed revenues in accordance with their assessment of the likely market value of such contracts. The submission by ElecLink Limited only considers their central scenario for the revenues received from long term contracts [BUSINESS SECRET]. However, the price received for the long term capacity could differ from that projected. (86) As the intention is to enter into long term contracts, an appropriate market test undertaken by ElecLink Limited could have helped to establish the likely long term revenues in advance. (87) In the absence of such information, more recent market information is also relevant. In this regard London Economics in their report to the NRAs note: [BUSINESS SECRET] most recently available IFA yearly capacity auction prices [the IFA 2014 annual] average price was 13.77, and with the [BUSINESS SECRET]. Thus these represent what would clearly be a marketbased informational-estimate, of a very similar product, [BUSINESS SECRET], where the most up-to-date prices suggest a [BUSINESS SECRET] price difference on the long-term capacity. (88) A related issue is why the long term contracts would be discounted compared to historical prices rather than projected prices of interconnector capacity. In that situation the modelled congestion rents (see below) would provide a better starting point. The modelling of expected congestion revenues provided London Economics gives a capacity value of about [BUSINESS SECRET] 21. (89) London Economics do conclude that the [BUSINESS SECRET] discount for a long term contract is plausible (though without endorsing it) 22. However, from the above it is clear that there are considerable grounds to question the value of capacity to which this discount is applied. Overall London Economics conclude that revenue has significant upside risk and [BUSINESS SECRET] Additional information submitted on 16 June P.33 of London Economics Report: If we take the discounted average price as the value of the price differential, or implicit auction congestion rent, in either direction, we get a capacity value of about [BUSINESS SECRET]. London Economics also note that the [BUSINESS SECRET] discount could be seen as equating to an IRR of about [BUSINESS SECRET] when inflation is taken into account. P 32 EN 14 EN

15 Market risk short term revenues (90) Short term revenues may be different to those modelled. It is never possible to be certain about modelling predictions, which inevitably depend on the assumptions made. London Economics [BUSINESS SECRET] figures for the values of congestion rent [BUSINESS SECRET] provided by Redpoint on behalf of ElecLink Limited. (91) ElecLink Limited provided assessments of projected revenues, also undertaken by Redpoint, under different scenarios based on: Different gas price scenarios; Different generation mix scenarios in Great Britain and France; Absence of carbon price floor in UK; Higher interconnection. ElecLink Limited also provided an estimation of the sensitivity of revenues to higher forced outage rates. The sensitivity analysis provided shows the impact on the project rate of return of changes in short term congestion revenues for the 20% of capacity sold on the spot market. In the financial projections sensitivities congestion revenues do not have any effects on the revenues to ElecLink from the 80% of capacity assumed to be covered by long term contracts. (92) The outcomes of the modelling provided by ElecLink Limited are set out below in Figure 1 Eleclink financial projections sensitivity analysis. As can be seen, in no circumstance do these result in a rate of return equal to or below [BUSINESS SECRET] though with a lower proportion of long term contracts this sensitivity would be correspondingly greater 23. Therefore, in all scenarios provided, there is a significant margin above the likely debt finance costs of the project and a corresponding positive return on equity. The sensitivity analysis could be different in case other risks, as discussed above, were taken into account. [BUSINESS SECRET] Figure 1 Eleclink financial projections sensitivity analysis (from application) National regulatory authority restrictions on long term contracts (93) In their joint opinion, the NRAs agree that if all capacity were to be sold through yearly or shorter-term products, the degree of risk associated with changes in the electricity markets would likely prevent long-term financing on acceptable terms for ElecLink Limited. They therefore consider that ElecLink Limited will only be effectively able to contract for debt if they can sell long term contracts for the capacity, and that without such products, the project may not be realised. NRAs therefore consider that ElecLink should be able to allocate capacity in this way. (94) However, because there is a possibility that the 80% of the capacity allocated through long term contracts would generate regular cashflows above ElecLink Limited s financing requirement, as indicated by the London Economics analysis, the NRAs also consider that in addition to ElecLink Limited s proposed limit of 80% of total capacity, long term contracts for capacity allocation should be subject to a cap based on the associated revenues. This is designed to ensure that revenues from long term contracts do not exceed what is necessary to secure project finance. (95) The associated revenues are calculated by taking the total value of the revenues from long term contracts, discounted at the nominal rate of [BUSINESS SECRET]. The associated revenues may not exceed an amount which takes into account The impact depends on the actual effect of the restrictions imposed by the national regulatory authorities. This cannot be seen in advance as they in part depend on the outcome of the capacity allocation process. ElecLink Limited Exemption application, Exhibit E Project financial information, p. 8 EN 15 EN

16 [BUSINESS SECRET] and [BUSINESS SECRET] costs as well as [BUSINESS SECRET] costs National regulatory authority provisions for revenue sharing (96) Based on the analysis provided by London Economics, the NRAs consider that the projections submitted by ElecLink Limited as part of their application for an exemption understate potential revenues from the project. This is not confined to the potential upside from long term contracts, but also to the revenues from short term products. Moreover, the NRAs are of the view that the probability of high or low revenue from interconnector capacity products is not evenly distributed and that very high revenues are possible, noting that short term volatility of electricity prices may provide a natural lower bound to the price of interconnector capacity while very high revenue may result from extreme conditions prevailing (for example extremely cold weather in France or generation outages). (97) As there is a strong possibility that the revenues will significantly exceed those set out in the business plan, which they do not consider to be balanced by countervailing downside risk, the NRAs consider that a complete exemption could result in ElecLink Limited earning a disproportionate share of the congestion revenues, which would otherwise be used either to expand interconnection or to lower transmission tariffs for network users. It is on this basis that the NRAs consider it essential that the exemption is accompanied by a mechanism to guard against such congestion rents resulting in excess profit. The chosen mechanism is to give network users 50 % of the profits exceeding a [BUSINESS SECRET] IRR. (98) The NRAs clarified to the Commission that they consider that a hard profit cap (i.e. without revenue sharing) could dampen (or remove completely) the incentives for the interconnector operation and availability when the cap is reached and that the sharing factor provides an incentive for ElecLink to maximise link availability and continue operating should profits exceed the cap. This they consider is in the interest of European consumers Commission assessment of the risk criterion (99) In the Staff Working Document, the Commission Services set out that there are two main risks to determine the assessment where there are sunk costs: the risk of non-use of the investment and the risk of a change in costs and/or revenues in the future. This has been reflected in the approach of the Commission in previous exemption decisions. (100) The Staff Working Document also recognises, as is the case for this project, that risks may originate from changes in flows caused by changes elsewhere in the system. In the present case, the use of the planned interconnector will depend on relative prices in Great Britain and France (and the wider Central Western Europe region). (101) The two specific reasons why this risk would not apply are also considered in the Staff Working Document: The lower the risk, the higher the likelihood is of the project in question to enjoy an unchallenged position; The level of risk would tend to be weaker where an integrated energy company builds a new piece of infrastructure. EN 16 EN

17 (102) However, in the present case neither reason applies (directly or indirectly). There are already alternative interconnectors operational between Great Britain and Central Western Europe, with several at a more advanced stage of planning. Moreover, Ofgem has recently proposed a revised approach to interconnectors as part of their Integrated Transmission Planning and Regulation project 25. This work builds on the work to date for the proposed new interconnector with Belgium (the Nemo project). This approach is expected to accelerate the delivery of increased interconnection under the regulated framework. (103) ElecLink is not part of an integrated energy company (see section 4.7 below) or of a wider energy infrastructure company, rather it is the result of a collaboration between its shareholders to realise the potential benefit of ensuring the maximum benefits from an existing piece of infrastructure (i.e. the Channel Tunnel). The Commission accepts that as a result, unless the project is subsumed into the wider regulated system, project finance will be necessary to ensure these benefits can be realised. The Commission also accepts that providers of project finance will require a degree of certainty around the capacity of ElecLink Limited to repay that finance which can be provided by long term contracts. (104) The Commission has also recognised in its previous decisions on exemptions that Long Term Contracts are in principle a legitimate way for to reduce the economic risk of their investment. While long term contracts do not necessarily require the granting of an exemption they may in principle also be concluded for regulated infrastructure contracts of the duration envisaged here are so clearly outside normal regulatory practice in electricity, and the developing European rules on capacity allocation and congestion management, that in effect an exemption is required to provide regulatory certainty. (105) However, precisely because such long term contracts depart so clearly from normal regulatory practice, and because it is only with great difficulty possible to adapt long term contracts to reflect new developments, it is critical these be kept to the minimum necessary to ensure that the investment can take place. (106) This upside potential for long term contracts is in this case a particular concern as it could result in more long term contacts than needed to secure financing for the project Normally the value of demand for such contracts would be established following a market test. In the Staff Working Paper, the Commission services explained that As a general rule, project promoters are required to test market demand before they can obtain an exemption Testing market demand is a crucial element to evaluate the riskiness of a project and to assess to what extent the planned project enhances competition Moreover, Article 17(4) of the Electricity Regulation explicitly requires that the NRAs while assessing the need for an exemption, should take into account the results of the capacity allocation procedure. (107) The absence of such a test is a major shortcoming in the submission presented by ElecLink Limited where they propose to sell contracts for up to 20 years duration. 27 In the absence of a framework to reveal the valuations placed by market participants on Box 3: Testing of market demand This concern would not apply where it is proposed to allocate capacity on a spot or short term basis as was the case for the Arnoldstein/Tarvisio exemption (SG D(2010)16980) or for that portion of capacity exempted only from Article 16(6) of the Electricity Regulation on the use of revenues. EN 17 EN