At first sight, it might appear that this is not a problem which directly concerns Scotland, since none of the eight new nuclear power stations is scheduled to be located here. Unfortunately, given Britain’s unified electricity market, Scottish consumers will end up paying for the excess costs of nuclear RAB too: so this issue is very much a Scottish concern.
To understand why RAB is such a poor choice for funding nuclear energy, it is necessary to start with a little background on how RAB funding works. RAB is a method for funding capital expenditure in privatised, but regulated, utilities which was introduced in the UK during the great wave of Thatcher privatisations, and was applied first of all in the water industry in England. The first step in the process is for the regulator to approve the amount of capital expenditure the utility needs to undertake: this is expenditure which the utility is permitted to add to its total of approved capital expenditure, known as the regulatory asset base – hence the name of the method. The regulator then works out an amount which is charged to the consumer each year over the lifetime of the relevant asset, to cover the cost of the capital expenditure. Since projects are typically funded by a mix of debt and equity, the regulator will make three key assumptions in working out the appropriate annual charge: namely, first, what proportion of the overall capital expenditure will be funded by debt, as opposed to equity: secondly, what the real cost of borrowing will be for the utility when it raises debt from the market: and thirdly, what a reasonable real return on equity would be, to compensate investors for the greater risk which attaches to equity investment.
While this sounds superficially straightforward, in practice there is much that can go wrong. For example:-
- The regulator may overestimate what the actual cost of debt will be for the utility.
- The equity owners might operate on a higher debt to equity gearing than assumed by the regulator. Since the cost of debt will be less than the assumed return on equity this generates a financial surplus in the future stream of guaranteed RAB payments, to the benefit of the equity owners.
- In an actual construction project, risk is typically highly skewed towards the early, construction phase of the project: while the risk premium in RAB payments is more evenly spread. So if the construction phase is completed with apparent success, there will be a future stream of risk payments which is effectively surplus: this is again to the benefit of the equity owners.
- Since every pound of RAB approved capital spending has a profit element attached to it, (for the above reasons), there will be a strong incentive for the consortium operating the project to inflate the amount of RAB capital as much as possible. This can be done either by gold-plating the original investment, or by arguing to the regulator that there are unavoidable, and justifiable, cost over-runs during construction.
- And once construction is complete, and the project is apparently lower risk, there will then be the opportunity for the original equity investors to capitalise any surplus in the future stream of guaranteed RAB payments, (by either increased borrowing, or by equity sale), and then to extract the capitalised profit as a windfall gain.
It is important to note that all of the above potential problems with RAB are well known, and have been commonly observed in historic applications of RAB in the UK. The resulting large excess profits, and unduly high customer charges, are obvious: (witness the dividends extracted from the English water companies: or the fact that the UK has some of the highest rail fares in Europe.)
It is also relevant to note that there are some key commonalities between the RAB approach, and that other problematic method of funding capital investment, namely, public private partnerships, (PPPs). Both are ways of funding the kind of large capital projects which are in effect public goods, and are essential for a modern society. Both involve the same dangerous practice of giving long term revenue guarantees to the relevant operators/owners, which are then liable to be capitalised, and extracted as windfall profits. But in RAB, the person who is on the hook for the stream of payments is the charge payer for the relevant utility – not the taxpayer. Another difference is that, under RAB, the consumer will start paying for the investment as soon as construction starts: while under a PPP payment of the unitary charge by the relevant public body will not start until construction is completed.
For present purposes, the important point to note is that the RAB problems outlined above are likely to be particularly acute in the case of its application to nuclear power projects. There are two main reasons for this. First, the construction phase of nuclear projects is extremely long, with the current working assumption used by the government being 13 years, which could well itself be an underestimate: further, nuclear construction is notoriously beset by technical difficulties. Both of these factors will offer ample scope for inflation of the RAB base during construction. And secondly, the operating life of nuclear projects is again very long, with the government’s current working assumption being about 60 years. This means that any surplus which is built into the stream of future RAB payments will be available to be capitalised over this long period – which will greatly increase the potential windfall profits to be extracted by the original equity investors.
The windfall profits in nuclear RAB projects are, therefore, potentially vast. I developed a simple financial model of a typical nuclear RAB project to explore the returns available to equity investors under some very modest assumptions. The results were sobering. To give just one example: consider a nuclear project with a build period of 13 years, and a production life of 60 years. Assume that the regulator had assumed that capital would be 60% financed by debt: that the real cost of debt would be 3% per annum, and that the real return on equity should be 8%. In actual fact, however, assume that the consortium operated on a higher gearing ratio of 80%, and that the regulator had overestimated the real interest cost of debt by the fairly modest margin of 1 percentage point. Then if the equity holders capitalised their return at the end of the construction period, and extracted it as a windfall profit, they would receive a real annual rate of return on the average unit of equity capital invested of around 25%.
Given the scale of the problems that are likely to arise, our last prime minister’s decision to implement RAB as the funding model for nuclear is both surprising and disappointing. One can really only speculate why such a poor decision was taken: possible reasons are:-
- While RAB is bad news for the unfortunate electricity charge payer, it will be very good news for the owners of equity. So maybe part of what is going on here is just another example of traditional rentier capitalism – that is, the UK economic model which involves sweating every asset for the maximum benefit to the owners of equity – even though this is to the detriment of the ordinary customer or charge payer. (For an elegant discussion of how rentier capitalism has come to permeate the UK economy, see Brett Christophers’ book “Rentier Capitalism”).
- And there is another factor which is also likely to have been at work. One view is that most of the problems of RAB can be characterised as due to regulatory mistakes or weakness. On this view, if the regulators were tougher, and got their assumptions right, then it might seem that RAB would work satisfactorily. So maybe the view has been taken that, with proper choice of regulator, and a proper regulatory remit, RAB could indeed be made to work in the nuclear context.
In fact, this last view is fallacious, even though, as we will see, it does seem to have played a part in the nuclear RAB decision. There are two reasons why simply toughening up regulation, but holding to the current RAB model, is not a solution. First of all, because regulatory capture – that is, an over-alignment of the regulator with the industry being regulated – is almost inevitable. The main stimulus to which the regulator will be exposed will be extensive and sophisticated lobbying by the industry they are supposed to be controlling. And there are also the temptations offered by the revolving door of the industry itself, or lucrative industry funded consultancy, once a regulator has finished their stint on the regulatory treadmill. But in addition to the danger of regulatory capture, there is an inherent flaw in the RAB model itself. The misalignment between the actual profile of risk in a typical project, and the profile of risk premiums in the sequence of RAB returns over the life of the asset, means that there is virtually a guaranteed surplus in later years, just waiting to be capitalised, and extracted as a windfall profit. This leaves the customer over-paying, and the project itself exposed.
Earlier this year, and after some difficulty, I engaged with the Department of Business, Energy and Industrial Strategy, (BEIS), the Whitehall department responsible for implementing nuclear RAB. Having established contact, I sent them a copy of a paper, outlining my nuclear RAB model, and some of the results and implications. BEIS’s response was interesting, for two reasons. First of all, they did not disagree with the dangers I had highlighted. But secondly, their proposed remedy was that these issues should be tackled in the contract negotiation stage, and through the remit laid upon the regulator. To quote from BEIS’s response to me:- “The modifications to a nuclear company’s electricity generation licence that would be made to apply the RAB model for a specific project would be negotiated on a case-by-case basis. As part of these negotiations, our aim would be to ensure that the arrangements would be structured and regulated to mitigate the risks you flag.”
BEIS’s proposed remedy to the likely problems of nuclear RAB is patently inadequate. As has been argued above, regulators cannot be relied upon. And to expect adequate safeguards to be built into contract negotiations is wildly optimistic, when these negotiations will be being conducted in secret, and with the government very much in the supplicant position relative to the very small number of consortia actually capable of nuclear projects.
There are, however, a number of things which could, and should, be put in place before new nuclear RAB projects are agreed, and which would materially improve the situation:-
- There should be a limit to the extent to which the operating consortium can load a project with debt. That is, the regulatory assumption about the ratio of debt to equity in the project should be a control limit, not just something to be gamed by the consortium.
- There should be agreement in advance on how any future windfall profits arising from capitalisation of anticipated RAB returns should be fairly shared between the equity owners and the government, (or, better still, the electricity charge payer.) This could be achieved, for example, by a mechanism whereby future RAB payments, and hence charges, were reduced on a sliding scale if the ratio of dividends, or profit, to equity capital actually invested rose too high.
- There should be agreement in advance on how the equity risk component of RAB payments should be more closely tailored to the actual profile of likely risk in the project.
- And the government should publish in advance the criteria it will seek to incorporate in future contracts to ensure the above points are met: and it should make it clear that, without success in achieving agreement on these criteria, no new nuclear RAB contracts will be signed.
There was a two–page article in the business pages of the London Times on 14th May 2022, all about the opportunities offered by the government’s new RAB funded nuclear programme. The headline itself actually says all one needs to know: “Why nuclear push could be sweet music for City.” And the sub-heading was “A bold new investment model is lighting the way for big players to fund new plants.” The word “bold” here is presumably newspeak for “insanely generous”. There could be no clearer indication that the City sharks have already scented the blood in the water represented by the prospect of the nuclear RAB funding model, and are already circling. Without action and publicity now, they are going to make another killing at our expense.