First aid or state aid?

13 July 2004

In 2002 electricity wholesale prices fell by around 40% in England and Wales. Whatever the precise causes of the price fall, electricity generators inevitably suffered, none more so than British Energy (BE), the largest UK generator. BE’s problems led to a programme of state support, which the European Commission (EC) is currently examining to check for possible state aid. An explanation of BE’s woes – and the appraisal of the subsequent state support – both turn on the economics of nuclear power.

Many generators were able to effect two partial compensations for the problem of falling prices. First, as retail electricity prices fell much less than wholesale prices, those generators with a substantial retail business suffered much less – retail activities provided a hedge against wholesale price falls. Second, when generation was unprofitable, fossil fuel generators could choose to reduce output, mothball (or even close) expensive stations, and wait for better times.

But BE could not rely on either of these mechanisms to cushion the impact of price falls. It did not own retail businesses and its cost structure was inflexible – a structural feature of nuclear generation. Nuclear plants, being capital-intensive and difficult to operate flexibly, have costs which vary little according to output or price. The main components of nuclear cost are: fuel; debt service; operation and maintenance; and waste and decommissioning. With the minor exception of fuel, a tiny proportion of total costs, none of these varies much with either output or electricity price.

So in 2002 there was little that BE could do to adapt: it tried, with little success, to get BNFL to charge less for fuel and waste management services, but otherwise had to run its plant at virtually fixed cost as prices fell.

By summer 2002, prices were consistently below minimum BE cost levels and some BE plants had also suffered significant unplanned outages, which significantly worsened cash flow. BE informed the UK government that without early and substantial state support it could no longer remain solvent. By September the government had constructed a rescue package, but needed longer term EC approval.

The UK government chose to rescue BE for two main reasons. Firstly, BE accounts for over 20% of all UK generation, and rapid closure of this capacity would have run serious supply security risks and have caused wholesale prices to rocket. And secondly, it is not easy for BE to sell nuclear stations: it takes 18-24 months for a potential new owner of a nuclear station to obtain a site licence and the costs of acquiring a licence are significant. The most important terms of the government’s complex rescue package are:

  • The UK government assumes responsibility for a large proportion of BE’s liabilities for historic spent fuel management and decommissioning costs, worth about £3.3 billion (discounted) to BE.
  • BNFL has agreed to reduce charges to BE for future fresh and spent fuel services, and to take subsequent ownership of the spent fuel. The UK government estimates this to be worth around £500 million (discounted) to BE.
  • Other measures, including debt standstills, financial restructuring, deferral of business rates and sale of BE’s North American assets to ease BE’s cashflow problems.
The EC’s preliminary opinion on this package was that much of it constituted ‘state aid’ and would be disallowed. This left the UK government having to show that the package would not distort competition in European Union (EU) markets. But some of the EC’s preliminary views seem to be faulty. For example, the EC appears to believe that these measures affect BE’s pricing and output, thereby distorting competition, although they have little impact on its marginal costs. However:

  • Measures which relieve BE of historic costs and unavoidable decommissioning costs cannot affect current operations and therefore marginal costs at all.
  • Some measures (BNFL price reductions on current and future fuel services) will reduce marginal costs but not market prices. Market prices in competitive markets are determined by the highest marginal cost producer and BE’s marginal costs are always low.
The measures to help BE with historic liabilities therefore seem likely to be allowable under EU rules.

However, the BNFL deal for future spent fuel prices must also pass a test known as the ‘market economy investor principle’. The UK has to show that BNFL acted, in offering reduced prices, as a private investor would have done; in other words, to show that, in BNFL’s reasonable judgement, its own financial position would have been prospectively even worse if it had not offered BE new terms. As I suggested in a recent report, this may be difficult, given BNFL’s knowledge of its imminent change of status. Its assets will be largely taken over by a new state body, the Nuclear Decommissioning Authority, raising a question over BNFL’s incentive to act as a long-term private investor. In addition, BNFL’s taking over title to BE spent fuel may cause it to incur large future expenditures on waste management that the current terms do not seem to recognise. BE’s valuation of its own ‘avoidable costs’ also merits scrutiny.

Recent rumours suggest that the EC is ready to approve the package with relatively minor conditions – mainly a ring-fencing of BE’s existing nuclear assets to ensure that the aid cannot be diverted into other assets. Given the economic cost conditions facing BE and BNFL, and particularly the high level of sunk and fixed costs, this outcome would not, in the end, be a surprising result.

Author Info:

Gordon MacKerron, NERA Economic Consulting, 15 Stratford Place, London W1C 1BE, UK

Among the issues discussed was the possibility of setting up a consortium with European countries and Russia to produce enriched uranium

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