Ofgem Launches Consultation on Developments to Tender Process Under Current OFTO Regime

Energy & Infrastructure Alert | November.25.2020

In the midst of a flurry of renewed and invigorated commitments to offshore wind by the UK Government, the Office of Gas and Electricity Markets (Ofgem) has launched a consultation[1] on one of the key components of the sector – the offshore transmission owner (OFTO) tender process regime. Under the regime, Ofgem runs a competitive tender process to select and licence OFTOs to acquire and operate the offshore transmission assets connecting offshore wind farms to the UK's onshore transmission network.

The consultation looks at a number of items relating to the OFTO tender process which Ofgem proposes to implement in upcoming tender rounds to address some of the lessons learned from past tenders, and considers whether any additional changes should be made to help ensure that efficient and fit for purpose competitions are still run within the existing regime and to attract new entrants to the sector. The consultation further acknowledges the wider, longer term issues faced by the offshore wind sector and provides an update on expected next steps.

This is not the first time that Ofgem has consulted on the workings of the OFTO regime. Following a consultation in 2018 for tender round 6 (TR6), Ofgem implemented changes to the revenue term (increased from 20 years to 25 years), changes to the bid evaluation mechanism (an increase in the number of qualifying bidders that can be shortlisted and an increased emphasis on the bid price) and process improvements to improve the provision of information for due diligence.

Potential changes relevant to TR7

Given that the invitation to tender (ITT) for the first tender round 7 (TR7) project is expected to commence in April 2021, it is unlikely that all of the proposals in the consultation will be implemented in time for TR7. However, at the launch of TR7 last week, Ofgem mentioned that it may be possible to implement some of the proposed changes for TR7 (following engagement with the relevant stakeholders where necessary). The changes that fall into this category are:

  1. Changes to facilitate a shorter OFTO tender process. The Generator Commissioning Clause[2] imposes a requirement on a developer to divest its offshore transmission assets within 18 months of first power/after National Grid ESO has issued a completion notice. Ofgem usually aims to commence the ITT stage of an OFTO regime around this date. Ofgem notes that the ITT and Preferred Bidder (PB) timelines present challenges for certain parties, whether that is in supporting bids or expeditiously closing the transaction, and so the consultation is requesting feedback on the following suggestions to try and address this and facilitate a shorter process:
  1. Bid information: data room and site visits

    • Noting that a developer may not be in possession of all as-built documentation or have settled its capital allowance position by ITT, and to avoid impacting the firmness of the commercial terms and/or lead to issues during the PB stage, Ofgem is proposing either: (a) to permit bidders to access the data room earlier to facilitate a longer time to complete due diligence; or (b) to delay the start of the ITT until the data room is more complete and contains the necessary finalised documentation.
    • In addition, Ofgem has queried whether it would be viable or practical for site visits to both offshore and onshore substations to be conducted as part of the tendering process and if this would assist due diligence by reducing uncertainties and ultimately improve the firmness of bid pricing. If this is not viable or practical, Ofgem has sought views on what could be done in advance of bidders submitting their tenders to deal with this in a pragmatic way.
  2. Cost assessment. According to Ofgem, stakeholder engagement has indicated that the cost assessment process is robust, so whilst it is not proposing to change the manner of engagement with developers and the process of analysis undertaken at present, Ofgem notes there could be scope to revise timelines, as several stakeholders have noted that they consider that the time it takes to conclude cost assessment processes has delayed the divestment process. In order to finalise the final transfer value (FTV) earlier and allow PBs to conclude their confirmatory due diligence sooner, Ofgem considers that this would in practice mean that all costs (bar settlement of claims and/or future costs yet to be incurred at the time of making the estimate) would need to be settled as part of the indicative transfer value (ITV) so that the only costs that remain to be determined at the FTV stage are less material.  Ofgem recognises that although this will likely have the effect of commencing the ITT bidding phase after the completion notice has been issued (as costs could not be estimated with sufficient confidence until this point), it could potentially allow for a firmer price to be bid and accelerate the process from PB to asset transfer. However, Ofgem also acknowledges that such an approach would condense the cost assessment period and would remove the opportunity to consider further information to substantiate costs at the FTV stage, a point that is key for developers.
  3. Transfer and interface agreements. In order for bidders to price risk as fully as possible (and so avoid delays in agreeing the transaction agreements from PB), Ofgem's view is that these agreements need to be in near final form and represent what both parties consider to be a clearly defined apportionment of risk. One way to do this is to delay ITT until the transactions are more advanced, with only minor and immaterial changes left to be considered. This would involve Ofgem encouraging developers to take fuller account of bidders' comments and bidders to be clearer in their comments on areas that have greater pricing implications, with further iterations of the process if necessary. Ofgem has sought views on this generally, including any alternative approaches.
  1. Insurance requirements for OFTO bids. Ofgem has sought views on the ITT evaluation continuing to require bidders to take out LEG3 insurance or an equivalent package of cover in ITT bids. It has queried whether it should be less prescriptive here, and alternatively be more prescriptive about other elements of the insurance package (e.g. whether to take out business interruption cover, or set fixed levels for estimated maximum loss or the deductible).
  2. Reference rates (LIBOR to SONIA) and indexation (RPI to CPI). As LIBOR is no longer considered an effective interest rate for many financial products, Ofgem expects to provide SONIA-based, rather than LIBOR-based, benchmark rates for loans and derivates, and has sought views on this and potential challenges arising from a switch.

In addition, currently, OFTO bidders can chose to index any proportion of the TRS to RPI and hedge their exposure to inflation risk through a combination of index-linked debt and/or inflation swaps. Ofgem has queried the most appropriate revenue indexation for inflation measurement, and whether (and when) it would be more appropriate to move over to CPI/CPIH as a more effective measure.

Potential changes relevant to future tender rounds

  1. Ofgem's evaluation approach. Ofgem is seeking views on whether different evaluation approaches would address the concerns about the primacy of a low Tender Revenue Stream (TRS) potentially undervaluing certain elements of long-term asset management strategies which would look to ensure better, long-term consumer value. In TR6, bids are evaluated on a threshold basis with price robustness factored into this threshold, but with the bid score being 100% weighted on price. An alternative approach being considered by Ofgem is to assess qualitatively each constituent element to bidders' bids (financial and operational resilience, financial deliverability, tender revenue stream), providing a score for each section, which would then be weighted and added together to provide an overall bid score.
  2. Potential for debt funding competition. To avoid difficulties for many debt providers in holding terms long enough to support bidders and, as such, create barriers to entry for a range of debt providers (and possibly also new equity investors), Ofgem is keen to understand views on deferring debt finance to the PB stage (rather than requiring submission at the ITT bid stage). Bidders would still be required to outline their proposed approaches to and pricing for asset management, insurance and risk management, as well as the capital structure and sources of finance with committed equity returns. These would need to be shown as capable of a solid investment grade rating with a shadow rating (as a mandatory requirement). Bidders would also be evaluated on their plan for a debt funding competition.
  3. Role of reserve bidder. Some stakeholders have expressed views that PBs do not progress transactions in a timely fashion and attempt to leverage an asymmetrical bargaining position against the developer where the generator commissioning period is expiring. Ofgem has sought views on whether it should be more prescriptive in setting matters to be concluded to its satisfaction by PBs and expected timings by which they are to be concluded and, where they are not met, appointing the reserve bidder in its place (but at the same time, ensuring that it is not the developer that is delaying matters).

Wider regime development

The consultation document also touches on the work that Ofgem is doing around wider regime development in response to certain issues raised during its ongoing stakeholder engagement, and how stakeholders can engage further with Ofgem in relation to these matters. The wider regime developments include: (a) treatment of innovative design proposals in the cost assessment; (b) offshore transmission coordination (including co-location of technologies); (c) O&M/asset health/information sharing (important to determining whether an existing wind farm should be repowered); and (d) end of TRS policy (expected to be consulted on in early 2021).

The closing date for the consultation is 8 January 2021.