Risk Allocation and Regulation for CO2 Infrastructure

Introduction

Many European countries have now set out to develop carbon capture and storage (CCS) as a crucial element of their decarbonisation strategies. In addition to putting in place appropriate incentives to promote the capture of CO₂ currently emitted to the atmosphere, these countries are examining how best to build and manage the extensive new infrastructure that will be required for the transport and permanent storage (T&S) of CO₂. This includes addressing fundamental questions over the appropriate role of the state in ownership, funding, regulation, and risk management of infrastructure.

The UK’s approach to CCS infrastructure is a useful case study, as its use of a regulated asset base (RAB) model contrasts with the strategy adopted by several other European states that are also early movers on CCS. This policy brief provides a summary of the key features of the UK business model for CO₂ transport and storage – formally known as the Transport and Storage Regulatory Investment model (TRI) – and compares it with developments in the European Union.

Background

The UK’s heavily regulated approach to CCS may seem a surprising policy choice, given the country’s historical preference for privatised utility sectors. The current model has its origins in the failure of the ‘CCS Commercialisation Competition’ to deliver a large-scale CCS project in the power sector, which was cancelled by the government in 2015. A major factor in this decision was found to be the presence of several challenging project risks that had unnecessarily inflated the guaranteed electricity prices the projects’ required. In particular, these included ‘cross-chain risks’ which refer to the risks faced by each part of the value chain should another part of the value chain fail to operate for any reason.

Following detailed recommendations by an expert group ‘the CCS Advisory Group’, in 2020, the UK government proposed to adopt the RAB approach for T&S infrastructure, with incentives for CO₂ capture projects based on contracts for difference.^1,2 Essentially, capture projects are charged a regulated tariff to use the CO₂ infrastructure, and this cost is passed through and covered by various sector-specific subsidies (covered in an accompanying policy brief).³ This is sometimes known as a ‘user pays’ model.

The various UK business models have been carefully designed by the Department of Energy Security and Net Zero (DESNZ)⁴ with the aim of optimising the allocation of costs and risks between project developers and the state. This balance is intended to avoid excessive project costs while limiting the exposure of the state.Over three years on from its first conceptualisation, details of the UK’s T&S business model are currently being finalised, with Eni (network provider for the HyNet project) agreeing to heads of terms with the government in October 2023.⁵

The T&S Regulatory Investment Model: Overview

The UK plans to initially develop CO₂ infrastructure at a regional level, with a separate Transport and Storage Company (T&SCo) operating a network in each industrial cluster; these clusters and their T&SCos have been selected through the government’s competitive ‘cluster sequencing’ process. T&SCos are private entities (usually an oil and gas company or a joint venture including one or more oil and gas company) that will own and operate onshore and offshore pipeline networks and geological storage sites.⁶ 

The TRI consists of the Economic Regulatory Regime (ERR), together with supporting contracts that are designed to provide a financial safety net for certain challenging risks faced by the T&SCos. The ERR is the principal component, providing a regulatory framework which determines the ‘allowed revenue’ that a T&SCo can make to cover costs and earn a reasonable return on investment; this in turn dictates the tariffs that CO₂ capture plants must pay to use the network (Figure 1).

Figure 1. An overview of payment flows across the UK’s business models for CCS⁷

The Revenue Support Agreement (RSA) is a contract between the T&SCo and an ‘RSA Counterparty’, which is likely to be the Low Carbon Contracts Company (LCCC).⁸ In certain specified circumstances, it can provide the T&SCo with additional revenue – ultimately from taxpayers or energy consumers – to cover temporary shortfalls that might arise between the allowed revenue and the revenue obtained through the network user tariffs. 

In addition, the T&SCo enters into a contract directly with government, known as the Government Support Package (GSP), which is designed to guard against specific low probability, but potentially high impact risks that have been identified. It is essentially a direct government backstop against ‘showstopper’ events for the network, including stranded asset risk or significant CO₂ leakage from the storage site.

The Economic Regulatory Regime

As the chosen regulator for this new sector, energy regulator Ofgem will award an economic licence to the T&SCo once they have taken a final investment decision (FID). This licence gives the T&SCo the right to provide CO₂ transport and storage services under terms and conditions determined by an initial settlement between the T&SCo and Government. The settlement will include an ‘Approved Project Development Plan’ for the T&S network that describes how the network will be built out over an initial period, along with projected costs and network users.

A ‘first regulatory period’ will run from completion of construction for about five years, during which Ofgem will administer the economic licence based on these initial terms. From the second regulatory period onwards, Ofgem takes on a greater role, as it actively sets the price controls on the T&SCo, determining its allowed spend and rate of return, as well as performance targets and incentives (Figure 2).

Figure 2. Timeline of T&SCo development and decommissioning⁹

Calculation of allowed revenue

The allowed revenue is the total revenue that a T&SCo should require to cover costs and make a return on its investment, which will ideally be covered by network user tariffs. For a given year, it is calculated based on the value of the assets built out by the T&SCo (the Regulated Asset Value, RAV), its operational costs, and other costs, such as the future cost of decommissioning, according to the following formula:

Multiplying the asset value by a weighted average cost of capital (WACC) accounts for the regulated return the T&SCo can make on its capital investment, with the WACC chosen to appropriately reflect various risks inherent in investing in a network for a new industry. For example, the WACC is expected to be higher for the first clusters, which face greater risks. Different WACCs will be applied to capital investment that has delivered operational assets and ongoing investment in development and construction (the latter is known as ‘shadow RAV’).

Tariff structure

The parameters for this allowed revenue are pre-determined by DESNZ and incorporated in the economic licence awarded to each T&SCo. Once it commences operation (the ‘First Regulatory Period’) the T&SCo will collect its allowed revenue through network user fees, which will be based on several components (Figure 3).

Figure 3. The proposed structure for charges paid by the network users (BEIS, 2022)⁹

The capacity charge component is based on the network capacity booked by the user, and is intended to recover the T&SCo’s fixed capital cost. The volumetric charge is based on the tonnes of CO₂ actually delivered to the network, and should recover the T&SCos variable operational costs. A residual charge is applied to each user to make up any remaining shortfall in the T&SCos allowed revenue; this is based on the size of the user’s connection to the CO₂ network.

A key point is that the tariff will not vary according to location – users that are far from the storage site will not be penalised for the additional length of pipeline needed to connect them. This is intended to create a level playing field for the many existing industries that need CCS to decarbonise, but had little choice in their current location.

The T&SCo is responsible for setting the user tariffs according to this methodology, which is then verified by the regulator. They will be set on an annual basis, according to the users’ forecast of volumes of CO₂ to be injected.

Performance incentives

DESNZ has considered several additional mechanisms that could be used to encourage T&SCo to provide a high-quality service. One option that has now been adopted is an availability incentive, aimed at minimising network outages. The T&SCo will be given a target availability, which will likely be below 100% to allow for planned outages for maintenance. Allowed revenues will then be increased by some pre-determined amount for availability above the target, and reduced for performance below the target. An incentive to connect new users to the network has been considered, but deemed unnecessary, although the T&SCo is obligated to make the network available to new users that come forward, up to its design capacity.

The Revenue Support Agreement

The RSA is designed to cover the financial risk of certain events that might prevent the T&SCo from collecting its allowed revenue through network tariffs paid by users. The design of the RSA is somewhat similar to the business models created to subsidise capture plants, in that the contract counterparty is likely to be the LCCC, and it operates on the basis of a ‘Difference Payment’. The T&SCo provides a quarterly forecast of the shortfall between its allowed revenue and its expected revenue, which are made up by an interim payment from the RSA counterparty. At the end of the year, these payments are reconciled against the actual shortfall and adjusted accordingly.¹⁰

The Government Support Package

The GSP is a contractual arrangement between Government and the T&SCo that consists of two parts: First, the Supplementary Compensation Agreement (SCA) is intended to provide additional payments to T&SCo for events where commercial insurance has not been available. Second, the Discontinuation Agreement describes how the GSP can be ended in certain circumstances, and the level of compensation that T&SCo will receive. This could be activated if the T&S network becomes a stranded asset or the money paid out under the SCA is deemed unsustainable and the network is unlikely to return to economically viable service. The T&SCo will be compensated for its remaining equity and debt.

Future Outlook

The UK’s most recent plan for CCUS: ‘A vision to establish a competitive market’ lays out a trajectory towards a less regulated approach to CO₂ infrastructure.¹¹ The regulated asset base model is envisaged to remain until at least 2035, with economic licences to new T&SCos granted by Ofgem and the process of awarding subsidies to carbon capture plants moving from bilateral negotiations to a competitive model. From 2035, a more competitive market phase is expected, particularly for CO₂ storage sites, which are likely to be able to compete with each other on price as more become available and connected to shared networks. However, onshore CO₂ transport is expected to remain monopolistic and still subject to regulation. The government also indicates that it could continue to play a role in strategic coordination and planning of the network – at least until 2035, in order to promote efficient build-out of correctly sized transport routes and maximise decarbonisation.

International Comparison

The TRI and the UK’s complementary CCS business models are relatively complex policy instruments aimed at developing an entirely new industry and deploying capital-intensive infrastructure. The approach contrasts with the strategy for CCS deployment adopted in the Netherlands, which is also in the early stages of developing CO₂ capture in several industrial clusters combined with pipeline transport to offshore CO₂ storage. Like the UK, the Netherlands has implemented a subsidy for CO₂ capture plants based on a carbon contract for difference model (the SDE++), however, a less regulated approach to CO₂ infrastructure is preferred, with a greater burden of risk on the private entities involved.

Although the frontrunner project ‘Porthos’ – connecting emitters in the Port of Rotterdam to storage just offshore – is a joint venture between various state-owned entities, future projects in the Netherlands are expected to be led by the private sector, with some separation of ownership of CO₂ transport and storage (‘unbundling’). These principles are the basis for the Aramis CO₂ transport project, led by TotalEnergies and Shell (with state-owned EBN and Gasunie also holding 25% stakes). This proposed offshore ‘trunk’ pipeline will connect emitters with CO₂ storage in depleted gas reservoirs owned and operated by TotalEnergies, Shell, and Neptune Energy. The various entities along this value chain are expected to establish private contracts to appropriately allocate cost and risks among them. While a benchmarked cost of T&S services is included in the maximum bid permitted to CO₂ capture plants in the SDE++, there is no direct regulation of the service tariff paid.¹² 

This disparity in approach may be partly explained by the different contexts for CCS deployment in the two countries. The UK aims to cover a much wider range of sectors and over more geographically separated clusters and storage sites, while the Netherlands is able to focus initial infrastructure development around Rotterdam, where a terminal for CO₂ imports by ship is also planned. A role for state-owned entities in the Netherlands has nevertheless been pivotal in early market creation through the Porthos project, enabling long-term decarbonisation strategy to play a greater role in the final investment decision. An agreement on the state taking on the long-term liability for storage was also essential for progressing the project. The Dutch government has indicated that the state may retain an ownership stake (through EBN) in all future storage projects.¹³ 

In Denmark, where CCS value chains are also being advanced through government support, there is a similar proposal for the government to retain a 20% ownership stake in storage projects.¹⁴ This would be through state-owned oil and gas company Nordsøfonden, which already has a 20% stake in Denmark’s three existing storage exploration licences, and would give the state a share of any risks and revenues associated with the project. Currently, CO₂ capture projects in the country must apply for subsidies with a plan for a full value chain including transport and storage; cross-chain risks are therefore handled commercially between the entities in the chain.

The UK’s proposed direction of travel towards a more competitive market for CO₂ infrastructure suggests that there could ultimately be some convergence of regulatory approaches within Europe. However, the regulated asset base approach of the TRI has been selected as the most appropriate means of de-risking and driving investment in the large-scale CCS deployment needed to reach the UK’s targets to 2035.