Pumped Storage Hydro (PSH) developers in the UK face several challenges under the Long Duration Electricity Storage (LDES) cap and floor scheme, mainly due to the unique financial and operational characteristics of PSH compared to other storage technologies. While the scheme aims to reduce revenue risk and attract investment, its design raises several challenges specific to PSH:

1. Misalignment between contract duration and PSH asset life

The cap and floor scheme is designed with a 25-year contract duration, whereas PSH assets typically have lifespans of 50-100 years.

• Issue: The accelerated cost recovery model may result in higher floor payments in the early years, leading to concerns of excess consumer subsidisation.
• Investor risk: Uncertainty about post-regime market conditions may deter investment in large-scale, capital-intensive PSH projects.
• Potential solution: Ofgem is reviewing extended depreciation models to better align financial recovery with PSH’s long life.

2. Uncertainty around post-regime revenue model

Currently, there is no clear visibility of how PSH projects will earn revenue beyond the 25-year cap and floor support window and therefore developers and funders are likely to want to recover the full value of their investment within this 25-year period.

• Risk: Developers may hesitate to invest if post-regime financial sustainability is uncertain and they are unlikely to recover the value of their investment within the 25-year cap and floor support window.
• Comparison: Other business models, such as the Regulated Asset Base (RAB) model, might provide greater certainty for long-duration assets.
• Potential solution: Ofgem is considering a mechanism where post-regime revenues can offset past consumer-supported floor payments. Whilst this approach ensures that consumers who provided investment support through floor payments can benefit from the continued operation of assets beyond the 25-year regime period, if designed correctly it could ensure that developers do not ultimately record a negative return for their overall investment.

3. Risk of competitive distortions with shorter-lived storage solutions

The cap and floor design is uniform across all LDES technologies (e.g. flow batteries, liquid air storage), but PSH has higher upfront investment costs and a longer payback period.

• Issue: If the floor level is set too low, project financing may be difficult for PSH and investors/funders may look at other LDES technologies with lower CAPEX values but also lower asset lifetimes (e.g. lithium-ion with longer discharge) as being a more attractive investment opportunity.
• Potential financial disadvantage: The current model disadvantages projects with much longer lifespans due to their longer development cycles, potentially leading to longer-term financial inefficiencies.
• Potential solution: Calls for technology-specific financial structures are under consideration to avoid distorting investment incentives.

4. Financing risks despite revenue certainty

Debt financing is crucial for PSH projects, but the existing scheme:

• Treats all projects with a standardised cost of debt, rather than using actual borrowing costs for each project.
• May not offer sufficient flexibility for highly leveraged PSH developers who need longer-term debt.

• Issue: Lack of tailoring for actual debt and equity requirements makes it harder for private sector financing to work under the scheme.
• Potential solution: Ofgem is exploring a hybrid floor mechanism, where project-financed PSH developers could set their floor based on actual cost of debt (ACOD) rather than a notional benchmark.

5. Regulatory complexity and monitoring burden

The multi-stage assessment (eligibility, cost-benefit analysis, final award and post-construction review) creates a significant administrative burden.

• Issue: PSH developers will need to continuously demonstrate ongoing financial viability and system benefits, adding to the complexity of project planning.
• Potential solution: Developers are lobbying for a simplified regulatory process for proven technologies like PSH.

6. Restrictions on revenue stacking and ancillary services

PSH typically operates by stacking multiple revenue streams (arbitrage, capacity market, frequency response), but the cap and floor model does not incentivise seeking additional revenue streams.

• Issue: If revenues hit the floor level too frequently, PSH may be forced to rely more on the cap and floor mechanism than market-driven income.
• Lack of clarity: It remains unclear whether PSH can fully participate in ancillary service markets while under the cap and floor scheme.
• Potential solution: A revenue-sharing mechanism above the soft cap is being trialled to maintain market-based incentives.

Conclusion: a complex but potentially investable framework for PSH

While the LDES cap and floor scheme provides some much-needed revenue certainty, several unresolved challenges remain for PSH developers:

• Mismatch between contract duration and asset lifespan.
• Unclear post-regime revenue mechanisms.
• Risk of competitive distortions with shorter-duration LDES technologies.
• Difficulties in securing appropriate project financing under a notional debt model.
• Regulatory and administrative complexity.
• Approach to revenue stacking which could impact market participation.

These challenges can be addressed by:

• Extending contract durations for very long-lived assets.
• Allowing post-regime revenue-sharing mechanisms.
• Introducing a tailored floor rate for project-financed PSH.
• Encouraging PSH projects to generate ancillary service income.

While the LDES scheme is a step in the right direction, further adjustments are needed to make PSH investments more viable under this framework.

To discuss any of the issues raised in the article above or in relation to the LDES cap and floor scheme, please get in touch with one of our key contacts.