“The purpose of this condition is to provide for revenue adjustments to reflect certain costs that can be passed through to consumers as part of allowed transmission owner revenue.”
“The cover provided for internal faults is addressed primarily by way of the defects exclusions which, depending on the level of cover afforded, writes back an element of cover. The cover written back from the exclusion is referred to as a LEG clause. The London Engineering Group (LEG) is an informal association of engineering underwriters which has drafted various clauses to address the extent of defects cover which may be provided. These fall into three categories:
“The costs of an IAE are mostly passed back to the wind farm generator through the local transmission charge. …the generator that built the asset will be considerably worse off compared to competing generators.”
“42. In assessing whether an event or circumstance is an IAE under Limb (c), we have considered, consistent with the BTLAL Decision, the balance of risk and whether the Licensee is the most appropriate party to manage the risk of the event. To determine this, we have considered the extent to which the Licensee was, or should have been, in a position to foresee the event or circumstance and the level of control it had to mitigate the impact of such an event. … 44. As noted in the BTLAL Decision, we consider that such an approach [applying the BTLAL Factors] is consistent with the overarching design of the Offshore regime and with the Authority’s statutory duties, in particular its principal objective to protect the interests of existing and future consumers in relation to electricity conveyed by transmission systems. For example, we do not consider it to be in the interests of consumers to pass through those costs arising from a type of damage that was (or should have been) foreseeable to a bidder/OFTO, solely because the precise damage of the type that occurred was not foreseeable; we therefore consider it appropriate to adopt a narrower, rather than a broader construction of Limb (c) in this regard. Such an approach also seeks to ensure that bidders are properly incentivised to conduct due diligence in respect of the assets, to put in place appropriate commercial arrangements prior to asset transfer and to pursue any relevant third parties who may be liable (such as developers, manufacturers, installers and insurers). The OFTO regime facilitates commercial transactions for large-scale infrastructure investment. We consider that the OFTO is responsible for managing its investment including adopting what it considers are suitable risk management measures.”
“In summary there is nothing in the information provided that suggests to the Authority that the risk of the Event was of a type so unforeseeable or exceptional that a prudent licensee would not have contemplated that risk in assessing the project prior to submitting its tender or fixing the revenue entitlement. We note that the Licensee may be able to recover only part of the costs incurred through commercial arrangements. However, whether or not the Licensee can recover any or all of the costs it incurred through commercial arrangements, the Authority considers that the Licensee is the most appropriate party to manage the risk of the Event.”
“59. As stated in the BTLAL Decision, an overarching premise of the generator build model was that the developer bears the risks associated with construction of the transmission assets, such as increased costs from construction overruns and the failure to complete the assets on time during the construction phase. In contrast the OFTO is responsible for owning andoperating the transmission assets from the point of asset transfer, and for owning and operating the transmission assets from the point of asset transfer, and for the associated risks arising from ownership of the assets. The Offshore regime was not designed to insulate OFTOs from all risks that could somehow be traced back to the construction of the assets such as a latent defect. … 64. We have considered the potential wider implications for the OFTO regime as a result of this determination where relevant. In our view, this particular determination should not materially impact future OFTO tenders. We consider that the regime will continue to bring benefits to consumers by providing long term visibility on transmission costs through a competitive procurement process. Further, to address the issues covered in this determination, we believe it is incumbent on developers to work actively with OFTOs to ensure future issues are prevented through good practice in project development. We are keeping a watching brief on developments occurring in the industry regarding offshore transmission assets.”
“57. Similar to any other transaction involving a purchase of assets, a licensee should enter into such transactions with the awareness that it is assuming any risks arising from damage or defects that it has not been able to discover through its due diligence. The Offshore regime was not designed to insulate licensees from all such risks [footnote 15: The framework for the Offshore regime also reflects this through the STC which deems the OFTO, for the purpose of the STC, to have been the party that developed the transmission assets from the point of asset transfer…]. Even if a licensee believes, having conducted a reasonable level of due diligence, that the construction of the assets had been undertaken properly and to the level of reasonable skill and care expected, we do not consider it appropriate for the licensee to be able to pass on the risks arising from defective work in the construction of the assets to consumers. 58. We expect licensees to pursue third parties for remedies in respect of their negligent or below standard work and to put in place other commercial arrangements and risk management practices to ensure they can bear the consequences of risks in the event there may not be any such recourse. We also expect licensees to put in place appropriate insurance arrangements to manage risks and satisfy themselves that the insurance cover is suitable for their needs.”
“We understand that the Licensee took out an insurance policy that it believed would cover the costs of repair arising as a result of such a cable failure (under its ‘operating all risk’ policy with a LEG2 exclusion). This was a commercial decision it made at its own risk, and our understanding is that ‘operating all risks’ insurance cover at LEG3 level was available in the market at the time the Licensee bid for the Licence.”
“60. However, the Licensee has argued that its ability “to manage the risk of subsequent cable failure including the [SSEC2 Cable Failure] was impaired by the [SSEC1 failure] in March 2015, which limited the levels of coverage that insurers would have been and subsequently were prepared to offer”
“We therefore consider that the insurer would most likely have imposed an exclusion on any LEG3 policy between technical examination of the SSEC1 failure [on2 September 2015 ] and the Cable Failure [on25 September 2015 ].”
“67. Therefore, even if the Licensee had purchased LEG3 cover prior to the SSEC1 Failure, we consider it more likely than not that it would not have had insurance cover for the [SSEC2] Cable Failure. The Cable Failure was therefore likely to have been effectively uninsurable. … 69.
“In assessing whether an event or circumstance is an IAE under Limb (c), we have considered, consistent with the BTLAL Decision, the balance of risk and whether the Licensee is the most appropriate party to manage the risk of the event… ”
“We appreciate that an IAE would give the OFTO relief for expenditure and have wider consequences in terms of costs to consumers (including the generator). However the consumer base is realistically the only constituency able to withstand the risk of multiple unexpected cable failures. A generator would have other access to the consumer base through power prices, that is not available to an OFTO with its tightly controlled revenue stream set on the basis of this being intended to be a low risk asset with no construction risk..”
“[Kate Kendall] said that the Authority was sympathetic to OFTOs where assets have become uninsurable. We were proposing to issue further guidance on IAEs by the summer and one possible way forward might be to make licence amendments where an OFTO had been able to demonstrate that their assets were no longer insurable… [Shareholders] argued that the second failure at GYM would not have been covered by insurance. [Steve Taylor] said that the Willis report stated that the insurance position only tightened in 65. November 2015, after the second failure had occurred. This implied that the second failure could have been covered if the OFTO had taken out LEG3 at the outset.[Shareholders] said that the position was arguable – the OFTO would like an opportunity to set out the timeline on Insurance more clearly and discuss this point further with the Authority. He also asked what would happen if a cable failed before the guidance was issued or licences amended.”
“J This decision is delegated to me, so no particular action needed from you, but note the following: … (b) for the second failure at GyM (SSEC2) we have decided to seek further information on the insurance position. We were minded to reject their claim on the basis that they would have had cover for these costs had they put in place the correct insurance policy…The bidder has made a late claim (this week) that they have evidence to show that even if they had put in place the correct insurance cover at the beginning, the insurers would have withdrawn cover after the first failure event, and no other insurer in the market would have been willing to cover them, leaving the OFTO uninsurable – and therefore, unviable. We consider this unlikely, but I have deemed it safer to ask them for the evidence to avoid any risk of legal challenge later. We have done so, and this gives us a bit more time to decide this third claim. More generally, I briefly described to you the un-insurability issue for OFTOs, which threatens to make these assets unfinanceable unless the IAEs respond as insurer of last resort in the event the insurance market withdraws from covering an important risk category. We may for instance have a situation at GyM where the OFTO now knows it needs LEG3 cover, is willing to pay for it but cannot find an insurer who would write the policy. If a third failure occurs, it may well be out of cash, and will face a default situation unless there is fresh injection of equity. If equity withdraws and the lenders step in and try to replace the obligor, any new investor coming in will want cover for the costs of repair and installation (the costs of the cable itself will generally be recoverable from the originalmanufacturers under their warranties). Ofgem would face the same situation if it tries to retender or bring in an OFTO of Last Resort. So the most efficient solution in this case – provided a claimant can provide clear evidence that the insurance market as a whole has withdrawn from covering the risk of a latent defect failure event – is for IAEs to respond, and for us to pass most of these costs back to the generator through the recharging regime via National Grid. Our plan is to publish some guidance for the OFTO market on this un-insurability point later in the summer, which will help clarify the issue for lenders to TR4 and TR5 bidders.”
“35. From our dialogue with the Authority we note that the Authority recognises that the issue of the IAE mechanism to support property damage claims where insurance is no longer available is of fundamental importance in meeting the Authority’s responsibility to ensure that the OFTO regime can be funded by project finance, at high equity to debt gearing. 36. In the case of the GyM OFTO the senior debt and equity funders all invested in the expectation that in such circumstances, the Income Adjustment mechanism would allow recovery of reasonably incurred costs. 37. If this principle is not retained then the impact on the wider market will be (i) increased funding costs as a consequence of the increased risk from narrowing the availability of IAE claims, but more importantly (ii) that bank and bond financing markets will withdraw support from the OFTO regime….”
“…The key issue raised in the GyM letter of9 June 2017 is GyM’s hypothetical argument that if GyM had taken out LEG3 insurance cover at licence grant, its insurance would have been downgraded following its first cable failure…Having now investigated this issue, we conclude that it is possible that GyM’s insurer would have downgraded its insurance, and our current view is that we should be providing OFTO’s [sic] protection where something becomes uninsurable, but given it is a hypothetical it is not possible to know. Set out below are the considerations we have identified in determining whether or not to accept GyM’s argument and as a consequence grant the IAE claim… … Factors that support accepting the un-insurability argument 1. The experience of the Thanet OFTO is that an insurance exclusion was imposed 7 days after the cause of the outage was identified… .. 8. Lenders are concerned with the potential contagion effect of multiple cable failures. An OFTO can absorb one failure through its reserves. For a second event it has no reserves, noone will lend to it at this point and equity holders have no incentive to inject capital and remain in the market when they have no certainty of any future return on that asset. The potential contagion impact that follows an unfunded repair includes: stranded developer calls on its business interruption insurance (up to 18 months); excessive pay out of BI insurance could drive insurers out of the market; no lending without insurance and therefore the market would ultimately collapse. 9. Payment of a claim on an ‘un-insurable’ asset is likely to be consistent with our proposed uninsurability guidance, which we are currently developing and propose to release alongside the decision letter in early September 2017. 10. Moody’s has downgraded its assessment of the regime from AA to BAA, see note on how regime is assessed attached…. 11. The high probability of a repeat failure or a failure where the fibres in the [fibre optic cable] have begun to deteriorate isresulting in insurers placing exclusions on polices…If we don’t act as insurer of last resort then OFTOs will fall over leading to OFTO of last resort where it is likely that we will have to recompense the new provider for taking on the assets and so are likely to pay either way. 12. OFTOs are not responsible in any way for the failure of these assets and they are doing everything possible to ensure that they maintain the assets.”
“…it is true that we are seeing new lenders to the market becoming pretty aggressive in terms of pricing but they are blind to these issues surrounding IAEs as they have no knowledge of what is happening on the ground re uninsurability. As I attached to my previous email, the market is taking a different view of OFTO assets and Moodys have downgraded the regulatory regime following the first failure. My fear is this will be exacerbated where we decide not to protect OFTOs from uninsurability and we will see further downgrades. One of the original constructs of the OFTO regime was to create an asset class which looked and felt like PPP – in SOPC5 there is coverage for debt providers for uninsurability. If we go forward with a regime where we leave the risk of uninsurabiliity with the OFTO it is highly likely that either they will be required to put in significant reserves to cover cable failures (which will result in significant cost to all future OFTO’s going forward which will be of a contingent nature) OR we won’t be able to finance OFTO’s going forward. The risk of uninsurability could potentially push the OFTO asset class to junk status; bond holders and debt just won’t entertain the risk. I realise that the decision has already been taken about the issue of latent defect risk and we are not trying to unpick that. This is a genuinely new argument and is about whether we want to ensure a stable regulatory regime that insulates debt from risks that are completely outside its control. I think we have some work to do about how a mechanism might work, and whether it protects Equity. I would have thought as a minimum we might want to say that any event is equity risk up to a level whereby all its contingencies and equity surplus funds have been used but as soon as it impacts/eats into debt then it is for the consumer to bear that risk, as they are benefitting from the exceptionally low costs of finance attracted to the OFTO regime as a result of clearly packaging up risks that the OFTO can’t and shouldn’t deal with.…”
“5. Ofgem’s analysis of the BTLAL Factors, including its answer to the relevant Hypothetical Question, had concluded by31 August 2017 . That meant that, by this date, it was clear that the Authority would be allowing the IAE under the SSEC2 Decision. It was also clear that the insurance analysis was central to this outcome under the policy as formulated in the BTLAL Factors. 6. That conclusion triggered a wider review within Ofgem, in which Ofgem considered whether, for the purpose of future cable failures, it was content that it had adopted the appropriate policy or whether a different policy should be imposed. That review involved Ofgem considering broader economic arguments about the appropriate IAE policy in respect of uninsurable latent defects. Dermot Nolan (CEO of Ofgem), in particular, was concerned that the SSEC2 Decision should not be published until he had reassurances that the wider aspects of the policy (to be applied prospectively) would be consulted on and altered if appropriate. … 8. It is therefore wrong for the Claimant to suggest that I reached the decision under limb (c) of the SSEC2 Decision by reference to anything other than the BTLAL Factors, or that Ofgem in fact had a policy to take any other factors into account or to carry out any comparative exercise as contended for by the Claimant. It is true that I received representations, both from Ofgem employees and from industry participants, regarding the broader potential impacts of the SSEC2 Decision on the OFTO regime…But considerations separate from the BTLAL factors formed no part of the basis on which I reached the SSEC2 Decision.”
“Badly. He’s adamant that the OFTOs understood that they were taking the risk of latent defect, and of un-insurability; and that they should have been prepared for the fact that the licence will never respond under any circs to cover latent defects. Can you do something for me? Dermot wanted a quantitative demonstration of my assertion that it is better value for money for consumers to pay out for un-insurability protection on a few claims, than for bidders to price in a capped reserve of (say)£20m into the TRS [Tender Revenue Scheme], with the consumer covering any costs above this level?”
“74. It was a complex decision, with competing factors on either side. Individuals within Ofgem shared their views on the relative balance of the competing factors during the decision-making process and as we were gathering relevant evidence. See internal emails between relevant members of Ofgem.”
“Another commercial point you should consider is the contractual rights of the insured party. Normally, the insurer has full ability to impose exclusions or raise premia when the contract comes up for renewal. But in my experience it is untypical for them to be able to do so mid-way through an existing policy without the customer having any right of redress.”
“[26] … Where the Act has conferred the decision-making function on the Director, it is for him, and him alone, to consider the economic arguments, weigh the compelling considerations and arrive at a judgment. The applicants have no right of appeal: in these judicial review proceedings so long as he directs himself correctly in law, his decision can only be challenged on Wednesbury grounds. The court must be astute to avoid the danger of substituting its views for the decision-maker and of contradicting (as in this case) a conscientious decision-maker acting in good faith with knowledge of all the facts.10 As Lord Brightman said in R. v. Hillingdon London Borough Council, ex parte, ex parte Pulhofer. “Where the existence or non-existence of a fact is left to the judgment and discretion of a public body and that involves a broad spectrum ranging from the obvious to the debatable to the just conceivable, it is the duty of the court to leave the decision of that fact to the public body to whom Parliament has entrusted the decision-making power save in a case where it is obvious that the public body, consciously or unconsciously, is acting perversely.”
“These documents are to be read fairly and in bonam partem. If reasons are given in general terms, the court should not exclude reasons which fairly fall within them: allowance must be fairly made for difficulties in expression. The Secretary of State must be given credit for having the background to this situation well in mind, and must be taken to be properly and professionally informed as to educational practices used in the area, and as to the resources available to the local education authority. His opinion, based, as it must be, upon that of a strong and expert department, is not to be lightly overridden.”
“61. We are aware of three OFTOs that have had exclusions placed on their insurance directly following the occurrence ofthe FOC issues… 62. The Thanet OFTO had an exclusion placed on its insurance policy following a cable failure which occurred on23 February 2015 …The chronology of the Thanet OFTO events is as follows: the cable failure occurred on23 February 2015 ; technical examination of the damaged cable occurred on21 September 2015 ; and Thanet was informed by its insurance broker on28 September 2015 – one week after the technical examination –that a LEG1 defects exclusion was imposed on the cable withimmediate effect..”
“…if it were to be said that the subsequent disclosure demonstrates that there was a mistake in paragraph 62 of the SSEC2 Decision referring to the exclusion being imposed on28 September 2015 , I confirm that the knowledge that the exclusion was finally imposed on13 October 2015 would not have altered the outcome of the SSEC2 Decision. The question I was asking in relation to this aspect of the analysis was whether the Thanet OFTO’s insurer acted quickly to impose an exclusion, in particular within a period of 23 days. An exclusion being imposed on13 October 2015 likewise provides an affirmative answer to that question…”
“80. The Thanet OFTO insurer notified the OFTO about its intention to impose the exclusion seven days after the technical examination of the cable. The relevant question we had to answer was whether the hypothetical GyM OFTO insurer would have reacted between2 September 2015 (when the SSEC1 technical examination took place) and25 September 2015 (when the SSEC2 Failure occurred). This 23-day period was therefore a longer period than the mere seven days to react taken by the Thanet OFTO insurer…”
“…Of course, for Thanet OFTO, Codan was the sole insurer, whereas for GyM OFTO it was one of a pool of insurers. Further, we could not know (and did not consider it necessary to speculate) on the identity of the insurance pool in the hypothetical where GyM OFTO had LEG3 insurance – but it could well have been a different composition from that in fact [sic] obtained.”
“…the GyM OFTO is likely to have been considered to have been particularly vulnerable, because the GyM OFTO cables contained two fibre optic cables (as opposed to the single fibre optic cable in the other OFTOs that had experienced cable failures). As the Willis Report highlighted in relation to the SSEC1 Failure…”the [fibre optic cable] which failed was the ‘spare’ FOC which was not monitored and hence there would have been no advance warning of a developing fault through loss of fibres”
“That is one way to read the Thanet example. However it seems to me that it could also be read quite differently. We were told by Codan last week that they made a major insurance payment for repair costs following the first failure event at Thanet, prior to asset transfer, and told by Steve Griffin on 25 June that insurers had now paid out for the second Thanet claim….So the position at Thanet seems to be that under LEG3 policies (first held by Codan with the generator, and then by Codan with the OFTO) the insurers paid for both the first and second failure events, but moved very quickly to make an exclusion to the policy after the technical examination for the second failure. So the Thanet example could equally be read as implying that a LEG3 insurer at GYM might only have made an exclusion to the policy after the second failure had occurred.”
“It is common practice for policies in this sector to be “scheduled”, meaning that a number of insurers provide a specified percentage of the cover totalling 100%...for some time the largest lead line offered was 15% which would have resulted in an increased number of insurers being required to achieve a 100% placement. Policy amendments and often claims agreements may need to be sought from each participating market and there is no guarantee of a uniform approach in any matter. ”
“..We did not decide on one particular hypothetical legal or factual mechanism, and did not consider it necessary to do so. However we were aware of the ability to impose a contractual exclusion (as per [A OFTO]), and of the ability to threaten removal of cover if an exclusion was not adopted (as per Gabbard OFTO) – these were lawful, factual examples before us of exclusions being imposed. We were also aware, from the Thanet OFTO and Gabbard OFTO examples in particular, of the strong bargaining position that insurers were put in because of the real difficulties that would face an OFTO that had its insurance cancelled.”
“Thanks Akshay, a good question and one that we can ask JLT when we meet with them…however advice from Thanet, Gabbard and Ormonde is that they have all add (sic) exclusions imposed on their insurance mid-term directly following a cable failure or significant breakdown of fibres in the fibre optic cable.”
“..we found that the advice provided by JLT did not materially alter or assist Ofgem’s understanding of the relevant position. In Ofgem’s meetings with JLT, and to a certain extent in its written advice, JLT emphasised the fact-specific nature of our inquiries.”
“JLT refused to be drawn on the question of whether the hypothetical LEG3 insurer at GYM might have withdrawn LEG3 cover before the second failure occurred…”