Publication - Research and analysis

Small-scale hydro plant and machinery review: report

Published: 15 Jan 2020

The report sets out the findings of the review of small-scale hydro plant and machinery in Scotland.

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62 page PDF

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Contents
Small-scale hydro plant and machinery review: report
Review Group Deliberations

62 page PDF

955.6 kB

Review Group Deliberations

48. The following summary of the group's discussions does not seek to simply identify areas of agreement. On numerous occasions the group was unable to agree a consensus opinion and the summary attempts to avoid any editorial judgement on the merits of each argument and instead seeks to provide a flavour of the discussion over the seven meetings. Hyperlinks to the minutes of each meeting are attached in an annex to this report.

Options Considered

49. The group discussed in detail a number of possible options - each with their own pros and cons (including state aid considerations). The four options were:

Do nothing. The group's remit was to consider the present law and recommend any legislative changes required. If the group considered the concerns of the sector to be unfounded or flawed, the group could conclude that no action was required.

Reliefs. The group noted that non-domestic rating valuation does not usually lend itself to short term policy solutions but reliefs provide a flexible route to address anomalies and undesirable or unintended outcomes. The sector expressed concerns that reliefs were considered to be temporary and while the current relief was welcome, it was seen as a short term fix as opposed to a sustainable long term solution. In addition, the industry noted that funders of hydro schemes exclude the impact of the current relief from their assessment of viability.

The group noted that non-universal reliefs are subject to State Aid de minimis rules since they confer selective advantage on one, for example, geography, industry or sector. Reliefs are delivered through secondary legislation.

Exemption from the Plant and Machinery Order. The Plant and Machinery order could be amended to exempt some or all of the rateable plant and machinery relating to the hydro sector. The sector were clear that this was their preferred option but the group agreed there would need to be evidence-based grounds to justify such an intervention. In addition, it would be necessary to minimise any risk of unintended consequences for other sectors and maintain fairness between ratepayers.

A non-universal exemption would be subject to State Aid de minimis rules because it would confer selective advantage on one, for example, geography, industry or sector. The group also discussed the impact on harmonisation of legislative differences between UK nations.

De-Rating. The group discussed the option of de-rating which would see everything continuing to be rated but that a percentage reduction is then applied to the subsequent valuation. The group noted that de-rating was used more frequently historically and had effectively been replaced by reliefs in recent years and was very rarely used now.

De-rating was considered likely to require primary legislation and non-universal de-rating would be subject to State Aid de minimis.

Fairness

50. It is the contention of the hydro sector that the business rates system delivers an excessive and 'unfair' rateable value for small-scale hydro generation plant. Their concerns existed at the 2010 revaluation and there were many appeals, including six pursued by the Old Faskally Farming Company Limited and Others. However, the 2017 Revaluation resulted in significant increases in the rateable values for many small-scale hydro schemes. The sector has provided evidence to suggest that rateable values are now, on average around 24 per cent of gross turnover. In this situation, actual rates payable equates to around 12 per cent of gross turnover. The sector also provided evidence to suggest that the equivalent figures for solar and wind are three per cent and five per cent of turnover respectively so rates as a proportion of turnover for hydro are 2.4 times those for wind and 4 times those of solar.

51. While a significant number of hydro subjects appealed their 2017 revaluation rateable values, the group understands that, at the time of the drafting of this report, the 2017 Highland appeals on hydro schemes had been cited for hearing by the Valuation Appeal Committee on 5th November 2019, although they were subsequently referred to the Lands Tribunal.

52. Using the evidence presented, the sector demonstrated the financial impact such costs can have on scheme development, particularly during the early years of operation. The introduction of the 60 per cent relief scheme by the Scottish Government did allow previously paused development activity to re-commence but developers, and perhaps more importantly financiers, remain concerned over the temporary nature of the current relief pending the outcome of this review.

53. The group devoted a significant amount of time to discussing the concepts of fairness and the relative merits of using percentage of turnover as a metric by which to judge the fairness of a property tax. The group accepted that fairness is a subjective concept but did not unanimously agree that turnover was a valid comparative metric. The group also agreed that the impact on finances was not uniform across the entire sector with FIT supported schemes typically facing greater challenges than those benefiting from the historical ROC scheme.

54. Hydro representatives were keen to see fairness relative to other renewable technologies, as defined by percentage of turnover (see paragraph 50). This view is bolstered by reference to the design of the ROC/FIT support system which is implicitly designed to deliver a broadly equivalent risk adjusted rate of return on investment across all low carbon technologies. However, relative turnover is not a material consideration in the rating hypothesis which is based upon the principle that all occupiers should pay a contribution of the rating burden in proportion to the rental value of the subjects which they occupy.

55. The group discussed comparisons with other sectors where turnover information is available. Since the rates system is based upon open market rental values, turnover and income levels generally have no bearing on rateable value calculations. Consequently, neither assessors nor Scottish Government have evidence to directly compare rateable values to turnover or income for most business properties or sectors in Scotland.

56. One notable exception to this rule is rateable values for the hospitality sector such as hotels, guest houses and public houses which are often incorrectly considered to be based upon turnover. Contrary to common understanding the rateable value of these subjects is determined from the level of rents passing for those types of subjects in the open market, as is the case for all subjects valued on the comparative principle. However, turnover is used as a method of comparison between different hospitality subjects in a similar manner to floor area when comparing shops or offices.

57. While the group was unable to agree consensus on this point, there was a general acceptance that the burden of rates as a proportion of turnover would vary dependent on the capital intensity of a business model. For example, rates as a proportion of turnover for a multi-story car park with limited operating and labour costs would be significantly greater than the equivalent proportion for a relatively labour intensive/high operating costs sector such as financial services or sectors with high raw material costs or high purchase costs of goods for sale.

58. The group agrees that, as a proportion of turnover, rateable values of small-scale hydro generators are higher than that of other renewable technologies(see paragraph 50). The group were unable to reach agreement that proportion of turnover is a key consideration in the rating system but does accept that there is an incoherence in policy design between the FIT system and the Non-domestic rates system. The FIT regime seeks to equalise investment rates of returns (analogous to equalising turnover) but fails to do so because of different non-domestic rates valuation outcomes. Meanwhile any attempt to address different non-domestic rates outcomes through the design of the FIT scheme would perversely result in increased rateable value which would compound the problem.

Valuation

59. The remit of the group was to consider the present law governing rating valuation of plant and machinery for hydropower schemes in Scotland, as such, several meetings were dedicated to considering the evidence available to assessors in determining valuations including discussion over which plant and machinery was considered rateable in the valuation process.

60. The group acknowledged that the concerns of hydro sector were focussed primarily on the receipts and expenditure method and the apportionment of the divisible balance which is directly impacted by which components of plant and machinery are considered rateable and which are not. It was noted that aspects of this discussion were ultimately matters of valuation which are subject to an independent legislative appeals process. In addition, the group were made aware of ongoing 2010 revaluation appeals sitting with the Lands Valuation Appeals Committee (LVAC) involving the Old Faskally Farming Company Limited and Others.

61. At the second meeting, the assessors shared the arithmetic underpinning the rateable values of 168 anonymised small hydro subjects which allowed some discussion on the divisible balance applied. The group understands that this information had not previously been available to the hydro sector which had unfortunately undermined their understanding of the rateable value calculation.

62. At the time the entries were made in the roll the assessor did not carry out a survey of each subject in order to determine the plant and machinery at each heritage.

63. The group were advised that the evidence available to the assessors, and therefore used to derive rateable values, showed that civil construction works, penstocks, turbines and connections represent around 90 per of the rateable value calculation. The group noted that the landlord/tenant share of the divisible balance had been adjusted and where any doubt existed as to the rateability of plant and machinery, those elements had been excluded. On that basis, penstocks and turbines have currently been excluded from the valuation approach thereby reducing the percentage underpinning the divisible balance calculation to 55 per cent.

64. The assessors were of the view that treating 55% of the assets of a scheme as non-rateable was generous to the ratepayers, and that it could have been argued that a significantly higher proportion of the assets were rateable. The assessor's position was that even if, contrary to his view, plant and machinery was not rateable under Class 1, much of it could have been rateable under the other classes, in particular under Class 4.

65. The group acknowledged that this decision to give the benefit of doubt to the tenant had effectively delivered a lower rateable value than would otherwise have been the case. The group also discussed whether elements of plant and machinery that have currently been excluded in the valuation process could actually be considered to be 'in the nature of a building or structure' or part of the 'lands and heritages' in their own right.

66. The group also discussed whether exempting plant and machinery under Class 1 of the regulations would have any noticeable impact on rateable value assessments since much of the plant and machinery is in the nature of a building or structure and may therefore be deemed rateable under class 4 or as part of the lands and heritages in its own right.

67. The group also latterly discussed the hydro sector's view that the construction costs of the pipe installation should not be considered rateable. The group did not take a view on any of these matters and agreed that such issues are a matter of legal principle and valuer judgement and are therefore for the independent appeals process and ultimately the courts to decide.

68. At the group's meeting on 9th November 2018, the possible impact and relevance of the above rating litigation to the review was considered. The Old Faskally cases were heard at the Land Valuation Appeal Court on 15th January 2019. The cases, relating to a 2010 roll revaluation appeal, involve a dispute over the valuation methodology applied to hydro power generation and is therefore directly linked to the objective of the review group.

69. While the group had reached substantive deliberations by November 2018, given the relevance of the case it was unanimously agreed to hold back on concluding the report until this litigation was complete in order to:

a) avoid accusations that the review sought to prejudice or interfere with a judicial process; and

b) ensure that the group's conclusions appropriately reflected the current legal view on the rating of small hydro heritages in Scotland.

70. The Lands Valuation Appeal Court decision in the Old Faskally cases was delivered on 24th April 2019. The Lord Justice Clark held that Plant might be non-rateable under Class 1 but yet be rateable under some other category. Items may be non-rateable under Class 1 but nevertheless be rateable under Class 4. The items which may be included in Class 4 are set out in tables 3 and 4. They include dams; fixed cranes and gantries; conduits and ducts; foundations; supports; turbines and generators; chambers and vessels; pits, beds and bays; and filters and separators. In each case the items are excepted if they are neither a building or structure nor in the nature of a building or structure. Accordingly, an item may be non-rateable in Class 1 but rateable in Class 4 on the basis that it is, or is in the nature of, a building or a structure.

71. The assessor's appeals were allowed and the cases remitted to the Committee for it to reconsider the evidence in light of the court's decision, and to determine in each case:

(i) which, if any, parts of the plant and machinery from the end of the intake chamber to the end of the tailrace are rateable in terms of Class 4;

(ii) the appropriate rateable/non-rateable asset split for each of the appeal subjects having regard to the rateability of dams, intake chambers, turbine houses and any other plant and machinery which it finds to be rateable in terms of Class 4.

72. Whilst the decision of the committee is awaited with interest, it is not certain that the final outcome of the Old Faskally appeals will have a bearing on other 2010 roll cases where appeals have been lodged or be relied upon as a precedent in similar 2017 roll appeals. It may well be that if ratepayers and assessor cannot agree the outstanding 2010 and 2017 roll rating assessments then further litigation may be the only resort to determine the valuation approach – in particular in respect of the outstanding 2017 appeals.

Rateable Plant and Machinery

73. The group extensively discussed the specific plant and machinery that was considered rateable for small scale hydro generation whilst acknowledging that aspects of this debate stray close to the ongoing Lands Valuation Appeal Court case for Old Faskally Farming Company Limited.

74. Further information on the assessor's view on the specific elements is provided at Annex D. The group noted that civil engineering components of plant and machinery are generally considered to be rateable and that significant elements of capital expenditure of a small-scale hydro scheme relate to civil engineering works. As noted in paragraph 67, the sector do not believe that the civil engineering works associated with pipe installation should be rateable.

75. Acknowledging that every site will be different on the basis of the topography of each individual site, most small scale hydro schemes operate on the same basic structure outlined in paragraph 9 with each scheme typically incorporating a dam or weir, an intake chamber, a pipeline/penstock, thrust blocks and a powerhouse or turbine house, turbine, generator, controls, transformer and tailrace. Further details of whether all these components are currently considered rateable or not are provided at Annex D.

  • Dam or Weir. Dams are a named item in Table 3 of Class 4 of the Plant and Machinery Regulations and are therefore considered rateable.
  • Intake Chamber. Tanks, chambers and vessels are all named items in Table 4 of Class 4 of the Plant and Machinery Regulations and are therefore considered rateable.
  • Pipeline/Penstock. Whether a pipeline/penstock is rateable or not is the most significant area of debate in the rating of small scale hydro and is pertinent to the ongoing Old Faskally 2010 revaluation case. Further information on the nature of the debate is provided at Annex D.
  • Thrust Blocks. Foundations are a named item in Table 3 of Class 4 of the Plant and Machinery Regulations and thrust blocks are therefore considered rateable.
  • The Powerhouse or Turbine House. As a land and heritage in its own right, a powerhouse or turbine house is by definition a building and is considered to be rateable. As a further area of debate, turbines may or may not be rateable depending on the individual circumstances and further information on the nature of this debate is provided at Annex D.

Valuation methodology

76. The group discussed the merits of the three valuation methods. The members of the group were advised that it was accepted by both the hydro sector and assessors that there is insufficient open market rental evidence for complete schemes covering all rateable elements. The rental evidence that does exist tends to relate only to the land and water extraction rights and does not include rental for rateable plant or the powerhouse. Guidance from the Royal Institution of Chartered Surveyors[18] suggests that these payments may be agreed on a rate per megawatt of capacity installed or can be negotiated on fixed figures but in practice payments are typically based on a percentage of gross turnover. Further rents or payments can be obtained in respect of substations, cabling, access roads or control kiosks although these are considered to be immaterial. The hydro sector do not consider the reference to this best practice guidance note to be relevant as the standard reference point that they use as the basis of assessment for rental is a percentage of turnover.

77. Reasons for this lack of evidence could include the fact that small scale hydro plant are typically either owned and operated by the landowner; owned through arm's length agreements where the landowner has established a trust to operate the scheme; or the land and water extraction rights are rented with the 'tenant' providing the investment necessary to install and operate the plant. The latter category where the 'tenant' of the land and heritages was technically the landlord of the property (with associated debt) was a recurring theme in discussions on the divisible balance calculation.

78. Given the lack of substantive full scheme rental evidence, it is acknowledged that the comparative rental method is not feasible for application to small scale hydro. While there would be scope to deploy the contractors method, small hydro subjects are well suited to valuation by means of the receipts and expenditure method as the income that may be generated is inextricably linked to the geographical and topographical features of the employed site. These geographical and topographical features will directly determine the volume of water which can be collected and diverted through the hydro system. The fall in height between the header tank or intake chamber and the powerhouse will determine the force at which the water can power the turbine and thus the amount of electricity generated.

79. The group identified that the key determinants of the R&E calculation with regards to small scale hydro are the plant specific load factors, which in turn determine the level of income, and the landlord/tenant split of the divisible balance. It was acknowledged that high rateable values are directly influenced by the income flow – in particular the level of subsidy provided by the ROC/FIT support mechanisms and the degree of plant and machinery involved.

80. The group agrees that it is appropriate for small-scale hydro to be assessed using the receipts and expenditure method. However, there were questions about the extent to which the method was sufficiently flexible to accommodate subjects which are otherwise uneconomic in the absence of a Government subsidy.

81. Despite agreement that the R&E approach was correct, for context the group discussed the impact of adopting the Contractors Principle. The group noted that the methodology would deliver broadly comparable rateable values to that generated by the R&E approach. This correlation is not wholly unexpected given that both methods are ultimately driven by capital build costs. The Contractors principle is directly determined by the estimated capital rebuild cost of a subject. Meanwhile the R&E approach, as applied to hydro, is determined primarily by the tenants share of income/turnover – which is driven by the subsidy regime that has been established to support the specific level of capital investment necessary to deliver the UK Government's renewable commitments.

Economics and Small Scale Hydro Cashflows

82. The group considered some worked examples of anonymised summary valuations followed by examples of how those valuations impacted cash flows for anonymised projects. The Practice Note setting out the valuation approach adopted by assessors is attached at Annex E and an example valuation calculation is set out below.

83. The summary valuation model adopted by assessors uses the installed capacity of the site and the site load factor to determine a site-specific output and, by applying the appropriate subsidy regime, a gross income estimate.

84. Then operating costs are estimated on the basis of installed capacity and subtracted to leave the estimated operating profit (known as the divisible balance). Rates would typically be considered to be an operating cost but since the purpose of the exercise is to ascertain the rateable value (and thus the level of rates payable) they are excluded from this element of the calculation and deducted at a later stage.

85. The tenant's share of the divisible balance (which reflects amongst other things a return on the capital employed by the tenant and an element of risk) is then subtracted to leave the amount which is available (after deduction for rates) for payment to the landlord as rent. The rateable value reflects this derived rental figure.

Rating Valuation of a hypothetical 500kw run of river Hydro Plant

Gross Income (a function of capacity, load factor and the unit subsidy) £276,700
less operating costs (which includes operation and maintenance but excludes non-domestic rates) £75,000
Operating Profit £201,700
less depreciation on tenant's capital at 45% (as per paragraph 63) £36,750
Divisible Balance £164,950
less tenant's share adjusted for risk and rates @39.81%[19] £65,667
Landlord's share £99,283
less rates charged at 48.2p[20] £32,291
Rent (NAV) £66,993

86. As outlined in paragraph 10, a small-scale hydro scheme typically involves significant upfront capital costs with relatively low operating and maintenance costs over the life of the project. The income received will depend on prevailing weather conditions and topographical considerations (calculated as a plant specific load factor) multiplied by an index linked subsidy payment for each unit of generation. The FIT payments lasts for 20 years from the point of accreditation. Business cases for a small hydro scheme are based upon a 40-year operational expectation although schemes can continue to operate for many years beyond that.

87. A consequence of this cost and expenditure profile is that the early years of a scheme's operation are characterised by significant negative cash flows, particularly while any debt financing is repaid. Evidence presented by the sector and agreed by the group showed that with the current (pre-relief) rateable value approach, a typical 2014 accredited 500kw run of river scheme 80 per cent debt financed over fifteen years would experience negative cash flows until year 6 and would have a cumulative cash shortfall until year 16.

88. For an equivalent 500kw scheme accredited in 2019, the annual cash flow remains negative until year 16 and the scheme never experiences a positive cumulative cash flow. In this case, as a consequence of the greatly reduced subsidy, the scheme shows a negative internal rate of return and is unlikely to be built – irrespective of the level of non-domestic rates liability.

89. For a 1MW scheme, the economics are slightly better with positive annual cash flow in year 11 and positive cumulative cash flow from year 16 onwards although, without continued government support, the internal rate of return may not be sufficient to encourage investment.

Year 2014 2019 2019
Plant Capacity 500kW 500kW 1MW
Loan repayment 15 years 15 years 15 years
FIT Generation tariff £0.1603 £0.0620 £0.0620
Export value of electricity £0.0491 £0.0491 £0.0491
Positive net cash position Year 6 Year 16 Year 11
Positive cumulative net cash position Year 16 n/a Year 16
Internal Rate of Return (IRR) 7.00% -3.70% 4.00%

90. The above calculations reflect the impact of the 2017 revaluation rateable values. The equivalent IRR calculations reflecting the impact of the relief introduced from 01 April 2018 deliver returns of 10.9%, -1.7% and 6.5% respectively. By way of context, in 2015 when subsidy levels were being established, the UK Government concluded that the investment 'hurdle rate' needed to be in a range of 6.4%-10.3% with a 2015 reference point of 8.4%[21]. The equivalent reference points for wind and solar are 8.2% and 8.0% respectively.

91. These calculations highlight that the current relief significantly improves the economics for existing projects but that the investment climate for new build projects remains challenging even with continued Scottish Government rates support. The potential longer-term challenges facing the small hydro sector are not a matter for this review group but the analysis provided by the sector does help to highlight that changes to rates liabilities would have limited impact on a future project's internal rate of return relative to changes to the UK Government's low carbon support mechanisms.

92. The group agreed that, in terms of arithmetic and calculation, the practice note is being applied correctly and, on the basis of the evidence available to assessors, rateable values are therefore broadly correct. However, the group also notes that the apportionment of rateable and non-rateable plant and machinery has a significant impact on the valuation using a receipts and expenditure valuation model.

93. These factors are ultimately matters of valuation which are subject to an independent legislative appeals process and are beyond the remit of the group but the group notes that the exchange of information between assessors and ratepayers is critical to this apportionment calculation and that such information flows have been poor historically although the group notes that they have improved over the course of this review process.

94. As such, the assessors may not be in possession of sufficiently robust information to inform their calculations. If the assessors do not have accurate cost and generation information for each subject then the group acknowledges that individual rateable values may not be wholly accurate as the valuation will be derived by comparison to other similar heritages on the tone list.

95. The proposed reforms outlined by the Barclay Review of Non-Domestic Rates seek to deliver significant improvements in information flows between assessors and ratepayers. Those reforms would be expected to have a positive impact on the information available to assessors and help to ensure that more hydro subjects are valued accurately.


Contact

Email: NDR@gov.scot