Could the rise of bespoke business models for energy investments trigger a new wave of disputes between investors and states?

The transition to a low-carbon economy is fundamentally reshaping the energy sector. The first wave of energy reforms over the last two decades focused on increasing renewables capacity (primarily wind and solar) and phasing out coal and some CO2-intensive industrial processes.  Now, Europe is entering a more complex phase: decarbonising harder-to-abate sectors, building flexibility into electricity systems, and shifting how end-users consume energy.

This new phase requires huge investment in infrastructure – grids, power generation, hydrogen, carbon capture, and more.  Governments are responding with increasingly bespoke market and regulatory arrangements, which aims to attract transformational investment in the new energy supply chain by identifying and allocating risk. But once money is sunk, these arrangements can create the potential for disputes – depending on how markets, technology, demand, and policy evolve.

Frontier Economics’ experts have provided expert witness testimony, on both merits and quantum, across many major disputes that arose from the first wave of the energy transition in Europe. We’re also helping shape the next wave of market and regulatory design. That gives us a strong vantage point on what may be coming.

The challenge of risk allocation

The first phase of the energy transition was underpinned by a series of policies and regulations. Two (among several) key pillars of this were:

• the EU Emissions Trading System (EU ETS), introduced in 2005, which put a price on carbon emissions and hence increased the cost of fossil fuel-based power generation, particularly for high-emission coal and lignite plants, and also started to expose other heavy-emitting sectors such as steel, cement, aluminium etc to a carbon price (aka “the stick”). The ETS was flanked by other regulations such as the Industrial Emission Directive (2010) that required adaptation of technology in industrial plants to advanced emission standards; and
• the 2009 Renewable Energy Directive, which spurred the introduction of support schemes (aka “the carrot”) to drive investment in new renewable electricity generation technologies (primarily wind and solar). 

Most countries offered support schemes – feed-in tariffs, feed-in-premia, Contracts-for-Difference (CfDs), grants and other forms of investment support – to accelerate rollout of renewables. These schemes evolved over time – some countries (like the UK) phased out or transitioned certain schemes; while others (like the Czech Republic) continued to maintain multiple mechanisms in parallel, even as they evolved.  The rapid and unexpected fall in technology costs – especially solar power - triggered policy changes. This prompted waves of legal action, including in Spain, Italy, Romania, and Bulgaria.

Likewise, while some European countries (like GB) managed to phase out coal-fired plants smoothly, others - most notably the Netherlands - faced legal challenges. Investors argued that policy decisions which accelerated this phase-out constituted an unforeseeable regulatory change, and amounted to expropriation of their investments.  Some countries still have a coal phase-out ahead of them.

These cases reveal how difficult it is for policymakers to design a ‘complete contract’ which identifies all risks and unambiguously allocates those which are to be borne by investors, in the context of a highly uncertain trajectory for technology and demand shifts.

Facing in to the next transition phase 

Investments are underway across Europe in solutions such as the substitution of grey hydrogen with low carbon hydrogen; and carbon capture, utilisation, and storage (CCUS).  The steel industry is exploring conversion from blast furnace production (using coal) to technologies using electricity (Arc Furnace); natural gas with carbon capture; or green hydrogen (direct reduction approach). A major programme of investment in electricity grids and new power supplies is anticipated, both to increase wind and solar capacity (alongside building more flexibility to deal with intermittency), and - potentially - new nuclear stations.  

Attracting this capital investment requires a clear allocation of which risks are (and are not) borne by investors in new infrastructure.  

Key risks include:

• Pathway ambiguity: There’s no single route to Net Zero. Shifting policies, regulatory frameworks, technologies and political priorities add uncertainty.
• Market/demand risk: Will end-use demand shifts materialise, and at what scale and pace?
• Price volatility: Some low-carbon solutions will remain exposed to price volatility in energy markets.  For dispatchable technologies, this may be true even if they receive government support.
• Policy risks: Ongoing public support will be needed to underpin the recovery of sunk investments. Uncertainty over future policy direction and voter willingness to pay can create significant risks. 
• Financing pressures: Higher interest rates make capital-intensive projects harder to fund.
• Infrastructure inter-dependency: Many projects rely on whole value chains being built in sync. If one part lags, others suffer.
• Construction delays: Permitting, planning objections, and cost overruns remain ever-present risks.

Add cost-of-living pressures, and governments are walking a tightrope between the need to attract investment and the need to deliver secure, affordable energy supplies.

Bespoke business models may create new friction points

The scale and pace of the transformational investment required is enormous. The IEA has estimated that global clean energy spending must rise from $1.8 trillion per year in 2023 to $4.5 trillion per year by the early 2030s.  Its projections also illustrate the wide range of different solutions and technologies that will be needed (Figure 1). 
   Figure  1    Range of sectors and solutions needed for next phase of transition 

Source: IEA, Net Zero Roadmap: A Global Pathway to Keep the 1.5 °C Goal in Reach (2023), Figure 2.5 ‘CO2 emissions reductions by mitigation measure in the NZE Scenario, 2022-2050’

• Electricity grids: Significant expansion needed to support electrification. Regulators want to deliver at speed but also avoid over-investing. The UK’s ASTI framework for transmission grids, and per-unit allowances for distribution grids, are attempts to get this right.Other countries, such as Germany and the Netherlands, are contemplating fundamental changes in their approach to regulating electricity grids.
• Electricity markets. Alongside grid investment, there are systemic changes in the way electricity markets function across Europe.  This includes reforms to the grid connection queue; and the potential introduction of ‘locational charging’ for users connected at different points on the system in the UK, and similarly in the EU the so-called ‘bidding zone review’.  These changes are aimed at improving efficiency and accelerating deployment of new technologies – but they also have distributional effects which could leave some parties feeling their expectations or contractual rights have been impinged.
• Nuclear power: France has committed to building new reactors and extending the lifespan of existing plants, while the UK and several Eastern European nations are advancing plans for both large-scale nuclear and small modular reactors. The UK has shifted from CfDs (Hinkley) to a RAB model (Sizewell C) with a view to changing how construction risks are shared.
• Hydrogen infrastructure: Countries like Germany and the Netherlands are backing early infrastructure (i.e. transportation networks and storage).  Germany has proposed a system of revenue top-ups and cost amortisation so that investors still earn revenues while demand emerges. But the extent of long-term uptake remains uncertain – the German proposals also include provisions for investors to bear a proportion of stranding risk, should the expected volumes fail to materialise.  
• Hydrogen production: At the same time, governments are designing support schemes and striking contracts for hydrogen production capacity (e.g. in Germany, via state-backed intermediate company Hintco under the H2-Global mechanism; or in the UK via funding support schemes and a process for allocating contracts known as the Hydrogen Allocation Rounds).
• CCUS: Expanding across Europe, with investment underpinned by mechanisms like carbon CfDs, and new regulatory incentives / models to develop networks and storage infrastructure. But long-term liabilities (like leakage) and policy shifts could easily become future issues.

What next?

The examples above only scratch the surface – underlying each of these infrastructure challenges is a wealth of complexity.  And of course, there are many more new infrastructure investments and technologies being planned than those listed here.  

A transition of this nature needs private investment if it is to be delivered.  That in turn implies the need for well-designed risk-sharing arrangements. However, policymakers are unlikely to get the business model and regulatory design right from the outset, given demand and cost uncertainties as well as the complexity of designing support schemes that are effective, efficient and fair – and which meet the requirements for State Aid approval.  

The hope for policymakers and investors alike is that these arrangements mitigate the risk of future disputes. But these are novel support mechanisms which may have unintended consequences.  And there is increasing intervention in parts of the supply chain (e.g. final product manufacturing) where such interventions are less familiar. Add in the context of rapidly changing technology and scenario uncertainty, increasing the risk that Governments may have to adapt policy ‘in-flight’, and the associated prospect that investors in sunk assets believe their rights have been impinged. This prospect is also exacerbated by the growing trend towards more ‘negotiated’ prices for specific assets / products – which contrasts with the general trend in renewables support schemes towards auction mechanisms to set prices (which are then less susceptible to later disputes around the perceived fairness or implicit assumptions underlying the resulting prices).  

The current phase of the decarbonisation transition therefore creates the clear potential for disputes nevertheless to arise.

Click here to learn more about our work in disputes.

Frontier Economics experts provided testimony in the following investor-state disputes related to regulatory treatment of energy assets and RES.