Why British Energy is running out of steam

It generates a quarter of Britain's electricity. Yet the City and the DTI fear it could turn into another Railtrack

The British Energy official was exasperated. "It's not as if we're another Railtrack," he exclaimed. But that's not what many people, including senior Department of Trade and Industry officials, think.

With British Energy shares hitting an all-time low of 54p last week, a 93 per cent fall from their post-privatisation high, and City analysts estimating that the group could need to come up with £450m of cash in the next 12 months, there is a question mark over whether British Energy can avoid collapse. And The Independent on Sunday has learnt of a secret plan, code-named Project Blue and drawn up by DTI officials led by nuclear expert Stephen Spivey, that would take British Energy back into public ownership, a move that would cost the Government at least £500m.

So why is British Energy, which was privatised six years ago with a dowry of some of the most modern and efficient nuclear power plants in Europe, and which generates a quarter of Britain's electricity, now teetering on the precipice of disaster?

NETA

The New Electricity Trading Arrangements, to give them their full title, were a reform of the power industry in England and Wales, which was supposed to open up the market to competition and bring down domestic bills, as had happened previously in the gas market. The problem is that the system hasn't worked the way it should – and British Energy is feeling the brunt.

Neta, which was introduced early last year, created a market for wholesale electricity, allowing the retailers (such as London Electricity, TXU or British Gas) to get the best price from the generators (which include many retailers like TXU or Powergen, but also include the likes of British Energy and AES, who don't sell to the public).

But Neta is riddled with problems.

One is to do with the failure of Enron. As it was the largest trader of power contracts in the world, its collapse left a hole in the market. Other US rivals, such as Dynegy, Entergy and Aquila Energy, have either been unwilling, or financially unable, to fill the void. This means some of the Neta innovations, such as power derivatives that could be bought by generators to deal with problems like British Energy's closure of its Torness plant earlier this month, have not developed.

Another is the ability of the likes of TXU, London Energy or E.ON, the German utility that owns Powergen, to buy merely from themselves, so taking their electricity out of the market. The retail prices have yet to fall, despite a 33 per cent drop in the wholesale price of electricity over the last two years.

These problems, and a host of other Neta-related issues, have resulted in British Energy getting just £16 per megawatt hour (MWh), compared with an expected price of £27 MWh when it was privatised, and £21 MWh just to break even. The group lost £493m before tax last year, £300m of which was due directly to Neta-related writedowns.

Ontario

At least the Canadian business, which British Energy bought when the City loved it, is doing well. Its £37m of profit was one bright spot last year. But the Ontario energy market was deregulated in May – a year later than had been planned. British Energy says it has forward contracts lasting up to five years that will insulate it against any falls in the wholesale electricity price in Canada in the short term; that its plants produce electricity much more cheaply than in the UK; and that it hopes to buy a retail business to sort out the long-term issues. The City is not convinced.

Closures

The latest crisis has been caused by the closure of Torness power station in Scotland after two of the station's 16 gas circulation turbines broke. This in turn has led to safety checks at another reactor – Heysham – which is of similar design and may have to be taken out of commission for up to two months. The combined cost of the problems could be as much as £80m, and because of British Energy's insurance issues (see below) it will only get back about £10m from insurance. Followers of the company are getting jumpy. British Energy foolishly brought forward a planned shutdown of Dungeness in Kent, which led the City to conclude something was wrong there. British Energy cannot afford any more hiccups.

Waste

In a deal struck at the time of privatisation, British Energy pays British Nuclear Fuels (BNFL) £300m a year to reprocess old plutonium from its reactors. British Energy thinks this is a waste of money, as no one wants reprocessed plutonium and it costs about four times as much to deal with the waste this way than to dig a deep hole and store it, as is done in North America and most of Europe.

However, there appears no end to this contract, especially as British Energy is the largest customer of BNFL, which the Government is hoping to privatise. With the creation of the proposed nuclear Liabilities Management Authority (LMA), which will deal with all the "legacy" nuclear waste issues in the UK, there is a worry that British Energy may end up paying more money, not less. A recent report by the nuclear expert Mike Sadnicki suggested that British Energy could have a potential extra waste disposal liability of £5bn, a figure that British Energy itself dismisses as "fanciful".

Rates

As reported in The Independent on Sunday earlier this month, British Energy is lobbying to have its rates bill cut, arguing that it pays £14,000 per megawatt year for its power stations compared to £9,500 for gas- or coal-fired stations and just £3,000 for the old Magnox reactors owned by BNFL. It wants a "level playing field" and points out that if it only paid the same as the gas and coal generators it would save £25m a year.

Insurance

After 11 September, British Energy found it almost impossible to get insurance for its reactors, and the Government had to step in. However, this problem has eased, leading to a mere 7 per cent hike in insurance costs to around £25m a year.

But a fresh problem is around the corner. Under the terms of British Energy's privatisation, the company has to insure only the first €200m (£126m) of the cost of any disaster; the rest is covered by the Government. Now, under an international agreement, this limit will be raised to €700m.

British Energy would not say how much more this could cost it, but British Nuclear Insurers, an industry insurance company, says: "The cost of insurance won't triple but it will rise to take account of the increased liability."

Cash

According to Schroder Salomon Smith Barney, British Energy will have a net outflow of cash totalling £342m this year. It also has a £110m bond needing repayment next March. British Energy simply does not have £450m in its piggy bank to cover this. With a market value of less than £400m, it could not raise the money from the City. British Energy officials say they have contingency plans, but are unwilling to elaborate. With its credit rating about to be cut by the major agencies, it will be difficult and expensive for the group to issues bonds, and there is talk of it being in default on its £850m of borrowings.

Project Blue could be activated sooner than we think.