Energy and Petroleum Economics

Industry

Are Contracts for Difference a good option?

To meet the energy and climate change legal requirements and in line with the
EU targets, the UK has decided to reform the electricity market, aiming to
deliver low carbon energy and reliable supplies, while minimising consumer costs
(DECC 2013, GOV.UK 2014). The Government’s Electricity Market Reform (EMR)
provides ambitious measures to promote investment, competition and to replace
the UK’s ageing energy infrastructure with a diversified low-carbon portfolio
(DECC 2013). However, current research suggests that EMR’s attempts to
combine the market and a government-directed low-carbon investment plan,
may have negative consumer and macroeconomic impacts (Toke 2011, Politt
and Haney 2013a).

Consisting of changes to environmental tax and subsidy arrangements as well as

changes to market design (Politt and Haney 2013), EMR introduces two key
mechanisms: Contracts for Difference (CfD) and the Capacity Market. CfD are
long-term power purchase agreement contracts between a low-carbon generator
and a Government-owned counterparty, providing the generator with clear
contractual rights and legally enforceable, therefore increasing the investor
certainty (Toke 2011). CfD reduce the risk faced by energy producers, by paying
variable top-up from the market price to a fixed ‘strike price’, illustrated in Table
1 (DECC 2013). Consequently, CfD provide stable revenue, protecting
developers from volatile fuel prices. Furthermore, by ensuring the generator
pays back when electricity spot price goes above the strike price level, CfD
protect consumers. A 15 year contract for renewable technologies with payments
indexed to inflation (CPI) and an obligation to timely deliver the contracted
capacity, influence the balance of risk and reward available to generators under
CfD. From the developer’s perspective, this increase in certainty, reduces the
borrowing costs, allowing for the saving to be passed on to the consumers.
DECC therefore assumes that implementation of CfD will lower the costs of low-
carbon generation projects (2011), effectively developing diverse, robust, low
carbon electricity generation supply chain in the UK.

As the first CfD allocation round is currently taking place (November 2014), a
number of experts raised their concerns over the industry’s confidence in the
CfD scheme (Weston 2014, Lee 2014). Since the funding currently available,
may only support at most 800MW of offshore capacity, CfD may limit the scope
for development. Industry commentators claim, that the new regime risks
hindering effect on cost reduction, preventing sector to take advantage of
economies of scale. As confirmed, CfD mechanism will be inadequate to fund
1.2GW East Anglia One, setting this and similar developments to shrink (Lee
2014).

The budget for the first allocation round, illustrated in Table 2, was ‘far lower
than anyone in the sector had anticipated’ (Leek cited in Weston 2014). This,
according to experts had an adverse impact on the investor confidence in the
sector.

Furthermore, according to the current research on third party contracts and CHP
units, independent renewable developers are likely to obtain only 70% of the
stated CfD price, due to ‘imbalance of risks’ and an upward payment to
electricity suppliers to secure power purchase agreements (Toke 2011, Newbery
2011).

As CfD are subject to uncertainty over the size of future allocation rounds, the
scheme fails to provide enough foresight to encourage inward investment into
the UK, posing a degree of political risk and uncertain ROI, thereby questioning
ability of CfD to drive competition, industrialisation and cost reduction (Slark and
Edge cited in Weston 2014).

The CfD scheme currently in place, is essentially a form of state aid, as any
consumer levy is collected in one fund and distributed to private companies
(Pollit and Haney 2013). However, even though the energy generators would be
drawing from the same pool of funding and competing between each other to
provide lowest price of energy, the scheme favours large, established businesses
and energy sources. Less conventional technologies, such as offshore wind may
struggle acquiring a CfD, as the East Anglia One project proved so, scaling back
its ambitions. Some may argue, that picking winners was the ultimate aim of the
competitive system. However, as Slark and Ogilvie (cited in Weston 2014)
rightly suggest, the enormous investment in developing projects, that are now
ineligible to bid for support and the loss of trust in the UK Government’s ability
to efficiently co-operate with the industry, may cost the economy far more than
any short term benefits of CfD.
Figure 1. Administrative Strike prices applicable to applications in this allocation round. Sourced from DECC (2014)

Figure 2. CFD Budget Release for 2014 Allocation Round. Figures represent the total support payments available in a
given year. Pot 1 (established technologies): Onshore wind (>5MW), Solar Photovoltaic (PV) (>5MW), Energy from Waste
with CHP, Hydro (>5MW and <50MW), Landfill Gas and Sewage Gas.

Pot 2 (less established technologies): Offshore Wind, Wave, Tidal Stream, Advanced Conversion Technologies, Anaerobic
Digestion, Dedicated biomass with CHP, and Geothermal.

Sourced from: DECC (2014)

List of References

DECC (2013) Investing in renewable technologies- CfD contract terms

and strike prices [online] available from
<https://www.gov.uk/government/uploads/system/uploads/attachment_data/fil
e/263937/Final_Document_-_Investing_in_renewable_technologies_-
_CfD_contract_terms_and_strike_prices_UPDATED_6_DEC.pdf> [12 November
2014]

DECC (2014) Budget Notice for CFD Allocation Round 1[online] available
from
<https://www.gov.uk/government/uploads/system/uploads/attachment_data/fil
e/360129/CFD_Budget_Notice.pdf> [13 November 2014]

GOV.UK (2014) Maintaining UK energy security [online] available from

<https://www.gov.uk/government/policies/maintaining-uk-energy-security--2>
[13 November 2014]

Lee, A. (2014) Iberdrola warns on UK CfD crunch [online] available from

< http://www.rechargenews.com/wind/1382186/Iberdrola-warns-on-UK-CfD-
crunch> [13 November 2014]

Politt, M. G., Haney, A. B. (2013a) ‘Dismantling a Competitive Electricity

Sector: The U.K’s Electricity Market Reform’. The Electricity Journal 26 (10), 8-
15

Politt, M. G., Haney, A. B. (2013b) ‘Dismantling a Competitive Retail

Electricity Market: Residential Market Reforms in Great Britain’. The Electricity
Journal 27 (1), 66-73

Toke, D. (2011) ‘UK Electricity market Reform- revolution or much ado

about nothing?’ Energy Policy 39, 7609-7611

Weston, D. (2014) ‘Question of the Week: Confidence in CfD support?’

Wind power Monthly [online] available from
<http://www.windpowermonthly.com/article/1321023/question-week-
confidence-cfd-support>

Wilson, G., McGregor, P. G., Infield, D. G., and Hall, P. J. (2011) ‘Grid-
connected renewables, storage and the UK electricity market’. Renewable Energy
36, 2166-2170

Newbery, D. (2011) ‘Contracting for wind generation’. Electricity Policy

Research Group, Working Paper [online] available from
<http://www.econ.cam.ac.uk/dae/repec/cam/pdf/cwpe1143.pdf> [15 November
2011]