MAJOR CHANGES FOR THE RENEWABLE ELECTRICITY MARKET: A FOCUS ON UK CONTRACTS FOR DIFFERENCE (CFD)

The increase in 2013 was 30% over 2012.  This meant that the RO and the FIT have increased renewable energy to 13.9% of electricity generated in the UK[1].

While these two fiscal mechanisms have been successful in delivering investment and generation output over the past 12 years, there are drawbacks.  The investment needed to replace the UK’s ageing electricity infrastructure with a more diverse and low-carbon energy mix has been estimated at up to £110 billion[2] until 2020.  The current mechanisms were not designed to provide this level of investment and would place an unacceptable level of increase on consumer electricity bills.

As a result the UK Government has set out to develop and implement a package of policy measures, the Electricity Market Reform (EMR), to create the right framework to effect the transformation in investment needed.

The EMR comprises two main financial elements:

– Feed-in Tariffs with Contracts for Difference (CfDs) – long-term contracts which provide revenue certainty to investors in low-carbon generation such as renewables, nuclear and carbon capture and storage-equipped plant;
– Capacity agreements (within a capacity market) – payments for reliable capacity to be available when needed, helping to ensure security of supply.

These elements will be supported by:

– The carbon price floor – a tax to underpin the carbon price in the Emissions Trading Scheme; and
– An emissions performance standard – a maximum level of CO₂ emissions per kWh, to limit emissions from unabated fossil power stations.

Of these measures the CfD is the main mechanism that effects the future development of renewable electricity generation, as the other measures apply to large conventional generation (capacity market) or carbon based generation (carbon price floor and emissions performance standard).  For small scale projects, below 5MW, the FIT remains the support mechanism and the CfD has no impact on this.  Hence the CfD is the focus of the remainder of this article, due to its impact on the large scale renewable electricity investments.

The Feed-in-Tariffs with Contracts-for Difference

The principles behind the CfD are straightforward, however the details of the implementation include a degree of complexity.  The principles of the CfD are that:

– A generator is offered a 15 year contract with a known strike price for the renewable electricity sold;
– If the market price for electricity is below the strike price, the generator gets paid the difference as a public sector incentive, aside by levy from consumers;
– If the market price for electricity is above the strike price, the generator pays back the difference.

The principle is illustrated below:

Figure 2 Contracts for Difference principles illustrated (DECC)

Unlike the RO, where the price paid could fluctuate depending on the amount of renewable electricity generated, the CfD offers a certain payment per MWh over 15 years.  The price is inflated each year using the Consumer Price Index and the counterparty is a government backed company.  So a project with a CfD reduces a number of policy and commercial risks.

However during the development phase of the project the strike price that will be offered is not known.  This is because the strike prices will be set as part of an auction, which is where the CfD starts to become more complex[3].  This article describes the core elements of the CfD auction system, the full details are available on DECC’s web site[4].

DECC has established two budget pots, with a separate auction for each pot.  Pot 1 is for established technologies (onshore wind, solar PV etc.) and Pot 2 is for less established technologies (offshore wind, wave, tidal etc.).  There is a separate pot for power stations that convert to biomass.  There is a separate budget cap for two of these groups, which will limit the total amount of contracts awarded in any given year.  The budgets were increased in early October 2014 to become:

Table 1 Initial Contracts for Difference budget allocations (£million)

The auction process is complex, but key elements for each pot are:

– All projects in each delivery year are listed in order of price;
– Lowest bids are always considered first;
– If the budget is not breached all bids are offered the administrative price;
– The first project that breaches the budget in a delivery year is rejected;
– The delivery year is then closed to all other bids;
– The last accepted project sets the clearing price for that delivery year;
– The administered strike price is the maximum clearing price for a technology;
– When all years are closed, or when there are no more projects in the auction, the auction ends.

So the actual strike price will be set by the auction.  The administrative (maximum) strike prices have already been set, with the levels published out to 2018/19:

Table 2 Initial administrative (maximum) strike prices (£/MWh in 2012 prices)

As extensive competition is expected, the actual strike prices achieved are likely to be lower than these maximum levels.  The following examples illustrate how these principles will operate, using Pot 1 technologies:

– If the value of bids in Pot 1 is less than the budget, then all qualifying Pot 1 bids are accepted and the administrative strike price is used, if the value of qualifying bids exceeds the budget, an auction is held;
– If solar PV is the last accepted bid of all Pot 1 projects aiming to deliver in 2015/16 with a strike price of £115/MWh, then all onshore wind projects will clear at their 2015/16 administered strike price of £95/MWh;
– If the marginal bid for 2017/18 is an onshore wind project at £90/MWh then all cheaper wind onshore bids will receive £90/MWh, whilst all more expensive bids will not be allocated a CfD in Pot 1.

If bids into the auction are set at competitive levels, then the budget available will be able to stretch further to include more capacity.  So it is impossible at this stage to gauge the quantity and level of the bids.  However the trade body RenewableUK has observed that a single 500MW offshore wind farm would take £115million of the £150million Pot 2 budget.  So there could be significant impacts on the UK supply chain if the auction acts as a constraint on deployment.

The auction process introduces a new element of uncertainty compared to the RO.  Under the existing arrangements there is certainty that a project that met the criteria for renewable technology would gain income under the RO, what was less certain was the exact payment per MWh, and how this payment would change over time.  Under the CfD, there is much more uncertainty over obtaining a contract, but if the bid is accepted a 15 year known price can be obtained.

After many months of policy deliberation the CfD auction window is now open, with the bids being validated and the first auction being held at the end of November.  So the CfD principles are about to become the established practice for the UK renewable electricity sector.

Conclusions

The transition from the RO to the CfD is a major change for the UK renewable electricity sector.  This process must be a success for the trend of investment and generation output to continue.

For projects that win a CfD the arrangements offer greater certainty, which should lead to lower finance costs, feeding through to lower cost projects.  However the auction does add to development risk, at a time when more projects are being called in by government ministers for planning scrutiny.  Increasing development risk is more significant for projects where the economics ae marginal and hence the auction price needed may be too high.  With many of the best test already developed, new sites may have lower renewable energy resources or higher grid connection costs, so the changes may have an important impact.

So the results of the first CfD auction are eagerly awaited, as they will set out how the UK renewable electricity sector has adapted to the new mechanism and will set an important marker for the auctions in future years.

Biography

Colin McNaught is a managing consultant at Ricardo-AEA.  He leads the renewable energy team who undertake a range of policy studies, feasibility assessments and due diligence assignments in the renewable energy sector.

Ricardo-AEA is a leading energy and environmental consultancy.  Our work for government helps to establish the market conditions for investment in energy technologies and our practical advice helps investors identify and quantify the right investments.