CfD Mechanism Background

CfD Mechanism Background

How does the government support renewables projects?

 The Renewables Obligation (RO) system was the first mechanism to support electricity generation from renewable resources, and it came into force in 2002. A renewable project generates a certificate which can then be sold into a market place to help increase the project’s revenues. UK electricity suppliers – typically utilities and the Big-6 – were obliged to source an increasing proportion of their supply from renewables. Feed-in tariffs were then introduced in April 2010 to help support small-scale generation, typically those systems under 5 megawatts. The energy supplier, or utility, pays the renewable generator for each kilowatt hour of electricity that it produces and also for any excess electricity exported back to the grid. Policy changes from the last two years will effectively scale back budget for these two mechanisms, so as to now favour Contracts for Difference.

 How does the CfD mechanism work?

Any explanation of the Contracts-for-Difference (CfD) system should first perhaps be put into the context of how electricity prices are set. Generating electricity stations bid-in to supply power to the wholesale market every half-hour, under a reverse auction method. Broadly-speaking, prices have annually averaged between £30 and £50 per megawatt hour for the last decade. Gas-fired power stations are currently the marginal producers, as a result of their economics – desired revenue less gas and other operating costs – normally determine the final cleared price. This auction process represents the guts of how wholesale power prices are set. Renewables projects are typically at the lower end of this process, or on the left hand side of the curve, as they have no fuel costs.

CFD graph

Under the CfD policy scheme, renewable projects bid-in to supply power at a level that provides a sufficient return to its equity and debt investors, this level is commonly referred to as the ‘strike’ price. There is also a maximum price, or cap, which these bids cannot exceed. The auction is run in a similar manner to the wholesale electricity markets. The level of the strike payment is again set by a reverse auction, when renewable projects enter bids to supply a fixed amount of capacity, 100 megawatts for example.

In this hypothetical case, let’s say there are just four projects each with 33 megawatts of capacity – equating to £33m of budget per project. Project A bids-in with a levelised cost of energy (LCOE) of £55 per megawatt hour, Project B at £70, Project C at £75 and Project D at £85. Project C is the lowest bid that is included – and determines the auction’s clearing price of £75 – that meets the cumulative 100 megawatt capacity requirement. Project A will now make £20 per megawatt hour of profit and Project D will be shut out as it is £10 over the strike price. It is worth noting that different technologies compete with one another in separate auctions though, with one pot being allocated for the more mature technologies – such as onshore wind – and one for emerging technologies.

But there is a kicker. An average annual wholesale electricity price, known as the reference price, is then effectively subtracted from the auctioned strike price. For example, in the more mature technology pot auction, strike prices for the first UK auction fell between £79 and £83 per megawatt hour while the reference price was £51 per megawatt hour. Projects in this pot thus effectively get a top-up payment of about £30 per megawatt hour from the government. Returning to our initial example, with a reference price of £51, Projects A, B and C effectively receive £24 per megawatt top-up payments from the government. The generators in this auction receive the wholesale electricity price (on average £51/mwh) and then receive a top up from the government of (£75 – £51/mwh) = £24 mwh. The total amount is therefore always £75/mwh once you add the wholesale power price (£51/mwh) to the government reference price payment (£24/mwh).

What are the benefits and downsides?

Firstly, reverse auction systems give governments’ greater budgetary control than the ROC and feed-in tariff support schemes, which both predated the CfD mechanism. The latter two mechanisms were effectively determined by the size of the project and the speed of development and not by budget. Spending quickly spiralled. Governments can now set how much they want to spend on each auction in each year, with the only variable factor being wholesale electricity prices. Overall a win for the government.

Secondly, the reverse auction CfD system allows governments to set renewables technologies off against each other. As opposed to allocating budget to specific technologies, projects now compete with one another. The theory is that the competition will drive down overall project costs. The reality is that it is all about the details. The rules gently bend towards specific and more mature technologies. The system, in its broadest sense, maximises the efficiency of the taxpayer’s pound. Overall, a win for both the government and the consumer.

Thirdly, and most importantly, only the most competitive projects will qualify for these subsidy payments, meaning the taxpayer gets the best possible value for each pound of subsidy, or allocated top-up payment. Less economic projects will thus either not bid-in or win any auction budget while the strongest projects, with the best economics, prevail. In political terms, it is a market-based system that promotes renewable project development, drives cost reductions and limits the scope for overpayment, which suits the bent of a soft Conservative government. Overall, a win for the government, consumer and project developer.

All is not always bonny, though. Wholesale, and reference, electricity prices can change. If prices climb to £70 per megawatt hour, then the government will now only have to top-up projects with an additional £10. It should be cock-a-hoop. But the pendulum can swing both ways, and the reference price could fall to £10 per megawatt hour, meaning the government will be making up the difference of £70. Attempts to massage wholesale electricity prices slightly higher, via the carbon price floor, now appear less firm. Crucially, renewable project developers are guaranteed revenue of £80 per megawatt hour, allowing them to attain the long-term financing required. Overall, a win for project developers.

An argument could likewise be made that allowing all technologies to compete with one another will not optimise the reduction in project costs and help the UK achieve a diversified generation portfolio. Biomass and waste-to-energy projects will always have the constraint of feedstock costs, which do not inhibit wind and solar projects. A diversified generation portfolio should make the UK energy system stronger and more resilient over the longer term.

Is this a new policy mechanism? 

In short, no. But the UK’s adoption of such a method numbers among the first globally. The reverse auction mechanism has gradually now supplanted feed-in tariffs as the chosen governmental policy for supporting renewable project development around the world. Brazil moved first with European countries like the UK, Germany and the Netherlands then following suit.

What did the first set of results teach us and where do we go from here?

Solar projects when competing with wind will struggle to get the appropriate contracts for the next five years – or until its costs fall even further. The solar bids that won to deliver power in 2015-16 bid in at £50 per MWh. It has subsequently transpired that they will not be able to fulfill on this contract. It looks like these solar developers expected multiple projects to come in at higher prices. On a related note, the government did not allocate all its budget for this first year. Solar was the only technology with a quick enough construction timeline that could have fulfilled this quota, but it appears developers preferred to continue the support of the ROC and feed-in tariffs in place – while it was there.

The determined strike prices from the first auction compensated onshore wind at a similar, if slightly lower, level to ROC-qualified projects. As BNEF observes, “the expected 20-year compensation under the CfD scheme would be 9% to 11% below what a project today could expect to receive under the RO.” In its first incarnation, the CfD system did not substantially reduce the scale of the subsidies per project, but lessons from Brazil suggest costs and auction clearing prices will come down.

The second auction was due be held in December 2015 but was postponed until further notice. The government’s decision to back away from its support of onshore wind (and solar feed-in tariffs) has muddied the waters. The second auction round should have driven down onshore wind subsidies, but it appears the government may now have to adjust the rules. There has been limited information concerning how biomass conversion, utility-scale solar, biomass and waste-to-energy projects will be treated and which maturity pot they will qualify into – if they qualify at all.

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