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A contract makes all the difference

Finding the most efficient way to pay for the energy transition is not an easy affair—but lawmakers worldwide seem to be increasingly converging on contracts for difference as the mechanism of choice to fund emerging technologies

Contracts for difference have supported the growth of offshore wind in the UK and are now gaining traction elsewhere


SUBSIDY CHALLENGES
Market support mechanisms such as feed-in tariffs have had a patchy record with renewables in Europe

CONTRACTUAL CONFIDENCE
The contracts for difference model allows governments to share risk with private investors

KEY QUOTE
It is cheaper to do a contract for difference that might or might not pay out, than a subsidy that will definitely pay out


The UKs energy ministry was treading carefully when it published a white paper called Planning our electric future” in July 2011. A need to encourage growth in renewable energy was clear, but mechanisms to foster the sector had not worked out in other countries, such as Spain.

A feed-in tariff (FiT) scheme offering fixed, above-market rate payments for renewable energy capacity was crashing the Spanish economy as its government found itself facing higher-than-expected payouts into its incentive programme. The amount of money the administration was paying for solar and wind power was so generous that families re-mortgaged homes and took out expensive bank loans to fund projects for a slice of the FiT pie.

Spain’s FiTs would go to make up roughly half of a €30 billion tariff deficit” that was crippling state finances at the end of 2013, the year the government abolished the scheme. The abolition was extended to existing installations as well as new ones and left many small investors penniless. Spain’s retroactive action on FiTs soured investor attitudes and stalled further renewables development in the country for the best part of a decade.

FiTs caused similar problems in countries such as Greece and Portugal, compounding the after-effects of the 2007-2008 financial crisis and leading governments other than Spain’s to renege on renewables support scheme promises. Officials at the UKs Department of Energy & Climate Change (which has since become the Department for Energy Security and Net Zero) needed to do something better.

At the heart of our strategy to deliver this transition is a new system of long-term contracts in the form of feed-in tariffs with contracts for difference (FiT CfD),” the ministry said in a July 2011 white paper.


[caption id=“attachment_225430” align=“alignnone” width=“1024”] WORLD LEADER
The UK had the largest offshore wind fleet in the world until recently [/caption]


TOP-UP PAYMENTS

With a CfD, if the wholesale electricity price is below the rate agreed in the contract the renewable energy producer gets a top-up payment to make up the difference. If the wholesale price is above the contract price, meanwhile, the producer pays the surplus back.

The ministry explained that if the CfD model was used alongside a gradually increasing carbon price floor then wholesale electricity prices would rise—and the level of support needed for low-carbon generators would go down. CfDs would provide clear, stable and predictable revenue streams for investors in low-carbon electricity generation, the paper suggested.

This is a cheaper, more robust mechanism than the alternative support options available and provides greater certainty that we will meet our carbon emissions targets,” it claimed.

More than a decade later, the paper’s authors appear to have been vindicated. CfDs have helped Britain decarbonise its electricity system faster than any other rich nation and are being eyed in the European Union as a key tool to achieve the bloc’s net-zero goals.

The CfD model is also being touted as an enabler for other sectors, such as storage and demand response—and is being studied with interest in regions such as North America. To understand the attraction, it is useful to consider the role of public funding in the energy transition—and the limitations of other support schemes.

GUARANTEED RETURNS

In markets where the electricity system has been privatised, energy producers invest in plants with the expectation of making a return on their investment over the lifetime of the generating asset. Traditionally, thermal generators such as combined-cycle gas turbines were almost guaranteed to make money because they are relatively cheap to build and could be pressed into service often.

Early in the history of renewables, however, it was not clear how investors could make their money back. Solar and wind projects had high capital costs and investors needed to be assured of a return before they would back the schemes. In the United States, lawmakers came up with a system of incentives based on tax breaks. Companies with cash to burn found it worthwhile to invest in renewables because it would help cut their tax bills.

The system has worked after a fashion, although fears over the phaseout of the incentives have led to boom-and-bust cycles in the US renewables market for the past two decades. Only the Inflation Reduction Act, signed into law by President Joe Biden in 2022, provided long-term certainty to US investors. Furthermore, US-style incentives only work so long as you have corporations with large tax bills.

In Europe, the policy instrument of choice for early renewables support was the FiT. This encouraged investors to back costly projects by guaranteeing higher-than-market rates for energy, typically for up to around 20 years. The problem with FiTs was not that they did not work but that they worked too well.

In Spain, where the scheme was limited in its duration but not in the amount of capacity it could accept, FiTs helped more than double renewable capacity between 2005 and 2011. These subsidies led to a massive investment in these sectors on a much wider scale than the government had expected,” noted a European Commission paper in 2014.

The costs of support to renewable energy in Spain increased from €1.2 billion in 2005 to €8.4 billion in 2012,” it added, with a deficit being carried over from one year to another since 2008.



SCHEME DESIGN

Arguably the problems with FiTs in Spain and elsewhere were the result of poor programme design rather than an inherent fault in the concept. Germany, for example, used FiTs to build leading levels of renewables capacity without incurring a crippling tariff deficit.

Furthermore, the massive buildouts from Europe’s FiT era helped to bring down the cost of wind and solar to a point where they began to be competitive with traditional sources of generation. By 2018 investors were ready to back renewable energy projects in Spain again, just not those that depended on government subsidies.

Instead, they figured they could now build plants cheaply enough to make a return from selling energy on Spain’s electricity markets. Also, they were seeing growing interest from corporate electricity buyers seeking sources of clean energy. Between 2013 and 2021, the renewable capacity contracted under corporate power purchase agreements (PPAs) in Europe soared from 100 megawatts to 18.5 gigawatts, according to the utility trade body Eurelectric.

PPAs were given pride of place in a March 2023 paper on electricity market design from the European Commission. Member States should take into consideration the need to create a dynamic PPA market when setting the policies to achieve the energy decarbonisation objectives set out in their integrated national energy and climate plans,” it said.

Yet investors will only back merchant plants and PPA projects if the generation technology is cheap enough to compete in national and regional electricity markets. For technologies still reaching maturity, such as floating offshore wind or low-carbon hydrogen, this is an unfeasible business plan.

NEW TECHNOLOGIES

These immature forms of generation are being acknowledged as having a potentially critical role in the decarbonisation of energy systems, yet their costs would make them a challenging proposition for investors without some form of revenue guarantee. This is where CfDs come in. Assuming they are roughly aligned with market prices, CfDs allow governments to share most of the cost of novel renewable generation with electricity markets.

They also ensure any windfall profits are handed back to the government, which is an important consideration after a period in which European energy customers have been hit by record bills. The European Commission makes this point emphatically in its electricity market design proposal.

Some forms of public support guarantee the energy producer a minimum price by the government but allow for the producer to nevertheless earn the full market price even when this market price is very high,” it says. With the recent high prices much (cheap) publicly supported energy has been receiving these high market prices.”

To curb this and stabilise costs, it says, Investment support should be structured as two-way’ [a two-way contract for difference], which set a minimum price but also a maximum price, so any revenues above the ceiling are paid back.”

UK regulators and market observers would probably agree on the value of CfDs. Replacing its renewables obligation scheme, which forced electricity suppliers to source a growing amount of energy from clean sources, CfDs helped the UK build an offshore wind sector that was the world’s largest until China overtook it in 2021.


[caption id=“attachment_225433” align=“alignnone” width=“1024”] SURE STEP
CfDs allow investors to back innovative technologies with confidence[/caption]


COMPETITIVE ADVANTAGE

CfD support in the UK helped cut the levelised cost of offshore wind energy from roughly £120 per megawatt-hour in 2015 to almost £40 per megawatt-hour for projects coming online in the mid-2020s, based on research by Carbon Trust, an advisory body. This cost reduction has had far-reaching ramifications for the offshore wind industry, allowing developers to bid in European offshore wind auctions at zero or even negative subsidy rates—in other words, paying for the right to build plants.

The key to this cost reduction has been to combine CfDs with price discovery in reverse auctions, according to Dale Beugin of the Canadian Climate Institute, a policy think tank. The price discovery piece is a second layer where you’re using markets to identify what the optimal pricing point is for setting the thresholds for payouts,” he says. It really only works for competitive markets.”

This point is significant because CfDs on their own do not necessarily result in lower costs. In the UK, for example, the government has used the CfD model to lure private investment in new nuclear capacity, an area where competition between developers is essentially non-existent.

The agreed rate or strike price” for energy from the UKs Hinkley Point C reactor, due online in 2027, was set at £92.50 per megawatt-hour in 2013. Linked to inflation, this equates to around £123 per megawatt-hour in 2023—a high price to pay compared to offshore wind.

It is also important to note that even CfDs with price discovery do not automatically result in electricity price reductions, as became clear in the UK in 2022 when power prices hit record levels. This was likely because CfDs only cover a fraction of the electricity consumed in the country, and the island nation was particularly exposed to variations in the price of gas.

PRICE REDUCTIONS

It emerged that some renewable energy asset holders had delayed taking up their CfD contracts to benefit from high merchant prices. The government moved to close this loophole in 2022. In any case, the point of CfDs is not to reduce electricity prices per se, but to give investors the long-term certainty they need to build projects with emerging technologies.

Price reductions should come naturally as these technologies scale up to the point where they no longer need support and can compete in merchant and PPA markets. This has certainly been the case with offshore wind and there are hopes CfDs could do the same for novel asset classes such as long-duration storage.

The attraction of a contract for difference is when you have a new technology going into a market subject to massive change,” says Alan Greenshields of ESS Inc, which produces long-duration storage units based on iron flow batteries. You have large revenue uncertainty. It makes it difficult for private sector capital to fund these projects because nobody knows if you are going to make a return.”

Long-duration storage is a novel application for CfDs in Europe because assets such as ESSs flow batteries do not produce electricity—they store it and then return it to the grid later. This means a per-megawatt-hour payment mechanism such as that used for offshore wind might not be appropriate. This need not be a stumbling block, though.

To be able to do a contract at all you have to define what the battery is going to do,” Greenshields says. Then the question is, how stable or volatile are the revenues? If the answer is, not volatile at all, you don’t need a contract for difference—people will just build it if it generates a return for the investors.”

DIFFERENT MODELS

In the US, where renewables buildouts have been largely funded through tax incentives, CfDs are used in regional transmission operator and independent system operator-managed power markets operating over high-voltage grids. The purpose I am most familiar with is the use of CfDs in combination with financial transmission rights by power traders engaging in privately negotiated bilateral contracts,” says Leigh Tesfatsion of Iowa State University.

These CfDs are unlike those used for renewable energy in the UK. They are used by power traders to safeguard pricing in day-ahead trades if grid congestion affects the actual value of electricity sold. Nevertheless, their use in this context highlights the versatility of the concept.

In Canada, meanwhile, a March 2023 federal budget introduced CfDs for tradeable carbon credits that emitters can earn after cutting greenhouse gas emissions. The scheme aims to provide certainty that the market price for the credits will not fall below that agreed in the CfD, giving investors the confidence to back capital-intensive decarbonisation projects.

It’s trying to tackle uncertainty in carbon price futures,” says Beugin of the Canadian Climate Institute. That matters in Canada quite a lot because we’re still having a political debate about carbon pricing.”

Political debate is not a great motivator for investors, because it implies a change in rules could be just around the corner. If a tool such as carbon pricing is underpinned by CfDs then that adds a layer of contractual assurance to matters. It’s not a straight-up subsidy,” Beugin says.

It is a more nuanced public finance mechanism that shares risk and therefore decreases the fiscal costs of policy support. It is cheaper to do a contract for difference that might or might not pay out, than a subsidy that will definitely pay out,” he adds.


DISCOVERY VOYAGE
CfDs only help to reduce costs if combined with reverse auctions


PRIVATE CAPITAL

The investor certainty that comes with CfDs is also good for attracting private capital, Beugin says. That is a useful way to make private investment do more of the heavy lifting, which is good for the effectiveness of these kinds of policies,” he adds.

All this means CfDs are here to stay. The European Commission mentioned CfDs alongside PPAs as the main tools for achieving decarbonisation across Europe. Furthermore, although most CfDs should gradually disappear as low-carbon technologies become more competitive, there is growing evidence that the energy system might need assets that could never make money on conventional markets.

Take an asset built to sustain the system with low-carbon energy for up to a couple of weeks during an overcast, low-wind Dunkelflaute episode. Building such a critical asset, whether it is a hydrogen-fired gas plant, small modular reactor or exotic form of long-duration storage, is likely to be expensive.

If it gets used for only a few weeks or even days a year, it could take decades or even centuries to recoup its cost based on average market energy prices. No investor would touch such a project without the certainty that reasonable revenues could be guaranteed.

This could be achieved through the creation of highly rewarding capacity markets, another area that the UK is a pioneer in, but CfDs make sense because investors are more comfortable with them. Ultimately if the energy transition is to succeed then having CfDs for novel technologies and then merchant sales and PPAs for established assets is a reasonable package, for sure,” says Beugin. •


TEXT Jason Deign IMAGES Ørsted