I entered the world of energy policy in 2012, joining RenewableUK after a career in construction management, and was immediately plunged into Electricity Market Reform (EMR). What became obvious right away was the tension between short term and long term interests, and how an effective open policy debate could result in brilliant interventions. The Contract for Difference (CfD) framework and transition to auctions was a shock to the industry. However, the benefits it has delivered are clear, as other articles in this series will set out, and I believe it has played a key role in raising the social acceptability of investment in decarbonisation. In the early 2010s, public trust was eroding due to the reported ‘windfall profits’ of some generators who benefited from rising market prices whilst receiving fixed ‘top ups’ under previous schemes. Restoring this trust was crucial given the scale of ambition for build-out of new technologies.
So why is the CfD such a good intervention? And can we be confident it represents good value for money for consumers?
1. The CfD framework The CfD framework is composed of three key elements:
• An allocation process (contracts awarded through auctions, promoting competition);
• A generic private law contract, applicable to a range of technologies, offering 15 years of stable revenues (if the plant gets built) at the predefined price; and
• Forecasting and settlement rules designed to ensure effective cash-flows.
Auctions are often highlighted as the reason for the cost reductions seen in the offshore wind sector. However, this isn’t quite accurate. Auctions are the mechanism by which cost reduction is captured for consumers. Providing the allocation process works effectively, then the cheapest available projects at that point in time get given contracts. The real drivers of cost reduction are illustrated in the diagram above. While competition for contracts drives some of the commercial and technological innovation, the real benefit of the CfD framework is the contract itself, and its underpinning in private law. This structure ensures the availability of capital at low cost.
2. WACC-y stats So why does reducing the cost of capital matter so much? It is because it is one of the key levers of project cost that Government can tangibly influence, using tools such as the CfD. Measuring the scale of the reduction in the Weighted Average Cost of Capital (WACC) that is facilitated by the CfD is difficult. This is partly because counterfactuals have not existed. This might change as, in the build up to the fourth CfD auction, some projects might have a genuine choice between merchant build and deployment under the CfD. It also reflects how each project has unique characteristics, from the depth of the developer’s pockets to the specific site conditions. Even though we cannot accurately pinpoint the number, we have a high degree of certainty that a material effect exists. We have developed a tool: “Understanding the importance of WACC”. This allows anyone to explore how varying WACC impacts the cost of energy. This gives you a sense for the scale of the benefits and how rapidly these add up when you extrapolate the savings over the scale of deployment needed. Using the tool you can see that the benefits associated with lowering the cost of capital alone are likely to be in the billions of pounds as we decarbonise the power sector, assuming these are effectively captured through the allocation process.
1 Delivering decarbonisation – a market led or a regulated approach?, 2013
3. Price certainty cuts both ways In my mind, one of the features of the CfD that stands out the most is also one that is not well understood, and that is the protection it offers to consumers. Generators sign a contract that guarantees a price and not a penny more. If market prices rise above the strike price then generators pay back the difference. This mechanism protects consumers from uncertainty around not only future gas prices but also carbon prices. This means that the CfD acts as an insurance policy for consumers against higher prices (as well as insurance for generators against lower prices). In 2013, Pöyry published a report showing how. Carbon pricing “would deliver substantial gains to existing nuclear and hydro and to onshore wind generation, funded, ultimately, by the consumer.”
This conclusion is driven by the fact that incumbent non-fossil fuel generators did not invest on the basis of expectations of high, or indeed any, carbon pricing. The CfD will provide consumers with a very effective hedge if carbon prices are driven higher by tighter policy whilst CfD generators are protected against the uncertainty that surrounds Carbon Price policy. At current clearing prices this is a cheap insurance policy, and feels like a win-win situation.
Provided CfDs are procured effectively, I think the CfD is currently a good thing for consumers. To me, this is justified by the reduction in cost of capital and strike price protection for consumers; these are key to it representing Value for Money for consumers going forward. Underpinning that case for now and the future is evidence of project delivery under the CfD and availability of finance, insights on which we will share shortly.