Show me the money
As Ofgem prepares to release its decision on the domestic energy bill cap this week, it is timely to look at how the money is flowing around the CfD system now and in the coming quarter. The mechanism is working how it was intended to, with high market prices resulting in payments from generators to LCCC and thence to suppliers, but the amount is difficult to forecast accurately and hence working out how the CfD will contribute to the level of the bill cap is not an exact science.
Firstly, we should look at the recent past. In previous blogs (Contracts for Difference – delivering affordable low carbon electricity in GB) and Moving the money), we have set out how the CfD works when the ‘usual’ flow of money from suppliers to generators is reversed. In particular, it should be noted that while suppliers are invoiced daily when LCCC needs to pay generators, the reverse flow only happens at quarterly reconciliation points as regulations do not allow us to set a negative Interim Levy Rate (ILR), which has been set at zero since September 2021. So payments to suppliers are quite lumpy.
In ‘Moving the money’, we set out the numbers for Q4 2021 and Q1 2022 for accrued income from generators plus net changes to the ‘float’ that LCCC needs to keep on hand to ensure commitments can be paid (the Total Reserve Amount (TRA)). These were the first two quarters that market prices were above strike prices and hence LCCC was a net recipient of money from generators. While changes in the TRA affect the sums moved in the quarterly reconciliations, they tend to zero out over the year: ultimately it’s the amounts accrued to pay or be paid by suppliers and generators that consumers will see.
In Q1 of this year, LCCC accrued £140.7m in payments from generators. This number is slightly higher than reported in ‘Moving the money’ as reconciliation runs take into account adjustments to figures stretching back 10 quarters and thus there is some movement as time passes, though this is under 1% in this case. In Q2, however, day-ahead prices were lower and so LCCC accrued £43.6m in net payments to generators, which was taken from the TRA. This was because the UK was receiving cargoes of Liquified Natural Gas (LNG) at a rate greater than could be exported to continental Europe through the available gas interconnectors. Since we have very limited gas storage in GB, this meant that there was a relative glut of gas on the spot market and so marginal gas generation prices dropped.
So what is happening in this quarter, and importantly for the Ofgem price cap, what is forecast for the quarter coming? Here we can turn to LCCC’s In-Period Tracking (In Period Tracking) to show the current state of play. The glut of LNG in GB mentioned above has receded, and the renewed spike in gas prices across Europe has driven wholesale power prices higher. Consequently, LCCC is seeing payments from generators this quarter, so far totaling £94.5m, and our most recent forecasting sees that figure rise to £590m for the whole quarter. So the likelihood is that there will be a net payout to suppliers in the next reconciliation run in October (for more detail on the reconciliation process, see the presentation embedded here). Forecasting, difficult at the best of times, is particularly hard at the moment, however, so the accrued income from generators may well be less than we currently foresee. In particular, our forecasts are based around traded forward prices, which are currently including a significant risk premium. Actual out-turn day-ahead prices have been below forward prices, and hence our income from generators has been significantly less than the forward prices would imply.
It is particularly important to hold that thought about uncertainty in forecasts as we turn to Q4 and our expectations for how the CfD will operate as we move into autumn and winter. Our current forecast, including those forward prices, shows a big increase in payments from generators, to £2.9bn over the quarter. Remember, though, that forecasts are particularly volatile at the moment: our view in June, when the levy rates and reserve amounts were set for Q4, was that payments from generators would be £730m, so we have seen major changes in just the last two months. As the quarter progresses, we can have some more certainty about where we will land at the end of it, but the likelihood of surprises is high. In particular we have found that since last October, the out-turn of day-ahead prices is lower than our forecasting methodology would predict, so we have seen more modest income than expected at the start of the quarter.
What then can we confidently say about the coming quarter, as the domestic bill cap rises dramatically? That generators will be paying LCCC looks nailed on, and it appears likely that LCCC will be accruing more from generators than we have in previous quarters. Beyond that it is hard to make any prediction with confidence, however. We will be constantly updating our forecasting as the quarter develops, so readers should check our In-Period Tracking to get the latest on our view of how the money is flowing in the CfD system.
And what of the impact on the price cap? Ofgem has made some adjustments to its methodology so as to treat the CfD as if there was a negative levy rate, and thus recognise the payback from generators within the cap. Consequently, the cap level will be lower than it would otherwise have been. We have shared our figures with Ofgem and they are taking a judgement on exactly what discount to apply for this effect, but we would anticipate that it is in the region of 1% of the overall cap level. As more low-cost generators come on line in the CfD portfolio this effect could increase, though the hope is that market prices will drop in the short term, which would provide quicker relief than building new generation.