Commentary

Driving Investment in the Energy Transition

Contracts for difference have proved their flexibility, but are far from flawless, according to Victoria Judd, Counsel at Pillsbury Winthrop Shaw Pittman.

Increasing pressure to deliver short-term energy security in light of the war in Ukraine and rising oil and gas prices have added a new dimension to the renewable energy transition. There are now immediate concerns for delivery of short-term energy security in addition to pressures to commit to the longer-term energy transition.

Nonetheless, green energy remains at the forefront of national infrastructure planning, creating an attractive investment opportunity. This is further supported by the UK’s use of the Contracts for Difference (CfD) scheme. However, whilst CfDs can offer investors increased security, they are not a silver bullet for guaranteeing the UK’s short-term energy security, and whether the subsidies have struck the right balance to attract funding to green energy projects for the future remains to be seen.

The rise of CfDs

Introduced during the Electricity Market Reform of 2014, CfDs essentially aimed to revolutionise the subsidy structure for renewable energy projects. They replaced renewable obligation certificates with a bilateral contract pursuant to which the Low Carbon Contracts Company or LCCC (a company set up by the UK government) would pay the difference between the market price of electricity and the strike price to the relevant project developer (and vice versa in the event of a particularly high electricity price).

The appeal of CfDs for renewable projects lies in their 15-year term, thus guaranteeing certainty of revenue for specific projects, making them more attractive for project financing. Since the first CfDs or ‘investment contracts’, there have been four auction rounds, supporting 16 GW of low carbon electricity capacity.

Whilst CfDs have been granted to biomass conversion, solar and energy from waste projects, offshore wind projects reign victorious as the most successful beneficiaries. A total of 13 GW of offshore wind has received funding and early targets suggest a gross value add of over £40 billion to the UK economy by 2050, in return for £2.2 billion early-stage investment. CfDs have also permitted further investment into nuclear, with the Hinkley Point C project being awarded a CfD with a 35-year term in pursuit of bringing new nuclear to the UK.

Lower subsidies and new technologies

The success of CfDs to date is evidenced by the reduction of the strike price over time and how competitive the CfD auctions have become. The price per unit in offshore wind has reduced by as much as 65%, offering investors lower risk and better margins. At the same time, the available strike price decreased from £140.00 per MWh for delivery for investment contracts (prior to round 1) to as low as £39.65 per MWh for 2023/24 delivery (allocation round

3). As a result of this, UK offshore wind may well follow in the footsteps of Germany and the Netherlands, with the possibility that UK projects may no longer require subsidies at all, considering that wholesale energy prices have breached £200.00 per MWh and are predicted to stay high in the short term.

The success story of CfD funding of offshore wind arguably paves the way for further budget for newer technologies: with the current spike in energy prices and the fixed costs of onshore and fixed bottom offshore wind progressively reducing, fewer subsidies will be given to each offshore wind project such that those subsidies will be available for alternative technologies.

The flexibility of the model

The emergence of new technologies invites the CfD model to evolve and adapt to the ever-in- flux energy landscape, which in turn continues to create new opportunities for investors to capitalise on. As per the March 2020 UK government consultation, CfDs can now be awarded to projects in offshore floating wind (FLOW) as part of a different funding ‘pot’ from fixed bottom offshore wind. ScotWind recently announced a bumper round of seabed leases, including about 50% in waters deep enough to require floating offshore wind turbines, and it is expected that many (if not all) of these projects will apply for a CfD in the next allocation round in March 2023.

This evolution of the model is an illustration of the CfD regime’s flexibility and potential to adapt to the needs of the renewable energy market. Marine technologies and storage co-location projects could well be next in line to benefit from the potential of the CfD model.

Not without flaws

However, CfDs are not flawless. For example, a key criticism of the CfD model is that energy consumers are in effect directly funding projects. This is because the supply levy, used to collect ‘difference’ payments to be made to CfD generators, is passed through as a cost to consumers. Energy levies are forecasted to comprise between 17% and 28% of electricity and gas spend for the 2024-25 period. To the extent strike prices are set too high (whether as part of the auction design or as a result of competition), it is hard to dispute that the price ultimately affects consumers.

Hinkley Point C continues to attract criticism given the expense and long-term nature of the new nuclear CfD, and it has been targeted as a particularly contentious project by the CfD regime’s critics. Issues surrounding the application of CfDs to Hinkley Point C have led the UK government to consider other funding support models, such as the regulated asset base (RAB) model for further new nuclear projects.

The UK government estimates that the RAB model will lower project costs for future nuclear projects by more than £30 billion compared to the existing CfD model. It is unlikely that this one instance will deter investors from projects using the CfD model, but those looking to fund the transition are now presented an alternative with RAB funding, which could be worth considering.

More CfDs in the future

Despite these criticisms, the UK government has announced that CfD auctions will now be held annually, with the next round set for March 2023. Whilst CfDs have proven their potential to provide attractive renewable energy projects for investors, the UK government will need to ensure that it allocates sufficient funds to each round and considers what technologies are eligible to bid. Perhaps allocation rounds could be split so that Pot 1 (generally ‘established technologies’) and Pot 2 (generally ‘less established technologies’) rounds are on asynchronous years to balance subsidies granted to different types of projects. Availability of leases – particularly for offshore seabed – will likely need to increase alongside the number of CfD auctions in order to meet investor appetite.

New business models are expected to adapt the CfD model to fund the increasingly sought-after sector of carbon capture use and storage (CCUS) and hydrogen. The first example of this in practice is the government’s consultation on dispatchable power CfDs for CCUS and on the industrial carbon capture business model, but some questions remain as to the detail of the commercial aspects of the payment mechanics. The UK government is also actively consulting on hydrogen business models, based on the CfD format. Further consultation results in relation to both CCUS and hydrogen business models are expected this year and more administrative and legislative work is currently required to make these schemes operational.

It remains to be seen whether the UK government will be able to ensure that the CfD regime keeps pace with the ever-changing world of energy, and the ever-growing investor appetite for green energy projects. Nonetheless, at a time when the UK’s offshore wind pipeline stands at 86 GW, ahead of all other countries, CfDs, as a means of supporting such developments and encouraging investor buy-in, have proven their value. New technologies and business models will only add to the prevalence of this structuring tool.

This article was co-authored by Gibran Alaoui, Associate at Pillsbury Winthrop Shaw Pittman, in the finance practice, focused on transactions in asset and leveraged finance.

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