New Contracts Could Make a Difference to UK Energy Crisis

A wider CfD regime could be attractive to existing renewable energy suppliers and their investors, while bringing consumer bills down sustainably.

Crises have a habit of dragging into general view aspects of life that had previously been the preserve of specialists. Who, before the 2008 financial crisis, had heard of ‘sub-prime mortgages’? Until Covid-19 struck, talk of ‘transmissibility’ and ‘herd immunity’ was strictly for inhabitants of laboratories and white coats.

The current energy crisis has similarly turned the spotlight on a little-known piece of machinery in the UK electricity market: contracts for difference (CfDs). In principle, these act to smooth out fluctuations in the price of renewable energy, giving, it is hoped, the stability that would-be providers need to invest in solar, wind and other power sources.

There is a slightly different scheme for nuclear generators, but fossil fuel-based operators, such as oil and gas, are not offered CfDs.

They may hold the key to tackling our current energy woes, notwithstanding short-term fixes such as widely anticipated freeze on consumer bills. But, as we shall see, there are obstacles on the way.

Strike it rich

Every year, the UK government sets a ‘strike price’ for the supply of electricity from new projects, arrived at by an auction process. The lowest bid wins, and the others either proceed, if they can go ahead without CfDs, or are cancelled, if they cannot.

Cancelled schemes can always be revived for the next auction if the proposers wish.

Each bidder must supply details of the project concerned and the proposed strike price, measured in megawatt hours. There is an upper limit to strike-price offers, set by the government.

Successful bidders sign contracts that run for 15 years, under which they agree to pass on to consumers any revenue received when prices rise above the strike price and to receive through consumers’ bills any shortfall in revenue caused by prices dropping below the strike price.

The strike price is adjusted to take account of inflation.

The beauty of the scheme is that, over time, suppliers and consumers are protected from extreme swings in the market. Surely this is the answer to the sort of market volatility we are now experiencing? This, however, is where the problem starts.

“For now, only a small fraction of the total fleet of operational renewable energy projects have a CfD, so the saving on consumer prices is quite small,” according to the UK Energy Research Centre, an independent multi-disciplinary institute. “Most existing large-scale renewables are remunerated through a scheme called the Renewables Obligation (RO) that preceded the CfD arrangements.”

This is a more generous system, providing the wholesale market price plus a “renewables” subsidy. It started in 2002 and was closed to new entrants when the CfD system was launched in 2014. But because it offered 20-year contracts, the last of these will not expire until 2037.

It may be possible to persuade some renewable operators to exchange ROs, for CfDs ahead of time. More on that in a moment.

What is incontestable is the extreme volatility of all energy prices, especially gas, which sets wholesale power prices in general. On 16 February, days before the Russian invasion of Ukraine, gas was selling at 133.49p a therm. More than six months of fighting later, it stood at 627.51p a therm on 25 August.

By 5 September, it had eased to 396.41p.

But if CfDs currently have only a limited role in helping us navigate the current turmoil, what alternatives are there?

Simon Puleston Jones, Chief Executive of Climate Solutions, which helps companies raise capital for climate-focused infrastructure projects, said: “This is really about four things: politics, the net zero commitment, international competitiveness and the design of the energy market.

“Politics: whose bears the cost? The electorate? The energy companies? With an election on the horizon, it isn’t going to be the electorate. But as the collapse of Bulb showed, if it is the energy companies that carry the costs, then there is a need for hedging.”

Sound reasons for bidding

In Puleston Jones’ view, the pressure for radical and structural change to existing arrangements is irresistible.

“The net zero commitment has not had much of an airing in the Conservative leadership campaign. There has been a lot of talk of new oil licences, and of coal and fracking. But in the US, the Inflation Reduction Act has completely transformed the renewable economics in that country with tax credits and carbon markets. In the UK, renewables are competing for investment, opportunities and employees. It is hard to see how the UK can compete internationally without a similar act of its own,” he said.

“In market design: the cost of electricity is tied to the cost of gas. The industry has suggested that prices should be de-coupled. We need to evaluate the situation and the market design needs to evolve.”

Aside from the continued attraction of ROs for those who still have them, there is another potential obstacle to the expanded use of CfDs – the fact that they are open only to new renewables projects, not existing ones. They have been specifically designed to bring forward new capacity.

This may have made sense in normal times, but the present energy crisis has spurred a search for new solutions, and one may be to re-write the rules to permit all renewable generators that wish to do so to bid for CfD contracts.

Stefanie Mollin-Elliott, Fundamental Analyst with fund management company Unigestion, said: “This is being talked about. There is 100 terawatt hours of capacity that could be covered by a new CfD regime. That makes it an attractive idea at a time when there are urgent energy needs to be addressed.”

Were the government to offer such a “new CfD” to existing renewables suppliers, she added, the strike price would be below today’s sky-high market level, but there were sound reasons why suppliers would nevertheless be interested in bidding.

Include existing schemes

“The price is not going to stay where it is indefinitely,” she said. “The benefit for them is that they would be exchanging a high but uncertain price for a lower but guaranteed one. Locking in a stable price could give them more headroom on the balance sheet, more leverage with their banks.

“As lenders can be more confident about the company’s income stream, borrowing costs may be reduced.”

There is, she said, a further reason suppliers may wish to bid for such a CfD. With high energy bills being a major issue in the UK and Europe, energy suppliers may see CfDs as preferable to alternative solutions, such as windfall taxes.

The UK Energy Research Centre agreed that such a “new CfD” could be implemented quickly, as opposed to the long lead times involved in bringing new renewable capacity on stream. Director Rob Gross asks: “What if more of our existing renewables and nuclear generation were to get paid via a CfD? CfD auctions are run each year for new renewables schemes.

“Why not run a CfD auction open to existing wind, solar and biomass generators?

“They may then be able to contribute power at much lower cost and in return receive long-term stable revenues.”

The centre has made some calculations as to the effect of what it calls its unorthodox and potentially controversial idea. Gross said: “Savings start at around £5 billion per year or about £70 per household if the CfD price is quite high and around 23% of renewables take part. If most existing renewables and nuclear take part in the scheme then the saving would be around £22 billion per year.

He said: “Household bills could be reduced by over £300 per year. Industrial and commercial electricity users would also benefit from lower prices.”

“A clean energy version of the banking crash”

Gross goes on to ask why existing renewable operators would wish to take part in a CfD scheme, given they are either enjoying more generous support under the RO system, or enjoying current high prices – or both.

“Some might,” he explained, “because the RO contracts that they are currently under will begin to expire soon.” Even were this not the case: “A bit like a fixed-price mortgage in reverse, the idea would be to heavily discount the current very high prices in return for a long period of secure revenue.”

An equally radical alternative move would be for the state directly to subsidise renewables generators for the duration of the energy crisis, alongside the existing CfD system. Victoria Judd, Counsel at Pillsbury Law, said: ““There is certainly a case for direct state subsidies to utilities such that consumers won’t see such a rise in prices.

“This is the route that has been taken in France at the moment for instance. However, from what I have seen, the UK government is not going down this path at the current time.”

Puleston Jones noted: “Direct subsidies may make sense to avoid a clean energy version of the 2008 banking crash. They should be decided on a case-by-case basis.

“But there is no case for subsidising oil and gas companies, which are making very healthy profits.”

Mollin-Elliott saw little chance of direct subsidies at present, and isn’t sure they are necessary. “The economics of the renewables producers, with ever-improving technology, ought to be good enough to ensure they can sell electricity at a decent price without help.”

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