3 reasons why government is underestimating the cost of supporting renewables

February 4, 2015

Earlier today we published a blog setting out 4 ways in which government can reduce the cost of supporting renewables projects under the new Contract for Difference (CfD) mechanism. In this second blog we unpick some of the assumptions made by DECC to assess the cost of the CfD mechanism, and identify several potential issues.

Budget management is a key aspect of the CfD system – since the overall budget is restricted by the Levy Control Framework. DECC has made a series of assumptions which we think could lead to an incorrect calculation of the costs (of individual projects and the CfD scheme in totality), which means there is a significant risk of over or under allocation.

1 – Firstly, the budget calculation depends on DECC’s wholesale electricity price forecasts, which it produces internally on a periodic basis. DECC’s forecasts historically showed wholesale prices climbing substantially throughout the 2010s and 2020s, to the point where the subsidy to some technologies such as onshore wind and nuclear would be minimal by the late 2020s. This has supported DECC’s case that the cost of pursuing low carbon options and overall bill impacts are low.

However, the world is changing. Fossil fuel prices have reduced substantially in recent months. Add to that the impact of renewables subsidies, the capacity mechanism, and interconnectors – all of which will depress wholesale electricity prices in the long term. DECC has begun to recognise this and has downgraded its 2020 wholesale power price forecast from £64/MWh to £55/MWh (Sept 2013 forecast versus Sept 2014 forecast, both in 2014 prices). However – some commentators think that wholesale prices will be substantially lower still. For example Aurora Energy Research forecasts a price of £47/MWh in 2020. The CfD model insulates generators from this change – the lower the wholesale price, the greater the subsidy under the CfD model.

On this basis, DECC could be underestimating the cost of CfD support by in the order of £8/MWh in 2020 (or at the very least there is a risk of this outcome). We recommend that DECC updates its forecasts more frequently, building in the impact of changing fossil fuel prices as well as the impact of other policies.

2 – Secondly, the CfD valuation methodology uses the average wholesale price to calculate likely difference payments, not the actual price a renewables project is likely to receive (“capture price”), which will be determined in part by the profile of output. The more wind capacity there is on the system, the more prices will be dampened on windy days – a phenomenon known as ‘price cannibalisation’. Aurora Energy Research estimate that the wind ‘capture price’ may be some £4/MWh lower than the baseload price by 2030 (the actual impact will depend on the level of deployment). Conversely, as solar PV generates during the day when prices tend to be higher, the solar capture price is some £3-4/MWh higher than the baseload price.

This means that DECC is likely to underestimate the cost of supporting wind projects, and overestimate the cost of supporting solar PV through the CfD. We recommend that DECC’s price assumption (for valuing CfD support) should reflect the likely capture price of a given technology, not the average wholesale price. This would mean, for example, that large scale solar PV would become more competitive with onshore wind.

3 – Thirdly, DECC has used a very conservative assumption for the power output from offshore wind projects. DECC assumes a ‘load factor’ of 38%, which corresponds to the current offshore fleet average, but the latest projects coming forward are likely to have a much higher load factors (in the region of 45%), due to ongoing improvements in technology. As CfD payments are tied to actual power output, this means that the current assumption underestimate the cost of an individual offshore wind project by a further 15-20%. Therefore there is a risk that DECC over-allocates capacity in this auction, and the costs turn out to be higher than expected.

Overall – we think there is a significant risk that the costs of the CfD mechanism deviate significantly from DECC’s predictions. We recommend that DECC revisits and updates the assumptions used to calculate the costs of CfD support – specifically its assumptions on power prices and load factors. We also think that using technology-specific capture prices would provide a fairer and more realistic estimate of the actual incremental cost of supporting each technology.

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