4 ways government can reduce the cost of renewables support

February 4, 2015

This week the renewables industry went to the auctions – completing the first allocation round under the government’s new Contract for Difference (CfD) subsidy regime for renewables. Participants still active in the process have until today to submit their final bids in the form of a “strike price”.

The premise for the CfD mechanism has always been to reduce cost to consumers whilst providing greater certainty for investors. Whilst we think that the CfD is an improvement on the previous Renewables Obligation (RO), it can still be improved to maximise its value and cost-effectiveness.

In this blog we revisit themes from the Policy Exchange report Going Going Gone on how to drive down the consumer cost of supporting renewables.

1 – Accelerate the timetable for introducing (technology neutral) auctions

DECC has recognised the role of auctions in renewables support, but the introduction of auctions has been slow, and we think DECC should move quickly towards technology neutral auctions.

Renewables developers can still receive support under the Renewables Obligation on a non-competitive basis until 2017 (although this route is being closed down for solar PV from April 2015). Technologies receive widely differing levels of support depending on their maturity. The largest sector in terms of deployment to date is onshore wind, which remains the most cost-effective large scale renewable technology available in the UK. But there has also been significant deployment of more expensive technologies such as offshore wind (4.4GW to date) and solar PV (4.5GW), and the re-banding process to manage costs has been clunky at best. As long as the RO route remains open, it reduces the incentive for developers to complete in the CfD.

We think that the RO should be closed early to force price competition through the CfD mechanisms and minimise the cost to consumers.

In implementing the new CfD regime, DECC put in place a transitional regime known as FIDeR (Final Investment Decision Enabling for Renewables). FIDeR was not an auction process – it was more like a procurement exercise, with prices set in advance, followed by a bilateral negotiations. Government allocated 4.5GW of contracts, with a total subsidy estimated at £16.6 billion over the project lifetimes. The process favoured large-scale and more expensive technologies such as offshore wind and biomass. Given that the demand for FIDeR contracts vastly outstripped demand (i.e. 57 applicants versus 8 contracts awarded), we think it should have involved price competition in order to minimise costs to the consumer. DECC was criticised by the Public Accounts Committee for failing to “adequately secure best value for consumers” through this scheme, and “failing to defend consumers’ interests.”

It is too late to change the FIDeR contracts, but government must learn from these experiences and use price competition to allocate contracts rather than bilateral negotiations (such as the mooted negotiations for a tidal lagoon at Swansea Bay), or more nebulous criteria (see discussion of supply chain criteria below).

Encouragingly, the new CfD regime will allocate contracts on the basis of a price auction, although mature and immature technologies will participate in distinct auctions. But the lion’s share of the budget is allocated to more expensive technologies, which means that cheaper projects could potentially be constrained in favour of more expensive projects. The timetable for moving to technology neutral auctions remains unclear – although DECC has suggested that it is currently considering strike prices for the 2019-21 period.

It is too late to amend the 2014/15 CfD allocation round, but going forward we think that there should be a single auction for renewables, minimising cost to the consumer. If government wishes to guarantee budget for certain technologies (or technology groups) then it should do so transparently using capacity minima/maxima. This setup would aid the transition towards technology neutral auctions. DECC should also substantially narrow the band of acceptable costs in the 2019-21 period – moving more quickly towards a technology neutral auction.

2 – Avoid domestic jobs or supply chain requirements in allocation decisions

The CfD system places an obligation on developers of large projects (>300MW) to have their supply chain plans ‘approved’ before they are allowed to participate in an auction. At present it is unclear whether any projects failed to meet the criteria in this CfD round, but if this is the case then the impact will be to reduce competition in the auction (and likely increase prices). The FIDeR regime went even further by using supply chain impact criteria to allocate support.

The use of such criteria has been justified on the basis of promoting supply chain development – the being somewhat ambiguous since it is technically illegal to put in place local content regulations under EU law. However, in practice it is questionable whether these policies have been effective, since UK content still remains below government’s aspirations.

As well as creating ambiguity in the process, supply chain requirements also have the potential to drive up costs and distort supply chain markets – as identified in our report Going Going Gone.

We think that going forward, the ‘supply chain plan’ aspect of the CfD regime should be ditched, and projects should compete on price alone – minimising cost to the consumer.

3 – Open up the CfD to international projects

Our report Getting Interconnected identified the potential for overseas renewable energy projects located abroad to link to the GB market (e.g. importing onshore wind from Ireland or geothermal power from Iceland). . Some of these projects could potentially be cheaper than the most expensive options being pursued in the UK, but the regulatory barriers to projects coming forward remain extremely high, and projects have been delayed. On current plans, renewable import projects will have to wait until at least 2018 before they can compete against domestic projects.

In our view, DECC should fast track the ‘International CfD’ in order to open up the CfD competition to non-domestic projects from 2016, not 2018. International projects should compete on a level playing field against domestic projects, and should be compared against the ‘marginal’ projects being developed in the UK (e.g. offshore wind).

4 – Improve the CfD auction design

Government and National Grid recently developed auction systems for both the CfD and the Capacity Mechanism (CM), which despite having been developed at the same time, are completely different. The CfD is a system of sealed bids, whilst the CM is an iterative ‘descending clock’ auction. Our report “Going Going Gone” suggests that a descending clock auction would be preferable to the sealed bid system, since it reveals market information to all participants, potentially reducing prices. It also allows greater scrutiny from outside organisations, and offers greater flexibility for bidders.

The recent Capacity Mechanism auction potentially offers evidence of the benefits of a descending clock system – it delivered a very low price which surprised policymakers, commentators, and even participants. It seems unlikely that a sealed bid system would have delivered such a low price. However, despite the compelling case, government dismissed the idea of using a descending clock system for the CfD due to concerns over collusion, which we think were misguided.

We recommend that the CfD auction should be redesigned as a descending clock auction along the lines of the CM auction. Much of the system architecture is already in place, having been developed by National Grid for the CM auction.

To conclude, for the time being we think that the Contract for Difference is the right mechanism to promote the deployment of renewables (and other forms of low carbon energy). But at a time when everyone is talking about energy bills, we need to ensure that systems like this are offering the best value to consumers. We think that there is still significant room for improvement.

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