What are Contracts for Difference?
Over the next decade, it is estimated that the UK will need around £100 billion of capital investment in its electricity infrastructure to meet projected future increases in electricity demand and to replace ageing coal fired power stations; we discussed this challenge with experts including Rolls Royce at an event on Tuesday.
To meet this demand, the Government passed the Energy Act in 2013 which introduced a policy entitled Electricity Market Reform (EMR) that sought to bring private capital investment in low carbon electricity. This comprised of two mechanisms: the Capacity Market, which provides an insurance policy against the possibility of future blackouts, and Contracts for Difference.
A Contract for Difference (CfD) is a 15 year contract between a generator of low carbon electricity and a government-owned entity called the Low Carbon Contracts Company (LCCC). A generator who enters into a CfD is paid the difference between the ‘strike price’ – a price for electricity reflecting the cost of investing in a particular low carbon technology – and the ‘reference price’– a measure of the average market price for electricity in the GB market. The benefit of a CfD over other subsidies is that it simultaneously benefits both generators and consumers. It gives greater certainty and stability of revenues to electricity generators by reducing their exposure to volatile wholesale prices, whilst protecting consumers from paying for higher support costs when electricity prices are high. For example, when the market price exceeds the strike price, the generator is required to pay back the difference, thus protecting consumers from over-payment.
It was initially intended that there would be one auction per year procuring power up to six years in advance. But budgetary constraints in the Levy Control Framework have meant that there has been over two years between the first and second auction. The CfD process is run as a reverse auction, which enables it to have greater budgetary control, rewarding those who bid the lowest on £/MWh basis. It is predicated on the theory that competition will drive down overall project costs.
A watershed moment?
Many people doubted that renewable energy could ever be economically competitive with conventional fossil fuel generation or to be specific whether grid parity could be reached. That is when an alternative form of energy generates power at a cost of electricity that is equal to or less than the price of buying power from the electric grid as a whole. The results of the 2017 Contract for Difference auction contradict this assertion. This is a watershed moment for both the UK renewable energy industry and UK energy policy.
Prior to the auction analysts predicted winning bids would be in the region of £70-80 per mega-watt hour (MWh). However, winning bids fell far below predicted levels with 71 percent of all capacity clearing at £57.50/MWh.
A victory for competition?
A comparison of these prices with winning bids from the previous auction illustrates how far the costs have fallen. In the 2015 CfD auction the lowest clearing price for offshore wind was £114.4 – almost double the lowest price of the 2017 results. In just two years, the competitive nature of the auction has seen prices fall by almost 50 percent, a case study that would not be out of place in a microeconomics textbook.
Given that CfDs are funded from a levy applied to household bills, a reduction in the costs should translate to lower costs for the consumer. Indeed, the government estimates that capacity procured in this auction will cost consumers up to £528m a year less than it would have in the absence of competition. The Government had allocated up to £240 million per year for the CfD subsidies, but because the winning bids are so low, the overall spend will not exceed £176 million even in the most expensive year.
Whilst cost reductions in offshore wind will grab attention, Advanced Conversion Technologies (such as energy from waste) have driven greater cost reductions than any other technology class. In the delivery years 2021-22 there is a 40 percent reduction against the strike price and in 2022-23 there is a 65 percent reduction. This compares with 29 percent and 43 percent respectively for offshore wind.
Clearly the auction results demonstrate the effectiveness of competitive reverse auctions – and competition more generally – in reflecting the cost and efficiency savings made by the industry and its supply chain.
Who are the big winners?
As with the 2015 round, wind was the big winner. Of the 3.34 GW procured, just three wind projects accounted for 95.5 per cent of this capacity. Despite it being a technology neutral auction, nuances in the bidding strategy tend to favour offshore wind.
Of the three successful offshore projects, Triton will undoubtedly be happiest as it secured a strike price of £74.75 – £17.25 higher than the other two offshore winning projects Hornsea and Moray. It is likely that Triton bid lower than this but it was uplifted by Advanced Conversion Technologies as, under the rules, the opposite could not happen. We can therefore assume that Advanced Conversion Technologies set the price for 2021-22. This suggests that all offshore wind must have bid very low indeed. One reason for the further cost reductions in the subsequent delivery years is likely to be the use of bigger turbines with greater efficiency.
Only time will tell if successful schemes are built and deliver electricity at the winning prices. It should be noted that reverse auctions can drive a race to the bottom. A number of projects in the first auction failed to secure project finance, presumably off the back of unrealistically low but ultimately successful bids. The test will be to see what eventually gets built and at what price.
Comparing the economics of nuclear and offshore wind
Many people will argue that the CfD prices do not reflect the true cost of offshore wind. In order to make an accurate comparison of the relative cost of technologies, it is important to factor in the additional cost of increasing intermittent generation on the system. These additional costs are reflected in the System Integration Costs (SIC) that include the increased balancing cost, cost of additional backup capacity and the cost of reinforcing network infrastructure. SIC tend to be greater for intermittent generation and factoring this in enables a more accurate comparison of the true cost of baseload and intermittent technologies.
SIC also tend not to be linear so in a world of greater renewables penetration these costs increase exponentially. However, Imperial College London has estimated the SIC for offshore wind to be in the region of £10/MWh. Even when this level of SIC is combined with the 2017 auction results for offshore wind (£57.50/MWh + £10/MWh) it is much more cost-effective when compared to nuclear generation with a guaranteed strike price of £92.50/ MWh over 35 years, more than double the contract length of offshore wind.
However, as the Hinkley CfD is over 35 years and the offshore wind CfD is over 15 years the comparison above is slightly crude. Therefore the prices need to be compared over the same time period. When the CfD strike prices are averaged for the first 15 years of operation for both Hinkley and offshore wind, the difference becomes even greater. The strike price of Hinkley becomes £154.45/MWh and the cost of offshore wind becomes £81.65/MWh (before any additional SIC). Using the real term strike prices values for both technologies allows the total CfD cost over the first 15 years of operation to be calculated. The table below illustrates this.
|Offshore Wind||Hinkley Point|
|Average 15 year CfD Strike Price (£/MWh)||81.65||154.45|
|Total 15 year CfD Cost (£B)||32||54|
Over the first 15 years of its operating life, the power station at Hinkley Point will generate 357 billion megawatt-hours of electricity at a total cost of 54 billion pounds to British consumers. Over the same time period (assuming 2025-40) the three wind projects awarded CfDs in the auction will generate 168 billion megawatt hours at a cost of 15 billion pounds. If we assume that these wind projects could be replicated and scaled up to generate the same amount of electricity as Hinkley Point, then the cost would be 32 billion pounds or 38 billion if you include SIC costs at a further £10/MWh. In other words, wind power could generate the same amount of electricity as Hinkley Point C at a cost saving to the British public of between 16- 22 billion pounds. Is this really a price worth paying for reliable and dispatchable power?
It is also worth noting that in the example above the subsidy for offshore wind will cease in 2040 as it is only a 15 year contract (assuming commission in 2025) and so the total lifetime cost is £32 Billion. As the CfD for Hinkley is 35 years, there will be a further 20 years of CfD payments. This amounts to £120 billion in addition to the £54 billion for the first 15 years, making the total nuclear CfD cost £174 Billion.
The future of UK energy policy
The immediate question is does this spell the end for nuclear? The CfD auction has just procured the almost same amount of capacity as Hinkley Point but it will be delivered at much lower cost and years earlier.
The results of the 2017 auction expose the increasingly challenging economics of Hinkley Point. When Hinkley was first conceived, the cost of offshore wind was predicted to be closer to £150/MWh and the cost of oil and gas was predicted to be far higher. However, given how far and how fast the cost of offshore has fallen, the disparity in cost has never been so great. The auction has exposed that locking the UK into a large centralised technology with an indexed linked 35 year contract no longer seems sensible. Competition has been at the heart of UK energy policy. The development of Hinkley Point is the antithesis of this, awarded without a competitive market process
Other questions remain about the next steps of UK energy policy such as the future of onshore wind and whether the Government will reverse its decision to exclude it from subsidies given that it is almost certainly the cheapest form of renewable energy. The Conservative manifesto pledge has left the door open for further development of onshore wind in the remote islands of Scotland. It will be interesting to see if this is covered in the Energy Cost Review headed by Dieter Helm.
More importantly, as baseload coal fired power stations continue to decommission, the UK capacity margin will tighten further and long before Hinkley comes online. Although the CfD auction will bring more capacity online it will do little to address the issue of baseload power – or the lack of. In order to mitigate this there is a pressing need for the Government to replace coal with new Combined Cycle Gas Turbines (CCGTs) and take a greater role in procuring this power as wholesale power prices alone will not provide the necessary income to facilitate this- a point Lord Howell – a former Energy Secretary – made at this week’s Policy Exchange panel discussion on how we meet our low carbon energy needs. The government will need to look at new mechanisms to leverage capital investment in CCGTs, whether this is through a revision of the current Capacity Market rules or further changes to embedded benefits that have historically favoured smaller distributed generation. This should be done in conjunction with greater interconnection, energy efficiency, storage, demand side response and looking further ahead possibly small modular nuclear reactors if significant cost reductions are achieved.
Despite the long delay between the auctions industry has clearly worked hard to drive down costs despite the political uncertainty. Now that this has been demonstrated, going forward the Government needs to outline a predictable long term strategy (hopefully in the Clean Growth Plan due in autumn 2017) for the deployment of both low carbon technologies and baseload power so that businesses have the certainty needed to continue driving down costs.