What can we learn from the renewables CfD auction results?

February 26, 2015

Yesterday afternoon, the Rt Hon Matthew Hancock MP, Minister of State for Energy, spoke at Policy Exchange, outlining his vision of energy policy going forward. Central to his vision was that idea that we must transform our energy system at least cost – using market processes and competition wherever possible. Policy Exchange has long promoted the power of competition and auctions as a means to driving down the cost of renewables – for example see our 2013 report ‘Going Going Gone.

For evidence of the power of competition, one needs to look no further than the results of the Contract for Difference (CfD) auction which were published earlier today. The 27 successful projects, totalling 2.1GW of capacity, will share subsidies of £315million per annum by 2020/21. Crucially, the strike prices achieved were some 17-18% below the auction starting prices (solar achieved an even greater reduction, but this is most likely misleading as explored below).

The corollary of this is that the Renewables Obligation and FID Enabling scheme (which the CfD replaces) failed to achieve best value for consumers, and most likely over-compensated projects relatively to what a competitive system would have achieved. On the FID Enabling scheme, DECC was criticised by the Public Accounts Committee for failing to “adequately secure best value for consumers”, and “failing to defend consumers’ interests.”

In our view, the CfD regime is a massive improvement on what came before it – both improving budget management, and adding a competitive dynamic to renewables support which has previously been absent. However, there is still significant scope to improve the CfD further to maximise its usefulness and reduce cost to the consumer – as I highlighted in a recent blog “4 ways government can reduce the cost of renewables support”.

In short my main recommendations are:

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

a. Close the Renewables Obligation early to force price competition through the CfD mechanism. The continued existence of the RO reduces competition in the CfD.

b. Allocate CfDs on the basis of price competition only. DECC failed to secure best value for money through the FID Enabling Process, which used criteria other than price. DECC should avoid bilateral deals such as that for Hinkley Point C and the proposed Swansea Bay Tidal Lagoon.

c. Hold a single auction for CfD support (not separate pots for different technologies). If government wishes to support immature technologies it should do so transparently through capacity minima/maxima (which should be removed over time).

2. Avoid supply chain requirements in allocation decisions

a. Ditch the ‘supply chain plan’ aspect of the CfD process, and compete on price alone.

3. Open up the CfD to international projects

a. Fast track the International CfD to open up the CfD to non-domestic projects from 2016

4. Improve the CfD auction design – using a descending clock auction as per the Capacity Mechanism

It would seem that the Competition and Markets Authority would agree with a number of these points. Their updated ‘Issues Statement’, released on the 18th February, identifies the ‘strong efficiency arguments for replacing ROCs with CfDs’, particularly the use of competition to set the strike price. The report also states:

  • ‘We are concerned that some elements of the allocation process may restrict the use of competition in setting the strike price.’
  • ‘Dividing the CfD budget into three separate pots runs the risk that projects from one pot may be displaced by more expensive projects from another.’
  • ‘The fact that potential bidders for CfD contracts still have the option of seeking support for their projects under ROCs until March 2017 risks placing an effective floor on bids for CfD contracts, reducing the effectiveness of the competitive process.’
  • ‘there is an alternative, non-competitive approach to allocating CfDs…the Final Investment Decision enabling for Renewables…. the Secretary of State has the power to direct the CfD counterparty to award additional CfDs in a non-competitive manner in the future. By being awarded outside of a competitive process, there are risks that such contracts will unduly raise prices for consumers.’

However, whilst on the whole we should celebrate the competitive results from the CfD auction, there is one potential area of concern – the so-called ‘winners curse’ of developers bidding too low and then never building out projects (a problem which beset the NFFO scheme of the 1990s). The CfD projects which stand out most are the 2 solar projects which bid in at £50/MWh for delivery in 2015-16. The only explanation is that they bid low to secure a contract, on the hope that the auction cleared much higher, but unfortunately for them there were no other bids in this delivery year. It is inconceivable that solar PV could be viable at this level in the next 12 months.

Another possible cause for concern is the two offshore wind projects with strike prices of £115-120/MWh. This is significantly lower than the administrative strike price (£140-150/MWh), lower than what was agreed for the 5 FID enabling projects just last year (same), and lower than the latest cost information released today by ORE Catapult / The Crown Estate  (Levelised Cost of Energy of £121/MWh, which equates to a strike price of around £135-40/MWh). My provisional modelling (based on publically available information on project costs) suggests that a strike price of £115/MWh is significantly below the required hurdle rate, and substantially lower than the returns possible for offshore wind under the RO (even building in the latest expectations of lower wholesale prices).

This implies one or more of the following statements is true:

  • Offshore wind costs have reduced substantially in one year (unlikely)
  • DECC massively overpaid under FID enabling (likely)
  • The winners from this auction round will struggle to get their projects away (possible).

Only time will tell whether the ‘winners curse’ is real or otherwise. Luckily we won’t have to wait too long – as the winning projects now have exactly one year (from contract signature) to secure their finance, or else they lose the contract. It is plausible that there could be a pinch-point in financing availability next Spring – since the industry will be looking to get away the CfD winners (roughly £5bn CAPEX), plus the FID enabling contracts agreed last year which were given slightly longer (a further £12 billion), and the final flurry of projects looking to hit the tail end of the Renewables Obligation (£unknown) – all at the same time.

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