European countries are poised to use Contracts for Difference as the default way they award support for new renewables projects, but policymakers must also learn lessons from the UK experience.
Governments in Europe will have to use Contracts for Difference (CfDs) to support new renewables projects. That was one of the main headlines when the European Commission last month set out planned changes to Europe’s electricity market.
The Commission wants to replicate the success of the UK, which has used CfDs to support growth in offshore wind capacity from 3.7GW in 2013 to over 13.7GW now.
CfDs are a revenue stabilisation mechanism where developers agree a strike price with government, usually via auction, for electricity generated at their projects. If the price of electricity on the open market is lower than the strike price, the owner of the project receives a ‘top up’ payment from government. When the price of electricity on the open market is higher than the strike price, the owner pays back the difference to government. This has given developers financial certainty at their projects.
However, the news that the EU is going ‘all in’ on CfDs comes at an interesting time. Last Monday, the UK Government announced it was considering changes to CfDs so they do not judge projects solely on the strike price, but other ‘non-price factors’ too: support for the supply chain, fixing skills gaps, energy security, and so on.
This is a timely review. CfDs have done well at getting offshore wind built in the UK, but they have not attracted universal acclaim. European policymakers have already been looking at how they can add ‘non-price factors’ into the CfD process in the recently-proposed EU Net Zero Industry Act. But they would do well to follow the results of the ongoing consultation, which closes on 22nd May. This should give a good gauge of industry sentiment on CfDs.
CfDs have encouraged competition in the offshore wind industry that has helped it to achieve commercial maturity and go global. But there have been criticisms too.
The main one is that CfDs have encouraged a “race to the bottom”. Developers have won at lower strike prices and have had to pass on those cost reductions, leading to pressure through the value chain. It is no surprise that offshore turbine makers have been struggling financially in recent years while grappling with this pressure.
This fixation on low prices has led to business failures too. For example, in late 2020, Scottish engineering firm BiFab entered administration because it argued it had been unable to win work at UK offshore wind farms due to overseas competition.
This is not solely a CfD problem. It would be an issue for any mechanism that gives support to whoever can deliver projects the cheapest. Even so, it is an issue that we have been talking about for the last five years. A major review is long overdue.
The volatile economic situation in the last 18 months has highlighted another issue with CfDs. Developers and governments agree a strike price in an environment that may be very different than when the project gets built. Both sides can suffer.
In early 2022, the issue in the UK was of developers delaying the start of their CfDs so they could benefit from high power prices on the open market. This has not yet been matched by inflation, and the UK Government urged them to act “fairly”.
However, this year, the script has flipped and now the developers are complaining. Power prices are still high, but the cost of building offshore wind projects has been rising fast too. Their CfDs have been inflation-linked, but this has prompted firms to argue that they need more government financial support to make projects viable.
The most notable example is Ørsted’s 2.9GW Hornsea 3 project. This project won a CfD in July 2022 following a process that started in December 2021, but Ørsted says this does not match the current market reality. This UK may not be able to fix this: will always be a gap between when CfDs are signed and when the contract starts. Even so, picking winners solely based on price can only exacerbate the pressure.
The idea of judging projects on ‘non-price factors’ is not totally new. Bidders in the ScotWind seabed leasing auction had to include details of investments they would make in the local supply chain, and it may be the UK Government looks to follow a similar approach in CfDs. This is a sensible step, even if it creates more admin.
However, our big reservation so far is about the government’s motivation.
We want to be optimistic. We want to believe the UK Government is seeking to end the myopic focus on cheapness, so it can support a healthy wind supply chain. This would return economic benefits to communities and boost support for offshore wind.
But the pessimist in us can’t help but wonder whether this review is simply a way to keep strike prices down, while getting already-stretched offshore wind companies to make additional commitments to investment that would further raise costs.
For now, though, let’s be optimistic. We’ll keep a close eye on the consultation, and no doubt this will excite a lot of discussion at our Financing Wind event next month.
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