Financing the green transition: the evolution of contracts for difference

January 2021  |  SPECIAL REPORT: ENERGY & UTILITIES

Financier Worldwide Magazine

January 2021 Issue

Contracts for difference for the energy market (CfDs) were first conceptualised by a white paper in 2011 and subsequently launched in 2014 to replace the renewables obligation (RO). They are a standard form commercial contract entered into by a generator with the Low Carbon Contracts Company (LCCC).

CfDs support new technologies by shielding the electricity generators from wholesale price volatility. The LCCC guarantees a strike price and tops up payments when the wholesale price is below this amount, and vice versa.

Since launch, CfDs have been evolving, including with amendments to the technologies to which subsidies are granted and an evolution of the strike prices available. This article considers these developments, likely future developments to CfDs and the extension of the model’s applicability to other investment forms and jurisdictions.

A new system for incentivising renewables

CfDs were introduced in the UK by the Energy Act 2013 to replace the RO which many viewed as an expensive method for incentivising renewables.

The first CfDs were approved in parliament by the secretary of state in April 2014. At that time, eight investment contracts were awarded, with the expectation that those eight would represent 15TWh of energy by 2020. The goal was to reach 30 percent of renewable electricity generation in the UK by 2020.

There have now been a further three allocation rounds, or competitive auctions, for CfDs, commencing in 2015, 2017 and 2019. The current share of renewable electricity is above 37 percent of electricity generated in the UK, and this would seem to indicate that CfDs have helped the share of renewables grow as part of the energy mix.

Under the CfD scheme, contracts have already been awarded for around 16GW of new renewable electricity capacity, of which 13GW has been offshore wind capacity.

Solar PV is another prevalent and established technology. Such established technologies form part of ‘pot 1’ for the purpose of the competitive auctions for CfDs. Less established technologies, such as anaerobic digestion and tidal stream, form part of ‘pot 2’ and have their own auction.

Evolution since inception

CfDs have not remained static since they were first introduced in the UK renewable energy markets.

First, the competitive nature of the scheme has meant that the strike prices applicable to CfDs continue to decrease. The third allocation round, for instance, had applicable strike prices per technology below the administrative strike prices (or maximum strike price that may be given) in that year. This reflects decreasing technology costs.

In the case of offshore wind, costs fell by around 30 percent from the previous allocation round. This trend of decreasing strike prices is expected to continue, as component parts and deployment of renewable technologies become cheaper.

Second, policy decisions continue to influence the technologies that get the most support. In the case of biomass, for instance, the UK government has already stopped almost all subsidies for new biomass plants and has stated that there will be no further support for coal to biomass conversion plants post-2027.

In addition, pursuant to the March 2020 consultation on proposed amendments to the CfD for low carbon electricity generation scheme, biomass conversion projects will be excluded from future CfD allocation rounds.

Thirdly, wind and solar will now be represented in the next allocation round in 2021. They had not been able to participate in competitive auctions for CfDs since the first allocation round, and given that projects have continued to come to market in the intervening time without CfDs, it will be interesting to watch the uptake of CfDs for these more established technologies.

Finally, floating offshore wind will be considered separately from fixed bottom offshore wind in the next allocation round in 2021 further to the recent consultation results, published on 24 November 2020. This split will recognise the additional costs pertaining to floating offshore wind projects and encourage its development. Hywind Scotland is the only operating commercial floating wind farm in the UK currently, but this policy change should encourage new floating offshore wind projects that are waiting in the wings.

What about other technologies participating in the energy transition?

Battery storage parks may hold a generation licence and are commercially viable but cannot benefit directly from CfDs unless co-located with other renewable technologies and, even then, only if they are separately metered.

Instead, subsidy options for standalone battery storage parks are restricted to participation in the capacity market. This was established contemporaneously with CfDs to ensure security of electricity supply by providing payment for a reliable source of electricity capacity. To date, the success of this support has been limited but amendments to the capacity market as of May 2020 will help support smaller scale participants in the future. Given that battery storage projects typically need to take advantage of multiple revenue streams as part of a revenue stack in order to create a business case, it is hoped that the UK government will provide more flexibility for a renewable power project with a co-located battery storage project to apply for a CfD in future allocation rounds.

Less established renewable technologies need to become commercially scalable before they can consider applying for a CfD as generators, and the technology type needs to be eligible for a CfD.

It is likely that as such technologies become scalable, the eligibility criteria for CfDs will be broadened to ensure such generators can benefit from CfDs. Before they reach this point, government grants or tax breaks may provide more readily accessible incentives.

Hydrogen is one technology hot topic in respect of which availability of funding is unclear. Given the political attention given to hydrogen in 2020 and the UK government’s intention to boost investment into this industry across the supply chain, one would expect there would be no major roadblocks by the time hydrogen-related projects are looking for a bankable route to market. Work is needed though to settle on a business model to support low carbon hydrogen and to ensure that production facilities are an investable proposition. There is also the outstanding question as to whether hydrogen technology will primarily be used to generate electricity or whether it is more of an energy storage solution in the near term, in which case it might need to look to the same incentives available to battery storage.

A carbon capture or offshore wind generator with an associated hydrogen component could benefit from a CfD already but the current structure does not provide for a strike price that would acknowledge the low carbon hydrogen component.

Where next for the CfD model?

The volume of legislation required to introduce the CfD scheme in the UK was such that it is probably not easy to duplicate in other jurisdictions without a large amount of political will, even though there are certainly some benefits that can be derived from replicating a system that has already been tried and tested. After all, each jurisdiction has its own unique systems for agreeing new laws, which cannot be circumvented.

That said, the CfD model is appealing, because it has successfully driven deployment of renewables at scale in the UK and improved the bankability of projects, thereby facilitating third-party investment and funding.

Jurisdictions such as India have certainly considered the model, though it may be that a CfD unlinked to government might be more attractive in the short term. One such implementation is the virtual power purchase agreement (PPA) which combines a PPA with a CfD entered into with a corporate that wants to benefit from the green attributes of the renewable electricity manufacturer to settle a price on a daily basis, without, however, receiving a delivery of power.

These structures are interesting in that they benefit from the advantages of CfDs, such as the commercial contract, the long-term nature of the commitment and the fact that they can provide certainty so as to help make a project more bankable.

In contrast to UK energy market CfDs, however, they do not rely on allocation rounds, can be concluded with any contractual counterparty willing to contract and would have a shorter form contractual structure, more akin to that of a standard PPA with associated power delivery. They can also be individually negotiated and can apply to any technology type that the commercial parties want.

Of course, local regulations on entering into contracts for difference (here referring to the product in general) still need to be considered.

Conclusion

The CfD scheme in the UK has been very successful in driving successful deployment of renewables at scale while rapidly reducing costs. Whether it remains an interesting tool for projects that no longer need a subsidy but would benefit from price stabilisation remains to be seen, given that paying out monies when the strike price is below the wholesale price of electricity could be seen as paying out profits.

In relation to new and evolving technologies, the key will be for the CfDs to be able to continue to evolve. The next step to watch out for is which technologies will benefit from the 12GW of capacity that will be available in the next CfD auction in 2021 and thereafter how CfDs can help encourage the hydrogen revolution.

 

Victoria Judd is counsel at Pillsbury Winthrop Shaw Pittman LLP. She can be contacted on +44 (0)20 7847 9713 or by email: victoria.judd@pillsburylaw.com.

© Financier Worldwide

BY

Victoria Judd

Pillsbury Winthrop Shaw Pittman LLP

©2001-2024 Financier Worldwide Ltd. All rights reserved. Any statements expressed on this website are understood to be general opinions and should not be relied upon as legal, financial or any other form of professional advice. Opinions expressed do not necessarily represent the views of the authors’ current or previous employers, or clients. The publisher, authors and authors' firms are not responsible for any loss third parties may suffer in connection with information or materials presented on this website, or use of any such information or materials by any third parties.