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Offshore Wind Journal

CfD 2.0 on the horizon as UK debates future support mechanisms

Tue 14 Aug 2018 by David Foxwell

CfD 2.0 on the horizon as UK debates future support mechanisms
Offshore wind is extremely capital intensive – merchant projects could be risky if they rely solely on the wholesale price of electricity

The UK government’s commitment to hold regular auctions for renewable energy was excellent news for offshore wind, but as cost reduction continues and as the industry transitions to zero-subsidy projects undertaken at merchant risk, support mechanisms will need to evolve

By the mid-2020s – possibly sooner – it is anticipated that offshore wind in the UK will be subsidy-free. In the nearer term, the government in the UK is undertaking a five-year review of its Electricity Market Review or ‘EMR’ and plans to carry out a formal review of the capacity market, a process that might or might not open it up to renewable energy technology.

So, whilst the commitment to biennial auctions and the pot of money that comes with it is very welcome, there’s no doubt that in the medium- to long-term, change is coming to offshore wind and the way it is supported.

Faced with impending change, the last six months have seen a lot of discussion in the industry about new sources of revenue for offshore wind, and whether it might compete in the capacity market or other segments of the electricity market that have long been the preserve of thermal generators.

However, the August 2018 commitment to biennial contract for difference (CfD) auctions and the money available for those auctions mean that in the short-term at least offshore wind seems unlikely to need to use the capacity market.

It had been argued that opening up the capacity market up to renewables would not only benefit consumers but help deliver decarbonisation, but it now seems highly unlikely that offshore wind in particular will want to use the capacity market*, at least for new plant, certainly as long as CfDs are available on ‘reasonable terms.’ 

However, as Aurora’s head of GB renewables, Hugo Batten told OWJ, as older offshore windfarms come to the end of their renewable obligation deals and CfDs, they could participate along with other by then unsubsidised renewables in the capacity market.

As Energy UK has argued, the CfD framework has been a successful tool for delivering investment and bringing forward low cost low carbon generation. “It is important that the CfD regime (based on competitive auctions) continues to maintain the momentum,” Energy UK argued in a May 2018 statement, noting that CfDs have providing an ‘enabling environment’ in which cost reduction targets for offshore wind of £100/MWhr were met four years ahead of target. In fact, the last auction saw clearing prices well below expectations at £ 57.50/MWhr.

“In driving substantial cost reductions and stimulating innovation, the regime has benefitted the UK consumer, economy and delivering cost-effective decarbonisation. We therefore support the continuation of the CfD framework to provide the stable investment climate that developers and the supply chain need and believe that the five year review should focus on refinements to the scheme,” Energy UK argued. “The introduction of a revenue stabilisation CfD is paramount in deploying the least cost, low carbon technologies to the benefit of the environment, economy and consumer.”

As RenewableUK head of policy Barnaby Wharton told the Westminster Energy, Environment & Transport Forum Keynote Seminar, which took place in London in July, “lumpy policy kills industries.” Stable support allows them to thrive. Ask anybody in any industry what they most need and stable regulation, that enables steady growth and creates confidence among investors is surely at the top of the list.

Mr Wharton noted that in the UK, which has around 7.5 GW of operational offshore wind, 4.6 GW under construction and another 10 GW approved or in planning, a stable regulatory environment in the form of the CfD regime has created the conditions that have enabled the industry to thrive.

Green Investment Group head of policy Graham Meeks said the stable regulatory environment CfDs provided had delivered investment. “CfDs created volume, price certainty and stable revenue and enabled offshore wind to access a huge pool of capital. And the cost of that capital has fallen,” he told delegates.

But so much for the last several years. Times are changing, and offshore wind is quickly transitioning away from subsidies of the type in CfDs to a subsidy-free, merchant risk future when the wholesale price of electricity will play a growing role. “Will investors provide the same level of support for merchant risk projects? How will the cost of capital play out? How can we provide the same sort of security over revenues going forward,” Mr Meeks asked?

CfDs have been a huge success, but now, with the five-year review of EMR underway, opinion in the industry seems to have coalesced around the need for new type of CfD, one that would provide the same kind of stability going forward and facilitate investment but reflect the fact that offshore wind no longer needs the same level of support.

So what form might a ‘CfD 2.0’ take? Delegates at the Westminster event agreed that some form of revenue stabilisation mechanism or intervention is required, potentially a floor price for low-carbon generation, rather than straight subsidisation. Like ‘CfD 1.0,' a ‘revenue stabilisation CfD’ could help de-risk investment and reduce the cost of capital and provide the kind of stable, enduring regulatory regime that is required.

Wholesale market revenues under a subsidy-free, merchant based approach could be highly risky. Even as the cost of low carbon technology come down, low marginal cost, high capex low carbon technologies are exposed to wholesale price fluctuations caused by fossil fuel price volatility. Conventional price-setting gas generation is not. That being the case, in order to compete on a level playing field these technologies need ‘technology agnostic’ revenue stabilisation contracts to be able to contribute to the longer term cost-effective decarbonisation.

Analysis by consultants such as Aurora Energy Research shows that, in the right circumstances, subsidy-free renewables could almost eliminate the need for high-cost gas-powered electricity generation. That will make it easier for governments to meet carbon targets, but the merchant nature of investment for subsidy-free windfarms would expose the market to increasingly complex drivers of capture prices –  that is, the price an asset or technology actually achieves in the market.

As Cornwall Insight noted recently, the value earned from wholesale power is going to become increasingly important for renewables, but price cannibalisation will be a major complication. This is because of the depressive influence on the wholesale electricity price at times of high output from intermittent, weather-driven generation such as solar, onshore and offshore wind.

When there is a lot of wind in the system it tends to drive down the wholesale price – so much so that there is a risk of price cannibalisation – whereas, when the wind is not blowing, the wholesale price goes up. Contrast this scenario with the existing CfD regime, where generators are guaranteed a price for the power they produce, and the consumer effectively meets the difference between the wholesale price and the agreed ‘strike price.’

Power purchase agreements (PPAs) are an option in the long term but that market is not sufficiently developed to help meet renewable energy targets right now. Moreover, a company entering into a PPA might struggle to manage intermittency from renewables and there might not be many large enough to enter a PPA for a large offshore windfarm, so some form of intermediary would probably be required, Mr Batten argued.

All in all, there is a need for offshore wind to find a way to reduce its dependence on the wholesale market as it makes the transition to zero subsidies. There are potential solutions, but just as the CfD scheme has provided certainty, reduced risk and played a key role in the hugely successful roll-out of offshore wind in the UK, so a new arrangement will be necessary as offshore wind transitions to zero-subsidy CfDs. It seems likely there will need to be a mechanism – such as guaranteed top-up payments when the capture price is low – that provides a solution, at least in the short term.

Cornwall Insight’s head of research Ed Reed said he agreed that a CfD with a floor price could make zero-subsidy projects more attractive to investors and alleviate concerns about the effect of wholesale prices.

“There is a lot of interest in the renewable energy sector at the moment that subsidy-free investment could call forward significant renewable generation capacity, but we have cautioned that the outlook for wholesale power prices challenges these assertions,” he told OWJ.

In its Wholesale Power Price Cannibalisation paper, Cornwell Insight detailed how the value earned from wholesale power is going to become increasingly important for renewables investments as subsidies are removed.

As highlighted above, price cannibalisation that arises from the influence on the wholesale electricity price at times of high output from intermittent, weather-driven generation – such as wind – leads to suppressed or sometimes negative wholesale power prices. The greater the fraction of output on the system to meet demand from intermittent generation at any given time, the greater this effect becomes.

“We are hearing that developers are being offered PPAs where price cannibalisation effects are already factored into the offer, which may be risking investment, and alternative approaches to underpin investment would likely be welcomed with open arms,” Mr Reed said. “Against this backdrop we have begun to explore how wholesale revenue stabilisation mechanisms will be necessary to attract investment in renewables while keeping consumer costs manageable.”

“For generation that is commercialised – by which we mean anything that can currently compete in an auction for a CfD we see merit in developing a CfD floor price,” Mr Reed told OWJ.

“Project finance banks will always want to de-risk wholesale price exposure. Under a floor price CfD, contracts would be auctioned in the same way as today, but applicants would bid in the floor price, rather than the fixed price payment they require to make the project investable.

“If wholesale power prices fall below the floor price, then levy funded payments would be made to the recipient up to the floor. Where wholesale power prices rise above the floor again, the recipient would not receive the positive difference until the gross value of payments received under the CfD had been reimbursed to the Low Carbon Contracts Company.

“The potential for investors to capture upside would likely mean a lower floor price would be acceptable than the fixed strike prices currently bid into CfD auctions.

“Investors are likely to view the floor level as the means to raise their target level of project finance debt,” said Mr Reed. “Only if wholesale power prices were drastically below the floor price for most of the 15-year CfD period would there be any serious risk of unrebated consumer costs. This is unlikely. In simple terms, investors would capture some upside with a safety net capable of raising debt, while consumers remain protected against rising levy costs in a rebate-style model.”

As Mr Reed noted, a Department for Business, Energy & Industrial Strategy senior official recently confirmed there would be no changes to the CfD rules ahead of the next CfD auction in 2019, but with a longer-term review of the EMR under way, there will be opportunity for the case for reform to be made.

Looking even further ahead, in the far long-term, the next generation of offshore wind – widely perceived to be floating offshore windfarms built further offshore, which will have much larger capacity than existing bottom-fixed windfarms, where more regular winds will reduce intermittency – could enhance its credentials as a form of generation.

“Floating offshore wind could also potentially have a role in the capacity market,” Mr Batten told the Global Offshore Wind 2018 conference, thanks to its high capacity factor and regularity.

Government regulations contain provisions which enable renewable capacity to move from renewables obligations and CfDs to the capacity market, but technology already receiving state aid, such as offshore wind, would not be consistent with the European Commission’s capacity market state aid clearance. That would suggest that offshore wind could not compete in the capacity market until wholly subsidy-free.

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