Contracts for Difference – Devilishly Detailed

Tom Steward, IGov Team, 30th May, 2013

About Tom: http://projects.exeter.ac.uk/igov/people/igov-team/tom-steward/

Twitter: https://twitter.com/Steward_T

It seems the Government and EDF may be moving towards shaking hands on a deal to financially support to a new nuclear plant in Somerset,  Hinkley C. Unsurprisingly, this has led to enormous speculation over how much consumers will have to shell out over the coming decades – such as  here, here and here.  These figures are little short of terrifying, and although I think they should be taken with a healthy pinch of salt[1], I want to explain why they are not the only reason that Contracts for Difference (CfDs) represent such a bad deal for everyone – except maybe anyone looking to build a new nuclear plant.

What are CfDs and how will they work?

CfDs are now widely-discussed, and fairly well-understood, so this section may be worth skipping for anyone who is well-acquainted with the mechanism. I include an explanation here to lay out as clearly as possibly the complexities of the CfD, in order to highlight what effect they are likely to have. As with any complex policy, the devil is in the detail, and the CfD is nothing short of devilishly detailed.

The CfD is essentially a financial support mechanism for low-carbon generators in the form of a contract between the generator and a government-owned counterparty.  The CfD will eventually replace the Renewables Obligation (RO) but expands support from just renewables to include new nuclear and Carbon Capture and Storage (CCS) as well. The level of payments from a garden-variety CfD is based around two things – a ‘strike price’ and a ‘reference price’. The strike price is set in advance of the start of the contract and is likely to be fixed in real terms (The exact method by which the strike price will be inflation-adjusted is yet to be confirmed). The reference price is  dynamic and moves in reference to the wholesale electricity price. The payment that is received by the generator is the difference between the reference price and the strike price. If ever the the reference price exceeds the strike price, the generator is required to pay that difference back to the counterparty. So far so good.

The detail…

There are essentially two different types of CfD – one for intermittent generation (ie renewables) and one for baseload (ie nuclear and CCS). These differ principally around three things – length of contract, the reference price calculation, and the strike price.

Contract Length – Contracts for renewables are likely to be in the order of 15 years, CCS 10 years, and nuclear is as yet unclear. Discussion for Hinkley C, the only new nuclear plant under specific discussion at the moment, have been rumoured to focus around the 35 – 40 years mark.

Reference Prices – Even more devilish is the mode by which the reference price is set. For renewables it will move with the day-ahead market, meaning the reference price and the market price will track each-other quite closely. However for baseload generation, the reference price will be set for 12 months at a time on the basis of the average year-ahead wholesale price.

Strike prices – These will be set differently between baseload and intermittent technologies. By this, not only do I mean that different technologies will receive different strike prices (this seems quite logical, and is what occurs under the current RO). But also, that where renewables will have their strike prices imposed upon them, baseload technologies (namely nuclear) will negotiate strike prices on a project-by-project basis. This is exactly what is currently happening between the Government and EDF in relation to Hinkley C.

So what does this all mean?

Inequality of contract length is fairly self-explanatory, but things get a little murkier when looking at the reference price setting. Essentially it means that if the wholesale price spikes above generators’ respective strike prices, renewables will have to make payments back to the counterparty (because their reference price tracks the wholesale market), but nuclear generators may in fact make super-normal profits during this time as their averaged reference price does not so closely track short-term spikes in the wholesale market. Ie they will continue to receive CfD payments based on a reference price below the market price, and additionally be able to sell into the market at a higher price.

The method for setting strike prices are too, somewhat unclear. Centralised-setting of strike prices, as occurs under the RO, could be argued as fairly logical (possibly with a few caveats). However, negotiations between a generator and the government over the appropriate level of support, held behind closed doors, surely sets alarm bells ringing for everyone. A robust strike price is essential to the working of the CfD. The central premise has always been that the strike price should act as an upper-bound to support, so that if wholesale prices rose sufficiently high, generators would begin returning payments to the counterparty. If the strike price is set at a level that the wholesale price is never likely to reach (or even approach) these return payments will never occur.

What are the other issues?

PPAs – The CfD also means that renewables may be facing a tougher future than they would under the RO. The nature of the RO requires suppliers to source a certain amount of their electricity from renewable generation (or purchase equivalent ROCs) – which gives renewable generators, which are often independent from suppliers, some leverage when negotiating supply contracts (PPAs). The removal of this obligation, and with no prioritised access to the market, removes this bargaining chip. This removal also means that vertically-integrated suppliers like the Big-6 have a reduced incentive to invest in renewable generation.

Affordability and Generation Mix – The interaction between CfDs, affordability, and technology-mix is particularly interesting. CfDs will fall under the Levy Control Framework (LCF) – this limits the direct financial impact that DECC’s policies have on bills. The level of the strike price for Hinkley C, and the future wholesale price, will have huge impacts on how much money is left in the pot for other projects. The nature of the mechanism means that as the wholesale price increases towards the strike price, less subsidy is paid, leaving more room in the LCF for investment in other technologies. However, obviously high wholesale prices mean high retail prices – not very affordable.

However, if we faced a situation where the wholesale price was fairly low, a large proportion of the LCF would be swallowed up by the support for nuclear. This would leave little room to support other technologies, likely creating a knock-on effect for their attractiveness for investment. It is not hard to imagine that in such a situation, we could see an upswing in investment in traditional generation such as gas plant – helping to bind retail prices to the notoriously volatile wholesale gas market – again, not very affordable.

Added to such concerns around affordability, is the lack of clarity over the degree to which the government may agree to underwrite the cost of construction overruns of nuclear plant – something that new nuclear has become famous for.

All in all, I agree with many spectators that the level of support likely to be given to nuclear (a technology that has been in commercial operation since the 60s!) is completely exorbitant. However I worry that the anger at huge figures distracts from the more concerning underlying features of the CfD that risk stemming the flow of investment in renewables.

Posted by: rhoggett

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