A new piece of research from the Oxford Institute for Energy Studies is seeking to discover the balance between market efficiency and economic risk.
The paper, titled Contracts for Difference – CfDs – in the energy transition: balancing market efficiency and risk mitigation examines the various benefits and risks of different types of CfDs in order to recommend an energy pricing system that delivers the most benefit to the market and energy consumers.
The authors note several flaws with the current system used for CfDs in the UK, known as the two-sided CfD. Under this system, owners of renewable energy assets are guaranteed a fixed £/MWh price for the electricity they generate over a fixed contract period, with the government paying the renewable energy producer the difference if the market price falls below the contractually agreed fixed price. While this does have advantages, several drawbacks have been noted, including that this model does not encourage generators to amplify production during high price durations or curtail during low price periods, with the authors noting that “encouraging consistent electricity production can nullify their worth as adaptable resources”.
The paper examines the nature of this kind of CfD contract, highlights its shortcomings, and analyses suggested models proposed in previous literature. One such idea involves decoupling renewable generation payouts from actual generation levels and instead paying out based on a benchmark volume of predicted generation. Although this was calculated to create fewer market distortions than the current CfD system, it inherently brings a level of baseline economic risk to the system, which the report’s authors note may discourage more risk-averse lenders from funding projects.
The report does suggest that “proposed reforms which decouple payout from actual generation offer promising avenues to enhance market integration and address the shortcomings of traditional models”, adding “these reforms introduce the basis risk, which poses financial challenges for generators and governments alike. The inherent trade-off between incentivising efficient behaviour through risk exposure and ensuring revenue stability for renewable energy projects underscores the complexity of CfD design.”
Concluding the report, the researchers call on the government to further analyse the CfD system, stating: “Governments must balance the need for market efficiency with the financial implications of supporting renewable energy through CfDs. Financial institutions and specifically consumers also play a crucial role, as they ultimately bear the risks and costs associated with CfD mechanisms. Policymakers, therefore, must carefully navigate this trade-off, considering the diverse perspectives and interests of various stakeholders.”
Calls for CfD reform ongoing
While many in the industry were pleased with the UK government’s recent announcement that the budget for the CfD Allocation Round 6 (AR6) was increased by 50%, calls for longer-term CfD reform have been ongoing for some time.
A report by climate and energy think tank Ember, released before the budget increase, urged the government to both increase the budget in the short term and make larger scale reforms in the long term. The report suggests that after the AR6 and AR7 auction rounds, the government should “explore profit-sharing mechanisms to both reduce consumer bills and lower the risk of setting the strike-price too high”, as part of an overall plan to “evolve the CfD process to move a large number of sites through development.”
