Update on Electricity Market Reform: Contracts for Difference

by Reed Smith

This is the second of a series of three client alerts considering recent developments in the UK Government’s Electricity Market Reform (EMR) programme.

In the first alert, we gave an overview of the EMR programme. One of the most important aspects of EMR is the phasing out of the Renewables Obligation regime and the introduction of Contracts for Difference. In this alert, we will focus on the recent publications relating to the transition to Contracts for Difference, and the draft terms for such contracts.

Transition from ROCs to Contracts for Difference Since 2002 the UK’s primary mechanism for stimulating investment in large-scale renewable electricity generation assets has been the Renewables Obligation (RO). Under the RO, renewables obligation certificates (ROCs) may be issued as a reward for generation of renewable energy by projects with installed capacity of 250kWp and above. An obligation is placed on the electricity suppliers to supply an increasing percentage of electricity from renewable sources, and to submit ROCs to Ofgem demonstrating compliance, or else face penalties. This creates a market into which generators can sell their ROCs.

Under EMR, the intention is to phase out the RO regime and replace it with a new system of support (effectively a form of feed-in-tariff) based on long-term contracts for difference (CfDs). CfDs will be introduced, at first as a parallel option alongside ROCs, from 2014; after 31 March 2017, the CfD will become the only choice available, and the RO scheme will be closed for new entrants.

In most cases, RO-accredited projects will be “grandfathered” for 20 years or until 2037. From 2017 until the end of the maximum period of grandfathering, the RO will effectively be in “run-off”.

The consultation paper published (albeit with application for England & Wales only) on 17 July (Transition from the Renewables Obligation to Contracts for Difference) provides further detail on how this transition from RO to CfD will work, and seeks views on some possible changes of approach compared to earlier proposals. Specific points of interest include:

  • Details on when “choice of scheme” decisions must be made and the possibility in some cases for “duel scheme plant” benefitting from support (non-overlapping) under both the RO and CfD. This could apply, for example, where additional capacity of more than 5MW is added to an existing RO-accredited project; it will be possible for the additional capacity only to be subject to the CfD, while RO support applies to the pre-existing project;
  • A possible change to the timing of the annual determination of the supplier obligation under the RO for each subsequent obligation period, from 1 October to 1 February;
  • A proposal that there be no support (under RO, CfD or small-scale FiT) for additions to existing plant of 5MW or less, where those additions are made after 31 March 2017;
  • A proposal that there be only limited permissible movement between RO bands for fuelled (e.g. biomass) generating stations after 31 March 2017. Importantly, it is proposed that co-firing stations will be able to move between low-, medium- and high-range co-firing bands but not able to move into the higher “biomass conversion” band if not already there by 31 March 2017;
  • To off-set the impact of the last point, however, there is also a proposal that co-firing biomass stations or units be able to move from RO co-firing support to CfD support provided they achieve full biomass conversion, subject to a 31 March 2027 support end date (the one exception to the general principle that capacity which has previously received RO support will not be eligible for CfD support). There will be no support for biomass co-firing (i.e. less than full conversion) under the CfD;
  • A one-off option for RO-supported plant to bid for and transition to the Capacity Market (thereby relinquishing their RO support in favour of revenue from a Capacity Agreement);
  • Proposals to offer greater freedom to developers of offshore wind stations to choose between RO and CfD for discrete turbine construction phases throughout the transition phase from 2014 onwards. It will be possible (provided that the different phases are metred separately) for generators to hedge the support levels by accrediting part of an offshore wind project under the RO and the remainder under a CfD.

In addition to these proposals, the RO transition paper also noted that the Government may be reconsidering its approach to how to maintain a “false market” for ROCs, once the RO regime closes in March 2017 and moves into run-off mode.

Up until now, the plan (as discussed in a previous alert) has been that the RO regime will remain a market-based mechanism until 2027, during which period a large pool of capacity will remain, sufficient to ensure that ROCs will retain their value. According to the original proposals, from 2027 RO projects would be transferred to a premium feed-in tariff system until 2037.

However, apparently in response to stakeholder concerns that the ROC market price could fall below the buyout price (i.e. the amount of the penalty payment), the Government is now reconsidering its approach. The 17 July consultation invites views on the alternative option of bringing the so-called “fixed-price scheme” forward to 2017.

The fixed-price scheme, whether it is implemented in 2017 or 2027, would provide a fixed feed-in tariff based on the ROC buyout price (as it stood at the first year of its operation) plus 10%. Subsequent years’ support would be indexed at Consumer Prices Index. At current ROC prices this would seem reasonable, but previous years have shown average ROC prices significantly in excess of the buyout price (and on some occasions up to 50% higher). It would therefore seem that, adopting the fixed-price scheme, generators would not realise the returns they would otherwise receive from being able to sell ROCs at market value.

The current ROC system provides compensation for periods of lower renewable generation: during low-generation years, fewer ROCs would be in circulation and there would therefore be higher demand for ROCs, increasing their value. This compensation for lower generation periods would no longer be available under the fixed price scheme.

Without a fixed-price scheme, ROC targets would be set by looking at anticipated generation, plus 10%, thereby (assuming that the assessment of anticipated generation is reasonable) always creating a demand; in addition, it could be argued that it will be easier to predict anticipated generation, given that the RO scheme will be closed to new entrants. Therefore, this headroom mechanism could actually increase the likelihood that ROCs will hold their value.

Contracts for Difference: Strike Prices CfDs will be long term contracts between the relevant low-carbon electricity generator (whether that be renewables, nuclear or a power station utilising carbon capture and storage (CCS) technology) and a (government-owned) CfD counterparty. In simple terms, the CfD will set a “strike price” which is designed to represent a fixed rate of return for the generator on the power it produces, irrespective of the prevailing wholesale electricity price. During the life of the contract, if the prevailing wholesale electricity price is below the strike price, the generator will receive a top-up payment to make up that “difference”, and when wholesale prices exceed the strike price the generator will be required to pay back that notional difference.

It is expected that contract length will be 15 years for renewables, with the term for CCS and nuclear projects still to be fixed. It should also be noted that the wholesale electricity price, and not the actual price at which the electricity is sold, is the only relevant metric here – it is up to the individual generators to attempt to negotiate the best sale price possible, but there is no additional support if the negotiated price is less than the wholesale price.

In June, the Department for Energy & Climate Change (DECC) published draft proposed “strike prices” for the first time. The proposed prices for each supported technology are as follows:

Source: DECC, Electricity Market Reform: Delivering UK Investment, June 2013

These proposed strike prices indicate that DECC is hoping that offshore wind will make up a significant portion of the UK’s low carbon generation; to incentivise this, the strike price for offshore wind is higher than many had anticipated. This strike price, allied with the

Government’s recently publishedOffshore Wind Industrial Strategy, is aimed at promoting investment in this technology.

It is also important to note that, for some technologies, CfDs will only be offered if the plant is a Combined Heat and Power plant. Again, this is to promote lower carbon generation.

Contracts for Difference: Further Details Further details on how the CfDs will operate have also been published recently:

  • On 7 August, DECC published the outcome of its consultation regarding the supplier obligation to pay the CfD counterparty.
  • On the same day, DECC published its draft terms for the CfD and its proposed allocation process for CfDs.

The publication of these documents, especially the draft CfD terms, provide further certainty as to how the CfDs will operate in practice. DECC is planning to consult with industry members regarding the draft CfD terms over the next month, with the aim of producing the final form of CfD in December. 

Written by:

Reed Smith

Reed Smith on:

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