Offshore wind requires Contracts for Difference – not subsidies

Based on newspaper headlines, 2023 appears to have been an annus horribilis for offshore wind.

Between projects cancelled or abandoned in the US and the UK, several auctions foregoing bidding interest, massive impairments booked by utilities, major contractors bleeding cash, the news appear to have been unrelentingly bad. This has led some to questioning whether the sector can materially contribute to the transition towards renewable energy.

However, the doom has been overplayed. 

Some of the problems are temporary, as the sector had to deal with unusual volatility in the prices of the three biggest drivers of its business case – commodity and industrial prices on the cost side, power prices on the revenue side, and interest rates, which heavily influence investment decisions in a capital–intensive industry.

Higher supply and financing costs have made the average long-term cost of generating electricity from new projects more expensive today than it was two years ago, and this has created challenges for developers relying on sales contracts with fixed prices, set sometimes years ahead.

But costs have increased for all forms of power generation, so this is not impacting relative competitiveness of the sector. Rather, it is a clash between expectations that the past ten years of substantial cost reductions would continue, and the reality of a world hit by the combined inflationary effects of COVID supply chain disruptions and the war in Ukraine, followed by the increase in interest rates decided by the world central banks to fight that inflation.

CfDs – if well designed – are not subsidies but rather risk management tools, allowing generators to swap volatile short-term prices for fixed long-term prices

Higher for longer

Some industry players, in particular oil and gas majors, are embracing this new market situation by focusing their investments in markets where they can benefit from the upside of higher power prices – witness BP and Total’s large bets on German licenses, where they will sell the electricity on a merchant basis.

Despite the apparent randomness of successive announcements by these majors to increase and decrease investment volumes in renewables projects, it is consistent with longer-term strategies to focus on the high-returns trading business rather than lower returns from power asset ownership.

Governments, however, may not appreciate such an open bet on persistently higher power prices.

In fact, the real evolution in the past years has been the increasing embrace by regulators of contracts for difference (CfDs), which provide price stability to power producers while ensuring they are still subject to the necessary discipline of short-term spot markets – vital to ensuring the continuous balancing of electricity supply and demand.

The EU is now explicitly promoting two–way CfDs as the main tool to provide price support to renewables. As I wrote with academic colleagues in a paper recently published by Nature Energy, this recognizes the fact that CfDs, if well designed, are not subsidies but rather are risk management tools, allowing generators to swap volatile shorter-term (spot) prices for fixed long-term prices, just like one can enter into a long term fixed–rate mortgage with a lender for house financing.

In the absence of liquid forward markets for electricity beyond a few years, governments can help determine a long-term price for electricity supply by organizing competitive auctions for long term deliveries.

The lack of bids in the recent UK Allocation Round 5 auction reflected the fact that the government had imposed a low maximum price ceiling, which was no longer compatible with the price evolutions on the cost side, and not a failure of CfDs as a tool. The rapid announcement of an increase in the price cap for forthcoming UK offshore wind auctions was a recognition of both the relevance of CfDs and of the changed market circumstances. In itself, it does not mean that the future CfD prices will necessarily reach that cap level – just that bidders will not be artificially constrained to unrealistic prices. 

The regulator can still ensure that the auction will be competitive and that qualifying projects will provide their best prices by explicitly limiting available capacity; this to ensures that not all bidders win, and thus forces them to make their most competitive offers to have a chance to win a CfD.

It should also ensure that developers do not make unrealistic bids that they can abandon at limited cost, as in the case of Vattenfall’s Norfolk Boreas scheme, by setting very high penalties for non-delivery of projects. These two key tender features sift out the best projects for ratepayers while preventing unrealistic “free-option” bids from being submitted.

Simple but effective

CfDs are the simplest and cheapest way to attract low-cost capital to the offshore wind sector, where projects need to sell large volumes of electricity – a project like the recently announced Hornsea 3 generates around 12 TWh of electricity per year, which is more than the consumption of any industrial user in the market.

The absence of medium-term merchant exposure allows the transfer of long-term ownership – after the risky development and construction phases are complete – to risk averse investors such as pension funds, which provide cheap capital. By integrating that low cost of long-term capital in bid assumptions from the start, developers can lower the overall cost of generation and offer more competitive bids.

As we have seen in times of volatile power price this can represent significant gains for consumers – that is, if the difference is allocated to them.

With a stabilised macro–economic context, and a recognition of CfDs as a good instrument to ensure new investment while protecting the regulator’s legitimate requirement to minimize the cost to ratepayers, offshore wind will have a bright future.

But this requires us not to forget that CfDs are a risk management tool rather than a subsidy, and are useful – indeed, necessary – even when the industry is cost–competitive against incumbent generation technologies.

Jérôme Guillet is Managing Director of SNOW, a firm focused on the development and financing of renewable energy projects. Additional editing by Philipp Beiter of NREL.