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UK power market reform: why we shouldn’t put all our eggs in the CFD basket

Contracts for difference (CfDs) are doing much of the heavy lifting in decarbonising the UK’s electricity system. But CfDs are not without their drawbacks. If the government doubles down on CfDs as the primary mechanism for supporting large-scale renewable generation – as indications suggest it might – it could hobble critical parts of the UK’s power market, raising risks and costs for companies and consumers.

If CfDs come to dominate how developers – particularly offshore wind – underpin the revenue of their projects this will fundamentally alter the way wholesale power is bought and sold in the UK. The forward power market – which is already very illiquid – would dry up, making it difficult and costly for companies to hedge their power costs as all the physical power from CFD projects would be sold in the spot market. It would also, as I have blogged about before, transfer large amounts of risk to consumers who are ill-equipped to manage it.

However, a simple fix – exempting companies entering into corporate power purchase agreements (CPPAs) from the CfD levy – could help alleviate some of these risks.

Consulting on decarbonisation

The UK government is currently undertaking a major consultation on the future of the national electricity system, its Review of Electricity Market Arrangements (REMA). The process is intended to identify key policy changes to enable a “decarbonised, cost effective and secure electricity system”.

In this current REMA consultation, the government seems to be moving towards increasing its reliance on CfDs. First introduced in 2014, the CfD scheme involves generators bidding for long-term contracts with a government-owned company that, essentially, ensures they receive a guaranteed price for the power they produce. Potential reforms are being focused on this area, with ever-continuing expansion of the scheme envisaged.

However, there are considerable risks with putting all the UK’s eggs in the CfD basket.

The case for caution on CfDs

CfDs have helped underpin considerable growth in the UK’s renewables capacity, particularly in offshore wind. However, a CfD-dominated electricity system has a number of drawbacks for buyers, generators and the market as a whole.

Firstly, an increasing proportion of UK electrical generation will become effectively detached from the normal market forces of supply and demand. With their revenues already guaranteed by the government, CfD projects will simply sell their power at the prevailing spot market price. This means a decreasing proportion of generators will be willing to sell their power on a forward-hedged basis. This will increase volatility in market pricing, make it difficult and expensive for companies to find counterparties with whom to hedge their power purchases, creating greater uncertainty for buyers on what price they will have to pay for power.

Secondly, the costs of supporting this CfD roll-out will be socialised across all UK electricity market participants, no matter whether they have separately sourced their electricity from other electricity sources. The cost of the CfD scheme has the potential to grow greatly as more generation is subsidised, and as power prices return to historic levels. The cost of this scheme is both unpredictable and unhedgeable for corporate buyers.

Thirdly, for developers, the fixed nature of the CfD scheme means that renewable projects that do not align with its strict auction timetables and contractual constraints will find it hard to get built if they can’t get an alternative like a CPPA. This will have the overall effect of reducing the amount of renewables generation built across the UK.

Supporting the CPPA market

Corporate PPAs offer a complementary method to promote investment in UK renewable generation. For companies, signing a PPA can demonstrate a clear commitment to renewable energy, supporting the development of a specific generation project. They also have the advantage of providing the buyer with a stable source of physical renewable power at a fixed price for a long period of time, acting as a useful hedge against future price rises and enabling the company to secure physical green electrons.

However, as wholesale power prices fall from their peaks in 2022 and 2023, many corporate buyers are proving reluctant to enter into long-term PPA contracts. Citing the high price expectations of developers – who need higher prices because of the higher levelised costs of energy they face  – as a reason for not doing deals. What the market needs is additional incentives for companies to enter into CPPAs, otherwise the government will be forced to use CfDs to hit our green energy targets, resulting in the unintended consequences outlined above.

A potential solution that would help would be to exempt corporate PPA buyers from the costs of supporting the CfD scheme. This is one of the reforms that we proposed as part of REMA process. While most of those proposals seem to have been put on hold for now, this is a key reform we believe is worth exploring further.

Exempting CPPAs from CfD costs – and fixing a market distortion

Currently, electricity suppliers are subject to the CfD Supplier Obligation Levy, which funds any payments to generators under the CfD. Electricity suppliers pass the cost of the levy on to their customers.

The current application of the CfD Levy to all volumes supplied to an end user reduces the relative attractiveness of supporting projects with corporate PPAs. For example, a company that has committed to support a renewable generation project with a PPA will pay a fixed price for the power that it buys from the project. In addition, the company must also pay the CFD Supplier Obligation Levy on that power, to subsidise renewable generation projects from which it does not draw power. With a CfD levy, that could rise to more than £10/MWh, which creates a significant distortion in the all-in cost of power for a company buying directly from a project, as they also have to pay the CfD levy on this volume of power within their supply agreement. At its extreme, if a company bought all its power via a CPPA – as a hydrogen project would need to, for example – then this company is effectively supporting projects both directly via its CPPA and indirectly via the CfD levy.

The implementation of a CfD levy exemption should be relatively straightforward and could be enacted through a variety of mechanisms. One such option could be via the creation of CfD levy exemption in the same way that many industrial and commercial consumers are exempt from some Renewables Obligation and Capacity Market payments, and will soon be exempt from some network charges under the Network Charging Compensation Scheme. The exemption could be based on the proportion of a corporation’s total supply volume contracted under a CPPA.

To focus policy reform on incentivising additional renewables capacity, this CfD levy exemption could apply only to CPPAs linked specifically to new-build generation assets. Assets that are either operational or at a late stage of development can be judged to be already economically viable and thus do not require policy support.

Conclusion

It’s clear that an electricity system dominated by CfD-supported renewables has a number of drawbacks, socialising price and capture risk, shrinking the forward power market and reducing volumes available to corporate buyers. Growing the CPPA market could help fix some of these problems. As a falling market price challenges the economics of these deals, fixing the unfair application of the CfD levy is an achievable reform that can help to improve the relative attractiveness of CPPAs, further driving the sorely-needed development of additional UK renewables capacity.