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Contracts for Difference


THIS CASE STUDY COVERS THE CONTRACTS FOR DIFFERENCE SCHEME WHICH WAS IMPLEMENTED BY THE UK CONSERVATIVE PARTY



SUMMARY FOR POLICYMAKERS

Contracts for Difference (CfDs) are a mechanism to support renewable energy by guaranteeing generators a price per kilowatt hour of electricity produced for fifteen years. The price is determined by sealed bids at auction so energy producers compete to drive down the price. By separating out potential funding for different types of electricity generation they can also target specific technologies, for instance, providing a separate pot for less established technologies.

The Conservative-led Government in the UK introduced CfDs in 2014 to encourage the uptake of renewable energy. This has led to huge investment in the renewables sector with the UK generation of electricity from low carbon sources overtaking fossil fuels for the first time in 2020. CfDs have also resulted in greater innovation in renewable technologies, which has in turn led to greater capacity and a lower cost of energy production.

CfDs are a success for the UK as the price has fallen at every round of auction, with the cost now below that of electricity produced by new gas plants. This is barely above the wholesale price and for many projects it means that suppliers are paying money back to the Government, which is translating to lower energy bills for consumers.

CfDs have helped the UK energy market increase energy security by providing a diversity of energy sources and increasing the capacity of the grid. They have also proven that the many doubts about renewable capacity were wrong.

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BACKGROUND

In 2008 under the last Labour Government, the share of electricity generated from renewable sources was only 6%, with some four fifths of UK power coming from fossil fuels. The carbon intensity of electricity generation fell as coal’s share of generation nearly halved but almost all of this was replaced by gas which limited the ability for the UK to cut carbon in the longer term.

Barely a decade on and this picture has changed dramatically. The share of renewable and low carbon energy overtook fossil fuels for the first time in 2020, and when the Government announced in 2021 a target to decarbonise the power sector, this was no longer seen as unrealistic but a goal that may be achieved early. This dramatic turnaround is a result of the Government’s promotion of private investment in new clean technologies and its vision of becoming a world leader in renewable energy. One of the most successful aspects of this strategy is the policy of Contracts for Difference.

The UK’s national memory of the three day week, where coal strikes led to a limit on commercial electricity consumption, keeps the importance of energy security in sharp focus for many, even to this day. A common argument in favour of energy from non-renewable sources is that they are necessary in order to combat intermittency and ‘keep the lights on’. In 2008, however, Britain experienced its greatest blackouts for over a decade - due to outages not from solar or wind power, but from nuclear and coal powered stations. Longannet coal station in Scotland and Sizewell B nuclear power station in Suffolk both went out within a few minutes of each other, plunging many homes into darkness for hours.

Following this, there was a resurgence of fears around energy security and the then cabinet minister responsible for energy policy, John Hutton of the Labour Party, called for new coal power stations in order to ‘keep the lights on’. This approach was criticised by David Cameron, then the Conservative Leader of the Opposition, who opposed building new coal-fired power stations, arguing that coal was at risk of higher fluctuations in price, risked being eclipsed by new technology, and that the way to increase energy security was to diversify supply.

David Cameron had been elected three years previously in 2005 as the leader of the Conservative Party and sought to reform the reputation of the party to make it more electable. These reforms included a huge shift on environmental policy, with the phrase ‘Vote Blue, Go Green’ defining the Conservative Party in the years leading up to the 2010 election. This declaration was backed up by the policy positions of the Conservatives while in opposition in the lead up to the election.

The Green Investment Bank, a policy that had been developed by the shadow chancellor George Osborne, was co-opted by Labour and featured in the 2010 budget, and the Climate Change Act of 2008 was endorsed by the Conservatives, with David Cameron becoming the first party leader to back a bill being brought before Parliament. The Conservatives went on to propose more ambitious measures in the bill, such as allowing the Climate Change Committee to set targets and raising the targets to every year rather than every five years. The Act passed with cross-party support; only five Conservative MPs voted against it.

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THE COALITION GOVERNMENT

Cameron’s modernising efforts proved popular with the public and three elections after the Conservatives’ worst ever defeat at the polls in 1997, they were once again the largest party in Westminster. In May 2010 the UK general election unusually resulted in a hung parliament, with no party having overall control. Instead of governing as a minority, the Conservatives created a coalition with the smaller Liberal Democrats party.


The joint document ‘The Coalition: Our Programme For Government’ laid out the priorities of the new government, including a number of policies designed to increase energy security and increase the share of renewable electricity in the UK. In 2010 the share of electricity generated from renewable energy was incredibly low - just 6.9%. The largest single source of energy production was gas at 46% followed by coal at 28.2%. The Coalition document announced that the Government intended to implement a new emissions performance standard for coal-fired power stations which would prevent any new stations from being built unless they had sufficient carbon capture and storage to lower their emissions below the new standard By the end of 2010, the Government had also launched a consultation on energy market reforms. This served to mark a shift towards renewable energy and away from unabated fossil fuels.

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HOW DO CONTRACTS FOR DIFFERENCE WORK?

A CfD is a contract between an electricity generator and a Low Carbon Contracts Company (LCCC), which is a company owned by the Government which distributes the contracts. If a renewable energy company can meet the entry requirements, which are based on feasibility, type of generation and generation targets, it is able to make a sealed bid at an auction. There have been three auction rounds to date, pitting different renewable technologies against each other for competing pots of money according to how established the technology is. The bids then determine the strike price. Successful bidders enter into a contract with an LCCC. The successful bidders are then paid a flat rate for the contracted 15 years. When the reference price - which is the average market price for electricity - is below the strike price, the LCCC pays the difference so generators do not lose money when the electricity price is low. Equally when the reference price is above the strike price, the generator pays the difference to the LCCC, effectively making the electricity generation subsidy free when the price of electricity is higher. This money is then returned to the consumer in the form of reduced energy bills.



The auctions are split into different pots so that less established technologies do not have to compete against more established technologies. What is considered a less established technology has changed from round to round as the technologies have developed and become more competitive. For instance, offshore wind technologies started in the first auction round as emerging technologies and now are so competitive they are separated from other technologies.

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CFD ALLOCATION ROUNDS


The first round of funding for CfDs was announced in April 2014. The funding went to five offshore wind farms and three biomass plants. Because of the way CfDs work, they can still prove appealing to investors even if the reference price is projected to be above the strike price because of the fixed certainty for fifteen years on returns. The strike price for the first round of CfDs was lower than expected, which means that it was more likely for the suppliers to pay the difference to the LCCC.


Bids in the second round of CfDs, announced in September 2017, were even more ambitious. The strike price of £57.50/MwH for offshore wind projects wasn’t much higher than the projected electricity wholesale price. At this price it became cheaper to produce this renewable energy than new gas stations would be. Even though the auction results were only announced three years after the first auction round was announced, the strike price had nearly halved for emerging technologies such as offshore wind.


The third round of CfDs in 2019 continued this trend downwards; the strike price came in at just £39.65/MwH. This round focused particularly on wind power, with successful bids going to offshore wind, remote island wind and advanced conversion technologies (new biogas technologies). Offshore wind proved so competitive that it was moved for the next round to a separate pot so that other technologies could compete.


The fourth round will be announced in summer 2022, the biggest round ever with £285 million available to be distributed to power developers to produce 12GW of electricity. For the first time these auctions have also included a pot for tidal power to promote a wider range of electricity generators. Solar and onshore wind power, which had not competed since the first round, were included as well, following pressure from Conservative MPs in the Conservative Environment Network who urged an overturn of the de facto ban on onshore wind development. It was announced in February 2022 that CfDs would take place annually from 2023 which will encourage greater innovation in the renewables sector..

Many renewable technologies such as offshore wind, require significant upfront capital investment. An offshore wind farm requires cabling and installation - as well as the skills investment in engineers to service the turbines. With CfDs offering a flat rate of return, there is less risk for pioneering projects, as they have guaranteed returns per unit of electricity they produce. Once the technologies are up and running, these technologies can increase efficiencies and bring the costs down in a competitive market.


IMPACT ON THE UK ENERGY SECTOR

The impact on British energy generation has been impressive. Since the first round of CfDs was awarded, the UK’s share of electricity produced by renewables and nuclear power has, for the first time, overtaken the share produced by fossil fuels. Britain’s last coal-fired power plant is due to close in 2024 and the country is on track to achieve its 2035 power sector decarbonisation target. The carbon price floor, also introduced by the Conservative-led coalition, helped to raise the cost of coal and make investing in CfDs and other renewables a more appealing prospect for many investors.


It is important to note that projects which do not receive funding from CfDs directly still benefit from the confidence and growing market that they have stimulated. While in 2018 there were only 3000 large sites which would have been eligible to apply for CfDs, there were over 800,000 smaller sites that would not have been eligible but still benefit from the technology improving and falling in cost. There are currently 26,000 jobs in the offshore wind sector alone and this is projected to rise to 69,000 by 2026. These jobs are largely in less well-off regions of the UK and are an important source of highly skilled, well paid employment and have been important in the Government’s domestic ‘levelling up’ agenda, driving economic prosperity in all parts of the UK, rather than just the traditionally prosperous south east of the country.


The graph below shows how fossil fuels as a share of UK electricity generation have declined steadily since 2010. Low carbon generation exceeded fossil fuel generation for the first time in 2020, and the share of renewable energy has gone from just 6.9% in 2010 to 43.1% in 2020. This would not have happened without CfDs; they have improved confidence and allowed renewable energy (particularly offshore wind) to scale up, making costs fall. During this time, the UK experienced economic growth in no small part thanks to renewable energy: the Confederation of British Industry calculated that renewable energy made up a third of the UK’s economic growth from 2010 - 2011 which helped to pull the UK out of recession.




LESSONS TO BE LEARNT FROM CONTRACTS FOR DIFFERENCE
  • A diversity of energy sources serves to increase energy security - Many expressed doubts about the energy security of relying on renewable energy due to fears around intermittency. The fear of keeping the lights on featured heavily in warnings about wind power, particularly with the question of ‘what happens when the wind doesn’t blow?’. However, a diversity of energy generators means that if one source fails, the systems can still remain online.

  • Worries about intermittency have proven unfounded - The intermittency argument doesn’t hold up to much scrutiny because of the advances in battery technology over the last decade meaning that there is currently the ability to store 1.3 GW of technology with developments that could store up to 16GW currently under development. This means that it will be unlikely that intermittency will pose a problem as the grid shifts ever more towards renewables. Additionally, the use of interconnectors such as BritNed and lower carbon power stations that run on nuclear energy or natural gas (combined with carbon capture and storage) means that there are low carbon alternatives when renewables do not run at capacity. Renewable technologies have proven far more resilient that critics feared; there have been no power blackouts due to generator failure since 2008 (with the exception of a brief shutdown due to lightning strikes in 2021).

  • Decarbonisation moves fast once it has proven economically viable - The example of offshore wind having to compete separately rather than with other emerging technologies shows that CfDs have been effective in making low carbon technologies compete. For example the confidence in investment has driven innovation in the design of offshore wind, leading to higher capacity factors so that they can produce more consistent electricity.

  • Being a pioneer makes business sense - There is a first mover advantage to investing in growing technologies. The UK is now home to a large Siemens Gamesa blade factory, the second biggest offshore wind turbine manufacturer in the world, which increases the UK’s export potential and provides jobs in East Yorkshire. The number of jobs in offshore wind alone in the UK is set to rise to 69,000 by 2025, mostly in traditionally poorer areas of the country which also host the majority of apprenticeships, supporting the next generation’s training in these highly skilled jobs.

  • Providing confidence for the markets is effective - The first round had a separate pot for ‘less established’ technologies - then including offshore wind - which provided a much higher strike price in order to support them. This served to encourage innovation and provide emerging technologies with the confidence to develop. Energy from waste, solar and onshore wind all competed for a pot for established technologies and subsequently had a lower strike price at £82 per kilowatt hour, compared to the £117 for establishing technologies. This approach has been vindicated by the need to allocate separate funding for offshore wind in the fourth allocation round.

  • This approach is not universal but is still adaptable - The UK was primed for the phasing out of coal, as coal mining had all but ended and many coal power stations were due for decommission between 2010 and 2020 anyway. The UK also benefited from geographical conditions (being a windy island) that meant that there was high capacity for wind power. However, many countries could take advantage of a system such as Contracts for Difference and adapt it to the most viable technologies in their country including carbon capture and storage which is not bound by geographical constraints.



The Conservative Environment Network is the independent forum for Conservatives who support decarbonisation and conservation. As part of CEN’s international work, we are compiling case studies of successful centre-right environmental policies from across the world. If you would like to help contribute or have any further questions please email fin@cen.uk.com






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