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Negative wind subsidies help cash-strapped UK energy suppliers
The Contract for Difference mechanism is easing the big squeeze on retailers
The UK government is facing a political crisis over soaring energy bills. The next increase in the retail price cap in April promises to be brutal: average household bills will rise by around 50% to £2,000 per year, and could hit £2,300 in October. Ministers are scrambling for ways to square the circle of alleviating suppliers’ ballooning wholesale costs without heaping too much pain on hard-up consumers. Is the answer to their problems blowing in the wind?
Moves are afoot for the Treasury, or more likely lenders, to underwrite UK energy retail sector losses — which are estimated at £20 billion and rising. Even with government intervention, regulator Ofgem will have little choice but to pass some costs through to utility bills come April. Its priority is to stop more suppliers from going bust. This will add fuel to the fire of the cost-of-living crisis that threatens to dominate the UK political agenda in 2022.
In the meantime, some power generators, energy producers and traders are making obscene profits from blistering wholesale prices. If only there was a market mechanism to redistribute those windfall profits… Oh wait, there is – say hello to the humble Contract for Difference!
There’s a silver lining to the doom and gloom of the winter energy crunch: UK wind subsidies are going much, much deeper into negative territory. And the Contracts for Difference (CfD) mechanism that makes this possible might offer a long-term solution to mitigating future bouts of extreme pricing, which promise to become more frequent and spikey as the energy transition progresses.
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Energy Flux first reported on negative UK wind subsidies back in September, when the market reference price (i.e. wholesale power prices) rose above the ‘strike price’ for wind CfDs. When this happened, wind farms started paying money back to suppliers. To recap:
In ‘normal’ times, the UK’s CfD subsidy regime pays a top-up to eligible generators up to a pre-set maximum (the strike price). Since wholesale power prices are almost always below the strike price, the CfD holder receives a premium, which suppliers charge back to electricity consumers.
But with the price of UK day-ahead power soaring to eye-watering levels amidst a Europe-wide energy crunch, CfD strike prices are now below the amount that generators are earning for their power. So, they have to pay back the difference (hence the ‘d’ in CfD).
Since I wrote that, wholesale gas and power prices have gone from merely stratospheric to fully interstellar. This has turned the concept of UK consumers ‘subsidising’ wind farms on its head. Today we are sitting squarely on the other side of the CfD looking-glass: between October and December 2021, wind generators paid more than £108 million back to suppliers:
As winter drags on and plunging temperatures keep wholesale gas and power prices firmly in ‘berserk’ territory, negative subsidies will plumb new depths. Total CfD reconciliation payments to suppliers are expected to total £353 million for Q4’21 and top £774 million by the end of Q1’22. And it won’t stop there.
Looking further ahead, enduring high wholesale prices are expected to keep wind subsidies negative throughout summer 2022 and into the next winter. Wind farms are not forecast to receive any CfD payments until April 2023 at the earliest, meaning inflated wholesale prices — rather than consumers — are keeping investors whole:
Relief for suppliers
Markets are whipsawing and outturn could diverge greatly from these forecasts. But the direction of travel is clear: the CfD is preventing renewable generators from profiting at the expense of consumers, and (unintentionally) alleviating hard-up suppliers that are sorely in need of the cash due to the constraints of the retail price cap on their operating margins.
The Low Carbon Contracts Company, which administers the scheme for the government, funds the CfD through a levy on suppliers. This levy has been set to zero (the statutory minimum) for Q1’22 and Q2’22, since wholesale prices are all but guaranteed to remain well above strike prices. Negative subsidy payments from CfD generators are paid to suppliers via an end-of-quarter reconciliation process. Gordon Edge, head of strategy, stakeholders and business development recently commented:
“The forecast amount we expect to pay to suppliers is very volatile so what is currently up there will likely not be the final outturn, but we are expecting a net payment to suppliers. In the current circumstances this money will probably reduce supplier losses a bit, but in the longer term when paying back is more normal, this should be passed on to consumers through lower prices.”
The CfD was designed to offer stable revenues to renewables projects, not help struggling suppliers. But it is now doing both of those things. If the UK had maintained the previous subsidy regime, the Renewables Obligation, then those millions currently being paid from CfD wind generators to the handful of remaining solvent energy retailers would be siphoned off as windfall profits for (mostly overseas) investors in wind projects.
The Renewables Obligation (RO) was a simple top-up on the wholesale power price, and drove the first major wave of investment into UK wind farms. But it did not respond directly to wholesale price swings, meaning there was no simple way to contain costs and prevent excessive wind profits.
The UK government ‘grandfathered’ the RO for those lucky early recipients, meaning there are many older wind farms still receiving RO payments on top of stratospheric wholesale prices. As the search for quick and impactful ways to reduce consumer bills gains urgency, the “optics” of this “do not look good”, Robert Buckley of Cornwall Insight said in a recent blog post. Ministers must be thankful they can point to the CfD when put on the spot about ‘unaffordable’ green levies on utility bills.
A cure for volatility?
Could the power of the CfD mechanism be leveraged further to protect against future stinging wholesale price surges? If one thing is for certain, the energy transition means more structural volatility in global energy markets. Liberalisation allows extreme price swings to be passed through to consumers more quickly than in regulated markets, meaning there is a big ugly political problem brewing around energy transition affordability and market design.
Reports emerged this week that unnamed UK energy companies are proposing a CfD for wholesale electricity prices. This would require government to agree a wholesale strike price deemed tolerable for consumers. Per the FT:
“If prices rose above that level, suppliers would receive payments from the government. When wholesale prices were below the agreed level, suppliers would return money to the government, meaning the mechanism could potentially be ‘self-funding’, several people with knowledge of the proposals said.”
The trouble with this idea is that imposing a single administratively-set wholesale price effectively brings an end to market competition, and is a step back towards the pre-privatisation era of the clunky state-controlled Central Electricity Generating Board. UK electricity was privatised and the CEGB was eliminated precisely because its tariff-setting arrangement was inefficient and burdened consumers with unnecessary costs. Fast-forward 30 years and liberalised markets are heaping pain onto consumers too. There must be a better way.
Would the CfD work for gas?
There are other ways the CfD could help, for example in the procurement of natural gas. “[I]t is interesting that we are prepared to contract long-term for power at long-term prices (through CfDs) but for 30 years and more we have viewed such mechanisms for gas as a ‘bad thing’,” Buckley of Cornwall Insight observed.
The UK relies heavily on gas-fired power generation, and gas is the marginal power source, which means the ‘marginal molecule’ sets the clearing price for electricity. A CfD for gas might in theory stop spikes in global gas prices from driving wild electricity price swings, although it seems hard to implement.
If a ‘gas CfD’ were applied to gas imports, it would prevent the UK from competing in international markets to lure liquefied natural gas (LNG) spot cargoes away from Asia and into British LNG terminals. And if a CfD were applied to gas-fired generators, these would not dispatch at all when their fuel costs rise above the strike price.
Still, the fact remains that the CfD is benefitting the UK energy market at a crucial moment. It is striking a balance between the needs of consumers, retailers and investors, and could provide the basis for an enduring solution that spreads the costs of global fossil fuel price volatility among market participants. Brighter minds than mine are working on this problem. The CfD might just offer some clues to a system-wide solution.
Seb Kennedy | Energy Flux | 7th January 2022