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UK Contracts for Difference:
Risks and opportunities
UK Contracts for Difference:
Risks and opportunities
The UK Government is set to introduce a Contracts for Difference (CfD)
support mechanism for new low carbon electricity generation.
Peter Sherry of Baringa Partners explores some of the key risks and
opportunities for investors.
In November 2012, the UK Department
of Energy and Climate Change (DECC)
presented its long awaited Energy
Bill to Parliament. This marks the
beginning of the final phase of DECC’s
‘Electricity Market Reform’ (EMR)
project, which has the explicit aim of
attracting the estimated £110bn of
investment required to decarbonise
the electricity sector and maintain
security of supply. The centrepiece
of the reforms is the proposed
introduction of CfDs, essentially
long-term contracts which will be
available to all low carbon generation
from 2014. The current Renewable
Obligation, or RO (a tradeable
certificates mechanism), will be closed
to all new generation from 2017, and
developers will be offered a one-off
choice between the CfD and the RO
mechanisms between 2014 and 2017.
In this paper, we explore some of
the key risks and opportunities, and
explain how they may differ between
the mechanisms.
3
Policy
risk
One of the key objectives of the CfD
mechanism is to provide greater
long-term certainty to low carbon
investors. The CfD will be a long-term
contract where key terms cannot be
altered, even in the event that a future
government seeks to change policy
objectives. At the time of contract
award, investors will be able to lock
in a CfD strike price for 15 years,
set at a level sufficient to cover the
long-run costs of their low carbon
technology. Strike prices will likely be
at least partially indexed to inflation,
and for some technologies indexation
to fuel prices may apply (e.g. coal/
gas with carbon capture and storage).
There will otherwise be very limited
circumstances in which the strike price
can be altered. Therefore provided the
developer can continue to sell power
into the market and achieve close to
the relevant reference price, locking
the CfD strike price into a long-term
contract should significantly reduce
price risk for investors.
Viewpoint – UK Contracts for Difference: Risks and opportunities
Previous industry concerns around
counterparty risk under the CfD
mechanism now appear to have
eased with the proposal for a
single counterparty body owned
by Government. Under the current
proposal, all difference payments
would flow through the newly formed
counterparty body, with liabilities
passed through to suppliers (as
illustrated in Figure 1, overleaf).
The RO allows for the support levels
for each technology band to be
locked in for a period of 20 years, and
the value of Renewable Obligation
Certificates (ROCs) in the market is
held up by creating an artificial excess
demand of 10% (‘headroom’). To
ensure certainty for investors as the
mechanism winds down, the headroom
will be maintained until 2027, at
which point ROC prices will be fixed
until the mechanism finally closes
in 2037. However, investors under
the RO remain fully exposed to the
long-term wholesale price, which can
be fundamentally affected by policy
decisions of Government.
Figure 1: CfD payment flows
CfD
Legal obligation
to pay CfD costs
Government
owned
counterparty
Suppliers
The variability in CfD support payments
may introduce a risk for new investors
looking to secure support. As the
Treasury has placed a cap on total
support payments (the ‘Levy Control
Framework’, or LCF), the volume of
investment that can be supported
by the CfD mechanism will fluctuate
over time, in particular with wholesale
prices. Although the LCF also applies
to support payments under the RO,
the variability in payments is less of
an issue. Investors looking to establish
long-term supply chains in the UK may
be concerned at the potential for the
‘pipeline’ of support payments to dry
up as wholesale prices reduce, or if the
volume of large low carbon investment
under CfDs (e.g. nuclear) is greater
than anticipated.
Long-term
price risk
The difference in long-term price risk
is arguably the most fundamental
difference between the RO and CfD
mechanisms. The RO leaves developers
exposed to long-term movements
in wholesale prices, as it pays a
4
CfD paybacks
CfD
Figure 2: CfD mechanism operation
Generator pays difference between
reference price and CfD strike price
Price
Consumers’ Bill
Payments
CfD
-
+
CfD strike price
+
+
Reference price
Generator receives difference between
reference price and CfD strike price
Time
premium on top of a variable market
price. This creates both upside and
downside risks for developers, as
outturn total revenues could be higher
or lower than expected at the time
of investment. The CfD removes the
exposure to long-term wholesale price
movements, as support payments
are variable based on the difference
between the market reference price
and the fixed strike price. This has the
effect of stabilising revenues at the
Viewpoint – UK Contracts for Difference: Risks and opportunities
strike price, removing both upside and
downside long-term price risk. Figure
2 illustrates schematically how the CfD
mechanism operates.
Given this difference in risk profile,
investors are likely to seek higher
returns under the RO mechanism
relative to a CfD mechanism (all
else being equal). The need for
higher returns under the RO may be
exacerbated by the long-term ‘price-
Offtake
cannibalisation’ effect, in which RO
plant are exposed to diminishing
returns as the volume of subsidised
renewables on the system increases.
The CfD mechanism is intended to
largely shield investors from this effect.
The potential for the CfD mechanism
to lower the required rate of return for
investors and thus costs to consumers,
while maintaining market-based
incentives, were the primary reasons
offered by DECC for preferring it over
alternative options under EMR.
Short-term
price risk
The degree to which investors are
exposed to within-year market price
volatility is another potential area of
difference.
Under the RO, independent developers
typically sell their power to suppliers
under long-term Power Purchase
Agreements (PPAs), alongside ROCs and
Levy Exemption Certifications (LECs).
The power element of the PPA is
typically indexed to day-ahead or
month-ahead prices, and there may
be a floor price which sets a minimum
level of revenues. The market index
stipulated in the PPA affects the degree
to which short-term price risk is shared
between developer and offtaker. For
example, a day-ahead index will expose
the developer to increased risk (as total
revenues will fluctuate with day-ahead
prices), whereas a month-ahead index
will deliver more stable total revenues.
This risk allocation, as well as any floor
price, will affect the level of discount
applied by the supplier as a fee for
managing physical offtake and balancing
risk (and potentially LEC price risk).
5
The CfD will pay the difference
between the strike price and the
chosen reference price index. DECC’s
current proposal is for intermittent
generation technologies (e.g. wind,
wave, solar) to be paid on the basis
of an hourly day-ahead index. This
reduces price risk for developers, given
that the difference payments adjust
dynamically with the reference price
to ensure recovery of the strike price.
Provided that the developer/offtaker
can sell the intermittent power at the
day-ahead price, the only ‘basis risk’
that remains will be the difference
between the day-ahead and the
intra-day or balancing price. Much of
the short-term price risk is effectively
transferred to UK consumers via the
CfD levy. The CfD reference price for
baseload generation technologies (e.g.
nuclear, coal/gas CCS, biomass) is yet
to be confirmed, but DECC is mindedto adopt a basket of forward indices.
This would leave an element of shortterm price risk with the developer/
offtaker, which DECC considers
appropriate given that generation from
these technologies is dispatchable.
Viewpoint – UK Contracts for Difference: Risks and opportunities
risk
Independent developers have raised
concerns that it is increasingly
difficult to secure long-term PPAs on
favourable terms with large energy
suppliers, making financing of projects
challenging. Further, industry has
suggested that the big suppliers may
become even less willing to enter
into long-term PPAs under the CfD
mechanism, since they will no longer
be looking to purchase ROCs to
manage exposures imposed by the RO.
The reasons for the decline in PPA
availability may include a preference
for the large players to focus on
their own projects, credit concerns
surrounding smaller players, and nonfavourable treatment of PPA liabilities
on constrained balance sheets
(especially those with price floors).
General policy uncertainty around
EMR may also be an important factor
in terms of current PPA availability.
However, it is not clear that these
issues in the PPA market will be made
worse under the CfD mechanism, given
that physical generation priced at or
close to the reference price offers
suppliers a hedge against exposure to
the CfD levy. As DECC suggests, there
may actually be a case for lower PPA
discounts under the CfD mechanism,
since the need for a floor price is
removed. This may in turn lower CfD
strike prices.
The
2014-17 period
The 2014-17 period offers some
interesting tradeoffs for renewables
investors considering whether to
seek support under the RO or CfD
mechanisms. The CfD mechanism
offers lower long-term price risk, and
significantly lower short-term price risk
for intermittent generation. The key
decision points for project developers
will be the level of the CfD strike
price versus the RO band for their
particularly low carbon technology, as
well as their expectation of wholesale
prices. Once clarity emerges on these
parameters, developers will be looking
to secure support as soon as possible
to avoid the possibility of missing
out under the LCF. In the operational
phase, independent developers are
likely to remain reliant on PPAs
for a route to market under either
mechanism, therefore Government and
Ofgem initiatives to improve market
liquidity will be important.
The different long-term price risk
profiles offered by the RO and CfD
mechanisms may appeal to different
investment classes. While some
investors may prefer stable but
lower returns (e.g. pension funds),
others may prefer to take on the
price exposure in exchange for a
higher return (e.g. private equity).
6
Figure 3: RO-CfD portfolio opportunities
Return
Higher hurdle rate investors
(e.g. Private Equity)
RO projects
RO-CfD portfolio
opportunities
Lower hurdle rate investors
(e.g. Pensions Funds)
CfD projects
0
The introduction of CfDs offers the
opportunity to tap into large pools of
available capital from non-traditional
sources, however it should be recognised
that the lower risk profile may not suit
all investors in the long-term. It may
take some time for the new lower risk
financing model to be established.
The 2014-17 period may offer some
interesting portfolio opportunities for
all investors, as illustrated in Figure 3.
Risk
Some portfolio players may opt for
the RO mechanism so as to maximise
exposure to wholesale prices, in the
knowledge that lower risk CfDs will be
available to rebalance their portfolio
in the medium to longer term. Others
may seek to rebalance their existing
RO portfolio with lower wholesale
price exposure under CfDs at the
earliest opportunity.
Baringa Partners’ Wholesale Energy practice has a strong track record
working with numerous companies in the international commodities
trading markets. Our capabilities and experiences extend across gas, oil,
power, coal, carbon, metals, and soft commodities markets. Our clients
in the trading space comprise energy majors, oil majors, investment
banks, regional utilities and funds.
Viewpoint – UK Contracts for Difference: Risks and opportunities
For more information please contact:
[email protected] or
Phil Grant, Partner +44 7867 794 204
Duncan Sinclair, Partner +44 7887 500 856
About Baringa Partners
Baringa Partners LLP is a management consultancy that specialises in the energy,
financial services and utilities markets in the UK and continental Europe. It partners
with blue chip companies when they are developing and delivering key elements of
their business strategy. Baringa works with organisations either to implement new or
optimise existing business capabilities relating to their people, processes and technology.
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won the Commodity Business Award for Market Policy and Advisory.
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