How to design an offshore wind auction
It's possible to have cheap power and negative bidding
The current discussions on offshore wind tenders focus on so called “negative bidding”, effectively auctions where projects have to be built on merchant pricing (i.e. the wholesale price available to all producers on the spot market) and sponsors additionally have to add an upfront payment to win the concession and the right to build the project. This is where the Netherlands, Denmark and Germany are today. The industry is pushing back against such notion (see WindEurope’s take on this) but is not really coming back with any unified consistent proposal.
CfDs have been rightly pushed forward, but as we see in the UK and US, they do not prevent, on their own, the obligation to make large upfront payments for the concessions, as shown in the recent tenders for Round 4 and NY bight leases.
But this has very little to do with the pricing formula, but rather with the two-step auction process, whereby developers in the UK and the US first have to bid for leases (to gain access to marine zones which they can develop, at their cost and risk) and then, once they have obtained the permits for their projects, they can bid for a CfD. The reason they have agreed to make large lease payments is that leases are the bottleneck, and once they are past that stage, competition is much less strong, and only amongst parties that are paying similar lease amounts, which means that these amounts can then be included in the prices bid in the second auction, for the CfD contract. This simply amounts to a transfer from future ratepayers to current taxpayers (a novel way to finance governments, maybe) but it will make future offshore electricity more expensive (especially if not all leases lead to actual permits).
The Northern European auctions have one thing right: they tender a fully permitted zone, with sufficient data to have a good idea of construction conditions and costs, and the ability to start building very quickly once the tender is won. This reduces development costs and larger eliminates development risk for investors.
But their pricing formula, which forces offshore wind projects to compete on the spor market, is inefficient. Wind is a capital intensive structure, and it is not well adapted to spot markets (and the fact that projects nevertheless get built is a testimony to the sector’s competitiveness). Offering a long term fixed price allows to get cheaper projects built (I’ll come back to that point in a future blog with numbers, but a project with a fixed price tariff delivers power which is 40% cheaper to produce than a project which has to sell o the wholesale market). A straightforward tender for a strict CfD (where projects pay back the difference to the public authority when wholesale prices are higher than the agreed price) would be the simplest solution, and would determine the long term market price of electricity, but it is actually possible to design an auction that provides an outcome that combines cheap power over a long period and an upfront payment.
The trick is to have an auction for a fixed price contract at a level preset by the public authority, and deemed to be reasonably cheap in the long run, say (in a reference to the French ARENH tariff) 42 EUR/MWh, and then ask bidders to offer the largest amount to win the concession - in the context of a Dutch-like auction where the winner gets a long term lease, permit and grid connection.
This would have several advantages:
a straightforward price competition would have a single, uncontested winner, without the risk of lottery or appeals against more or less transparent qualitative decisions
the mechanism would offer the fixed-price equivalent formula that allows developers to attract cheap capital and bring the cost of financing the project down, ensuring lower cost of electricity
the fixed price revenue formula in the context of an immediate construction start would reduce risk for the supply chain, by allowing them to quote firm prices in a context where they are no longer asked to bear, implicitly, some of the merchant risk. It would give an advantage to developers that have the best understanding of construction riss rather than those that are the most bullish on future power prices, or the most adept at squeezing supplies chains to the point of endangering them
the fixed price formula would offer governments the certainty that an increasing proportion of electricity is available at a fixed cost, and it could use such volumes to ensure that retails tariffs are less directly correlated with gas-driven wholesale prices (for instance by imposing that retailers provide a minimum proportion of their sales under fixed long term prices, such proportion being linked to the share in the market of fixed-cost production; increasing that obligation would also be a powerful tool to encourage retailers to gain access to fixed price production volumes)
Such an auction would likely lead, if smartly designed (for instance, by offering a partly indexed tariff, and longer periods, such as 25 or 30 years), to substantial upfront payments (and favorable headlines for politicians) while optimizing the cost of construction of wind farms.