Offshore wind requires Contracts for Difference – not subsidies

CfDs are not subsidies!

Last month, I got an article (written with several academic colleagues (Philipp Beiter, Malte Jansen, Elizabeth Wilson & Lena Kitzing) into Nature Energy, titled The enduring role of contracts for difference in risk management and market creation for renewables. It is a much improved, and indeed peer-reviewed, version of a first draft note that I wrote two years ago or so, called simply “CfDs are not subsidies”, informed by many discussions with these colleagues, including a seminar at Columbian University that also led to the “Five grand challenges of offshore wind financing in the United States” article which was also published late last year.

I am not sure how accessible the Nature Energy article is without an academic subscription, but I will send it to anyone who requests it in the comments or by email.

Abstract

Governments procure renewables through a variety of mechanisms. Contracts for difference (CfDs) have been used for more than 50% of the global offshore wind supply. The payments awarded through CfDs are sometimes labelled subsidies, suggesting that they support uneconomic activity. Here, we argue that the primary role of CfDs is rather risk management by creating a market for electricity supply at stable long-term prices. Similar to its use in other sectors of the economy, this contract type transforms a variable to a fixed price to reallocate volatility risks. Such long-term contracts are often necessary for renewables financing due to limited hedging options in existing markets. Our perspective could imply a shift in perception towards CfDs as a fundamental and lasting market feature. We hope to stimulate a timely discussion about the impact of greater CfD diffusion on electricity market mechanisms, risk allocation and the potential for combining fragmented streams of energy finance, market and policy research.

Lena Kitzing did a first publication around it, which should be accessible to all, in Aegir: ‘CfDs can make offshore wind a fundamental feature in a future decarbonized electricity market’

Markets are not providing adequate long-term future products and risk hedging options to encourage and manage sufficiently high levels of investments. Declining support payments leave offshore wind projects more and more exposed to volatile market prices.

This is a significant barrier to investment, as I noted in a paper just published in Nature Energy.

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For offshore wind in mature markets, the risk management aspect will be a key feature of coming CfD schemes, not the financial payout. In other words: CfDs are not just support instruments, they are hedging products (more precisely: fixed-for-floating swaps) provided by the government into a market that structurally underprovides these products and government and industry need to acknowledge that projects can be economically feasible without financial support needs – in terms of positive net payout – and still need CfDs to become bankable and thereby enable investment.

Now I have written my own accompanying article, in EnergyVoice, “Offshore wind requires Contracts for Difference – not subsidies.” This is one is unfortunately behind a paywall. I discuss the market evolution of the past year, the evolving strategies of oil majors (increasingly focused on trading, and thus favoring merchant regimes and, implicitly, higher power prices), and the welcome generalization of CfDs as a public policy tool:

the real evolution in the past years has been the increasing embrace by regulators of contracts for difference (CfDs), which provide price stability to power producers while ensuring they are still subject to the necessary discipline of short-term spot markets – vital to ensuring the continuous balancing of electricity supply and demand.

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In the absence of liquid forward markets for electricity beyond a few years, governments can help determine a long-term price for electricity supply by organizing competitive auctions for long term deliveries.

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CfDs are the simplest and cheapest way to attract low-cost capital to the offshore wind sector, where projects need to sell large volumes of electricity

Again, I’ll be happy to send the full version to anyone who requests it in the comments or by email, but I encourage you to visit the EnergyVoice E-Forward website in any case, there’s a lot of interesting articles on the sector.