Some positive thoughts about the UK CFD 5 auction

Cost discipline is a good thing

There were no successful bids from offshore wind projects in the latest CfD auction in the UK, and that is already described variously as a setback for net zero plans in the UK, and yet another nail in the coffin of the industry, already struggling from headwinds in the US and UK, where various projects are being cancelled or postponed, and PPAs abandoned or renegotiated.

But I actually take it as a good thing, in that (i) it reflects cost discipline, and (ii) it proves that the tariff design is smart in that it avoids crazy bids like we have seen in other markets.

The short term reason for the failure of the auction is that there was a price cap at 44 GBP/MWh, which reflected the prices in the previous round of auctions (close to 37 GBP/MWh) but did not reflect what had happened in the meantime, including cost increases in the supply chain (which increased the investment amounts required) and interest rate increases (which increase the overall cost of financing the investment and spreading it over the life of the project).

And the reason developers did not bid in the auction, contrary to what they did in Germany (where they faced the same issues of inflation and increased interest rates), is that the CfD mechanism offer a largely fixed revenue level, and you thus cannot “cheat” by betting on high merchant power prices. The CfD imposes cost discipline because revenues are capped and you cannot make a project work if you have any cost uncertainty (let alone overruns).

CfDs are good for the industry because the price certainly allows to attract cheaper capital, which reduces costs relative to merchant options, but obviously the industry is not immune to inflation, and certainly not to interest rate hikes, which increases the cost of capital. So the competitive price is higher than 2 years ago, and most likely above 44 GBP/MWh. But probably not that much higher.

The solution thus is to do another auction with a higher cap, but not to change the price system. Anything that lets the developers move to non-fixed prices and merchant exposure (qualitative criteria, smaller volumes under fixed prices, etc) will allow them to make irrational price bets that they don’t take responsibility for (and try to wiggle out of, like utilities have done in the UK and US recently).

Fixed prices allow for reasonable negotiations with the supply chain, and shared effort (with a lot more transparency on the business model). Merchant prices offer a moving target and put never-ending pressure on suppliers to reduce costs (this is part of what led to the current crisis in the supply chain - they were squeezed beyond reason)

So:

• increase the price cap to allow for honest bids

• keep the volumes available relatively small to keep competitive pressure

• increase the penalties for not entering into the CfD contracts