This week, we look at how the UK Government structures the electricity supply market to ensure it meets the country’s climate change obligations. A new UK regime is coming into force right about now, which makes use of Contracts for Differences (CFDs)
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In the context of the electricity market, a CFD is a long-term contract between a low carbon electricity generator, and the CFD Counterparty (in the UK’s case, the Low Carbon Contracts Company Ltd or ‘LCCC’, a limited company owned by the government).
It agrees a fixed price for electricity produced, known as the ‘strike price’, and it’s relevant every time a clean energy generator sells its electricity in the wholesale market.
When the market price is below the strike price, the generator receives a top-up payment (from the electricity supplier through which the electricity’s being distributed to consumers), for the additional amount. This top-up payment is reflected in consumers’ electricity bills. Conversely, when the market price at which the electricity’s sold is above the strike price, the generator must pay back the difference to the supplier.
This new mechanism, aimed at encouraging more renewable energy generation through price stability for the producers, replaces an earlier process – the Renewables Obligation (‘RO’).
It’ll be a gradual changeover, and effectively provides financial support for new low carbon electricity generation - including renewable energy producers such as on- and off-shore wind, solar PV and marine / hydro generators. It’ll also extend to nuclear energy generators, and to carbon capture and storage facilities. It’s aimed at large-scale low carbon generation, so it won’t affect those small-scale UK installations supported by feed-in tariffs (FITs).
It’s all part of a wider programme of reforms, known as the Electricity Market Reform or ‘EMR’. EMR is a package of measures which the UK Government has introduced, so as to support the investment needed to replace the UK’s ageing electricity infrastructure with a more diverse and low carbon energy mix. It was originally set out in the EMR White Paper in July 2011, and it’s something that’s taking place in developed countries around the world - and some less developed ones too.
According to the UK, up to £100 billion of capital investment is going to be needed in the UK by 2020, if it’s to make the changes to a cleaner, more efficient energy infrastructure. This new CFD regime, and the Electricity Market Reform package of which it’s a key part, has been designed to ensure long-term revenue certainty to investors in low carbon generating plant.
Of course, big changes such as the EMR take time – but the UK government doesn’t see this as an excuse to delay in meeting its obligations as a good global citizen. So while the CFD regime gets under way, it’ll be incentivising low-carbon generators by way of an interim measure - using ‘investment contracts’.
For these purposes, an investment contract means a payment to a generator that is broadly similar to a CFD, but is being issued by the government before the CFD regime is formally established. The government hopes that this’ll avoid any hiatus in investment in the low carbon electricity generation industry, that might otherwise occur until the CFD regime is implemented.
In most cases, an investment contract works very much like a CFD, with payments being made to generators by reference to a strike price again set by the UK government. The first renewable electricity projects to be awarded investment contracts (worth a total of around £16.6bn) were announced in April 2014 by the Department of Energy and Climate Change.
They included five offshore wind farms, two coal-to-biomass conversions and a dedicated biomass plant with combined heat and power.
There’s been some controversy over the types of projects which have been approved/turned down for support - and also over whether DECC is managing to secure best value for consumers during the transition period, but overall the scheme is enabling valuable new projects to get under way – thereby helping to ensure the UK’s energy supply and price security for the future, whilst also protecting against environmentally and economically damaging climate change. A number of organisations are working together to make this all happen:
l The UK’s National Grid, (snappily known under EMR as the ‘System Operator’ or the ‘Delivery Body’), which will publish allocation guidelines, and design and implement operating processes and systems.
l The Department of Energy and Climate Change (DECC), which sets policy objectives and the budgets, on behalf of the government.
l The Office of Gas and Electricity Markets (Ofgem), which will regulate National Grid and provide some dispute resolution services.
l Low Carbon Contracts Company Ltd (LCCC), which acts as the CFD counterparty and is a limited company wholly owned by the government. LCCC will enter into each CFD with each generator, and will also be responsible for operation of the CFD.
l Elexon, a limited company that will provide payment and settlement services.
Long-term, the UK government intends to set all strike prices competitively, through auctions. However, that’s a way off – until market conditions can support proper competition, prices for some low carbon technologies will be set by the government itself, either administratively or through negotiation. The government envisages that by the 2020s, new CFDs won’t be needed any more, as the low carbon generation market should by then be sufficiently mature to drive competition naturally.
The aim of the CFD allocation process is to allow developers to secure a CFD, while ensuring that the budget available to support decarbonisation is used effectively. The risk of not being allocated a CFD contract is a key issue for developers of renewable projects, in particular, for technologies that are less established, and that have long and expensive developments.
The government’s ambition is to move to competitive auctions for all low carbon technologies as soon as possible, but of course not all technologies are at the same level of development. A technology-neutral auction right now would probably have a bad outcome, making for lots of new projects using cheaper technologies, and limited deployment of technologies that’re currently more expensive, but that have long-term potential, and could support further cost reduction.
To try to make the system workable, government has split its CFD budget into three groups:
l Group 1: ‘established’ technologies. These include onshore wind (over 5 MW), solar PV (over 5 MW), hydro (between 5 MW and 50 MW), energy from waste with combined heat and power, landfill gas and sewage gas.
l Group 2: ‘less established’ technologies. These are offshore wind, wave, tidal stream, advanced conversion technologies, anaerobic digestion, dedicated biomass with Combined heat and power, and geothermal.
l Group 3: biomass conversion plants, which will be considered as an ‘established’ technology but stand alone for budgeting purposes.
Some technologies, like nuclear and carbon capture and storage, don’t yet have a strike price, though in due course they’ll also have competitive CFD allocations. For now, strike prices for them will be set on a case-by-case basis. There are also special rules for ‘private network generators’, where electricity is generated either solely, or mainly, for an ‘onsite’ customer - these will work under most of the same rules as other generators, with some tweaks to do with grid connection criteria to take account of the unique aspects of private network generation.
It’s clear that the UK, like many other countries, has put a lot of time and planning into ensuring that its people’s energy requirements are properly planned for.
The Isle of Man, of course, is vastly smaller and with a very different electricity ‘market’; but the same challenges over climate change, and adaptation to a clean-energy future, still affect us. It’s time we, the public, pressed for real evidence that this planning is happening, and the inclusion of our views in the key decision-making processes.