In response to stomach-churning increases in electricity prices of 2022, prompted by the invasion of Ukraine and issues with the French nuclear power fleet, European institutions have been devising reforms to put consumers on a more solid footing. One of the central ideas was to promote greater use of contracts for differences (or CfDs) for renewables like wind or solar.

Dominic Scott has a chat with his inner teenage sceptic about some new innovative CfD designs:

Look I already read the other CfD blog – only ´cos you made me – so can we not end this chat here?

No! I want to delve into some more details of innovative design that Monika briefly alluded to.

Yep, teenage Monika warned me this might happen. Best get this over with then… so I guess you´re going to start by outlining what ‘CfDs’ are?

Great idea! They happen when a government conducts auctions for a given volume of a new renewables plant, like wind turbines. The government commits consumers to pay top-ups to investors when the market prices they pocket on their energy output falls below a given price. In return investors commit to pay money back to consumers when market prices rise above the same given price. These payments to generators, which can be negative or positive, are called difference payments. Competition in the auction is used to identify the given price — the ‘strike’ price — that will satisfy investors.

CfDs sound like a good idea — I mean in the world of boring that is.

Yep. CfDs aren’t a bad idea at all. They reduce risk for investors. This lowers the cost of getting a loan from the bank, and translates into lower costs, ultimately to the benefit of consumers. And they protect consumers from those stomach-churning high prices, as investors commit to pay money back to consumers at precisely those moments when market prices sky-rocket.

What’s the problem then?

Not all CfDs are the same. Most traditional ones suffer from design issues that lead to inefficiencies in operation, maintenance and investment, thus creating higher costs than necessary. This typically happens because difference payments are linked to actual production of energy by the plant and hourly reference price.

Honestly, do you expect me to care?

Yes! Linking difference payments to actual production stimulates multiple problems. Example? It encourages wind plants to situate in the windiest spots: when you get the same price for each unit of energy, the investor’s best strategy is to maximise annual output.

Yeah, but … this actually sounds like a good outcome…

Well, this may not be optimal for the energy system itself — market prices might indicate that a better fit for the energy system would be a wind plant that maximises energy output during a subset of hours when prices are particularly high, even if meeting those moments entails a trade-off in annual energy output. Similarly, poorly designed CfDs can stimulate, for example, south-facing solar when there is already an abundance of production at midday, but a shortage in early evening hours that could instead be met by west-facing solar.

Well done — you’ve spotted a problem. Are we done?

Fortunately, wonks working in the energy sphere have been labouring day and night to come up with design improvements.

Oh, now you’re going to talk to me about the solution… these ´innovative new designs´… so we’re only half-way through now?!

Their eureka moment is to delink the difference payments from the observed energy production of these CfD investments. What should these difference payments be linked to? Reference plant possibilities include the theoretical capability of each plant as determined by manufacturers or regional forecasts of locally aggregated wind or solar output capability.

These ensure that the signal for plant investment decisions — for example selecting location and technological capability — are ultimately informed by energy market prices. The CfD no longer gets in the way!

Are we done? 

‘Fraid not. We are still going to have to deal with all the devilish details in developing robust reference plants, sharing good practice and getting investors and consumers on board to deploy smart CfDs. So there’s plenty more to be done.

Yes, but are we done?

Yep, we’re done. Promise! Though actually I might yet chat with you on a different topic — price cannabilisation and renewables investments.

Noooooooooo!

*Cover image created with the help of Midjourney AI.