The European energy sector is facing a triple challenge: ensuring a speedy and cost-efficient rollout of renewables, protecting consumers from price shocks and safeguarding security of supply. As the 2022 energy crisis showed, political acceptance of high electricity prices is limited, and it is prudent to assume that it will remain this way. At the same time, the sheer scope of regulatory challenges associated with getting to net zero is so vast, that whenever possible, we need to find regulatory solutions that support many objectives at the same time.
Well-designed two-sided contracts for difference (CfD) for renewables are a promising tool to deliver on these multiple objectives. A state-backed risk-sharing tool between investors and consumers, they protect consumers from price shocks, and by lowering the cost of capital, they lower the cost of RES (renewable energy sources) deployment.
Wind and solar currently provide around one-fifth of EU electricity generation. The massive expansion plan put forward by the REPowerEU Plan means that the share of these technologies in total EU electricity generation could reach 50% by 2030 (Figure 1). Limiting the cost of this build-out is therefore important to keep total system costs in check and preserve public support for renewables.
Note: This paper is accompanied by the related Blueprint deep dive ‘The search for an efficient two-sided CfD design efficiency – a Shakespearean history,’ which points policymakers towards innovative CfD designs that minimise the market distortions that plague many of the older and less smart CfD designs.
Fit-for55 and REPower EU wind capacity figures for 2030 as revised by WindEurope downwards from initial commission’s estimates owing to turbine improvements. Originally: 427 GW and 510 GW.
Source: RAP figure. Author’s analysis based on Ember , EU Commission .
In this briefing, a deep dive in our Power System Blueprint, we explore the rationale for making wider use of smart-designed two-sided CfDs for non-dispatchable renewables (wind and solar) in European energy markets and propose a framework for assessing optimal CfD design.
We focus specifically on wind and solar, as two-sided CfDs are particularly well suited for low variable cost non-dispatchable energy sources with sufficiently large project pipelines. Further, we keep new nuclear out of scope of this paper, given its particular challenges and different risk profile.
The paper is structured as follows:
This paper is accompanied by the related Blueprint Deep Dive ‘The search for an efficient two-sided CfD design efficiency – a Shakespearean history’ which points policymakers towards innovative CfD designs that minimise the market distortions that plague many of the older and less smart CfD designs.
Two-sided contracts for difference are well placed to be the go-to support mechanism for stimulating cost-efficient deployment of new renewables investment.
They are the only support mechanism that provides both downside protection for investors and upside protection for consumers. They are particularly effective in lowering the cost of capital and with it the cost of the energy transition.
Governments looking to increase participation in CfD auctions could consider:
The absence of a quick fix here points to the importance of addressing the most pressing obstacles to renewables deployment – grid connection difficulties, supply chain challenges, slow permitting – as without solutions here, neither CfD auctions nor the market will deliver desired outcomes.
Both CfDs and long-term power purchase agreements (PPAs) have a role to play in supporting a quick build-out of renewables, and as such the regulatory framework should facilitate both. Removing unnecessary regulatory barriers to PPAs is a prudent strategy. However, intervention in the PPA market should be limited. In particular:
An important part of any CfD design is its financing of cost and disbursement of surplus. An approach that balances both efficiency and equity objectives and accompanying trade-offs may include:
In the accompanying CfD paper 2 we outline how CfDs can be designed in a system-friendly way, so that they minimise wholesale market distortions and ensure efficient dispatch, operation and investment decisions. To support this end, the European Commission may consider issuing a guideline for good CfD design and a simplified state aid approval procedure for compliant CfD designs to drive further harmonisation of RES support schemes in Europe.
There are two powerful reasons to introduce two-sided CfDs as a default support mechanism for deploying wind and solar at scale:
As PPAs have their own merits – offering advantages for off-takers, placing investment risk on investors rather than taxpayers (if they do not receive state guarantees), and being purely market driven are free from administrative CfD auction cycles – this therefore suggests a prudent strategy is to pursue a mix of PPA-driven and CfD-backed renewables deployment.
This section provides background on the thinking underpinning these conclusions. It sheds further light on the case for CfDs, outlines CfD characteristics and recent auction results, explores the influence of two-sided CfDs on the cost of capital for RES investments and considers whether PPAs on their own (without CfDs) would be sufficient.
Over the last 20 plus years European countries have introduced a plethora of different renewables support schemes to help meet their decarbonisation targets. Most popular over the years were feed-in-tariffs, where an appointed buyer would buy the whole output of a given RES generator at an agreed price and free the generator from any balancing responsibility. These were deployed in times when renewables were still a nascent technology and needed full de-risking in order to support speedy deployment. However, as the price levels were set up administratively and most of the time did not keep pace with technological developments (and resulting cost decreases), they proved more costly than necessary in driving the desired speed of deployment.
Another major type were tradable green certificate (TGC) schemes, a market-based instrument allowing RES producers to earn a premium on their generation by selling tradable certificates, which were bought by supply companies obligated by the state to cover a certain share of their sales. These instruments proved effective in some countries. However, Member States gradually moved away from them, linked to challenges in setting optimal targets in relation to the speed of RES deployment, which prompted price volatility and calls from investors for alternative tools to give them greater confidence.
The third instrument that gained popularity in recent years were feed-in premiums, whereby RES assets received a fixed or variable (sliding) premium on top of the captured market price — which worked well to protect the downside risk for the investor but did not protect consumers from high cost in times of elevated market prices.
Noting the cost of schemes with administratively set payments, the EU mandated in 2014 that support should in principle be awarded based on competitive auctions that provided optimal cost discovery. At the same time, Member States started to develop two-sided contracts for difference Member States started to develop two-sided contracts for difference Two-sided CfDs were first introduced by the UK in 2014 which provided a blueprint for further applications (albeit with some significant variations, as discussed later in this paper). that provided consumer protection at high prices and that offered clarity and predictability for investors.
A two-sided CfD is a long-term financial contract between a public entity and an investor with settlement traditionally on energy generated. The settlement is between the agreed price for RES generation (the strike price, determined by auction and limited by an administrative ceiling price) and a reference price dependent on the wholesale electricity market. When the strike price is higher than the reference price, the investor receives a top-up from the central counterparty. When the strike price is lower than the reference price, the investor pays back the difference. The contract does not entail an actual buy-sell electricity relationship; the contract is purely financial. Figure 2 provides a graphical representation of the functioning of a two-sided CfD (far right) in comparison to other support mechanisms mentioned above.
Source: RAP figure based on Joint Research Center .
The two-sided CfD is the only mechanism that provides both downside protection for investors and upside protection for consumers. This feature makes the CfD attractive in the current context of heightened price volatility. A two-sided CfD is a risk-sharing tool between consumers and investors. By providing revenue certainty, it protects investors when prices are low. This lowers the cost of capital and thus deployment costs, which in turn benefits consumers. And it shields consumers from prolonged periods of very high market prices by shifting revenues from generators to consumers, thus supporting affordability.
CfDs are particularly well suited for low variable cost non-dispatchable energy sources, notably solar and wind. It is only at close-to-zero variable cost that an investor is able to commit to a long-term fixed price contract without demanding a significant premium for fuel price risk — because the cost of generating electricity is largely fixed as the plant is constructed.
By end of 2021, nine EU countries plus the UK were using two-sided CfDs . Recently, Belgium has also announced moving in that direction for the upcoming offshore wind auctions after considering the effects direction for the upcoming offshore wind auctions after considering the effects The Belgian government announced moving existing offshore projects from one-sided to two-sided CfD upon advice of the NRA CREG, in order to limit possible windfall profits. of the current one-sided support scheme . Romania has also announced its first CfD tender for the fourth quarter of 2023 .
Figure 3 shows CfD auction results achieved in eight European countries from 2019 to Q1 2023. Even for the same technology and same auction year, there are significant differences between strike prices achieved. This is partly explained by fundamentals — such as differences in resource potential (less or more windy or sunny countries) or in cost of capital between countries stemming from country risk — and partly by differences in CfD design, which can be substantial and sometimes result in inefficiencies (as evidenced in Italy ). Nevertheless, most of the strike prices achieved were within 50-70 EUR/MWh range, and thus quite attractive from a consumer perspective compared to wholesale power prices.