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For-profit schemes can’t drive the transition to net zero

The failure of the last contracts for difference auction showed that market mechanisms alone won’t decarbonise the energy grid.

By Chris Hayes and Melanie Brusseler

Contracts for difference are the main tool used by the government to support the development of renewable infrastructure. They work by setting the “strike price” of electricity that generators receive across the period of a contract. As the wholesale cost of electricity is prone to wide fluctuations, contracts for difference (CfDs) provide certainty to investors by offering subsidies when prices fall below the strike price, as well as establishing a mechanism for refunds when there’s a surplus above the set price.

Last week the government raised the subsidised administrative strike price that sets the starting point for next year’s CfD allocation round by 66 per cent. This followed the embarrassing failure in September to secure the planned development of a single offshore wind farm in the midst of rising interest rates, construction costs and supply chain disruptions that rendered projects insufficiently profitable at the prices the government was offering – £44 per megawatt-hour. By raising the price to £73 per megawatt-hour, the government has followed the approach urged by advocates of privately owned and operated renewable energy generation – increase the profitability of renewable projects by guaranteeing higher prices on the backs of consumers.

The upwards redistributive logic embedded in this response reflects the structural problem facing power decarbonisation: the UK is relying on the market to try to coordinate a just transition. The alternative is to address the issue at its root, replacing investment based on project-level profit with public investment and planning to deliver the secure, coherent and green energy future that we collectively have already identified as necessary.

The CfD scheme is seen as the jewel in the crown in the UK’s energy policy regime. It is a programme of indirect public procurement contracts for private renewable generation. For-profit renewable generation struggles in wholesale markets like the UK’s because of their variability and high upfront capital costs. But through the CfD scheme, the state offers a fixed power-purchase agreement that guarantees a stable and certain revenue stream backstopped by state support. It’s a way of taking risk out of private investment, operating as a bribe for private capital to continue pouring money into renewable infrastructure.

And yet on its own terms, the CfD programme is insufficient for creating and coordinating investment in clean energy generation. The scheme’s auction process only indirectly sets an overall target for energy generation capacity. This is to be achieved each round, without a mechanism to set a floor for energy generation capacity, nor to coordinate system-wide sequencing of the renewable projects needed.

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[See also: South Africa’s long road to energy independence]

The last round of the CfD auction failed because in the face of rising costs of capital and supply chain uncertainty, private developers deemed the strike price too low to assure them of high enough financial returns compared with other investment opportunities internationally. This failure points to fundamental tensions and flaws, both in the systemic architecture of the CfD scheme and the wider structural reliance on private investment. These can’t be easily solved by higher subsidies for clean energy projects, nor by reforms to the auction process that were announced along with the higher £73 strike price made public last week. Leaving aside the well-known issue of private developers’ higher cost of capital and focusing on the robustness of delivery, there are four big tensions.

First, it’s difficult to respond flexibly to external shocks when relying on private profit-seeking investors whose fixed capital investment decisions are dependent on assurances given long before. An approach which sets electricity prices based on average actual costs would allow for greater resilience of investment, especially during periods of turbulence, which climate destabilisation and geopolitical volatility are likely to bring.

Second, in the middle of a cost-of-living crisis, there’s continuing tension between maintaining profitability of both private generation and private production in the supply chain while pushing for the lowest possible consumer costs of generation through contract auction models, leaving the sector vulnerable to shocks down the chain. The fragmented allocation process has instead foisted risk onto the wind turbine manufacturers who, from a strategic perspective, are most in need of guarantees from the state.

Third, September’s auction failure points to the more fundamental issue with relying on private investment – it is subject to subjective hurdle rates, or expected rates of return, to meet generation capacity targets. The Department for Energy Security and Net Zero assumes an 8.3 per cent return on investment for offshore wind for last week’s announced strike price. We don’t know if September’s failed £44 strike price would have actually been loss-making – only that it wasn’t deemed profitable enough for investors, with profitability defined by internally set hurdle rates and relative to other market and investment activities.

Finally, the limits that private hurdle rates pose for delivering sufficient investment in clean generation capacity speaks to the broader deficiencies of a project-by-project approach to investment as opposed to an approach that considers projects against both system-level costs and the priorities of developing system-level generation capacity. In other words, we need to think about decarbonisation of the system as a whole, not whether individual company projects are profitable. The greater the number of private actors whose individual projects need to be backed up by throwing energy consumers’ money at them, the greater the overall expense.

The common thread running through all these tensions is that the privatised and fragmented nature of the UK electricity system leaves necessary system-wide transformation vulnerable to private and uncoordinated investment decision-making based on individual projects’ profitability. The energy transition remains vulnerable.

Labour will have to grasp this if it is serious about hitting its 2030 clean power target. It will need an investment programme that will not be knocked over by a stiff breeze. Instead of this indirect public procurement mechanism, direct public procurement through public enterprise such as Labour’s proposed Great British Energy would be more effective. Instead of increasing subsidies in the hope that private investment is undertaken, within the first 100 days of a Labour government, Great British Energy could run competitive procurement auctions for bids to build public generation assets as the best route to clean energy security. This alternative approach would immediately deploy private building capacity backed by the certainty of socialised investment decision-making.

[See also: Do pensions hold the key to the UK’s net zero transition?]

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