Thought piece by Tom Smout, Senior Research Associate for GB.
On Friday 8th September, at 7am, the UK government unveiled the results of its latest, and certainly not greatest, Contracts for Difference (CfD) auction. As CfDs are the government’s primary mechanism for ensuring the deployment of renewable energy in Great Britain, previous auctions—or “Allocation Rounds”—have been useful indicators of the direction of travel on the path to Net Zero. This morning’s results urgently signalled that we are off course. Allocation Round 5 (AR5) procured no offshore wind at all and the government’s stated target of achieving 50 GW of capacity by 2030, which was ambitious at its inception, has never looked further out of sight.
How bad is it?
Thanks in large part to previous CfD auctions, Britain is currently on track to deploy about 26 GW of offshore wind by 2028. To meet government targets and install 50 GW by 2030 we would need to build 12 GW in 2028 and again in 2029.
That’s not going to happen. China was the world leader last year in deploying offshore wind, commissioning 6.8 GW. The UK would need to deploy as much capacity in 2028 and 2029 as it did in the preceding 15 years. This would require commissioning three offshore wind turbines each day for two years. To give a sense of the scale of that effort, a modern, 12 MW turbine is almost as tall as the Eiffel Tower.
This is just the physical challenge. Financially, the offshore sector is suffering from increasing costs well over inflation, which is already high. Britain’s grid operators are struggling to accommodate all of the renewable power plants seeking to come online and grappling with how to manage high levels of renewable penetration. On top of all of this, it seems government support is falling behind what is needed.
How did we get here?
The UK currently has about 12 GW of operational offshore wind capacity. That’s enough to meet roughly 15% of domestic energy demand and by all accounts this is a major success story. The UK has historically been a world leader in developing offshore wind, recognising the technology’s technical potential early, as well as its ability to avoid planning constraints and local opposition (“not 48km out in the ocean” just doesn’t quite have the same appeal as “not in my back yard”).
Based on its historical success in acquiring offshore wind, the government set a target in 2019 of achieving 30 GW of capacity by 2030 as a part of a now largely forgotten policy, the sector deal with offshore wind. In the following years, facing public and political pressure, ministers have increased that target, first to 40 GW and now to 50 GW.
At the time, this was perceived as a very ambitious policy. 30 GW was already at the high end of what the existing policy instruments were expected to be able to deliver—50 GW would require radical changes. Unfortunately, since the latest target was published in April 2022, the UK has gone through three Ministers for Energy, two Prime Ministers and a reshuffle that split the Department for Business, Energy & Industrial Strategy, all in 17 months.
Against this backdrop it is hardly surprising that the government hasn’t introduced new policy instruments to bring forward offshore wind. Unfortunately, we now seem to be running into the limits of what our existing instruments can do.
CfDs, a success story?
Contracts for Difference have been the UK government’s chosen subsidy regime since 2014. CfDs are procured at auction via a competitive process, called Allocation Rounds (or AR for short). Different projects from different classes of technology compete on a “strike price” metric. Winning projects are guaranteed to receive this price via a “Contract for Difference,” a financial mechanism which settles the difference between the market price and the strike price.
One benefit of this system is that the CfD has a limited budget impact. In periods of high power prices, generators sell into the market as usual, and then after the fact they pay back any money they made above their strike price to the regulator. On the other hand, when the price is low, renewable generators are remunerated up to their strike price.
Essentially, this means that CfDs provides certainty to both the government and electricity generators. Generators don’t have to worry about power price volatility, while the government doesn’t run the risk of paying out subsidies for projects that might not need them to be economical.
In practice, a lot of CfDs will result in higher payments to regulators than to generators, so there is some debate as to whether they can be described as “subsidies” in a true sense. However, they have been the main route to market for offshore wind farms, with 15 GW of the 26 currently contracted being secured via this route.
Generally the CfDs have been a feather in the cap of British energy policy for some time. A large amount of capacity has been brought to market, without damaging consumer bills or massively increasing government debt. The EU is moving towards 2-sided CfDs for future renewable auctions, following the success of the scheme. So what went wrong?
Turning sour
One of the key parameters of the CfD auction is the “Administrative Strike Price”. Each technology has its own strike price limit that bids cannot exceed in each auction, putting a practical cap on the prices that projects can achieve.
In 2022, AR4 procured 7 GW of offshore wind (or so it seemed at the time). A high level of competition in that auction drove offshore strike prices down to £37.35/MWh. At the time this was considered great news, prices were falling, capacity was high, and investors were keen.
Unfortunately, prices have not continued to fall. In fact, Norfolk Boreas, which accounted for 20% of the capacity contracted in AR4, has been shelved, with developer Vattenfall citing a cost increase of as much as 40%.
In spite of these pressures, AR5 featured an administrative strike price of £44/MWh for offshore wind, a decrease of 4% from AR4. If there was any ambiguity about the outcomes of this decision, it is now gone. As my colleague Ashutosh explained in his excellent post on the auction results, “In August, the government increased the budget for Pot 1 by £20m but chose not to change the ASP for offshore wind – it just offered more contracted budget at a price no one wanted!”
Where do we go from here?
Barring a miracle, Britain is not going to deploy 50 GW of offshore wind, at least not by 2030.
The simple reality is that offshore wind development is more expensive than government figures suggested. Future auctions will require more government spending than past ones have. In fact, there’s a real possibility that AR4 cleared at an artificially low price, and that those projects will simply be loss-making, or not delivered at all when they face up to the actual costs.
For CfDs, today’s results also raise one big question: why were the ASPs set so low? Is it simply the case that the government, keen to avoid extra spending commitments, is unwilling to finance the ambitious targets of a previous regime? Come to that, why are administrative strike prices such a critical part of the auction outcomes? If the point of the auction is to procure energy at a low cost to consumers, wouldn’t it be best to let the bidders compete on an even footing?
More generally the question is: can British energy policy adjust to a world where prices aren’t dropping each and every year?
The impacts of this latest auction are still coming to light, but subscribers to our GB Power & Renewables service can look forward to reading more in our forthcoming policy note, and our next Power & Renewables Market Forecast, coming in October.
