Could Contracts for Differences Speed Up Norwegian Investments in Renewable Energy?

Ever since the Netherlands pioneered in using Contracts for Differences (CfDs) as a tool for incentivising investment in power production from renewable energy sources in 2011, CfDs have become increasingly significant. CfDs are now the preferred subsidy instrument for promoting the development of renewable power production within the EU. The trend of utilizing CfDs to incentivize investment in renewable power production has reached Norway as it prepares to launch offshore wind tenders in the first quarter of 2023.[1] [2]These developments prompt the question as to why CfDs play such a critical role in the development of renewable power production. The answer to which presupposes an explanation of what CfDs entail in the context of renewable power subsidization.

What are “Contracts for Differences”?

To have a better comprehension of the concept of CfDs, one must first understand why subsidies are needed as well as the different categories of support instruments that exists.

Many renewable generation projects fall victim of so-called market failures, where the lack of commercial profitability fails to incentivize private investments in the realization of socio-economically profitable projects. This discrepancy in profitability, or market failure, can be overcome by state intervention in the form of, inter alia, subsidies to ensure commercially profitable investments in renewable power generation projects.

There are two main categories of subsidies available to renewable power generation projects: (i) investment support and (ii) operational support. Investment support is granted prior to the project’s operational lifetime. Enova’s Offshore Wind 2035 subsidy scheme, where a one-time amount is paid out to developers of floating offshore wind components before the project is operational. Operational support, on the other hand, is granted during the projects’ operational lifetime. CfDs are an example of operational support.

During a predetermined period of the operational time of the renewable power generation project, the project developer will under a CfD receive the positive difference between an agreed upon “strike price” and the market price obtained from the sale of the generated electricity in the market. Whether the project developer will also receive the negative difference between the strike price and the electricity’s market price depends on the CfD agreed to is a one-way or two-way CfD.

Under two-way CfDs, the project developer is obligated to remunerate the state for the negative difference between the strike price and the produced electricity’s market price. Consequently, the project developer will always achieve the agreed strike price regardless of the market price as the state assumes the risk of the market price falling below the strike price (downside risk) and the developer assumes the risk of the market price exceeding the strike price (upside risk). The two-way CfD, therefore, secures the developer against the market’ s price volatility in exchange of a potential upside.

One-way CfDs, on the contrary, bestow the project developer with a right to keep the negative difference between the strike price and the market price. Consequently, as the developer keeps the upside risk, the strike price exclusively functions as the minimum price the power producer can achieve from its power production. Thus, the developer is shielded from any downside risk without renouncing a potential upside.

Why are Contracts for Differences the preferred instrument for imposing subsidies for renewable power production?

Contracts for Differences expose developers to the electricity market as they sell generated electricity to the market, and their profits are influenced by market prices. To maximise profits, the power producer will thus produce electricity in accordance with the market’s power demand and thereby operate efficiently.

However, market exposure is higher under the one-way CfD as the developer takes on the upside risk and is only shielded from the downside risk. Unlike two-way CfDs, the one-way CfD thus provides the developer with an incentive to produce electricity when high demand and low supply push the electricity’s market price over the strike price. To ensure efficient electricity production under two-way CfDs, there should be an anti-curtailment clause in the contract. Similarly, both the two-way CfD and the one-sided CfD should include a clause that exempts the state from paying support during times of negative electricity prices. The absence of such a clause would incentivize high electricity generation during periods of low demand and cause a risk of over-compensation.

Nevertheless, investment support provides even greater market exposure to developers compared to CfDs since the developer is exposed to both downside and upside risk because the support is granted before the project is operational. The key differences, and the explanation behind CfDs popularity, can be sought by assessing developer predictability and required support levels under the different schemes.

CfDs provide renewable power generation developers with greater economic predictability than investment support would as developers are protected against market volatility once the project is operational. This predictability manifests itself in two ways.

Firstly, control with the rate of return on the investment during the operational phase of the project will reduce investment risk and lower the cost of capital to finance the project. The required support level to incentivize investment will consequently also be reduced. This effect may be even greater under one-way CfDs where the developer retains the upside risk of electricity sales assuming an outlook of high electricity prices. However, uncertainty regarding the upside risk may also result in over-compensation of the developers and reduce their incentive to innovate and reduce costs.

Secondly, and closely related to the first, the control with the rate of return during the renewable generation project’s operational phase, give developers a better overview of the support levels required to realize the project. This reduces the incentive for developers to place high bids for support to mitigate the downside risk during the project’s operational phase which they are exposed to under investment support schemes. Therefore, the risk of over-compensation and too high support levels is reduced for CfDs.

CfDs’ popularity is caused by their ability to strike an efficient balance between market exposure and developers’ need for predictability. In turn this causes efficient support levels to incentivize investment in renewable power generation projects. Nevertheless, the maximation of these effects, are conditional on the use of competitive allocation procedures, such as negative auctions, where developers bid for the lowest strike price to obtain the CfD. Consequently, both the EU Commission’s 2022 Guidelines on State Aid for Climate, Environmental protection and Energy and the corresponding ESA 2022 guidelines stress that subsidies, like CfDs, shall mainly be allocated on the basis of competitive procedures. Moreover, CfDs may favor more mature and low-cost renewable generation technologies and the application procedure can be complex and induce high costs on developers. Therefore, competitive allocation procedures may mitigate these entry-barriers for smaller players in the renewable generation sector by for example subsidising the application procedure as France does and establish separate budget pots for different generation technologies as the UK has done.