Comparison of the UKs Contracts for Difference Scheme

and the Renewables Obligation

EG551L
Legislation, Planning
and Economics

Dr. Olivia Wood

Pamela Chantiri Dorantes

Student ID 51660970

20/03/2017
 EG551L Legislation, Planning and Economics Comparison of the UKs CfD Schemes and RO

Comparison of the UKs Contracts for Difference Scheme and the Renewables
Obligation
Renewable Energy has been a topic of recent interest in most European Countries, including
the United Kingdom, due to the increasing concern in the past year to reduce greenhouse
gases emissions and assure energy security. For this reason, different policies have been
developed. One of the most important is the EUs 20/20/20 policy for a low carbon transition,
which set an overall binding target of 20% renewable energy consumption within total energy
consumption of the EU by 2020 (Macrory 2014). Also, the Climate Change Act 2008 set legally
binding targets to achieve an 80% cut in CO2 emissions from 1990 levels by 2050 (Macrory
2014). These and other compromises have put the UK under an obligation to expand the use
of renewable sources for energy generation and ensure that it has effective policy mechanisms
for their introduction.
As many other countries, the UK has faced difficulties with promoting renewable energy, due
to the barriers these technologies face in comparison to conventional energy sources,
including subsidies for production of fossil fuel, lack of cost-competitiveness, legal and
regulatory barriers and high market risks. (Ottinger, Matthews et al. 2008)
As a response, support schemes to promote the use of energy from renewable sources were
implemented under the Renewable Energy Directive 2009/28/EC. Different types of support
schemes have been proposed for this purpose, including feed-in-tariffs, obligation schemes
and premium schemes (Woolley 2015). The main difference between these scheme is that
feed-in-tariffs provide the generator a guaranteed income but lacks market exposure;
obligation schemes open the way to market exposure, but the revenues obtained from it are
uncertain; and premium schemes are aimed to meet both market exposure and reduction of
price volatility.
In the UK, support schemes have been based on obligations for projects with installed capacity
greater than 5 MW, but this is about to change (Ofgem 2017). Starting from March 2017,
obligation schemes will be replaced by premium schemes with the implementation of the
Certificates for Differences mechanism. The question that have raised from this proposal is
whether these schemes will provide a better means of promoting the growth of renewable
energy generation, which is discussed in this essay. To do this, the way these mechanisms
operate, as well as their pros and cons, must be addressed. With this purpose, both schemes
are then presented for comparison.
The Renewables Obligation Order (RO) is one of the main support mechanisms for large-scale
renewable electricity projects in the UK (Ofgem 2017). This scheme came into effect since
2002, but has been modified several times in order to improve its performance for renewable
energy promotion. The most significant changes this scheme has faced were: (a) the
implementation of a guaranteed headroom to address the certificates price crash if the annual
RO target is met; and (b) banding of the RO to give more certificates (and therefore greater
financial support) to less developed technologies, such as offshore wind, wave and tidal energy
generation developments. (Woodman, Mitchell 2011)
This mechanism operates by placing an obligation on electricity suppliers to source a specified
proportion of their electricity supply from renewable sources. In addition, the compliance of this
obligation must be demonstrated by the provision of Renewables Obligation Certificates
(ROCs), which generators are issued for every megawatt hour of electricity they produce and
that can be sold apart. This gives the generators two separate revenue streams to recover
investment, which may result attractive for investors. But at the same time, it gives the projects
supported under this scheme high capital cost because of the risks associated with it, due now

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 EG551L Legislation, Planning and Economics Comparison of the UKs CfD Schemes and RO

to the existence of two different markets. As pointed by Wooly in Renewable Energy

Consumption, the cost of capital tends to be higher for projects funded by obligation schemes
because the risk that uncertain revenue streams from electricity and certificate sales will not
cover the development costs (Woolley 2015). This situation limits renewable energy
development to large-scale incumbents who can afford to finance projects, and leaves low
opportunities for new market entrants.
In addition to this, other risks associated with the Renewables Obligation scheme arise that
increments the lack of confidence among investors to support renewable energy projects. The
first of them is the market risk, derived from the necessity of the generator to find a buyer willing
to purchase the generated energy. The second one is the transaction risk originated by cause
of existing added costs to the development, since two different markets must be addressed.
Finally, and perhaps the most important of them, is the price risk. Price risk is caused by the
fact that the energy market rules the output price for energy, thus, price volatility cannot
guarantee a defined revenue for the generator; a situation that creates big distrust among
investors.
To cope with this price uncertainty, the UK Government has proposed a new mechanism for
renewable energy promotion that is about to replace the Renewables Obligation (which now
will be closed to new generating plants), this is the Contracts for Differences (CfD) scheme.
The Contracts for Differences scheme is a type of premium scheme where electricity is sold
into the markets, but risks associated with exposure to price volatility are tempered by the
payment of a premium. (UK Government 2017)
The Contracts of Difference will pay a premium with the value of the difference between a
market reference wholesale price, reflective of average market price levels in the UK grid
during periods for which payments are claimed under the contract signed, and a price for
electricity intended to reflect the cost of investing in a particular low-carbon technology, called
strike price, set under a contract. Applicants must state a desired strike price in a sealed bid
and after that, contracts are allocated by auction. Successful applicants receive a contract with
a stablished counterparty, that in this case is the Low Carbon Contracts Company (LCCC), a
government-owned company (UK Government 2017). In order to get a contract of this type,
three funding pots will be offered:
1) for established technologies, such as onshore wind and solar;
2) for less established technologies like offshore wind, wave and tidal and;
3) for fossil fuel conversion generating plants to run on biomass.
This feature means good for less established technologies, since they will not have to compete
with established technologies, that tend to be cheaper and more demanded, for a support by
virtue of the different allocation pots. This means an advantage for the development of newer
technologies like offshore wind, tidal and wave energy generation schemes, that were not
totally encouraged under the Renewable Obligation since alternative options were chosen over
new and risky ones.
As mentioned earlier, this scheme is intended to remove long-term price risk for renewable
energy generators faced by the Renewables Obligation and, thereby, stabilize their revenues
and reduce the cost of financing their projects. It also means to promotes market competition.
In this sense, it fulfills its purpose in terms of reducing price volatility by making forecast
revenues more stable, while keeping the market exposure of the Renewables Obligation
scheme, a situation that and will enhance investors confidence in this type of projects. To my
perspective, it is of great importance the fact that market exposure still a key component of the
scheme, since this can allow the project developers to search for better and more efficient

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 EG551L Legislation, Planning and Economics Comparison of the UKs CfD Schemes and RO

ways of generating energy, leading to cleaner and more sustainable ways of securing the
energy demand in the future. Doing this could mean that a greater variety of renewable energy
schemes may be developed, as well as an increase of opportunities for research and
technology development in the field. Also, as all of these technologies develop and grow in
popularity, they will be more demanded and so they will gradually become cheaper and more
feasible.
Nevertheless, the Contracts of Difference scheme exposes the low-carbon energy generators
to various risks due to various reasons. Some of them may have significant impacts in terms
of investment attraction, as pointed out by the Scottish law firm Brodies in its report for
Comparing Contracts for Difference to the Renewables Obligation and by Natalie Kozlov in her
document Contracts for Differences: Risks faced by generators under the new renewable
support schemes in the UK.
To begin with, payments of CfD will be controlled by the Levy Control Framework, whose
budget will be shared with other type of support schemes like Feed-in-Tariffs and ROs. This
means that it is not certain if there will be enough money available and on time for the CfD to
fund the deployment of all the proposed project. (Kozlov 2014, Brodies 2013)
In addition, the auction process to get a contract mentioned above will rise allocation risks. It
will not be certain that a project will get the CfD support, as Kozlov says, only projects which
are sufficiently advanced to have a realistic prospect of progressing through to commissioning
are eligible for a CfD. (Kozlov 2014)
Another point to be taken into account is the route to market risk, since there is still the
necessity for generator to find a buyer, like in the ROs scheme. Therefore, investors confidence
for investing in projects with such uncertainty will not be improved from the previous scheme.
Brodies, in its analysis, suggests that it is necessary to develop a long-term power purchase
agreement (PPA) market or another mechanism that gives generators the certainty that their
electricity will be bought for a determined period in order for this market risk to be tempered.
(Brodies 2013)
Moreover, generators may face price risks if they sell their output below the market reference
price. Particularly, small sellers may result prejudicated if selling their energy to whole sellers,
since prices may not be as high as desired for them. Also, if the selling price of the generators
output overpasses the market reference price, the excess price between market price and
premiums must be paid. This may incur in cash flows risks for small generators, due to the
difficulty of managing fluctuations in cash flow.
What is more, since the contract duration is for 15 years, cost recovery risk may occur if the
project is not ready to operate at the time the contract begins. Under this condition, the
investment could fail to be recovered seeing that any delay will proportionately reduce the term
of the CfD support (Kozlov 2014), which means no good for the generators willing to attract
investors for their projects. Not to mention that they may also incur in additional costs for
getting licenses and planning for their projects, a situation that can lead to the encouragement
for the development of less costly technologies projects and not necessarily better ones, for
they are more expensive.
Last but not least, loss of support will now mean a significant risk, as there are more potential
termination events under the CfD scheme than they were in the ROs. Besides that, some of
these events could impact the financing terms of the projects, as pointed out by Brodies in its
analysis (Brodies 2013), which is, again, not good for investment attraction.

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 EG551L Legislation, Planning and Economics Comparison of the UKs CfD Schemes and RO

As it can be observed, the CfD scheme entails a considerable number of additional risks that
may not be favorable in terms of finding investment opportunities for new renewable energy
generation projects. The fact that these projects will be exposed to allocation risks, route to
market risks, cost recovery risks, additional costs and possible changes in contracts and legal
aspects seems to be discouraging for investors to get involved.
Also, another big disadvantage of changing from ROs to CfD schemes is the fact that an
obligation will no longer exist, so there is no guarantee that renewable energy sources will be
required in the energy market. Notwithstanding, I believe that by this point investors interested
in the energy sector are more conscious and mature about the environmental, social, and
economic advantages of investing in renewable sources for energy generation, rather than
conventional energy production projects. It should be evident that this is the energy of the
future and that many other countries are attempting to go 100% renewable in the coming years,
at least for electric power generation. Some European countries have already achieved
considerably high targets in this matter, like Denmark, who was able to supply the energy
demand with only wind power for a day (Walker 2017). For this reason, imposing obligation
schemes should not be the main driver for clean technology development, even though they
have been of great assistance for this purpose and a necessity in the early stage of their
implementation.
In conclusion, it can be said that the Contracts for Difference scheme does not completely
strike the right balance between creating investor confidence and exposing renewable
electricity to market forces, since, as cited by Brodies, the additional risks created by the
proposed CfD arrangements may delay investor decision-making, affect investor participation
and affect the rates of return required by investors (Brodies 2013). Thus, investor confidence
will not necessarily be targeted by this mean. Nonetheless, adjustments to the scheme
arrangements can be made to deal with this trammels as the scheme is implemented. Several
changes are expected to be made for the CfD to reduce the burden of the already mentioned
disadvantages on renewable energy generators, as it has happened with the previous
schemes. Depending on the investors and energy generators capacity and disposition to adapt
to this new legal scheme, the CfD may evolve as an effective mechanism to promote
renewable energy.
To my concern, even if some disadvantages stand by the Contracts for Difference scheme, it
is not a bad way of promoting renewable energy for the reasons mentioned above. Particularly
because the process of developing these technologies has to evolve in order for them to be
more competitive and have a greater value in the market. The ideal scenario should be that
where there is no need for a support mechanism to use renewable sources for energy
production; unfortunately, we are still far from that goal due to the lack of competitiveness of
this sources over conventional ones. However, staying stagnant with a support mechanism
does not allow developers to get out of their comfort zone and thus, no improvements neither
in technology nor in markets can be achieved.
Whether the Contracts for Difference scheme will the better option for promoting renewables
to target the compromises acquired, both nationally and internationally, to reduce carbon
emissions and assure energy security by increasing the consumption of energy from
renewable sources is about to be seen in the coming years. For now, we can only wait to see
the results of this new support system and put our trust in the authorities responsible for
improving any aspect necessary for them to function as good as possible. As mentioned by
Woodman and Mitchell, new proposals for encouraging clean energy generation suggest
developing alternative support mechanisms, but whether these are more successful than the
existing ones or not of course remains to be seen and the devil will be in the final detail of the
new mechanisms design. (Woodman, Mitchell 2011)
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 EG551L Legislation, Planning and Economics Comparison of the UKs CfD Schemes and RO

References

BRODIES, 2013. Electricity Market Reform: Comparing Contracts for Difference to the Renewables
Obligation. An analysis undertaken for Scottish Renewables Updated to take account of the Draft CfD.
Scotland, UK: Brodies Publications.

KOZLOV, N., 2014. Contracts for difference: risks faced by generators under the new renewables
support scheme in the UK. Journal of World Energy Law and Business, 7(3), pp. 282.

MACRORY, R., 2014. The UK Climate Change Act: Towards a New Brave Legal World? Regulation,
Enformcement and Governance in Environmental Law. Heart Publishing, pp. 261-274.

OFGEM, 2017-last update, About the RO [Homepage of Ofgem Environmetal Programmes], [Online].
Available: https://www.ofgem.gov.uk/environmental-programmes/ro/about-ro [February 27, 2017].

OTTINGER, R., MATTHEWS, L. and CZACHOR, N., 2008. Renewable Energy in National Legislation:
Challenges and Opportunities. In: ZILLMANN D. ET AL, ed, Beyond the Carbon Economy: Energy Law
in Transition. Oxford: Oxford Univeristy Press, pp. 183-206.

UK GOVERNMENT, 8 February 2017, 2017-last update, Policy Paper: Contract for Difference
[Homepage of Department of Bussiness, Energy and Industrial Strategy], [Online]. Available:
https://www.gov.uk/government/publications/contracts-for-difference/contract-for-difference [February
26, 2017].

WALKER, P., Thursday 2 March 2017, 2017-last update, Denmark runs entirely on wind energy for a
day [The Independent], [Online]. Available: http://www.independent.co.uk/news/world/europe/denmark-
ran-entirely-on-wind-energy-for-a-day-a7607991.html [March 10, 2017].

WOODMAN, B. and MITCHELL, C., 2011. Learning from experience? The development of the
Renewables Obligation in England and Wales 20022010. Energy Policy, 39(7), pp. 3914-3921.

WOOLLEY, O., 2015. Renewable Energy Consumption, Chapter 6. In: WOERDMAN, E.,
ROGGENKAMP, M. AND HOLWERDA, M., ed, Essential EU Climate Law. Cheltenham: Edward Elgar,
pp. 142-156.

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