This article was originally published as an editorial by Julian Hentschel and therefore reflects his personal experience and opinions.
In December, the Norwegian Government set out its plan for a new support mechanism for offshore wind. Contracts for difference (CfDs), which pay generators a sum based on the difference between market power prices and a pre-agreed price level, are at the heart of its proposals.
I was lucky enough to be a part of the team that helped develop this approach in the British energy department almost ten years ago. To be clear, there’s a lot that the Norwegian proposals get right. However, I cannot help but be somewhat disappointed by the missed opportunities—presumably the result of a rushed process and limited expert input. Here, I want to set out a few of the areas for improvement as I see them.
Breaking the link between payments and production decisions
CfDs traditionally link payments to production. Unfortunately, this can create perverse incentives. Experience has shown that, even for renewable generators like offshore wind, these perverse incentives result in inefficient outcomes. Depending on how the system is designed, generators may continue to generate when it is downright unhelpful, they may cut production when it is still useful and they may fail to provide other services necessary for the management of the power system.
The fundamental problem is that generators stop making decisions based on market prices alone and start factoring in the impacts of their decisions on the support regime. The Norwegian proposals make some attempts to address these problems, introducing a cut-out mechanism that stops payments during problem hours to prevent the most egregious issues. However, these workarounds have potential side effects. Most notably, they leave would-be developers in a position where they need to guess how frequent and severe such cut-outs are likely to be.
This can undermine the auction process used to allocate CfDs. Fundamentally, developers' bids in these auctions need to reflect not just their costs, but also their future expectations about the cut-outs. This can colour the auction results, which partly reflect how optimistic a bidder’s expectations are, and encourages developers to ask for more to protect themselves against the greater uncertainty involved.
The latest thinking in this area suggests that payments ought to be decoupled from production decisions precisely to avoid the perverse incentives discussed above. Offshore wind is now a sufficiently mature technology that robust estimates of potential generation can be developed using actual data on generation conditions at a wind farm.
If payments were linked to potential generation instead of actual generation, developers would no longer need to worry about factoring in the effects of their production decisions on support payments and the support system would cease to motivate potentially perverse production decisions.
Managing tax risk
Part of the rationale for providing CfDs is for the government to remove those risks that are beyond the reasonable control of developers and to thereby clear the way for low-cost investment.
Unfortunately, the Norwegian Government has created considerable uncertainty as to the future tax treatment of offshore wind, having just introduced proposals to tax existing onshore wind while stating, rather vaguely, that taxing offshore wind is not relevant now. This has left the Government in the slightly absurd position where, with one hand, it is trying to provide developers with certainty, while the other hand ostentatiously draws up potential surprises.
The consultation documents place significant emphasis on the need to ensure that the auction design avoids a situation in which developers' bids are largely a reflection of developers’ guesses about an uncertain future. This concern rings a bit hollow, however, given the apparent lack of thought that has gone into managing the tax risk facing developers.
If the Government is serious about giving developers certainty about those factors beyond their control, it ought to more actively address this risk, potentially by offering to adjust support payments to compensate for increased generation taxes that are not detailed ahead of the auction.
Doing better than average
Under the proposals, payments will be calculated with reference to average annual market prices. This has some advantages but, if done badly, can again introduce risks for developers that they cannot control.
Of particular concern is the fact that offshore wind generators’ market incomes will not reflect a uniform average of prices across all hours of the year. Their incomes will be skewed to reflect wind conditions, with most production occurring during those hours when wind conditions are favourable. The price level in these windy hours will, in large part, reflect political decisions on the future development of offshore wind in Norway. With rapid offshore wind development, prices in windy hours might be much lower than otherwise.
To avoid a situation in which the support system fails to protect developers against these political uncertainties, and thereby results in them demanding higher support prices, the average price used in the support system needs to accurately reflect developers' potential market incomes. Ideally, it should therefore be weighted to reflect potential generation at the actual park and be set to reflect current, rather than historic price levels.
One man’s risk is another man’s hedging
CfDs work by transferring power price risk from developers to, in this case, the government. This implies that when prices are low, the government might need to pay out large sums. However, in high-price periods, the government receives payments from generators. This volatility is something of a nuisance when it comes to setting the government’s budget. However, for new power-intensive industries, like hydrogen production and battery factories, this sort of volatility might actually be helpful as a means to hedge against variable power prices. Such industrial users might be willing to pay something to take this risk.
One concept that has been discussed recently is the use of back-to-back CfDs, in which the government effectively sells on a CfD to industrial off-takers. It has the advantage not just of helping the government manage its budget but can also be used to create supportive conditions for industrial development.
The current consultation is too rushed to realistically accommodate the development of a back-to-back CfD component. However, the government should ideally make sure that the CfD mechanism it creates now keeps open the possibility of selling forward the payment streams to industrial actors in the future. At the very least, it should ensure that offshore wind developers can voluntarily exit the CfD arrangements if they find better commercial terms with industrial users in the future.