What are Contracts for Difference?
A Contract for Difference (CfD) ensures that a power producer receives a fixed price for electricity generated by a power plant. These contracts help mitigate the investor’s exposure to future market price fluctuations and can also provide a subsidy.
By reducing market risk, CfDs lower capital costs for investors. Since all power production is capital-intensive, capital costs are critical for profitability. CfDs transfer market risk to the counterparty, typically the state.
When are Contracts for Difference relevant?
CfDs can be useful when energy policy targets require increased power production, but existing market conditions are too uncertain to trigger new investments in generation capacity. This uncertainty can be the result of market risks linked to energy and climate policy developments, as well as uncertainty regarding the investment case for different technologies. Developers may also be unable to manage their risks using the financial market.
In Sweden, CfDs are particularly relevant as a means to support the expansion of nuclear power and offshore wind but may also be appropriate to support investments in onshore wind and solar power. This study analyses how CfDs can be best designed to support different power generation technologies and explores the potential for common contracts awarded through technology-neutral competitive processes.
How best to design CfDs
CfDs should trigger the desired investments while avoiding overcompensation. Traditional CfDs provide support linked to actual production, whereas financial CfDs guarantee support in a way that avoids affecting production incentives. Specifically, a financial CfD provides the developer with fixed payments based on the value of a theoretical potential production volume in exchange for the revenues the developer receives from the market.
Key design choices when creating a financial CfD include the following:
The contract’s reference value is the product of a reference price and volume. The more accurately this parameter matches the market conditions facing the generator, the better the risk mitigation provided by the contract. The reference volume must also be objective and beyond the producer’s control to prevent potential manipulation.
Ideally, the contract duration should match the economic lifespan of the project. However, differences in time preferences and long-term price expectations between investors and the state may justify a shorter contract period.
Allocation must be efficient, meaning that CfDs should be awarded to those projects that provide the highest possible value (i.e., those requiring the lowest possible price). This is typically ensured through competitive bidding. However, if too few projects are available (for example because of a lack of sufficiently mature potential projects), contracts may need to be allocated administratively.
Contracts for Difference in Sweden
The Swedish government has set a target for the power system to generate 300 TWh by 2045 and to ensure security of supply. In practice, that means that the power system must be able to meet demand where it exists, at the right time, and in sufficient quantities. The government has also set an interim goal for nuclear expansion and is evaluating the state’s role in facilitating the required investment.
To determine the best approach, this study considers what an optimal CfD design would be in each of the following four cases:
- Dedicated allocation for nuclear power
- Dedicated allocation for offshore wind
- Joint allocation for nuclear and offshore wind
- Technology-neutral allocation for all zero-emission power generation
Further details on each of these four cases can be found in the full report, linked below.
Funding mechanisms for CfDs
Since CfDs function as a subsidy mechanism, they require funding. The main funding options are either financing through the state budget or consumer charges. Both models have pros and cons. State-budget financing protects consumers (as it does not directly impact electricity bills) but often requires a spending cap, potentially shifting some risk back to investors. Consumer-charge financing may avoid budget caps but exposes end-users to unpredictable price surcharges.
Regulatory framework for CfD design and allocation
CfDs have gained increased attention in recent years—the EU’s revised Electricity Market Regulation mandates that direct price support for new power generation be provided through CfDs. Such CfDs should preferably be awarded through competitive processes to prevent overcompensation.
In Sweden, CfDs constitute state aid and therefore require approval from the European Commission. Approval requires a clear justification, meaning the purpose of the aid and the market failure it addresses must be explicitly defined. The regulatory framework includes specific provisions for different types of aid based on their objectives. Generally, rules are more lenient for projects that reduce greenhouse gas emissions and stricter for others. To ensure compliance, it will be crucial for Sweden to demonstrate how CfDs contribute to achieving the EU’s climate, environmental and energy goals.
The study is commissioned by the Swedish Energy Market Inspectorate (Ei)
The purpose of this study is to enhance Ei’s understanding of how CfDs can be implemented in Sweden. This work is part of a broader investigation into the future structure of the Swedish electricity market, which is expected to be completed by the end of April. Ei is Sweden’s national regulatory authority for the energy market (NRA).
