CfDs for renewables deployment: multiple design choices to support them all

Highlights from the FSR Insights “CfDs to support renewables: the devil is in the details”

On 26 June 2024, FSR Part-time Professor Lena Kitzing presented the FSR technical report “Contracts-for-Difference to support renewable energy technologies: Considerations for design and implementation”, during the FSR Insights event on “Developments in the European energy and climate policy”.

Contracts for differences (CfDs) has gained momentum in the public debate by virtue of the prominent role assigned to them in the electricity market design (EMD) reform issued by the European Commission (EC) in March 2023 and now in the final phases of adoption. In particular, the EC proposed CfDs as one of the instruments to support the deployment of renewable power plants.

CfDs, which are already in use in at least ten EU Member States, consist of financial contracts between a power-generating facility operator and a counterpart, usually a public entity, that provides both minimum remuneration protection and, in the case of 2-way CfDs, a limit to any excess remuneration for the operator.

By offering an alternative to liquid long-term markets that Europe currently lacks, CfDs improve the business case of renewable energies, which are often characterized by high upfront investment costs and negligible variable costs.

However, beyond these basic common elements, CfDs can take many forms. In particular, Professor Kitzing pointed out that there is not a single design model for CfDs; on the contrary many different design choices can be made to align a CfD with the specific objectives pursued by the policymaker, e.g., the possibility to have a generation-based or generation-independent contract, the option to pause the pay-out when negative prices occur, or to opt for a specific referencing method (e.g., quarterly rather than hourly to avoid the so called ‘produce and forget incentive’). To properly make these choices, one needs to analyse the features of the context in which CfDs will operate, e.g., the generation technologies available and the market situation.

While the patchwork of design elements can enable a fine-tuning of support mechanisms, it certainly poses a risk of fragmentation. In this context, FSR researcher Sofia Nicolai asked whether clusters characterized by similar design elements could emerge out of this fragmentation. Kitzing highlighted that clusters could emerge based on: a) the production technology choice, because of similar unit sizes; and b) the market size, since CfDs are financial derivatives and mature financial markets could foster similarity in the design choices of CfDs.

During the webinar, prof. Kitzing underlined that CfDs allow to hedge against different types of risks, but a small degree of risk should be maintained, ensuring that market parties have an incentive to maximise the value of renewable production and to allow the market to still do its job in proposing alternative hedging options.

Jörn Richstein asked a question about one of the design choices, i.e., the reference price, wondering about the advantages and disadvantages in moving to a pure intraday reference price. According to Kitzing, there is currently no good reference price for intraday markets: multiple auctions take place and a significant part of the transactions occur on a continuous basis. More in general, a good reference price should reflect well enough the actual source of revenue of RES producers: it is unclear whether such producers currently earn a significant part of their income from the intraday market. Finally, Kitzing suggests being cautious to use intraday prices as the reference for CfDs, as this might induce RES producers to be less active on the day-ahead market, with potentially negative implications for system efficiency.

During the Q&A session with the audience, Kitzing answered a question on the role of National Regulatory Authorities in the implementation and evaluation of CfDs, affirming that such a role is very limited: ministries and energy agencies often take the lead in the design of CfDs. Furthermore, addressing a question on the potential for clawback mechanisms, she stated that much depends on the design choices and on the expectations about the future of electricity markets, e.g., the risk of scarcity or the prospects of prices going up, higher than the strike prices. Considering the long-term horizon of CfDs, typically from five to twenty years, it is important to consider the possibility that other crises will occur; after all, it is normal for industries with a significant amount of fixed assets to face cycles with peaks and shallows. Lastly, Kitzing was able to comment on the possibility of conceiving a CfD design to incentivize the deployment of storage capacity in a RES power plant. She asserted that in this case a specific support might not be needed. It should be the market to provide an incentive, in case such hybrid solution makes sense in economic terms compared to other technologies.

In conclusion, Nicolò Rossetto summarized that there is no perfect CfD design; it is necessary to take into consideration the context of deployment of CfDs as well as the specific policy objectives in order to correctly evaluate the implications of such support schemes and make the most appropriate design choices.

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