What are Contracts-for-Difference (CfDs)? How are they designed? And how do they apply to the markets?
This article provides more information about Contracts-for-Difference (CfDs).
What are Contracts-for-Difference (CfDs)?
Contract-for-Difference (CfD) is a mechanism to incentivise investment in energy production assets with a high upfront cost, by providing stable prices over a long period. They can also be used to protect consumers against high electricity prices.
The term Contract for Difference (CfD) stems from finance practice, where CfD is a financial derivative contract. A CfD contract can be concluded on a number of different products. The largest markets for financial CfD products are currency exchange and interest rate swaps. In derivative contracts, not the actual good is traded (in financial terms: the underlying). The transaction is purely financial. In CfD contracts, an agreement is made between two parties to exchange payments depending on the price of an underlying. It is the price movements of the underlying that trigger payments between the contract partners without the actual good ever-changing hands, i.e. without physical delivery of electricity.
Renewable CfDs are fixed-for-floating swaps. These swaps are relevant when one contract party is exposed to variable prices and wishes to stabilise them. They sell their ‘floating rate’ to a buyer who returns a ‘fixed rate’. Renewable producers are exposed to variable power market prices, they become the ‘seller’ of the floating rate. The state authority is the ‘buyer’ who provides the fixed rate. During the CfD duration, the fixed and the floating rates are compared and financially settled against each other to determine the net payment obligation between the parties for each settlement period
How do Contracts-for-Difference apply to the markets?
The typical and largest route to market for merchant electricity production is the day-ahead market. Day-ahead markets have variable prices (typically on hourly basis), that are formed depending on the supply-demand balance and the technology mix available at any given time. Renewable producers operating on these markets are exposed to these variable prices. Therefore, the floating rate of a renewable CfD is typically determined to be either the hourly day-ahead price itself or another measure derived from (an average of) the day-ahead market prices. The variable rate determined for the CfD contract is referred to as the ‘reference price’.
The level of the fixed rate provided by the state is one of the most important decisions to make in CfD contracts. It is typically found through a competitive bidding procedure, a tender or auction, where renewable producers compete against each other on which fixed price is sufficient for them to go forward with their respective project. Therefore, these fixed prices are typically referred to as the ‘strike price’ (the price at which the auction was won).
After the renewable producer and state have entered into a CfD contract, the renewable producer will continue to sell their power on the day-ahead market (and, as a matter of fact, on any market they like). In a separate financial settlement, the CfD payments are determined based on the relative levels of floating (reference) market price and fixed strike price. If the strike price is above the reference market price, the state pays the difference between the strike price and reference price to the renewable producer (we refer to this as ‘payout’). If the strike price is below the reference market price, the renewable producer pays the difference between the two prices to the state (we refer to this as ‘clawback’).
Both transactions together (the power sales on the day-ahead market and the financial settlements from the CfD contract) yield a per-unit revenue for the producer that resembles the fixed strike price. This stabilises revenues, so that CfDs are essentially a financial hedge for producers, which increases bankability of the project and lowers cost of capital.
In principle, the choice of reference price can be agreed upon freely, and is not necessarily the current market price. We see an increasing number of CfD implementations in Europe where not the hourly day-ahead price is used as the reference price, but a longer-term average, e.g. determined as the average of the preceding month of day-ahead prices. The choice of averaging period is indeed one of the major choices, and subject to dynamic development in CfD design in Europe. Also, suggestions have been made to not use a per-MWh-price, but to settle CfDs on a capacity-basis. In principle, this is possible, but has in practice not been tried and tested for renewable electricity generation under current market conditions. The further away from actual achievable market prices (or revenues) the CfD is settled, the more risk the producer is exposed to. Price risk exposure increases e.g. for greater averaging periods.
The CfD contract is concluded and settled for a certain volume, as the determined price differences (e.g. in EUR/MWh) are multiplied with the respective energy production (in MWh) to arrive at the CfD period payment (in EUR). In all CfD implementations seen until now, this is defined as the actual measured output of the full asset for which the contract is concluded. This does not necessarily have to be the case: in principle, a CfD contract could also be concluded for only part of the production, for a predetermined production profile (similar to some types of Power-Purchase Agreements), or even for a fixed baseload (similar to market forwards). The further away from actual output the CfD is settled, the more risk the producer is exposed to.
As CfDs typically are symmetrical, meaning that the same conditions apply for payout and clawback, they do often not allow for any market upside to be collected by the renewable energy producer, meaning that the producer does not benefit from times of high market prices (reference prices above the strike price). In principle, a CfD contract can also be designed so that (some of) the market upside can be kept by the producer, e.g. by differentiating the strike prices that trigger payout and clawback (a higher trigger price for clawback will leave a larger portion of the revenues with the energy generator), or by only applying the clawback trigger at certain times, e.g. dependent on certain price movements.
The clawback is the reason for CfDs being a fixed-for-floating swap, and this differentiates the mechanism from sliding premium schemes, in which payments are determined only ‘one way’, i.e. they only trigger payouts, no clawbacks. From the perspective of a financial product, sliding premiums have more characteristics of a floor-price contract than of a swap-contract. Sometimes, sliding premium schemes are referred to as ‘one-sided CfDs’, as only one-side of the mechanism is applied (the payout). If the reference price never exceeds the strike price, e.g. at very high strike prices and low reference prices, CfDs and sliding premium schemes behave the same. This is more likely when the reference price is averaged over a period, i.e. a month or a year, because it then becomes less likely that the reference price exceeds the strike price. As strike prices were typically much higher than reference prices in the past decades, policy makers, industry and academics have in the past not always differentiated clearly between CfDs and sliding premiums. As the market situation is changing now (with lower strike prices and higher market prices), a clear differentiation becomes ever more relevant.
How are Contracts-for-Difference designed?
When designing CfDs, policymakers and regulators typically pursue two overarching goals: (1) to incentivise investment in renewables according to political deployment targets, and (2) to integrate renewables into power markets with as little distortion as possible. At the same time, the development of the energy system should follow security-of-supply and cost-minimisation principles. This translates into certain design criteria for CfD schemes regarding (1) incentivising system-optimal operational choices and (2) incentivising system-optimal investment choices, both regarding design (layout) and siting of projects. In practice, the chosen design elements that achieve this will differ from jurisdiction to jurisdiction depending on a number of market, regulatory and system factors.
Some common principles for CfD designs are to ensure that renewables always produce when the price is above, and never when the price is below short-term variable costs. For example, to minimise distortive bidding behaviour on day-ahead markets, many European countries seize payouts at negative day-ahead prices. Otherwise, renewable producers could be incentivised to bid into the market at levels corresponding to the payout with reversed sign, well below their marginal cost.. CfD designs should also ensure that maintenance and outages are scheduled at value-optimal times (instead of cost-minimal times). For example, if the reference price is based on a longer-term average, then renewable producers can improve their revenues by scheduling maintenance within the lowest-price hours of the reference period without payout or clawback price level being affected. CfD designs can incentivise projects to be sited at locations that maximise system value (not project value). For example, the system may need more production in low-wind areas, which can be incentivised through adjustments of reference or strike prices. Technologies and park layouts should be chosen so that generation profiles match (current and future) system needs. This can, for example, mean incentivising a broader use of low-wind turbines that produce less at high wind speeds and more at low wind speeds, or of west-facing solar power that produce more in the evenings, i.e. at times when other solar power parks do not. These incentivisation principles can be achieved by a number of policy designs, inside and outside of CfD schemes.
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