Early contracts for renewable electricity

In April 2014, the Department announced the award of contracts to eight renewable electricity projects under an early version of the new ‘Contracts for Difference’ scheme. Under the new scheme the Department fixes the price which renewable electricity generators can receive for each unit of electricity they produce (known as the 'strike price'). A newly formed ‘Counterparty Body’ will pay generators the difference between the market price and the strike price for the electricity they generate, where the strike price is higher. If the market price is higher than the strike price, generators will pay the difference to the Counterparty Body. The Counterparty recoups its costs from energy suppliers who in turn may pass on the cost to consumers, so the consumer picks up the bill. This scheme is replacing one which requires electricity suppliers to pay for Renewables Obligation Certificates which give renewable generators a premium over the wholesale price for each unit of electricity they supply, as the government’s main method for supporting new renewable electricity generation. The Department awarded these eight early contracts to reduce the risk of a delay in investment in renewable electricity projects during the transition to the new scheme. Two of the contracts are for power plants converted from burning coal to biomass, five are for offshore wind farms and one is for a purpose built biomass plant providing heat as well as power.

We are not satisfied that sufficient consideration was given to securing value for consumers during the transition from the existing arrangements to the new scheme. To avoid a gap in investment during the transition from the Renewables Obligation scheme to the Contracts for Difference scheme, the Department decided to offer early contracts without price competition. The Department argued that the early contracts were necessary to ensure continued investment and that they provided better value. But its quantified economic case shows no clear net benefit from awarding early contracts compared to allowing competition when the main scheme comes into force in December 2014. It is not clear that choosing to award so many early contracts was the best way to secure value for consumers. As the Department recognises, competition under the main Contracts for Difference regime may well secure better prices and less cost to consumers than those set administratively under the transitional arrangements. Recommendation: Before embarking on future major reforms, the Department should consider fully its options for managing the process of transition, weighing up the impact on value for money of different types of transitional arrangements with different scales and durations.

Most of the budget available for contracts to be awarded under the new arrangements through price competition has already been spent on the early contracts awarded without price competition. The Department has awarded 58% of its budget for renewable electricity projects from 2015-16 to 2020-21 on the eight early contracts agreed under transitional arrangements designed to prevent a gap in investment in renewable electricity generation. The Department maintains that these transitional arrangements have encouraged project developers to progress their projects and build supply chains to a point where the market may be ready for price 5 competition under the main Contracts for Difference scheme. But we are concerned that the Department has awarded 58% of the available budget to achieve this effect and that little now remains for the main competitive regime. Recommendation: The Department must now seek to award the remaining funds using price competition.

The Department had no detailed knowledge and understanding of the developers’ costs and estimates. They were too ready to accept arguments put forward by project developers that consumers should bear the risk of inflation in the prices they paid. The Department did not robustly challenge developers who claimed investment would be deferred if the contractors bore more of the risk of inflation. The Department also failed to challenge developers’ claims that investors would not come forward if contracts were designed to ensure that consumers shared in higher than expected profits. The early contracts include strike prices which are fully indexed to the Consumer Price Index (CPI), resulting in consumers rather than project developers bearing the risk of high inflation. The Department argued that this was necessary to avoid project developers demanding higher strike prices. The Department also decided not to include claw-back provisions which would have ensured that consumers shared in any excessive profits achieved by project developers, for example through re-financing gains. The Department asserted that including claw-back provisions would have made the projects ‘uninvestable’. However, no evidence to substantiate these assertions was available and in our experience of reviewing public contracts, particularly PFI contracts, claw-back arrangements are essential to protect the interests of taxpayers and consumers. Recommendation: For future Contracts for Difference, the Department should ensure it requires information from project developers on projects’ costs and returns and includes contract clauses to allow it the opportunity to claw-back for consumers a share of any excessive profits.

The Department awarded these early contracts without clearly identifying how much capacity it needed from each technology to keep on track to meet its strategic objectives. The Department awarded the early contracts to mitigate the risk of not meeting the 2020 renewable energy target and to support the development of renewable electricity. The Department’s data shows significant new renewable generation capacity is in construction, awaiting construction, or seeking planning permission. It is not therefore clear that these early contracts were all necessary to meet the 2020 targets. It is also not clear why the Department awarded so many early contracts to offshore wind projects, when offshore wind is currently the most expensive technology to support and other cheaper technologies could be deployed instead. Its early decisions have pre-empted resources and constrained future choices. For example, biomass conversion of coal plants could be an effective way of delivering energy until the next generation of nuclear energy joins the grid. Recommendation: The Department should ensure its future decisions on the budgets for support for different technologies and its process of allocating contracts are based on a clear understanding of how best to achieve the balance of 6 technologies required to meet its strategic objectives at least cost for consumers. In the event of a capacity crunch, clearly consumers will end up paying more.

The Department awarded these early contracts on the basis of wider benefits which it considered outweighed risks to value for money. The Department went ahead with the early contracts because it expected them to achieve wider benefits, on which it could not put a monetary value. The Department argued that there would be benefits to the renewable electricity supply chain, that it was necessary to show the new system could work and that early investment was required to meet the 2020 targets. The Department proposes to conduct an evaluation of the benefits from these early contracts. Recommendation: The Department should ensure it conducts and publishes a robust evaluation of the actual benefits and costs of this scheme. This evaluation should assess the quantified and unquantified costs and benefits against the Department’s business case for the scheme and make an evidenced assessment of what it has achieved and whether awarding early contracts has genuinely been worthwhile.

The government owned Counterparty Body will play a crucial role in protecting consumers’ interests. The Counterparty Body will need to actively manage contracts, to ensure claims for increases in strike prices are reasonable, to identify and apply reductions in strike prices, and to calculate who needs to be paid what and organise those payments. The Counterparty Body should also monitor information from project developers on projects’ costs and returns to determine whether returns are reasonable with a view to introducing claw-back clauses in new contracts if there are excessive profits. The Department is in the process of setting up the Counterparty Body. It has appointed a Chair and is in the process of recruiting staff. Recommendation: The Department must ensure the Counterparty Body is wholly independent of the industry and has the skills, resources and information it needs to manage all Contracts for Difference effectively and hold it to account for ensuring that the interests of consumers are fully protected. 7 1 The need for early contracts

The Department recognised that competition was likely to drive better prices for consumers, but it did not believe that it could have gone straight to competition for the early contracts.23 In particular it did not believe the market for offshore wind was mature enough.24 Accordingly, it had established a transitional system where the strike prices were administratively set. The Department did not negotiate strike prices with individual projects or attempt to investigate individual projects’ costs and returns before it awarded the contracts.25 The Department told us that the administrative prices had been underpinned by an extensive process in 2011 and 2012 to establish, with external expert input, the long-run costs of renewable technologies.26 The Department stated that the UK administrative strike prices for offshore wind were lower than prices elsewhere in the world.27 It accepted that its administrative price setting process meant that some projects might get a greater return than they potentially needed from those prices, but noted that when it released the administrative strike prices in 2013 some project developers had 18 Q 122 19 Qq 52-57, 163 20 Qq 34, 133 21 Qq 12-18 22 C&AG’s Report, figure 1 23 Q 49 24 Qq 49, 51, 56, 71 25 C&AG’s Report, paras 14, 3.28 26 Q 24 27 Q 45 10 walked away on the grounds that they had not been sufficient to support their offshore wind projects. 28

The Department noted that the UK needed to have a diverse set of generating assets and technologies to decarbonise the electricity sector and said that it was aiming to meet the target at minimum cost to consumers.29 The Department has set caps on the combined cost of consumer funded schemes which support the development of renewable and other low carbon electricity generation, such as the Renewables Obligation, the Financial Investment Decision enabling for Renewables scheme and Contracts for Difference. The Department caps these schemes through a mechanism known as the ‘Levy Control Framework’ so that consumers are protected from the cost of supporting renewable electricity rising beyond pre-determined limits.30 However setting caps does not in itself ensure consumers get the optimum value for money.

The Department told us that it had designed the selection process for the early contracts to support a mix of technologies. Five of the early contracts awards were for offshore wind, which at a strike price of £150 per megawatt-hour was significantly more expensive than both onshore wind and nuclear at £95 and £89.50 per megawatt-hour respectively.31 The Department agreed that biomass conversions were cheaper to support than offshore wind projects and were a good reliable source of renewable electricity. The Department noted that it regarded biomass as a transitional source of renewable electricity, because biomass only reduces carbon emissions by 68% compared to coal, thus providing a lower level of carbon savings than offshore wind to meet long-term decarbonisation targets. The Department hoped that carbon capture and storage on gas or coal plants would be part of the mix, but at present this was considered to be the most expensive. 32

The Department told us that the lengthy process of negotiating the terms of the early contracts, involving a great many advisers and conversations with multiple project developers, had in a sense been market testing of the contract.33 The early contracts protect consumers by only providing the strike price for electricity produced and paying no compensation to project developers who cannot deliver their projects, for example, because they fail to obtain planning consent.34 The contracts do not penalise project developers for not delivering the planned capacity, but do require them to come back with revised capacity figures within a year of receiving a contract so the allocated funding can be released for other projects.35

The early contracts’ strike prices are indexed to the Consumer Price Index (CPI) rather than the Retail Price Index used in the Renewables Obligation scheme.36 The Department 28 Qq 155, 58 29 Qq 70-72 30 Q 171 31 Q 70 32 Qq 80-81 33 Q 143 34 Qq 115, 137 35 Q 138 36 Q 29 11 told us that project developers would have demanded higher administrative strike prices had they not been linked to inflation.37 The Department considered that renewable generation projects were fragile and that passing inflation cost pressures through to consumers rather than project developers had improved the chances of projects going ahead.38

The Department received representations that claw-back provisions should be included in the contracts to allow consumers to share in any excessive profits. However, the Department decided not to do this as project developers had repeatedly maintained that including claw-back clauses would have been a “red light” for them, something confirmed by independent financial advisers consulted by the Department.39

We asked the Department what consideration they had given to a claw-back clause for any re-financing gains. The Department considered that such a clause would have made the contracts ‘uninvestable’. The Treasury agreed with the Department’s judgement on this but noted that there was a difference in the risks involved between the first contracts let and those let further into a programme.40 The Department promised to give further thought to how it should address the potential for project developers to make large refinancing gains through Contracts for Difference.41

The government owned Counterparty Body will need to actively manage contracts, to ensure claims for increases in strike prices are reasonable, to identify and apply reductions in strike prices, and to calculate who needs to be paid what and organise those payments. The Counterparty Body will also need to ensure that generators record and report their output accurately to protect consumers from paying for more output than is actually provided. For claw-back arrangements to operate effectively, contracts would need to include requirements on project developers to supply information to government on their actual costs and returns. This information would then need to be scrutinised by staff with appropriate expertise. The Department told us that it had recruited a Chair and was in the process of appointing a Chief Executive for the Counterparty Body which will have an independent board, and whose costs will be met by consumers through the Levy Control Framework.42 37 Q 21 38 Q 33 39 Qq 66-69 40 Qq 87-90 41 Q 84 42 Q 180 12