A Case Study in Market Dynamics

On September 8, 2023, the UK’s Department for Energy Security and Net Zero announced that not a single bidder showed interest in the offshore wind contracts in a recent auction. Historically, such auctions have always had successful outcomes, which has allowed the UK to become a leader in offshore wind, with 14 GW of capacity. Given that wind energy is pivotal to the UK's ambitious net-zero targets, what led to this outcome? Below, I unpack the mechanics of Contract for Difference (CFD) auctions and shed light on why this crucial market mechanism failed.

CFDs and their role in renewable energy projects

A CFD is essentially a financial agreement aimed at spurring investment in renewable energy by hedging price risk. In this contract, an energy generator and a counterparty (often backed by the government) agree upon a fixed "strike price" for a set period. Once the energy project is operational, if the market price of electricity drops below this strike price, the counterparty makes up the shortfall. If the market price rises above it, the generator pays back the difference.

They idea is to provide some level of revenue certainty for energy producers. Without this long-term revenue certainty, it can be less efficient for projects to secure financing and proceed with development. This is because electricity generation assets require large amounts of capital investment and are long-lived assets. More stability in future cash flows lowers risk (and therefore the discount rate) and increases the value of these projects to investors, making it more likely that the generation projects will move forward. In addition to these benefits to encourage investment, the CFD mechanism also protects consumers from excessively high electricity prices because generators only receive the strike price when wholesale prices are high.

The auction

Central to the CFD mechanism is the concept of an auction, a competitive bidding process that aims to allocate renewable energy contracts at the lowest cost. The process starts with a government or regulatory body announcing an upcoming CFD auction, detailing key attributes such as the total capacity to be auctioned, eligible technologies, and the timeline for the auction process. Potential bidders then undergo a pre-qualification process, meeting specified criteria such as financial stability, technical capability, and past performance in energy projects. This phase ensures that only capable and reliable entities can participate.

Come auction day, each bidder submits a bid specifying two crucial aspects: the amount of electricity they plan to produce and the "strike price" at which they can sell this electricity. This strike price is essentially the minimum amount a developer needs to make the project economically viable. Bids are ranked from the lowest to highest strike price. Contracts are then awarded starting from the lowest-priced bid until the total capacity earmarked for the auction is filled. Different auction models, such as pay-as-bid or uniform pricing, can determine how the strike price is set for each winning bidder. Some auctions implement price floors and caps to maintain a sustainable and competitive bidding environment. A price floor ensures that bids don't go so low as to jeopardize the feasibility of projects, while a cap prevents excessively high bids that could inflate energy costs for consumers.

Winners are awarded a CFD, usually lasting 15 to 20 years, providing them with long-term price stability. Contracts are finalised, specifying obligations for both parties. Once a CFD is awarded, the winning developers move on to the project implementation phase, which involves securing finance, obtaining necessary permits, and eventually, construction. Upon becoming operational, the CFD mechanism kicks in. If the market price for electricity is below the agreed strike price, the counterparty (often a government entity) pays the difference to the energy producer. Conversely, if the market price exceeds the strike price, the energy producer pays the difference to the counterparty.

Why Did the UK's Offshore Wind Auction Fail?

The UK government had set an ambitious price cap of £44/MWh, intending for generators to bid the price down from there in the auction. An example of how the UK had hoped the auction would work is illustrated in Figure 1 (numbers are fictious). In this example, two developers bid, one bidding 2 GW of capacity at £30 MWh and a second bidding another 3 GW of capacity at £25.

However, what actually happened was that the £44/ MWh price cap was too low for any developers. Although price caps are often politically popular for appearing to protect consumers, they can backfire by discouraging participation, as happened here. The resulting failed auction is presented in Figure 2, showing our two fictitious developers with minimum prices far about the government price cap, resulting in no bidders and 0 GW in capacity provided.

The problem comes from the instability and uncertainty faced by wind generators. Again, note that the intended incentives of a CFD is to decrease uncertainty in future cash flows, thereby lowering the risks associated with investing in the project. The problem is that UK energy markets are dealing with high uncertainty, in terms of inflation, currency instability, high raw materials costs (especially steel), a shortage of skilled labour, and an uncertain political and regulatory environment. The current high interest rates also raise financing costs. The grid infrastructure also needs crucial upgrades to ensure that renewable energy can be transmitted to consumers, further increasing uncertainty. All these factors increase risk and make the required future cash flows higher in order to pay for the initial investment.

In fact, the long durations of CFDs, usually 15-20 years, has clearly worked against the auction in this case. In stable periods, these long durations are a valuable benefit as they provide more revenue certainty and lower risk. However, in unstable periods, no generator wants to be locked into a fixed price that may turn out to be too low 8 years down the road.

At issue here is the price cap. Such caps are attractive politically because price caps appear to control costs for consumers. However, economists have demonstrated for centuries that price caps cause shortages. In this case, a shortage of bidders for offshore wind. It is particularly difficult for a single agent, in this case government, to set an “accurate” price in periods of high volatility. Just like pegs in currencies, they get broken and often cause huge political problems. Rather, a large number of agents competitively bidding against one another would result in a more efficient market price. Auction theory is generally well-understood, both in terms of pros and cons, and used in a stunning variety of activities, from Google searches to allocating radio spectrum in telecommunications.

While CFDs are generally an effective market-based mechanism for encouraging renewable energy projects, the recent failed auction in the UK highlights the pitfalls of not accurately balancing risk and reward. Policymakers must be cautious when setting price caps, especially in volatile economic conditions. Trusting market forces to establish a fair market price through competitive bidding can often yield better outcomes for both consumers and investors.