But wait… Aren’t CfDs de facto decoupling?
[This article follows on from my piece exploring why UK wind energy is expensive here. This is just for you, Ben Hall…]
In many ways, you’re spot on: Contracts for Difference (CfDs) are already doing much of the heavy lifting of decoupling energy markets. Its what they were designed to do!
However, they aren’t a total solution yet because of how they interact with the rest of the bill, and they have a couple of weird effects.
CfDs include a two-way payment mechanism. They pay out when prices are low… but, when gas has made the spot price expensive, renewable plants that have CfDs pay back the excess profit (above the CfD’s agreed strike price) to the government-owned counterparty (the LCCC).
During the peak of the 2022 energy crisis, CfDs lowered bills. While gas prices were driving the wholesale market to £200+/MWh, wind farms with £45/MWh strike prices were handing back hundreds of millions of pounds to be redistributed to suppliers.
So… why are we still talking about a more fundamental market reform?
I can think of at least three big reasons:
1. Legacy Problems (especially the RO)
CfDs only apply to newer projects (post-2015). A huge chunk of our older green power — onshore wind and early offshore projects — is still on the Renewables Obligation (RO) scheme. These older projects get the market price (i.e. the gas price) plus a subsidy. They have no payback mechanism, so when gas prices spike, they make windfall profits and the consumer pays twice.
2. A Consumer’s Pricing Input is Still Gas
In the UK, energy suppliers have to buy electricity at the gas-driven wholesale spot price first. Even if suppliers get a CfD rebate later, the “sticker price” they see on the screen determines their collateral requirements and the risk premiums they pass on to us.
Get Doug Cook’s stories in your inbox
Join Medium for free to get updates from this writer.
To continue the simple analogies, that would be like being charged £2 for EUR 1 by the Post Office Travel Bureau when going on holiday… and then being promised an 80 pence per euro discount by the Government 3 months later. It still cost you a sticker price of £2,000 to get EUR 1,000 (even if you knew there would be a £800 transfer back to you at some point in the future). You’d be out of pocket in the short term!
Why does that matter? When the wholesale sticker price is tied to gas, it creates three invisible costs that keep our bills high:
- A credit and collateral ‘tax’. Energy suppliers don’t just buy power; they have to prove they have the cash to cover it months in advance. When gas prices are volatile, the sticker price rises. Suppliers are obliged to lock away billions of pounds in collateral just to stay in the game. Those billions aren’t doing anything — they are just sitting there as a safety net. The cost of tying up that capital is added directly to your standing charge.
- Short term mixed messages around smarter use. As an industry, we want people to use electricity when it’s windy (so should be cheap). But if the wholesale sticker price is stuck to gas, the price signal to consumers is muffled. Let’s say it was a perfectly windy day in the North Sea, but a gas supply risk eventuates, raising the UK wholesale price. Consumers, aggregators or VPPs seeing the high price might (should!) reduce their demand, even though the UK actually had loads of available wind power at that exact moment.
- Longer-term investment paralysis. If you were a company wanting to build an electricity-intensive plant, a massive battery or a (cough) green hydrogen plant, you need to know what the spread (i.e. the difference between high and low prices) will be. If the sticker price is always set by gas, the market doesn’t accurately reflect the true value of what electricity is available, where. You are not privy to the net outcome, after the CfDs settle. Industry thus ends up building the wrong things in the wrong places because the price doesn’t tell the truth about the cost.
3. Cannibalisation amidst Negative Prices
Finally, because CfD generators receive a fixed price regardless of the market, they are technically incentivised to keep producing even when there is too much power (i.e. if and when we have negative spot prices). This increases balancing costs on our bills —i.e. the charges to keep the system stable — which in turn eats into the savings that CfDs provide.
How would I describe all this? CfDs aren’t inherently ‘bad’ (at all!) but I’d suggest they are a partial correction to deeper issues. They paper over broken foundations.
I guess on further reflection the previous paper was about taking some of the logic in CfDs and applying it to the entire system.
You’re welcome, Ben!
