Gavin Smart, ORE Catapult’s Head of Insights, explores the context surrounding the CfD Round 2 auction bids ahead of the announcement of the successful projects on Monday 11 September.
This is part one in a series of blogs analysing the UK Government’s Contracts for Difference Round 2 auction. Part two in this series, looking at the results, is here.
Background
In November 2016, the Department for Business, Energy and Industrial Strategy (BEIS) released a draft budget notice for the second Contracts for Difference (CfD) allocation round (AR2). A budget of £290m per delivery year was made available for “less established” or Pot 2 technologies, which includes offshore wind, wave and tidal energy. The commissioning windows covered by the budget notice are 2021/22 and 2022/23. This announcement was welcomed by the offshore wind industry, among others, as providing clarity on the future UK pipeline.
The allocation round opened for applications in April 2017, with results to be announced on 11th September 2017. Ahead of our analysis of the results themselves, this article explores the industry context surrounding the AR2 and the implications for offshore wind in the UK.
Strike Price
The 2017 auction results come roughly two and a half years after the first allocation round results in February 2015, and hot on the heels of a number of notable offshore wind auctions in mainland Europe. As shown in Figure 1, each auction has followed a similar trend of delivering bids substantially below the administrative price ceilings. Expectations are that the 2017 UK allocation round will again deliver bids substantially below the administrative price ceilings of £105/MWh and £100/MWh for commissioning windows 2021/22 and 2022/23 respectively. Just how much below has been the subject of much speculation, with various estimates in the range £65 – £90/MWh.
The Cost Reduction Monitoring Framework (CRMF) 2016 showed that the Levelised Cost of Energy (LCOE) of offshore wind has reduced from £142/MWh for UK offshore wind projects taking Final Investment Decision (FID) in 2010-2011 to £97/MWh for projects taking FID in 2015-2016, a reduction of 32% in five years.
Figure 2 shows a very simple extrapolation of the CRMF 2016 cost reduction line. We have kept Figure 2 as LCOE only, rather than showing strike price on the same graph, since CRMF LCOE is expressed in 2011 terms while strike prices are in 2012 terms. Assuming that projects successful in this allocation round will reach FID sometime in 2018 – 2020, a continuation of this trend could see LCOE in the region of £60 – £70/MWh. This range of LCOE would imply strike prices (very roughly) in the range £70 – £80/MWh. However, there are many other economic and strategic factors determining the level of prices bid and so this is an illustration rather than a prediction!
Affordable Capacity
The budget for AR2 has been set at £290m for each delivery year of all projects awarded a CfD in this round, whether commissioning in 2021/22 or 2022/23. There are a number of factors to consider when estimating the amount of capacity affordable within this budget. The amount of CfD budget required by any project can be calculated using the formula:
Budget impact = (Strike price – Reference price) x Capacity factor x Capacity x Days in Year
This is a simplified version and the exact valuation formula included in the Allocation Framework guidance is available on the BEIS website. This can be re-arranged to give:
Capacity = Budget impact / (Strike price – Reference price) x Capacity factor x Days in year
This shows that, even at its simplest, any estimate of affordable capacity requires four key assumptions to be made:
Before outlining a range of affordable capacity, it is worth noting that strike prices are quoted in 2012 real terms, while the £290m budget is stated in 2011/12 terms. For the affordable capacity estimate, the budget has therefore been converted to 2012 real terms, giving a budget of £296m.
Using the assumptions outlined above and, as illustrated in Figure 3, the minimum affordable capacity if projects are awarded the 2021/22 administrative price of £105 is estimated to be in the region of 1.3GW. At the other end of the scale, a bid price of £65/MWh could allow in the region of 5GW of capacity.
This assumes the full £290m budget is available for offshore wind. However, we must bear in mind that the allocation round is available for all pot 2 technologies and so part the budget may be utilised by other generation types.
Affordability
It is necessary to take a relatively static view (i.e. reference capacity factor and wholesale price) otherwise too many moving parts make a valuation for budget purposes virtually impossible. However, in reality, the amount of budget required each year will vary as a function of changes in power prices and actual capacity factors achieved. Figure 4 illustrates a range of theoretical affordable capacity at different combinations of strike price and capacity factor.
This shows that with unknown capacity factors, for each strike price, there can still be a reasonably wide range of affordable capacity. For example, at a strike price of £70, a 42% capacity factor would afford roughly 4.3GW but a 50% capacity factor would afford 3.6GW. In order to narrow this theoretical range slightly, we can also consider that all other things being equal, lower strike prices are more likely where higher capacity factors can be achieved. Figure 4 therefore also shows possible cross-over points (green dotted line) between strike price and capacity factor. This dotted line is intended to be broadly illustrative only and would move up if you assumed a lower return or lower costs and would move down if you assumed a higher return or higher costs.
In theory, any strike price/capacity factor combination within the green area is economically viable for developers, but combinations closer to the dotted line are more likely. For example, a strike price of £70/MWh (blue line) should be economically viable with 48% or greater capacity factor.
However, at less than 48%, the blue line is outside the green area and the £70 strike price would not give the returns required; on the other hand, with a capacity factor greater than 48%, the developer can afford to bid a lower strike price (i.e. move towards the purple £65 line) and still remain within the green area or at least on the dotted green line.
This illustrates, without pinning down a reference capacity factor, the affordable capacity for likely strike price and capacity factor combinations could be anywhere in the range 2.4 – 5GW, illustrating the point about needing to fix some of the moving parts for a working affordability valuation.
Conclusions
We expect projects with potential capacity in excess of 3GW to be competing in this allocation round. Our analysis suggests that there are pricing scenarios which would allow the full capacity eligible to bid to be successful. Similar conclusions have also been reached and neatly explained by Gordon Edge in a recent article carried in Offshore Wind Journal, which also highlights the importance of the timing of commissioning dates in determining affordability in the initial years.
Expectations on awarded strike prices depend on a number of assumptions including, at the very least, the relationship between costs, capacity factor and acceptable levels of return on investment.
With the fiercely competitive prices seen in Europe in the last 12 months, we do not discount any possibility. The only certainties are that there is a great deal of clever innovation and hard work required to deliver these projects and that we await the results to be announced on Monday 11th with great anticipation!