With the Contracts for Difference (CfD) Auction Round 5 (AR5) results released, our Head of Analysis and Insights, Tom Quinn, has detailed what it could mean for the industry. Read on to find out more:
Bottom-fixed and floating offshore wind bidders in the latest Contracts for Difference (CfD) auction (Allocation Round 5) have sent a clear signal to government that the economic terms of the revenue support scheme were not adequate to support the financial decision to invest in new wind farms in the UK. The auction budget, administrative strike price, and reference prices used in AR5, have all contributed to a lack of uptake.
The offshore wind industry has suffered from higher inflation than the rest of the economy, with the cost of components increasing by 40%. This inflationary pressure is a result of short- to medium-term volatility in natural gas prices (and other commodities), suggesting an increase to maximum strike prices will be enough to attract investment in the future.
However, this auction and other bottlenecks the industry is facing means the 2030 target to install 50GW of offshore wind is unlikely to be reached without significant renewed impetus. This would result in imported natural gas being a larger component of our electricity generation mix, exposing consumers to more volatile prices and increasing the UK’s carbon emissions.
We recommend the following:
Prospective developers have signalled to the UK government that the guaranteed power sales prices it has permitted them to lock in, if they build and run offshore wind (OSW) farms, are too low to make them economically viable.
The signal comes via the results, announced today, of the latest round of competitive bidding for these prices. There was 4GW of capacity eligible to bid, but none of the developers bid. This is without precedent in the UK.
The rights to these fixed prices are called Contracts for Differences (CfDs). These replaced the Renewables Obligation (RO) scheme and have seen projects awarded revenue support in five auction-based Allocation Rounds (ARs) since 2015, with AR5 results announced today.
Sources: ORE Catapult analysis, drawing on: Low Carbon Contracts Company I and II, and UK BEIS (now Department for Energy Security and Net Zero), 5 December 2022.
As shown in the chart above, the CfD allocation rounds 1-4 did an impressive job of awarding OSW capacity at ever lower strike prices.
By convention, and to allow comparison between auction rounds, the prices are referenced in 2012 terms. For reference, the AR5 Administrative Strike Price (ASP) of £44/MWh is worth around £60 in today’s money. Historically these prices were acceptable to developers as OSW supply costs – e.g. construction, operations and maintenance costs – fell over the years, reflecting the efficiencies of a maturing industry.
Starting in 2021, however, sharp rises in costs (due to inflation across the global OSW supply chain) and interest rates have occurred. Inflation on capital expenditure has been estimated at 40% for OSW, partially driven by the increase in gas price (as natural gas is used in the manufacturing process). Compounding this is the financial position of original equipment manufacturers (OEMs) such as Siemens Gamesa and Vestas. The OEMs have suffered operating losses as they attempt to deliver components for contracts signed prior to cost inflation, while also fighting an arms race to develop larger turbines.
These inflationary pressures have led some developers in the UK and US in 2022 and 2023 to seek to raise strike prices from those they had agreed to earlier, stating otherwise their projects would not be commercially viable. Although UK CfD strike prices are indexed to general inflation, OSW-specific inflation has exceeded this. A recent, high-profile, example is Vattenfall’s July 2023 announcement that it would halt development of the Norfolk Boreas wind farm, as rising costs meant that the £37/MWh strike price it had accepted a year earlier in AR4 would no longer suffice to make the project economic.
Today’s AR5 results indicate that the ASP of £44/MWh is still too low for developers.
While the result of AR5 has been disappointing, with minor reforms to the auction process future rounds can be a success at delivering low-carbon power at competitive prices, while creating jobs and boosting the UK economy. There is consensus that the CfD process is not working efficiently, but very little consensus on how to address this. Global natural gas prices are expected to remain high in the medium term, and these prices dictate the wholesale electricity price in the UK. Raising the ASP and reference prices in this high gas price world means OSW projects would on average continue paying back to the Low Carbon Contracts Company (LCCC) rather than being subsidised. This is a relatively minor change to the auction parameters that would allow projects to be sanctioned without burdening the UK taxpayer with additional costs.
The ambitious OSW targets set by UK Government (50GW by 2030) would have been a challenge to meet even if the AR5 auction was a success. To achieve the 2030 target, 7-10GW of capacity will need to be installed in each year towards the end of the decade. This would require much larger CfD auctions, reductions in consenting time, and a massive investment in the supply chain at a time when the rest of Europe and the globe are chasing similarly ambitious targets. The rapid scaling of supply chain to meet high deployment rates is not sustainable, as long-term deployment needs to be around 2-5GW per year to reach 100-150GW in 2050.
Winning a CfD is an important step for most projects to move towards a final investment decision (FID). However, as previously mentioned, some developers have had to hold or delay projects due to bidding at unmanageably low strike prices. With this in mind, it is important to note that UK consumers only benefit from low auction prices if the projects are installed. OSW (despite recent industry-inflation) can still provide some of the lowest-cost energy to the UK grid. Delayed or cancelled projects will end up costing UK consumers in the long run, as well as leading to a lost opportunity for job creation and the broader economic benefit projects would bring.
Supply chain companies are looking to invest to expand or start supplying the offshore wind industry. However, in order to secure finance, companies need to quantify the risk around future cash flows. Without a secure pipeline of projects at different stages of development and financial closure, companies will struggle to secure low-cost financing.
To drive efficiency in the supply chain, and increase expertise in the workforce, contracts need to run without long gaps in between. There is enough capacity in the pipeline to develop a sustainable supply chain, without over-investing. It will take a coordinated and considered approach to leasing, consenting and installation timelines.
Previous CfD rounds have seen strike prices drop faster than anyone predicted. As cost reduction was a primary objective of the CfD, this scheme can be viewed as a success. However, these low prices cut both ways, as developers are put under pressure to save costs, which includes spending less on research and development.
Turbine OEMs continue to be squeezed, as they are simultaneously competing to design larger turbines while delivering order books at ever decreasing prices.
Inevitably, reliability & quality will suffer due to these cost pressures, leading to:
Another effect of low strike prices is that some developers will start looking to develop projects outside of the CfD. We have seen bp suggest this approach with the Mona/Morgan wind farms. CfDs were designed to protect the revenue of developers, but in high-price environments (as we’ve seen in recent years) consumers are also partially protected. Developers who sell power for more than the strike price pay the LCCC the difference, which should benefit consumers.
Some developers may also look to generate revenue through alternative power-to-X options, such as the production of green hydrogen.
The total cost to consumers of the combined CfD auctions over time. Does not account for the payments made by generators back to the LCCC.