CFD Supplier Obligation: Consultation on improving efficiency and transparency
10th November 2015
The Department of Energy and Climate Change has proposed changes to the Contracts For Difference Supplier Obligation.
Introduction
The Department of Energy and Climate Change (DECC) has consulted on amendments to the Contracts For Difference (CFD) scheme. DECC stated that the purpose of the consultation was to set-out and seek views on proposals for a number of technical changes to the CFD Supplier Obligation (SO). The proposed changes are designed to improve efficiency and transparency.
Background
By way of recap, the CFD scheme was introduced in 2014 as a new mechanism for incentivising renewable and low carbon electricity generation. The CFD scheme replaced the existing Renewables Obligation (RO) and represents a better deal for consumers according to DECC. A CFD is an agreement signed between an electricity generator (the Generator) and the Low Carbon Contracts Company (LCCC). The CFD provides a mechanism for payments to be made to Generators in return for generating electricity from low carbon sources. The LCCC collects payments from electricity suppliers (Suppliers) and uses the money to make the payments to the Generators through the SO mechanism.
CFD Supplier Obligation
The SO requires that Suppliers make a series of pre-payments comprised of an interim rate payment, paid daily at an Interim Levy Rate (ILR) governed by LCCC, and reserve payments paid quarterly which ensure that LCCC has a Total Reserve Amount (TRA) that is sufficient to pay Generators in 19 out of 20 given scenarios.
At the end of the quarter, LCCC reconciles each Supplier’s pre-payments and their proportionate share of CFD costs (i.e. money owed to Generators for generation in that quarter) in order to determine whether any over- or under-payments have been made. Where the former is the case, LCCC makes a reconciliation payment six months after the original payment was made by the Supplier.
Proposed Changes
The Contracts for Difference (Electricity Supplier Obligations) Regulations 2014 (ESO Regulations) came into force 1 August 2014. The technical changes that DECC have identified, following feedback received since implementation, reduce the risk to Suppliers by lowering the costs of CFDs. This saving should (at least in theory) be passed on to consumers in the form of lower bills. The changes are summarised below and the draft ESO Regulations as amended can be found here.
Improving the efficiency of the SO
It has been proposed that the way in which the ILR is calculated will be modified in order to align it with Suppliers’ expected liabilities for a quarter. Similarly, the LCCC will be given the power to reduce (but not increase) the ILR without notice and within-period reconciliation of interim rate payments will be removed.
The payment period for making reconciliation payments will be reduced to five or ten working days following the issue of the relevant notice. This will prevent LCCC holding more reserves than necessary for a significant period of time. Additionally, the TRA calculation period will be adjusted to reduce the risk of a shortfall caused by the TRA being underestimated. Conversely, the LCCC will be given the power to reduce the TRA where it has been overestimated, reducing the risk of Suppliers making unnecessary payments. Furthermore, the LCCC will be given more time to issue invoices to Suppliers for reserve amounts owed.
Greater transparency
It is proposed that LCCC will be required to provide cost projections to Suppliers and large consumers, both of which seek to understand future policy costs. This will enable Suppliers to have greater visibility over estimated future CFD liabilities, thereby removing the need to price excessive risks into tariffs charged to consumers. The cost projections will cover the three quarters beyond the one during which the LCCC set the ILR and TRA.
Similarly, the LCCC will be required to publish Generators’ expected CFD start dates i.e. the date on which CFD generation payments start being paid to a Generator. The LCCC publish key information for all investment contracts and CFDs to which LCCC is a party, including the strike price, target commissioning date and the generation technology, within the CFD Register (the ‘Register’). One of the most important purposes of the Register, from a Supplier’s perspective, is to allow for transparency of key project parameters that will materially affect the SO. However, one key piece of information that is not included at present is a Generator’s expected CFD start date- the Register only includes the start of the Target Commissioning Window (‘TCW’). The TCW is one year in length, meaning that there is a wide window of uncertainty for Suppliers as to when payments to Generators will actually commence. Once again, this incentivises risk being priced into tariffs and increases costs for consumers. Including this information in the Register will allow Suppliers to make their own forecasts of CFD costs and adjust their tariffs accordingly.
Minor and technical amendments
Setting-off and netting of SO payments
At present, the LCCC is able to set-off a payment it is due to make to a supplier against (determined) payments that the supplier is due to make (to it) in the future. There are no caveats on the circumstances in which LCCC can retain payments or on how far into the future the determined payments may be due. This effectively means that Suppliers are exposed to the risk that payments are withheld unjustifiably. It has therefore been proposed that LCCC may only withhold a payment due to a Supplier where it considers that there is a high likelihood that the Supplier will fail to make payments that are due. Furthermore, LCCC may only set-off the payment against payments due within five working days of the date the withheld payment is due to be made to the Supplier.
The limitation that set-off can only be used when the amount LCCC is due to pay the Supplier is less than or equal to the sum of payments the Supplier is due to make to LCCC is to be removed. It is proposed that LCCC is able to withhold up to the total amount of payments due to be paid within 5 working days.
A new system is to be introduced which allows LCCC to automatically net-off payments against each other where it is due to both receive from and make a payment to a Supplier on the same day.
Generation payments
A Supplier’s liability for reconciliation payments (i.e. those payments paid to a generator) is to be determined by their market share in the quarter that the payment is due, rather than the quarter in which the generation took place. This means that, after the first determination, the CFD daily contribution made by a Supplier can only change due to a change in market share. Any other changes in CFD payments would be factored into the CFD quarterly contribution for the quarter in which the payments were made. The idea behind calculating Supplier liabilities using the most recent market share is to reduce the risk to Suppliers in having to meet historic costs that are no longer in proportion to the size of their supply business. Continuing with this theme of transparency, the LCCC would also be required to inform suppliers when they consider that there is a reasonable likelihood of a CFD quarterly contribution being due in a quarter.
Exemptions from CFD costs
It is currently possible for eligible Suppliers to benefit simultaneously from two exemptions under the Electricity Supplier Obligations (Amendment & Excluded Electricity) Regulations 2015. The first of these exempts suppliers from SO and operational payments on up to 85% of electricity supplied to eligible Electricity Intensive Industries (EIIs). The second, known as Green Excluded Electricity (GEE), applies to Suppliers who import electricity generated from renewable sources in EU Member states and supply it to customers in Great Britain. The exemptions work by exempting electricity from Suppliers’ market share for the purpose of calculating CFD liabilities.
It is proposed that Suppliers are prevented from receiving a double discount and thereby benefitting excessively as a result of the dual application of the exemptions.
Additionally, it is proposed that the list of EII eligible sectors will be amended. The proposed amendments represent a reduction in the number of eligible sectors; there are 14 specified activities that have been removed whereas only seven have been added.
Mutualisation
The ESO Regulations provide that, when a Supplier defaults on their SO payments, non-defaulting Suppliers are required to pay the defaulter’s share by way of mutualisation payments. The current mechanism provided for by Regulation 17(1) means that a defaulting Supplier may be liable for the payments of another defaulting Supplier whose payments have been mutualised. An obvious flaw with this is that the former Supplier is highly unlikely to make the payments as it is itself in default of the SO. It is therefore proposed that Regulation 17(1) will be amended to exclude Suppliers who have defaulted on a payment and whose collateral is exhausted or is likely to be exhausted within five working days.
It is further proposed that a rolling 30 day reference period will be used to calculate Suppliers’ liabilities for mutualisation payments. This is in response to criticism of the current system whereby different reference periods are used depending on the type of Supplier default.
Another proposed change to the current system of mutualisation concerns the amount of time that LCCC has to pay recovered mutualisation payments and interest earned on cash collateral. It is proposed that LCCC should be given fifteen days rather than 5 in order to give LCCC more time to process calculations and make payments to suppliers.
In the interests of transparency, it is proposed that the mutualisation notices sent to Suppliers should be simplified so that they no longer include information regarding the default that has occurred. Similarly, a notice will no longer be issued to the defaulting Supplier specifying details of the mutualisation. The latter measure is designed to prevent a situation whereby a defaulting Supplier receives a notice and consequently assumes that their debts have been paid. The amount of interest accrued to date will also be omitted from notices of default. The justification offered for this is that, as interest accrues daily, providing the interest that has accrued as at the date of the notice is misleading because it does not reflect the total interest that will eventually be payable.
Letter of credit expiry and bank ratings
Suppliers are able to provide collateral, needed to cover payments in the event of default, in the form of an appropriate Letter of Credit (LoC). It is proposed that LCCC should be able to call on LoCs which are due to expire, or are issued from a bank that no longer meets the required credit rating, and hold the cash as credit cover. This will reduce the risk: to LCCC that a Supplier will be without credit cover; of other suppliers having to pay any defaulting amounts; and will also bring the ESO Regulations into line with collateral requirements in CFD contracts and Capacity Market regulations.
Notices issued to licensed suppliers
The ESO Regulations require that LCCC send certain notices to all licensed Suppliers, irrespective of whether or not they are capable of making a supply. The consequence of this is that there are some 60 or so inactive suppliers whom the LCCC are required to send notices to but who are not making SO payments. DECC has proposed that this should be changed so that only Suppliers who are actually supplying electricity or who have the capability to supply during the period covered by the notice would be sent a notice. Where a notice covered past quarters, affected Suppliers would still be sent a notice with details of their liabilities. DECC have stated that the changes should reduce the administrative burden on LCCC, whilst ensuring that all relevant Suppliers are informed of their potential liabilities.
Next Steps
The consultation closed on 23 October 2015 and feedback from interested parties is currently being analysed by DECC. In the meantime, DECC has stated that those wishing to comment on the draft ESO Regulations have until 13 November 2015 to do so.
An update will be provided once the outcome to the public feedback has been made available.
