ROCs or CfDs – the choice is not clear cut

21st November 2013

With the Renewables Obligation scheme ( ROCs ) of support for new schemes to be phased out by 31 March 2017 and the replacement Contracts for Difference scheme ( CfDs ) coming into effect next year, there will be a period of time in which developers will have a choice of which scheme to seek support under. As more details of the Contracts for Difference scheme become available, we compare some of the key risks under each scheme

As we know, Contracts for Difference (CfDs) are envisaged to be introduced under the Electricity Market Reform (EMR). In essence, the clue is in the title, and payments will be made to generators by reference to the difference between a fixed notional price (the strike price) and the referenced electricity sale price (the reference price). Where the strike price is higher than the electricity price, the CfD counterparty is contractually obliged to pay the difference to the generator. Where the reference price is higher than the strike price however, (i.e. the price of electricity is greater than anticipated), the generator is obliged to pay the difference to the CfD counterparty.

CfDs will be available to new projects from some time in 2014, while the Renewables Obligation (RO) scheme will remain open to new entrants until 31 March 2017. Therefore, projects looking to commission between 2014 and the RO closure date will have a one-off choice as to whether to receive support under the RO or a CfD. Making that choice requires a detailed analysis of the risks and benefits of each support scheme and applying them to the particular project in question: different developers, funders and investors will have different approaches to risk.

With draft strike prices having been published, and the Government recently publishing a detailed update on the CfD scheme, generators will now be using this information as a yard stick for where their decisions in terms of future support should lie: for the time being, does the RO provide a subsidy that is tested and investors are relatively comfortable with, or are CfDs the future of sustainable investment into the low-carbon market? We set out below an evaluation of the different risk profiles between CfDs and the RO in light of what we now know.

What is the risk that a project won’t be eligible?

RO: accreditation granted on commissioning
CfD: CfD granted prior to the final investment decision
Risk balance: slightly lower risk for CfD as earlier certainty on eligibility. However, generators may be required to submit supply chain plans in respect of the CfD term. This could be onerous and the proposals in respect of this need to be considered once finalised.

What is the availability risk?
RO: low risk – if a project hits the eligibility criteria support will be available
CfD: CfD not guaranteed even if the eligibility criteria met and availability of contracts will potentially be limited. Availability risk increases as time goes by
Risk balance: higher risk under CfDs.

What is the risk if the project energy yield is lower than anticipated?
RO: income calculated by reference to metered output (at the point of generation)
CfD: income calculated by reference to metered output (at point of connection to the grid) and a ‘loss adjusted metered output’ will also be made
Risk balance: slightly higher risk for CfD (particularly for offshore technologies) as potential transmission losses between generation and grid connection point, as well as loss adjustment calculation.

What is the risk that revenue will be lower than forecast?
RO: two revenue sources – electricity sale and ROC sale, and market fluctuation risk in respect of both
CfD: two revenue sources – electricity sale and difference payment, but strike price reduces revenue fluctuation risk
Risk balance: forward selling/monetisation used to mitigate RO risk not necessary for CfD as difference payment is a mitigation in itself. CfD should therefore have a lower risk profile, subject to potential negative price risk if Reference Price is higher than Strike Price.

What is the risk if the electricity sale price is lower than anticipated?
RO: generator risk that electricity and/or ROCs sold below market price
CfD: reference price is linked to indices rather than real market price therefore generator risk that sale price is lower than reference price. Further risk that reference price is greater than strike price and payment is then due from generator to CfD counterparty
Risk balance: increased risk for CfDs currently. Potential clarification in respect of setting of indices from DECC anticipated.

What is the risk if the output delivered to the grid does not match the forecast output?
RO: risk passed to offtaker through power purchase agreement (PPA), subject to any tolerance provisions in the PPA
CfD: similar risk but PPA market more uncertain
Risk balance: similar risk. However, with RO balancing costs can potentially be mitigated by increases in energy prices. Less potential for CfDs as strike prices linked to index, (unless a pass through cost protection is developed).

What is the risk that the fuel cost is greater than anticipated for the life of the project, or that fuel will become less or unavailable?
RO: generator risk, mitigated by long-term supply contracts
CfD: generator risk, likely to also be mitigated by long-term supply contracts
Risk balance: similar risk (but note that there is no provision for amendments to the strike price in respect of fuel availability).

What is the risk that the relevant support payments aren’t paid out?
RO: risk mitigated by selling to offtakers with good credit standing, or requiring guarantees to ensure ROCs are purchased
CfD: risk uncertain – what will happen if the CfD counterparty is able to pay? CfD counterparty has been made ‘insolvency remote’ as it will not be required to pay out under the CfD until it has been paid by the supplier, however, how will the generator recover non-payment?
Risk balance: increased risk under CfDs, subject to revised proposals anticipated from DECC to protect generators.

What is the risk that a change in law affects payments?
RO: RO payments are grandfathered, so guaranteed
CfD: protection provided by CfD contractual provisions however no protection against wider industry regulatory changes or the possibility that the power to invoke a reduction in the strike price will be used
Risk balance: increased risk for CfDs – current gaps in protection under the contract.

What is the risk that the generator loses its entitlement?
RO: generator risk that ROC will be revoked or accreditation withdrawn, but circumstances limited
CfD: generator risk that CfD may be terminated, with significant list of events of default set out in CfD
Risk balance: possible greater risk under the CfD (pending clarification in respect of cure/remediation periods for events of default).

What is the risk that the project cannot secure finance?
RO: generator risk, but well understood
CfD: generator risk. Less exposure to electricity price volatility should be a positive for investors, but there may be increased price risk in respect of other risks under the CfD structure
Risk balance: current uncertainties and flaws in CfD lead to greater investor risk, however will these be ironed out? Will the market become more confident over time?

Conclusion
To conclude, there are still a number of question marks over the risks levels under CfDs as compared to the RO regime. Whilst the Government is keen to persuade that CfDs will provide a stable and long-term incentive to the low-carbon industry, for the time being the RO regime at least has the benefit of being well understood by generators and investors, with risk mitigation having been practiced. However, will fortune favour the brave and have the investors at EDF’s Hinckley Point C seen the future?

For more detail on the RO, CfDs, Electricity Market Reform or energy in general, please contact Ben Sheppard.