CfD rule change may have ‘significant unintended consequences’

The government’s plans to prevent future Contracts for Difference winners from receiving top-up payments when power prices fall below zero may have “significant unintended consequences”, Frontier Economics has warned in a new report.

The consultancy said the use of the day-ahead market as a reference price would create an artificial incentive for generators to sell their power on the intraday and balancing markets.

In March, the Department for Business, Energy and Industrial Strategy (BEIS) published a consultation on a series of proposed changes to Contracts for Difference (CfD) rules for the fourth allocation round (AR4) due to take in place in 2021.

As well as holding the first ‘pot 1’ auction for mature technologies such as onshore wind and solar in more than half a decade, the department also proposed to prevent contract holders from receiving top-payments during periods of negative prices.

Winners in the last two rounds in 2017 and 2019 are already prevented from receiving the payments if negative prices persist for six consecutive hours or more. BEIS has proposed to remove this minimum threshold for future contracts.

As the current reference price is set by the day-ahead market, Frontier Economics director and report co-author Dan Roberts said this could push affected generators to sell their power closer to delivery: “The test is – is the day-ahead market negative? If so then you lose your support. So collectively the AR4 and subsequent allocation round generators have an incentive to make sure the day-ahead market doesn’t go negative.

“If they either offer no volumes for prices below zero or just quit the market and don’t offer, then the day-ahead market should clear positive for anything other than low levels of demand,” he told Utility Week.

“They will retain their support and what you will probably observe is negative prices in the intraday market or balancing mechanism, because they will be willing to generate at negative prices.”

Roberts said emergence of negative prices in the intraday market would obviously bring buyers with them: “What you could see is the volumes in the day-ahead reducing and the volumes in the intraday market growing. Looking historically at what volumes you’ve seen intraday may cease to be a good guide because you’ve changed the incentives for people to trade there.”

He continued: “You’d see something of a change in the intraday market because clearly at the moment the intraday market is thinner and less liquid than the day-ahead market and people tend to use it more for fine-tuning positions.”

“You’ve implemented a rule which in some senses artificially pushes peoples to trade in market X or market Y,” he added.

“In an ideal world, what you want is for these markets to exist and people to choose the time and the place that they trade on the basis of what works for them; what the market design is; whether it’s continuous or it’s auctions; when they feel they’ve got good forecasts; how much they feel they can sell with certainty at any point in time.”

Roberts said: “I don’t think you can point to a clear distortion and say it is definitely going to lead to this and that problem, but it’s not obvious why it’s a good thing to do, and neither is it obvious that it meets BEIS’ stated objectives.”

He said the department could achieve its aims without the unintended consequences: “This comes down to the way the proposed rule is written… It seems to me there would be other formulations of that rule that could have the policy effect that they claim to want but without having these downsides.”

With developers already preparing their bids for the upcoming auctions, Roberts conceded that it is “a little bit eleventh-hour” but added “with a bit of a concerted industry effort it shouldn’t be beyond their wit to sort this out and get an updated rule.”

The report noted that the additional merchant risk created by the rule change would likely increase capital costs and hence strike prices, giving an estimated uplift of £2.50/MWh for a typical solar project: “This is clearly significant in the context of a competitive auction process.”

Speaking at the Conservative party’s virtual conference last month, prime minister Boris Johnson announced plans to double the overall capacity cap for the next set of auctions when compared to the previous round from 6GW to 12GW as part of a “green industrial revolution”.