The role of CfD in an age of uncertainty

Regina Finn, Ofwat’s first chief executive and now chair of the Low Carbon Contracts Company, talks to Utility Week about her career and the future of Contracts for Difference. She discusses the role of auctions for emerging technologies, starting with next year’s bumper round and whether they could extend beyond the power sector. She also gives her view on how regulation should reflect the net-zero journey.

Regina Finn’s first year as chair of the Low Carbon Contracts Company (LCCC) and the Electricity Settlement Company (ESC) has been far from uneventful.

The body, which was set up in 2013 following the Electricity Market Reform programme to run the Capacity Market (CM) and Contracts for Difference (CfD) mechanisms, has been at the centre of some seismic events for the sector over the past 12 months.

Shortly after the former Ofwat chief executive joined LCCC (the two businesses are generally referred to by this acronym), came the record-breaking third auction round, which saw strike prices plummet to as low as £39.65/MWh – 30 per cent lower than the floor in the previous auction in 2017.

A month later, the European Commission allowed the reinstatement of the CM, which had been suspended for a year following a legal challenge over its compliance with state aid rules. The shutdown meant more than £1 billion of deferred charges built up but Finn points out that the vast majority of this was paid in full, without the need for a second mutualisation.

In March, the government bowed to mounting pressure to readmit onshore wind and solar projects into the fourth CfD auction, scheduled for late 2021. Earlier this month, Boris Johnson went further by announcing a doubling of capacity for that round.

That is not to mention the gargantuan challenge of the Covid-19 pandemic to a business whose funding model is based on forecasting electricity demand.

This pace of change may be with LCCC for some time if the government sees its model – “essentially shorthand for a private law contract”, as Finn describes it – as a way of unlocking other maturing technologies. LCCC is already talking to government about the role of a CfD for carbon capture and storage (CCS). Could it also be the key to unlocking the potential of hydrogen?

Known unknowns

Finn says uncertainty is nothing new to the organisation, adding: “In some ways, you can compare the current situation (in relation to Covid) to when we started up. Because back then we didn’t know what it was all going to look like. We have dealt with uncertainty in the past. It’s just that this is a different uncertainty.”

Even so, the task of accurately predicting how much suppliers would have to pay to cover the cost of CfD generation was made far more complex by the impacts of Covid. This interim levy rate is calculated on the basis of forecasting the amount of CfD generation and the demand (netting off demand from energy intensive industries) to come up with a pounds per megawatt hour (£/MWh) figure.

As Finn puts it: “When all those numbers move around it creates a very different picture. What happened was that we continued collecting the amount per MWh but the MWhs were going down – so we were collecting less money.

“The mechanism was designed to cope with this sort of situation and there was never a financial risk to our business because of the way we are set up. But, there was obviously a question of whether it was the right thing to do to ask for more money when there were suppliers out there facing real problems.”

The solution was for the Department for Business, Energy & Industrial Strategy (BEIS) to offer a loan, capped at £100 million, meaning the extra amount owed was not levied on suppliers in the short-term. Finn stresses that this money will need to be repaid in the second quarter of 2020, but this means it will not compound the issues suppliers are facing this winter.

While the future remains uncertain, Finn points to a recovery in demand and the fact the CfD reserve pot has now been replenished (standing at £127 million at the time of writing) as signs that another loan is unlikely to be requested.

Finn says she was impressed by the resilience of the industry during the pandemic. As lockdown measures were introduced, the LCCC contacted all its generator projects to assess the likely impact. Out of 49 projects, 15 indicated they may need to access force majeure relief. However, to date only one project has required a time extension.

Bigger and faster

With the Covid conundrum overcome for now, LCCC turns to the small matter of next year’s auction, which is set to have twice the capacity and open to a wider pool of projects. Finn acknowledges a clear desire for this to happen but also highlights the practical implications.

“What industry tells me is that we need more auctions and they need to be bigger. That’s a policy call but the basic equation is that if the auction is twice as big or twice as frequent, we would need to deal with greater complexity and more participants.”

A proposal on whether offshore wind should operate in its own distinct pot for the next CfD auction remains up in the air, but can this technology’s success be replicated in other areas – such as marine technology projects?

Finn says: “New technologies tend to be very expensive. Some will work, some won’t and allowing the market to determine which ones are going to succeed is very powerful. That’s a really strong element of the UK approach – allowing the market to weed out those technologies that are going to work and scaling those up. I don’t see why that dynamic can’t work with other technologies.”

Hydrogen potential

There has also been speculation that the CfD model could help to stimulate a low-carbon hydrogen industry in the UK.

A study, submitted by consultancy Frontier Economics for BEIS in August, suggested that contracts like the CfD could either provide a premium on top of market revenue from the sale of low-carbon hydrogen or guaranteed returns to producers through top-up payments.

Finn says: “We are set up to deal with the power sector – that is our core competency. But, of course we’re aware that net zero has to go way beyond one sector.

“When you are encouraging investors into a new space you are going to want a mechanism they are familiar with to give them confidence.

“There’s clearly potential for that mechanism to be used in other areas and we are already working with BEIS on the role of a CfD in CCS in the power sector. There’s obvious parallels in that you can have CCS for the industrial sector. You could use a private law instrument in hydrogen.

“There’s certainly potential and there’s certainly investor appetite for that type of thing but what we need to do is offer our learning to BEIS and to the wider government. In so far as we could be made the counter-party to these things, then we need to make sure our business is ready to do what we’re asked to.

“Our job is to be nimble enough to be able to pivot to whatever is needed because it takes time to build the system and get things up and running.”

The evolution of economic regulation

As the helm of Ofwat between 2006 and 2013, as its first chief executive, Finn was integral to a shift in the way utilities are regulated – moving from a pure economic model to a greater focus on environmental and social targets.

She muses that the current conversations in the water sector around social contracts “were nowhere near the agenda when I joined Ofwat – and for that matter nor were sustainability and climate change”.

She adds: “It was really important to change the industry mindset from ‘our job is to pour concrete and build reservoirs’ to ‘our job is to provide our customers with a good service and an environmentally sustainable service’. That was a big battle. Embedding consumer outcomes in the price control was a huge shift. They (the water companies) were all so sceptical, they thought it was just outrageous but we got there. I’m really pleased that the strategic agenda we set then has informed where we are now.”

Finn believes the UK has moved from an initial approach to regulation, which focussed on the technical sides to a second iteration introducing a focus on customer outcomes and is now evolving into “regulation 3.0”. She believes this needs to focus on a “more holistic model” that engages with the fairness debate and the distribution of benefits across geographies and social groups.

She adds: “What we need now is regulators not so much setting targets, as setting expectations and driving behaviour.”

However, she warns: “What they definitely shouldn’t do is step in and try and take responsibility for running the businesses. It’s really important not to cross that line because then you take away the incentive on the business to be responsible for its own delivery.”

Former Ofgem chief executive Dermot Nolan expressed the view in a recent interview with Utility Week that the regulator would benefit from statutory guidance from government to clarify its objectives in the face of the net-zero task. He pointed to the success of charging guidance given to Ofwat in 2016.

Finn agrees that “clarity from government is always helpful” in embedding net zero more clearly in Ofgem’s decision-making, however she adds: “Regulators have always had to change over time to take policy framework into consideration.”

Asked whether a separate body should be established to take charge of delivering net zero, she says: “You have to be careful of the proliferation of institutions in this sector. What is important is the role, the function of holding people to account for delivering net zero, rather than the institution itself.”

And, despite its need for further evolution, the UK regulation of utilities is still held as an example across the world, Finn insists.

“I have been invited all over the world to speak about how it works and how it has developed. It’s a real success story for the UK and I’m proud of my part in it.”