The Contracts for Difference (CfD) schemes that have helped increase the build-out of renewables are now making the transition to net zero by 2050 harder and should be phased out, according to technology and innovation centre Energy Systems Catapult (ESC), which is partly funded by the UK government.

Government-led contracting should be replaced by decarbonisation policy mandates for power retailers, and policies and frameworks that allow a free market to innovate, ESC explains in a new report, Rethinking Electricity Markets. The study is focused on the UK market, which was the first to adopt the now-popular CfD mechanism, but its recommendations could equally apply to other nations with similar market frameworks.

“The current government-directed approach to energy is like Boris Johnson telling Steve Jobs how to design the iPhone,” says ESC strategy and performance director Guy Newey.

“History shows that consumers and markets are the key drivers of innovation — and crucially its widespread adoption. Government should step back from micro-managing the electricity mix and empower electricity consumers and markets to drive demand and shape investment for the biggest impact.”

But while this might sound like free-market dogma, ESC says that decarbonisation will only happen in such a system if power companies are legally obliged to reduce their carbon footprint through government-imposed “outcome-based policy mandates” that keep the UK on course to net zero emissions by mid-century.

Contracts for Difference explained

Under a Contract for Difference (CfD) mechanism, project owners are guaranteed a "strike price" for all energy sold on the wholesale market on a per-MWh basis.

The project owner immediately gets paid the market price. If that is lower than the strike price, the government will provide a top-up payment to ensure that the owner receives the strike price. If the wholesale price is higher than the strike price, the owner has to pay the difference back to the government.

For example, let's say the strike price is $50/MWh. If the wholesale price is lower, say $20/MWh, the project owner will receive the $20/MWh from the market, plus a top-up payment from the government of $30/MWh. If the market price was $75/MWh, the project owner would pay the government $25/MWh, so it ends up with its strike price of $50/MWh.

ESC advises the UK government to “[adopt] a more decentralised outcome-based market framework, where policy mandates require outcomes from the market, such as decarbonisation and reliability, but more decisions on how to achieve those outcomes — such as investments, technology choices, business models and innovation — are made by market actors, based on market signals that reflect the physics of the power system and the need to decarbonise”.

These mandates “could take the form of carbon intensity performance standards, obligations or targets (that could be tradable) applied to retailers’ portfolio of energy resources or sales”, the report explains.

The CfD scheme — which has been instrumental in reducing the cost of offshore wind over the past ten years — has led to a winner-takes-all market, in which only winning projects get developed, leaving other developers effectively without a route to market.

“[This] unsupportive policy [is] a key reason why the developer/investor and financing markets are not adapting fast enough,” the 101-page study says.

“The risk under current arrangements is that demand for innovation in contracting, PPAs [power-purchase agreements] and other financial and risk mitigation products will fail to emerge. This lack of risk-bearing opportunities ultimately results in an environment less likely to attract new types of investor and less supportive of innovation in financing.”

It adds that the current centralised policy framework is technology-biased towards generation and large assets, and that CfDs offer no access for aggregated resources such as virtual power plants that pool thousands of rooftop PV systems or EV batteries.

Capacity mechanism

The ESC report also calls on the government to scrap its capacity mechanism (CM), which ensures that the UK electricity system has adequate back-up for times when wind and solar power supply is low. However, this government-allocated capacity market has been dominated by fossil fuels, which have won 70% of the contracted value for 2021-22, the report points out.

It adds: “The existence of CM contracts distorts the bidding behaviour of contract recipients in the short-term wholesale electricity markets and tends to dampen price volatility and the scarcity pricing effect. Without scarcity pricing, neither the market nor system can be efficient.

“Current market arrangements are therefore unable to fully reward flexibility and DSR [demand-side response], thus inhibiting a potential counter influence against variable renewables’ price cannibalisation.”

It explains that “the CM applies restrictive eligibility criteria and is administratively burdensome for small or aggregated loads”.

ESC says that these market barriers and inadequate price signals “are hampering investment in low and zero-carbon flexibility and system integration”.

“[This risks] increased reliance on network reinforcement, overcapacity of renewable power, curtailment costs (to switch renewables off when there is too much power compared to demand) and the need for inefficient and expensive measures to ensure system reliability. The end result is a more costly and carbon-intensive energy system.”

Six recommendations

The ESC study proposes six “key reforms”:

1) Make electricity markets work more accurately in time and space (including more regionalised markets)

2) Phase out centralised contracting (CfDs and CM) by mid-2020s and replace with outcome-based policy mandates

3) Evolve policy to support financial market development and contracting for investment

4) Redesign support for immature technologies to avoid distorting markets

5) Overhaul governance for industry codes, system operation and energy data

6) Align sector strategy and policy mandates with carbon budgets

These recommendations have already won support from notable names in the energy industry, including Greg Jackson, the founder and CEO of Octopus Energy, the fast-growing renewables-based power retailer.

“Government subsidies have catalysed renewable power to rapidly scale up, and we are now ready to lose the training wheels and bolt on the rocket boosters,” he said. “These reforms could build a joined-up system that no longer subsidises renewables with one hand then taxes citizens on the other, but instead matches consumer demand with zero-carbon, zero-marginal cost, zero-guilt electrons.

“Adopting this approach we can make the green revolution faster and cheaper than anyone imagined. But we need to act now — neither the climate, nor citizens, should have to wait.”