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Contracts for Difference for renewable energy

The Contracts for Difference (CfD) scheme is a government subsidy that encourages investment in renewable energy in Britain.

It ensures that large-scale projects, such as offshore wind farms, receive a guaranteed electricity price, providing financial stability before construction begins.

The sections below explain the key elements of renewable energy CfDs.

• What are Contracts for Difference?
• How Contracts for Difference work
• Contracts for Difference strike prices
• The Contracts for Difference auction process
• Who pays for CfDs and how they affect electricity bills

What are Contracts for Difference?

A Contract for Difference is a long-term agreement between a private renewable energy developer and the government-owned entity, the Low Carbon Contracts Company (LCCC).

Under a CfD, the developer is guaranteed a fixed price per MWh of electricity generated, typically for 15 or 20 years after the project is completed.

This price certainty protects developers from volatile market prices and helps them secure long-term financing for new projects to encourage investment in wind, solar, and other renewable projects.

Why were Contracts for Difference introduced?

The Contracts for Difference scheme was introduced to replace the Renewable Obligation scheme, which stopped accepting new participants in 2017. The Renewable Obligation scheme provided subsidy payments to renewable energy developers regardless of current wholesale electricity market prices.

As renewable energy technology has improved, the cost of renewables has become more competitive compared with non-renewable technologies, meaning that the generosity of the subsidy could be reduced.

The CfD scheme has been designed with an auction mechanism that ensures the subsidy size (and therefore the cost to consumers) is as low as possible for each type of renewable technology.

How Contracts for Difference work

This section explains how a Contract for Difference works in practice to guarantee the price per MWh received by a participating generator. This price is known as the strike price and is agreed as part of the auction process.

Under the scheme, the government-owned LCCC does not physically purchase power; instead, it pays the difference between the agreed strike price and the current market price. Here is how it works:

1. Sale of electricity onto the wholesale market

Once built, the generator produces electricity and feeds it onto the national grid, selling the power on the wholesale electricity market.

Renewable energy generators typically enter into long-term Power Purchase Agreements (PPAs) with a licensed domestic or business energy supplier for all the power they generate.

The amount of electricity sold is measured by a half-hourly electricity meter installed at the grid connection and is used to calculate the number of MWh sold under the PPA.

2. Determination of wholesale reference price

The LCCC calculates a market reference price for intermittent electricity fed into the grid, based on a published methodology that reflects real-time conditions in the wholesale market.

This calculation is performed for each 30-minute settlement period.

The market reference price represents the market value of the power generated and is not necessarily the same as the price received by the generator.

3. Calculation of the CfD payment

For each MWh generated, the LCCC will either pay or receive the difference between the strike price and the market reference price.

Whether the LCCC pays or receives money from the generator depends on the state of the wholesale market. There are two possible scenarios:

i. CfD mechanism in normal market conditions

The guaranteed price is typically higher than the prevailing market price, as the CfD scheme supports renewable energy development by providing a stable, generous price.

The government pays the renewable energy developer a top-up equal to the difference per MWh. Here is an example:

• Strike price: £70/MWh
• Market reference price: £50/MWh
• LCCC top-up: £20/MWh

ii. CfD mechanism with high market prices

Less commonly, the price guaranteed by the government is lower than the market price. This occurred in 2022 during the energy crisis.

In such cases, the government receives payments from the renewable energy developer to reduce the amount they earn to the guaranteed strike price:

• Strike price: £70/MWh
• Market reference price: £85/MWh
• Developer owes: £15/MWh

Contracts for Difference strike prices

The strike price in a Contract for Difference is the price the government guarantees to a renewable energy developer.

The strike price is determined through a competitive auction process, in which developers bid for CfD contracts by offering the lowest price at which they are willing to supply electricity.

The government awards CfD contracts only to developers offering the most competitive (that is, lowest) strike prices.

The table below shows the awarded strike prices for different types of renewable technologies from the most recent CfD auctions.

Note: The figures in the table show the 2012 pre-inflation equivalent to allow direct comparison between strike prices.

Since the start of the CfD scheme, strike prices have generally decreased as renewable energy technology has advanced, reducing costs for developers. However, strike prices in more recent auction rounds have risen due to increasing costs in global supply chains for materials and equipment.

The Contracts for Difference auction process

The allocation of CfD contracts is conducted through a competitive bidding process, with long-term agreements awarded at the lowest cost to the government.

Here is a step-by-step overview of the auction process:

1. Eligibility requirements to enter the auction

To enter the auction for a CfD contract, it is necessary to meet the following requirements:

• Technology: The project must use one of the low-carbon technologies allowed in the round; see list below.
• Location: Projects must be located in Great Britain (England, Scotland, or Wales).
• Capacity threshold: Eligible projects typically require a capacity of 5 megawatts (MW) or greater.
• Planning consent: Applicants must obtain all necessary planning permissions and consents before applying.
• Grid connection agreements: Projects must have agreements for electricity grid connection to ensure they can deliver electricity to the network.
• Metering: Electricity exported from the project must be measured separately using settlement-grade electricity metering equipment.

2. Auction budget, capacity cap and Administrative Strike Price

The UK government determines the total available budget and capacity cap (in MW) for each auction, which is allocated across different types of renewable energy technologies.

The government also sets an Administrative Strike Price (ASP) for each category, which acts as the maximum strike price the auction will accept for each type of renewable energy technology.

Renewable energy developers apply to participate in the auction by submitting a minimum required strike price and the expected capacity for their projects.

3. Developers submit bids

CfD auctions follow a sealed-bid process, in which each developer’s minimum strike price remains private until the auction closes.

Typically, a CfD auction will accept bids during a five working day period. The auction process is administered by NESO, the system operator for the national grid.

4. Winning bids are selected

Once bidding ends, the government ranks all bids from lowest to highest strike price for each type of renewable technology.

CfD contracts are awarded starting with the lowest bid and moving upwards until either the budget is fully utilised or the Administrative Strike Price (ASP) is reached.

In Allocation Round 5 (AR5) in 2023, no offshore wind farm bids were submitted below the Administrative Strike Price. As a result, no CfD contracts were awarded in that category for that year.

5. Strike price is calculated

The CfD strike price awarded in the auction is set by the last successful bid for each technology type.

All winning bids within the same technology pot receive the same strike price, even if they originally bid at lower prices.

The Low Carbon Contracts Company (LCCC) signs CfD contracts with all successful bidders.

Who pays for CfDs and how they affect electricity bills

Payments made under the CfD scheme are shared among all domestic and most business electricity customers in Britain.

This section explains how the costs of the CfD scheme are passed on to consumers, and the broader effects of the scheme in reducing wholesale electricity prices and making them less volatile.

CfD supplier obligation levy

The payments made under the CfD scheme are funded by licensed suppliers in the retail electricity market.

Suppliers must pay a CfD supplier obligation levy for each kWh of electricity they sell to consumers.

Each quarter, the LCCC calculates the required CfD levy based on:

• Current market reference prices
• All active CfD contracts
• Total electricity demand on the grid

The table below shows the average CfD supplier obligation levy for the past three years.

Source: LCCC CfD Levy Rates

The CfD levy applies to all electricity supplied to customers on the grid, except for Energy Intensive Industries (EIIs), which are exempt.

Suppliers pass these costs on to consumers through the domestic or business electricity price per kWh included in their tariffs.

Reducing wholesale electricity prices

The CfD scheme has successfully accelerated the deployment of large-scale renewable generators, which incur no direct fuel costs.

As these generators produce electricity at near-zero marginal cost, they displace gas-fired power stations in the wholesale market that rely on burning natural gas.

This has the effect of lowering the prices at which electricity is bought and sold on the market, benefiting all consumers.

Reducing electricity price volatility

The UK imports piped natural gas from Europe and LNG imports from the USA, meaning the prices paid by gas-fired power stations depend on the global gas market. This exposes the UK electricity system to global price shocks, such as those triggered by the war in Ukraine.

The CfD scheme has significantly increased electricity generation from renewable sources, which improves the country’s energy security and makes wholesale electricity prices less volatile.

What technologies are eligible for Contracts for Difference?

In the latest CfD Allocation Rounds 7 and 7a, a range of renewable energy technologies were able to bid in the auction.

The technologies are categorised into three separate groups based on the maturity of the technology and its impact on the electricity grid:

Separate auction: Offshore wind

In the latest Allocation Round 7 (AR7), offshore wind has an entirely separate auction from other technology types.

This is because offshore UK wind farms are already the largest contributor of renewable electricity on the grid. They are separated within the auction process to prevent large-scale offshore wind developers from dominating the auction and displacing other renewable technologies.

Pot 1: Established technologies

Established onshore renewables include the following proven renewable technologies:

• Onshore wind
• Remote island wind
• Solar PV
• Hydro (>5 MW and <50 MW)
• Anaerobic digestion
• Dedicated biomass with CHP
• Energy from waste with CHP
• Landfill gas
• Sewage gas

Pot 2. Less established technologies

The renewable technologies in Pot 2 require higher strike prices to support their continued development. These include:

• Tidal stream
• Wave power
• Advanced conversion technology (ACT)
• Geothermal

Who runs the Contracts for Difference scheme?

The following regulatory organisations and government departments are involved in the delivery of the CfD scheme:

• Department for Energy Security and Net Zero – This government department sets the rules, timing, budget, and Administrative Strike Price for each auction.
• National Energy System Operator (NESO) – Oversees the auction process, including registrations and the review of pre-auction applications.
• Low Carbon Contracts Company (LCCC) – Acts as the counterparty for all CfD contracts.
• Ofgem – The energy regulator Ofgem handles appeals and disputes related to the CfD scheme.
• Elexon – The market operator Elexon is responsible for calculating CfD settlements for participants.

The future of the Contracts for Difference scheme

The Contracts for Difference (CfD) scheme has been highly successful in encouraging the development of renewable energy in Britain. It remains central to the UK’s goal of achieving a decarbonised national grid by 2030.

The eighth CfD auction is currently at the consultation stage, during which the rules are being agreed upon. Below, we explain some of the potential changes to the CfD scheme that could be incorporated into future auctions.

Non-price factors

Currently, the CfD auction process relies solely on financial bids to determine which projects are awarded contracts.

The government is considering introducing non-price factors that would favour developers that:

• Invest in local supply chains to stimulate economic growth in the UK
• Commit to measurable emissions reductions during construction

Nuclear CfDs

In addition to supporting renewable energy development, the CfD scheme could be expanded to support nuclear projects, such as the development of Rolls Royce Small Nuclear Reactors.

Notably, the most recent nuclear power plant development, Sizewell C, will not use the CfD model. Instead, it will operate under the Regulated Asset Base model, which allows the developer, EDF Business Energy, to recover costs during construction.

Other green CfDs incentives

Following the success of renewable energy CfDs, the mechanism is now being used to promote the development of other green technologies.

Here are two recent examples being implemented in the UK:

• Carbon Contracts for Difference (CCfD) – Designed to incentivise carbon capture technologies by providing a secure strike price for carbon emissions abated or removed.
• Hydrogen Contracts for Difference (HCfD) – Used to encourage the low-carbon production of hydrogen by offering a guaranteed strike price per kilogram of hydrogen produced.

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