The Orsted decision to put the Hornsea 4 project on hold has come as a surprise to the industry, and presumably to the government as well. At 2.4 GW, it would have been the biggest offshore wind farm in the UK fleet and its withdrawal is a setback for the Clean Power Plan.
There has been a lot of speculation about whether this is a tactical withdrawal of a difficult project, a corporate decision driven by Orsted’s balance sheet challenges elsewhere or a sign of a more systemic problem within the offshore wind sector. We don’t know the full details, and it could be all of the above, but coming after previous setbacks for CfD-backed projects and CfD allocation rounds, Hornsea 4 could provide a trigger for a more holistic look at how the CfD mechanism is structured and whether this particular form of price-contract revenue support is right for the next phase of large-scale renewable energy development.
Suggesting such a change may seem like sacrilege. No-one likes change and, in this case, the CfD scheme has been a notable success. The key advantage of CfDs, over a straight subsidy, is the nature of the two-way contract that gives developers a reasonable degree of revenue certainty while at the same time offering the consumer a price guarantee, with a payback if electricity prices are high. So, it meets the objective of supporting investment while allowing the consumer to share in the value of lower-cost renewables. However, this only works if the auctions are competitive and projects are actually built.
In other respects, CfDs are quite awkward. The timing is a bit betwixt-and-between. Developers would rather have a guarantee of revenue support at the start of the project, before they have to invest hundreds of millions in lease fees and development costs, yet the strike price setting, three or four years before construction and before supply chain contracts and finance have been raised, introduces a significant investment risk from cost increases, changes in the cost of capital and, indeed, policy or political upheaval. There is also the added risk of further delays waiting for planned grid capacity.
As a result, the award of a CfD is no guarantee that projects will be built. Too much can happen. There is even an argument that the timing of CfD awards may be increasing project lead times because developers are reluctant to fully commit to development until they have a contract and then face further delays while they finalise the project design, supply chain and finance. It could be better to give developers a guarantee of investment support at, or near, the start of the development cycle and then incentivise them to bring projects forward as quickly and cost efficiently as possible.
The problem for government and its Mission Control team is that there is limited visibility after CfD award as to how the project is progressing or whether it’s in trouble. The ultimate decision to build or not is often taken in overseas boardrooms. Even if Mission Control is aware of a problem, they have limited options. The CfD contract terms are mostly fixed, and so the only option for a developer is to cancel the project and perhaps bid again into a future CfD round.
What’s the alternative? Is it possible to retain the positive features of the CfD – the two-way value share and competitive pressure to reduce costs – while providing greater certainty that projects will be built, or at least the means to pre-empt when a project may be in trouble to allow a joint decision whether to cancel or adjust the level of support? Could an alternative approach also reduce lead times and create a route for greater levels of public investment and co-ownership?
A decision to change the basis of revenue support, risking an upheaval and investment hiatus, should not be taken lightly. It is, however, also the case that the CfD scheme has been subject to continuous tinkering, the latest round of which has included proposed changes to the CfD terms and qualification criteria. As price cannibalisation becomes more of an issue there are even calls for a deemed approach, breaking the link between CfD payments and actual generation. If that goes ahead the CfD is radically different from its original design and begins to function more as a revenue or return guarantee. If we go for zonal pricing – a bad move but still on the table – the government may be able to pull together sufficient price and volume protection for the next auction, AR7, but the level of protection for future CfD rounds is completely uncertain.
An alternative approach could retain some key aspects of the CfD auction rounds but lean more towards a regulated asset base-type model with an open-book arrangement to co-manage the investment case with government. The regulated asset base, or RAB, model is now the favoured approach for nuclear, after one CfD round for Hinkley C, and is the standard investment model for network infrastructure. It's a shock to be considering yet more regulation but, done well, RAB schemes can significantly reduce the cost of capital.
A key advantage of this model for generation is that it enables generators to participate more freely in the market, without the need to generate and trade in the day-ahead market. This could reduce market price distortions and increase liquidity in both forward and intra-day markets.
Going further, and putting government more firmly in the driving seat, a design build finance operate (DBFO), model with the government – or its agents in GB Energy and the National Wealth fund – acting as the ultimate developer, would allow greater public ownership.
The downside is that both of these options transfer risk on the costs of development from the private to the public sector. Under CfDs, the overrun on Hinkley C costs sits with EDF; for Sizewell C under the RAB model, cost increases will be paid for by the GB consumer. However, they provide more certainty that projects will be built and lower the overall costs of capital – a major part of the total bill for large electricity generation projects.
Less radical would be a reform that retained the core elements of the CfD (price-based auction and two-way contract) but with a more transparent mechanism for government to look inside project costs and finances and to make adjustments to the CfD strike price without the need for projects to cancel themselves and reapply.
“Too much scope for state interference,” some will say. Yes, that is a risk, but given the increased interdependence between projects, and with network and interconnections, the situation where individual developers can just drop a project without any state recourse is also untenable.
It's hard to see a silver lining in the Hornsea 4 decision, but setbacks can provide the opportunity and impetus for greater innovation. Changing the CfD system would be a significant upheaval at the time we are racing towards 2030. However, it may be time to at least start to consider what an alternative investment support arrangement would look like in a post-CfD world.
