Electricity generators must prepare for shift to CfDs model

With its electricity generator levy, the government is seeking to encourage generators of electricity from renewables to move onto ‘contracts for difference’ (CfDs) – a two-way mechanism for controlling what end-users of energy in the UK pay to support low carbon generation, such as renewables, and what generators of the electricity receive in return for supplying it to the grid.

However, the shift to a CfD model may not fit with arrangements generators have in place at existing sites, and wider questions need addressed around how improvements to Britain’s electricity grid infrastructure necessary for supporting the transition to a net zero economy should be funded. Some answers may arrive via the Review of Electricity Market Arrangements (REMA) – the much-anticipated government response to its consultation on potential reforms to the UK electricity market, which closed last year.

The energy generator levy and CfDs

Currently, the price that businesses and consumers pay for electricity in the UK is set with reference to the price of wholesale gas, even if the source of energy from which the electricity has been generated is different.

The drive by Western governments to end their reliance on gas supplied by Russia in response to the spike in global gas prices that followed Russia’s invasion of Ukraine last year led to sharp price increases for end users of electricity in the UK – despite government and regulatory measures to cap costs.

This has spurred debate about whether low carbon electricity generators benefiting from being able to sell their electricity at a price that reflects the cost of wholesale gas, and not the lower costs entailed with their operations, should be taxed more heavily.

In the EU, policymakers’ response has been to introduce a revenue cap on power producers. The temporary cap began to apply on 1 December 2022 and expires on 30 June 2023. Amidst political pressure, the UK government also decided to intervene, though it chose a different mechanism for doing so that seeks to incentivise long-lasting changes in the market.

The electricity generator levy (EGL) in the UK is a temporary 45% tax on exceptional revenues derived from electricity generation from certain sources. It was announced by UK chancellor Jeremy Hunt in his autumn statement last year. Draft legislation making provision for the levy was published in December 2022, though the EGL will not be put into law until the next Finance Bill – expected to be introduced before parliament this spring – is enacted. However, while the legislation underpinning the levy is still to follow, the period the levy will run for has already started – it will apply from 1 January 2023 and is proposed to expire on 31 March 2028.

Electricity generators that are signed up to CfDs will not be subject to the EGL in respect of the electricity they generate under those agreements.

CfDs mitigate the risk associated with price fluctuations by ensuring remuneration for supply at a pre-agreed "strike price". If the electricity price achieved by the generator on the market falls short of the agreed strike price, the state compensates for the difference, with consumers ultimately funding such payments through their electricity bills. If the electricity price achieved is higher than the strike price, the generator pays the surplus back to the state. 

By legislating for the EGL until 2028, the government is sending a clear signal that its preference is for electricity generators to move to the CfDs model and that those that do not will face additional taxation.

CfDs, investment and challenges

Substantial investment in new energy infrastructure, and in solar, nuclear and wind generation and the development of carbon capture, use and storage technology, is central to UK government ‘net zero’ targets and has been recommended in the recent Skidmore review. In this context, some renewables developers will be concerned about choosing between paying the EGL and moving to the CfD model and how it might impact their ability to invest.

The government favours CfD auctions as a means of supporting generation capacity and, from allocation round five next month, those auctions will take place annually rather than every two years – another sign of it ramping up its drive to decarbonise the energy sector and address security of supply issues at the same time.

Some reassurance can be taken from the fact that CfDs are a well-known instrument that have been proven for supporting renewables investment in the past – not least in growing the UK’s now-flourishing offshore wind industry from its nascent state around a decade ago – and from the perspective that investors and lenders like the certainty they provide.

However, there are practical challenges relating to transitioning to a CfD model in the context of existing generation sites. Being on a CfD in the UK means not only that the price generators supply power at is centrally fixed, but that the duration of the CfD is set at 15 years too. In respect of existing sites transitioning to the CfD model, generators need to consider whether their underlying project documentation reflects, or can be adjusted to reflect, the term of the CfD.

For example, generators need to ensure that planning, land use permissions and property rights enable them to supply power over the duration of the new contract. Any policy preference to transition existing renewable generators to a CfD will therefore need to track through to the key project consents and rights needed to ensure that the project can remain operational on the site over the lifetime of the agreement.

Private wires, exemptions and funding grid upgrades

Electricity generated which is supplied via private wire networks is also exempt from the EGL. This could encourage more power purchase agreements (CPPAs) to be signed in the months ahead – many businesses already partner with renewables developers to have access to on- or near-site low carbon energy generation to meet their own consumption demands.

However, as private wire arrangements bypass the grid, they raise other issues from a public policy perspective.

Currently, the cost of operating and maintaining grid infrastructure is paid for by fees levied on electricity supply licensees and users of that grid infrastructure. Encouraging generators to ensure that electricity they generate is supplied without needing to use the transmission or distribution system poses a threat to the existing funding model for the grid at the very time that there is a need for more businesses, not fewer, to help pay for the energy infrastructure improvements necessary to facilitate net zero.

Ofgem, Britain’s energy regulator, held a call for evidence around the electricity licence exemption regime in 2020 but has yet to respond publicly to the feedback it received.

Electricity generators would certainly benefit from an exemptions regime that is more generous – some exemptions place low caps on supply – and which is easier to navigate – some exemptions are tortuous to fall within. It would also send a signal to the market that those types of structures are those the government and regulator want to encourage. However, the challenge is that by using those structures generators are connecting to the grid ‘behind the meter’ and avoiding associated network costs.

It is this conflict that is perhaps delaying Ofgem’s announcement.

These issues highlight the conflicts that exist with energy policy and why a whole-of-government approach is necessary to deliver net zero. If the government wishes to encourage investment in low carbon renewables generation and for industry to enter into private wire / onsite PPAs in pursuit of net zero, real thought should be given to whether an alternative funding model is needed to ensure that the necessary improvements to the electricity grid to support the energy transition can be paid for.