Imagine investing in a solar farm or a wind turbine and being guaranteed a certain price for the energy you produce, despite fluctuating prices in that market. This is the basic premise of contracts for difference (CfDs), which is one of the tools being used to incentive the shift to lower-carbon energy sources.
Contracts for difference have been spurring investment in renewable energy sources, but they can lead to inefficiencies in how energy is produced and consumed, and ultimately, distort the energy market.
A recent paper published by the Oxford Institute for Energy Studies, “Contracts for Difference – CfDs – in the Energy Transition: Balancing Market Efficiency and Risk Mitigation,” explores alternative CfD designs that encourage better alignment with market conditions.
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The authors Abolfazl Khodadadi and Rahmatallah Poudineh write:
Historically, CfDs have been successful, particularly in the UK, where they have significantly expanded renewable capacity and reduced costs, especially for offshore wind. However, the traditional two-sided CfD model, while stabilizing revenues, has inherent challenges including market distortions, inefficiencies, and encouraging a ‘produce-and-forget’ mentality among generators.
“Contracts for Difference – CfDs – in the Energy Transition: Balancing Market Efficiency and Risk Mitigation,” by Abolfazl Khodadadi & Rahmatallah Poudineh. OIES Paper: EL56, Oxford Institute for Energy Studies, July 30, 2024.
Conventional CfDs often fail to align generators’ incentives with market signals, leading to overproduction and inefficient dispatch, especially during periods of low or negative market prices. This misalignment can exacerbate grid imbalances and increase system costs. In practice this means that the financial stability provided by CfDs comes at the cost of reduced responsiveness to market conditions, which is crucial for integrating higher shares of renewable energy.”
Some proposed models decouple the payouts from real-time generation, thereby pushing producers to be more responsive to market dynamics. This might sound like a great solution, but it introduces what is known as basis risk because the reference prices in the contract might not align perfectly with actual market prices.
These changes represent a complex balancing act between mitigating risks for renewable energy producers to keeps investments flowing, while ensuring a thriving energy market flexible enough to handle the varying supply and demand that comes with renewable energy.
Download full paper originally published by Oxford Institute for Energy Studies on July 30, 2024.
