OPINION | ‘CfDs can make offshore wind a fundamental feature in a future decarbonized electricity market’

December 8, 2023
4 min read
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Contracts for Difference (CfDs) need to be rethought as a risk management tool rather than a cash cow for government coffers. Doing so, writes Lena Kitzing, would contribute substantially to providing much-needed revenue stabilization investors want

The global offshore wind industry finds itself at a pivotal point in its history as leaders of 118 national governments put pens to paper on pledges at the COP28 climate summit in Dubai that aim to spur the world toward tripling renewable energy capacity, with new commitments on adopting ambitious energy transition policies underpinned by policies to strengthen market conditions and investment frameworks.

These political pledges come against the backdrop of a turmoil in the offshore wind energy sector, in which – ironically – policy plays a decisive role. After more than a year of supply chain travails, high inflation, rising interest rates, volatile prices and failed auctions, Reuters recently reported offshore wind power has “drifted off course”, quoting the Global Wind Energy Council’s CEO as saying: “The ratio between risk and reward is out of line in the offshore wind market in many jurisdictions. You can see this from investors not showing up.” And citing industry advocacy body WindEurope’s view that poor auction design has undermined the revenues of developers and turbine manufacturers.

ERM’s COP28 Global Offshore Wind Update revealed the world is not even currently on the path to building 50% of the offshore wind capacity needed by 2030 to keep global warming below 1.5°C.
Research shows allocation of risk and return is the most prominent task in designing support policy and key to ensuring investment. Unfortunately, the relation between risk and return is not adequate for offshore wind in many jurisdictions right now – precisely because of the way markets are designed and procurement schemes are implemented. Markets are not providing adequate long-term future products and risk hedging options to encourage and manage sufficiently high levels of investments. Declining support payments leave offshore wind projects more and more exposed to volatile market prices.

Picture of Lena Kitzing,
Head of Society, Markets & Policy, DTU Wind Energy Systems

'Markets are not providing adequate long-term future products and risk hedging options to encourage and manage sufficiently high levels of investments needed by offshore wind'

Lena Kitzing
Head of Society, Markets & Policy
DTU Wind Energy Systems

This is a significant barrier to investment, as I noted in a paper just published in Nature Energy. Offshore wind projects incur up to 90% of lifetime cost upfront and have very low operational costs. To finance the high upfront capital needs, projects typically take on long-term loans with heavy debt-service commitments. The economic viability of these projects hinges on stable, long-term revenues – but markets cannot deliver those, because of their volatile nature and limited hedging options.

Market price exposure creates problems for offshore wind assets at a level of magnitude higher than it is the case for most fossil-fuel-based power plants, which carry 70-80% of their lifetime cost during operations (mostly through fuel purchases), and so are not subject to the same financing burdens.

The different cost structure of the assets requires a rethinking of the way the markets are structured. This has been known in academic circles for some time, with researchers having argued that new ways of strengthening long-term markets for improved investment incentives are needed, while at the same time upholding the efficient functioning of short-term markets.

Governmental Contracts for Difference (CfDs) – on which 50% of all offshore wind projects globally have been procured to-date – can be a viable solution to provide adequate long-term products on European electricity markets if they are designed well and risks and returns adequately balanced. CfDs will have an enduring role on electricity markets not only as instruments to allocate support to otherwise uneconomic projects but even more as a mechanism to manage risk through price stabilization.

For offshore wind in mature markets, the risk management aspect will be a key feature of coming CfD schemes, not the financial payout. In other words: CfDs are not just support instruments, they are hedging products (more precisely: fixed-for-floating swaps) provided by the government into a market that structurally underprovides these products and government and industry need to acknowledge that projects can be economically feasible without financial support needs – in terms of positive net payout – and still need CfDs to become bankable and thereby enable investment.

To reach the enormously ambitious build-out targets for offshore wind and achieve our long-term climate action goals, CfDs can be an effective instrument for de-risking investments at scale. CfDs cannot solve all of the risk issues offshore wind is facing, as they are predominantly focused on electricity prices only (while current issues occur on multiple markets). But they contribute substantially to the much-required revenue stabilization that many investors need. In this regard, they can become a valuable fundamental and lasting feature in the future decarbonized electricity market.

• Lena Kitzing is Head of Society, Markets & Policy in the Technical University of Denmark's Wind Energy Systems division. Her recent paper with collaborators Philipp Beiter, Jerôme Guillet, Malte Jansen and Elizabeth Wilson, the enduring role of contracts for difference in risk management and market creation for renewables, can be found here.

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