Contracts for difference are a small part of the wholesale market now, but soon they will be affecting market behaviour, argues Mark Meyrick
Under the government’s Electricity Market Reform, its replacement for the Renewable Obligation is now upon us. The CfD, or Contract for Difference, now means there is about 6.4GW of power coming onto the grid, mostly between now and 2021. This is likely to have a profound effect on the wholesale market.
Consider how the contracts are designed: owners of a CfD only have to make sure they are dispatched via the day ahead auction to win their CfD price. This will influence their behaviour in two ways.
As merchant plant under the old Renewables Obligation system – if eligible – they would to some extent have sold power opportunistically in the forward market to ensure they captured a worthwhile sale price. Now they no longer have to do that – they simply need to ensure they get their CfD price. This will have a distorting effect on the wholesale market because there is now a whole slab of power with no interest in selling forward. Yet suppliers have to buy forward to hedge their customer positions, even if it’s only chunks of forward base and peak products. Result? We get an asymmetric market with a lot of suppliers looking to buy forward power, but a lot of generators only interested in selling day ahead. With too little demand chasing too little supply along the curve, the forward curve will steepen – go into contango – and more aggressively so as more CfD plant comes on to the system.
In the short-end, by contrast, CfD plant has to get scheduled – so it will come into the auction at zero, or lower, knowing it will get the cleared price anyway, but more pertinently, get its CfD price.
With too little demand chasing too little supply along the curve, the forward curve will go into contango
Given the volumes of CfD plant this raises the distinct possibility of auction prices actually out-turning at zero, something the Department for Business, Energy and Industrial Strategy (BEIS) eventually realised. So it revised the CfD rules for new CfD contracts from April 2016 such that if the day-ahead price out-turns as zero for six hours in succession, the CfD price will not apply, the difference payment will be set at zero and affected plant will get paid per auction clearing price – possibly negative. Existing CfDs will not be amended, so generators with these contracts will receive difference payments, capped at their strike price, during periods of negative prices, regardless of the length of those periods.
This does mean that second round CfD plant will have to be a little more intelligent when offering into the market.
We won’t know how much plant this will affect until the round two out-turn is known in September, but it does mean that round two CfD owners will have to try to forecast day-ahead prices and offer into the auction accordingly – at a positive price. If all participants do this, it should avoid a deluge of zero-priced offers and the possibility of negative pricing – thus preserving the value of the CfD contract. But 8GW of plant – if we include Hinkley Point C, if it ever gets built – is not an insignificant amount of plant, and it is not affected by the new provisions.
The further implication of this is that it’s likely to have a depressing effect on the short-term market, exacerbating the contango, as well as unhinging the merit order effect, particularly in relation to plant that does have a marginal cost, such as biomass. Marginal cost issues that normally underpin the merit order effect will be overpowered by the marginal revenue.
In any case, the merit order effect may be dislocated by the grid having to constrain renewables and run fossil plant for system stability reasons. But that’s another story.
First published in the July 2017 issue of New Power
OpenLink: Get ready to manage fast-response trading (subscriber-only)
Not a subscriber? To see if you qualify for our next FREE TRIAL send your name, job title, and telephone number to firstname.lastname@example.org