Auctions are generally an effective market-based mechanism for encouraging renewable energy projects. The recent failed auction in the UK highlights the pitfalls of not accurately balancing risk and reward

Ryan

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<h2>A case study in market dynamics</h2>
<p class="">On September 8, 2023, the UK&rsquo;s Department for Energy Security and Net Zero announced that not a single bidder showed interest in the offshore wind contracts in <a href="https://www.bbc.co.uk/news/business-66749344" target="_blank" rel="noopener">a recent auction</a>. Historically, such auctions have always had successful outcomes, which has allowed the UK to become a leader in offshore wind, with 14 GW of capacity. Given that wind energy is pivotal to the UK's ambitious net-zero targets, what led to this outcome? Below, I unpack the mechanics of Contract for Difference (CFD) auctions and shed light on why this crucial market mechanism failed.</p>
<h2>CFDs and their role in renewable energy projects</h2>
<p class="">A CFD is essentially a financial agreement aimed at spurring investment in renewable energy by hedging price risk. In this contract, an energy generator and a counterparty (often backed by the government) agree upon a fixed "strike price" for a set period. Once the energy project is operational, if the market price of electricity drops below this strike price, the counterparty makes up the shortfall. If the market price rises above it, the generator pays back the difference.</p>
<p class="">The idea is to provide some level of revenue certainty for energy producers. Without this long-term revenue certainty, it can be less efficient for projects to secure financing and proceed with development. This is because electricity generation assets require large amounts of capital investment and are long-lived assets. More stability in future cash flows lowers risk (and therefore the discount rate) and increases the value of these projects to investors, making it more likely that the generation projects will move forward. In addition to these benefits to encourage investment, the CFD mechanism also protects consumers from excessively high electricity prices because generators only receive the strike price when wholesale prices are high.</p>
<h2>The auction</h2>
<p class="">Central to the CFD mechanism is the concept of an auction, a competitive bidding process that aims to allocate renewable energy contracts at the lowest cost. The process starts with a government or regulatory body announcing an upcoming CFD auction, detailing key attributes such as the total capacity to be auctioned, eligible technologies, and the timeline for the auction process. Potential bidders then undergo a pre-qualification process, meeting specified criteria such as financial stability, technical capability, and past performance in energy projects. This phase ensures that only capable and reliable entities can participate.</p>
<p class="">Come auction day, each bidder submits a bid specifying two crucial aspects: the amount of electricity they plan to produce and the "strike price" at which they can sell this electricity. This strike price is essentially the minimum amount a developer needs to make the project economically viable. Bids are ranked from the lowest to highest strike price. Contracts are then awarded starting from the lowest-priced bid until the total capacity earmarked for the auction is filled. Different auction models, such as pay-as-bid or uniform pricing, can determine how the strike price is set for each winning bidder. Some auctions implement price floors and caps to maintain a sustainable and competitive bidding environment. A price floor ensures that bids don't go so low as to jeopardize the feasibility of projects, while a cap prevents excessively high bids that could inflate energy costs for consumers.</p>
<p class="">Winners are awarded a CFD, usually lasting 15 to 20 years, providing them with long-term price stability. Contracts are finalised, specifying obligations for both parties. Once a CFD is awarded, the winning developers move on to the project implementation phase, which involves securing finance, obtaining necessary permits, and eventually, construction. Upon becoming operational, the CFD mechanism kicks in. If the market price for electricity is below the agreed strike price, the counterparty (often a government entity) pays the difference to the energy producer. Conversely, if the market price exceeds the strike price, the energy producer pays the difference to the counterparty.</p>
<h2>Why did the UK's offshore wind auction fail?</h2>
<p class="">The UK government had set an ambitious price cap of &pound;44/MWh, intending for generators to bid the price down from there in the auction. An example of how the UK had hoped the auction would work is illustrated in Figure 1 (numbers are fictitious). In this example, two developers bid, one bidding 2 GW of capacity at &pound;30 MWh and a second bidding another 3 GW of capacity at &pound;25.</p>
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<p class="">However, what actually happened was that the &pound;44/MWh price cap was too low for any developers. Although price caps are often politically popular for appearing to protect consumers, they can backfire by discouraging participation, as happened here. The resulting failed auction is presented in Figure 2, showing our two fictitious developers with minimum prices far above the government price cap, resulting in no bidders and 0 GW in capacity provided.</p>
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<p class="">The problem comes from the instability and uncertainty faced by wind generators. Again, note that the intended incentive of a CFD is to decrease uncertainty in future cash flows, thereby lowering the risks associated with investing in the project. The problem is that UK energy markets are dealing with high uncertainty, in terms of inflation, currency instability, high raw materials costs (especially steel), a shortage of skilled labour, and an uncertain political and regulatory environment. The current high interest rates also raise financing costs. The grid infrastructure also needs crucial upgrades to ensure that renewable energy can be transmitted to consumers, further increasing uncertainty. All these factors increase risk and make the required future cash flows higher in order to pay for the initial investment.</p>
<p class="">In fact, the long durations of CFDs, usually 15-20 years, have clearly worked against the auction in this case. In stable periods, these long durations are a valuable benefit as they provide more revenue certainty and lower risk. However, in unstable periods, no generator wants to be locked into a fixed price that may turn out to be too low 8 years down the road.</p>
<p class="">At issue here is the price cap. Such caps are attractive politically because price caps appear to control costs for consumers. However, economists have demonstrated for centuries that price caps cause shortages. In this case, a shortage of bidders for offshore wind. It is particularly difficult for a single agent, in this case government, to set an &ldquo;accurate&rdquo; price in periods of high volatility. Just like pegs in currencies, they get broken and often cause huge political problems. Rather, a large number of agents competitively bidding against one another would result in a more efficient market price. Auction theory is generally well-understood, both in terms of pros and cons and used in a stunning variety of activities, from Google searches to allocating radio spectrum in telecommunications.</p>
<p class="">While CFDs are generally an effective market-based mechanism for encouraging renewable energy projects, the recent failed auction in the UK highlights the pitfalls of not accurately balancing risk and reward. Policymakers must be cautious when setting price caps, especially in volatile economic conditions. Trusting market forces to establish a fair market price through competitive bidding can often yield better outcomes for both consumers and investors.</p>
<p class=""><em>This article is also published on <a href="https://enodatech.com/news-insight/unravelling-the-uks-failed-offshore-wind-auction" target="_blank" rel="noopener">ENODA</a>. illuminem Voices is a democratic space presenting the thoughts and opinions of leading Sustainability &amp; Energy writers, their opinions do not necessarily represent those of illuminem.</em></p>
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Unravelling the UK's failed offshore wind auction

How continuous evolution of the grid enables the increasing demands of our energy-hungry civilisation

<p class="">The electrical grid is an impressive feat of human engineering that has evolved over time to become the most important infrastructure of modern society. From its humble beginnings as a simple network of wires and generators, the grid has grown and adapted to meet the ever-increasing demands of our energy-hungry civilisation.</p>
<p class="">But how did this remarkable system come into being? To answer this question, we must look to the forces of evolution, which have shaped the grid over time in much the same way as they have shaped all living things. Like all successful organisms, the grid has evolved through a process of natural selection, in which only the most well-adapted designs survive and thrive. The earliest grids were simple and inefficient, relying on large generators to produce a limited amount of power that was then distributed through a network of wires to homes and businesses. Many of them ran at different voltages from each other and represented massively inefficient infrastructure investment. Many of them used direct currents (DC) which required the generators to be located close to the end customer. Generally, these early grids were crude and unsophisticated, but they represented a crucial first step in the evolution of the grid.</p>
<p class="">Over time, however, the grid evolved to become more complex and sophisticated. Engineers developed new technologies, such as alternating currents (AC), transformers, and capacitors, that allowed electricity to be transmitted over longer distances with less loss of power. They also created new types of generators, such as nuclear reactors and wind turbines, that could produce electricity more efficiently and sustainably.</p>
<p class="">But the evolution of the grid was not a smooth and steady process. Like all natural systems, it was subject to the whims of chance and the caprices of its environment. Blackouts, brownouts, and other disruptions have plagued the grid throughout its history, forcing engineers to adapt and improve their designs in response.</p>
<p class="">One of the most important factors in the evolution of the grid has been the growth of our energy needs. Energy demand grows roughly at the same rate with the broader economy, increasing almost in lockstep with GDP. As our civilisation has become more reliant on electricity, the grid has had to adapt and expand to meet our ever-increasing demands. These evolutionary pressures have required engineers to develop new technologies and infrastructure, such as smart grids and energy storage systems, to manage the flow of electricity more efficiently and reliably.</p>
<p class="">Generally speaking, these innovations were not created by an omniscient Central Planner who optimally designed the grid from the outset. Rather, they are the result of trial and error, micro-improvements incentivised by a profit-seeking motive. The evolution of the grid therefore remains guided by a <em>Blind Gridmaker</em>, subject to the same forces of natural selection that govern all living things. It is a system that must constantly adapt and evolve in response to the changing needs and challenges of its environment.&nbsp;&nbsp;</p>
<p class="">And like all living things, today&rsquo;s legacy grid is subject to the laws of entropy, which dictate that it will eventually decay and die in its current form. As its environment changes from a world with fossil-fuel-powered generators with large amounts of inertia to a world powered by unpredictable renewable energy, it will need to evolve into the next generation that is better adapted to its new environment.</p>
<p class="">What types of innovative breakthroughs will evolve with the grid? It is clear that the grid of the future, like the internet, will be a two-way system, with information flowing both upstream and downstream. Legacy one-directional technologies, such as traditional transformers, will not survive the generational leap in their current form and will eventually be replaced by smarter technologies.</p>
<p class="">Flexible, modular technologies that quickly respond to local changes in load will be required. This need is enhanced by the fact that many renewable energy sources generate direct current (DC) power for a grid that runs on an alternating current (AC)*. These technologies will be &lsquo;smart&rsquo; and at least partially autonomous, with the ability to make decisions to optimise generation and load based on local signals without the need to communicate with a central authority. This also adds resilience to the grid, preventing the classical &lsquo;domino-effect&rsquo; blackout problems. When system problems such as blackouts are detected, these modular smart systems can quickly isolate the problem and protect the rest of the grid.</p>
<p class="">Consumers will also evolve into key market participants. The introduction of smart meters is a first step in this evolutionary process, but the grid of the future will ultimately result in a broad range of choices for consumers that should ultimately bring down costs, in a system that may resemble mobile phone plans today. Early mobile phone pricing allowed customers to add certain data limitations and also charged different prices for calling during peak times. The evolution of the internet alongside mobile phones allowed customers to know their usage and costs in real time, no longer waiting for a monthly bill to know their usage.</p>
<p class="">This new environment will need appropriate rules meant to encourage entrepreneurs, policy makers, engineers, and scientists to seek new ways to harness the power of electricity and use it to meet the needs of our civilisation. These rules should be simple, universal, and utilise the power of human innovation and motivation. Current policy and regulatory debates on issues such as data privacy/management and artificial intelligence (AI) should occur with an eye on the need to encourage technological innovation to power the grid of the future.</p>
<p class="">The history of the grid is a testament to the power of natural selection to shape and transform the world around us. It reminds us that the forces of evolution are not limited to the realm of biology, but extend to all aspects of our world, including the systems and technologies that we create.</p>
<p class="">As we continue to face new challenges and opportunities in the world of energy, the story of the grid will continue to evolve, driven by the forces of natural selection and the ingenuity of human engineers, scientists, and entrepreneurs. And as the grid continues to evolve and adapt, it will remain a testament to the power of evolution to shape and transform the world around us.</p>
<p class=""><em>illuminem Voices is a democratic space presenting the thoughts and opinions of leading Sustainability &amp; Energy writers, their opinions do not necessarily represent those of illuminem.</em></p>

Ryan Williams

Ryan Williams

Unravelling the UK's failed offshore wind auction

The blind gridmaker

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