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Understanding Contracts for Difference

Last month, the Government published a provisional timetable for the fifth allocation round of Contracts for Difference, the primary incentive mechanism for renewable generation in the UK. With the allocation framework and the window for applications expected at the start of December, here we lay out how the Contract for Difference system works and who can apply.

What are Contracts for Difference?

Contracts for Difference (CfDs) are used to incentivise investment in renewable energy by providing developers with direct protection from volatile wholesale energy prices. In turn, projects with high upfront costs can ensure that they remain profitable throughout the lifespan of the project. On the other hand, they are also used to protect consumers from paying increased support costs when electricity prices are high.

CfDs ensure that generators receive a fixed, pre-agreed price, known as a strike price, for the low carbon electricity they generate for the length of the contract. While generators sell their electricity to the wholesale market as normal, when market prices are below the strike price, they receive a top-up payment to make up the difference. This is calculated and paid out by the Low Carbon Contracts Company. If the wholesale price is above their strike price, then the generator is expected to pay back the difference. Only renewable generators can access CfDs, while a slightly difference mechanism is in place for nuclear generation. They are not open to oil and gas.

Many in the industry have argued that expanding the Contracts for Difference scheme would help to protect both generators and consumers from market volatility, and could help to mitigate the impact of price rises such as those being experienced currently. However, the percentage of renewable generation in the UK that holds a Contracts for Difference is still very low, and most large-scale generation instead is remunerated through the older Renewable Obligation system, which simply provides the wholesale market price plus a fixed subsidy. While closed in 2014, the 20-year contracts it offered means that it will still be in place for some generators until 2034.

Contracts for Difference Allocation Round Five

The fifth allocation round for CfDs marks the start of a significant change when they will switch from being released every two years to annually. Other changes are relatively minor, with a beefed-up Supply Chain Plan questionnaire and a new provision that generators hit with a Non-Delivery Disincentive for failing to meet delivery commitments will be barred from the scheme for two years.

Applications will open in March 2023, with a final decision coming as early as June. However, a lengthy appeals process could stretch that until September. The new, annual nature of CfDs is hoped to introduce more stability in price for end users into the wholesale electricity market, which combined with a proposed decoupling of gas and power prices could play an important role in what looks to be a lengthy recovery period from the energy crisis.

For businesses with their own renewable generation in place, it is likely that they would fall under the Smart Export Guarantee, which offers a similar incentive scheme for smaller generators.