Blog post

The lazy (and incorrect) use of the word “subsidy”

Energy Blog, 8 December 2020

We would like to make a stand against the lazy – and incorrect – use of the word “subsidy”, by too many in the media and even in the industry, to describe contracts for differences (CfDs).

A “subsidy” is a straightforward allocation of taxpayer money by a public authority to prop up the production of a good or service by the private sector, used to offset market failures and externalities for a greater good. A CfD, however, is a contract whereby one party (public or private) trades a volatile price for a good against a fixed price for the same good, and another party takes the symmetrical position. They are obviously different things.

CfDs are actually far more commonplace than people realise and exist for all sorts of goods, in particular commodities, energy and interest rates. If you have a fixed-rate mortgage, you have effectively entered into a form of CfD with your bank with respect to the interest rate payable on the money you borrowed. It’s unlikely that you consider your interest rate subsidised!

When entered between two private parties, such contracts are clearly not subsidies, even though they entail one party benefitting from a fixed price for a good for a very long time. So, why do they suddenly become “subsidies” when one of the counterparties is a public entity, or a regulated entity procuring energy? Apart from sloppy use of language, one possible reason that a CfD could be called a subsidy is if the price per MWh is set by a public authority or regulator at a level that is “obviously” out of the market. So, if the Government offers to enter into a CfD at a price of X/MWh compared to a much lower prevailing market price of Y, it becomes possible to suggest this CfD has the characteristics of a subsidy. This was used to criticise for instance the Hinckley Point nuclear project, which has been granted a CfD at a price of 92.50 GBP/MWh which compares unfavourable to “spot” wholesale power prices of ca. 50 GBP/MWh or less.

However, what constitutes being ‘out of the market’ is not always clear when we are talking about a contract that applies for 20 years – or even 35 years in the case of Hinckley Point. The current price may be higher, but the question is what the expectation as to future prices is. For many goods, there simply is no organized market for long term prices, given the uncertainty that can apply to such prices. For instance, just ask anyone if they would be willing to supply you oil or natural gas at a fixed price over 25 years. Or any company owning a gas-fired plant if they would provide fixed price power for the same 25 year period… They would not, because they cannot take the risk that at some point in the future the price of oil or gas will shoot up but they will be committed to selling at the same – then very low – price. So, the mere fact that a power plant, in this case a nuclear or renewable energy producer, is willing to guarantee a price for 20 or even 35 years has serious value and provides a cap to the cost of power to the buyer for a very long time.

If you organise a well-designed tender, and multiple players are able to compete to provide the most competitive offer to supply power for 20+ years, the resulting price (ie the cheapest offer) invariably provides what can only be described as the market price for long term electricity. A CfD is a contract, and its price level set by an auction is a market price, and definitely not a subsidy.

Now, it obviously matters how “well designed” the auction is, and how competitive it is, but that’s something that governments, in particular in Europe, are doing reasonably well, as we can see from record low prices in many markets.

The important point is that a long-term fixed price is not a subsidy, and that word should not be used about an industry now providing, by far, the cheapest form of power available.

The fact that renewables need regulations to ensure they have access to long term prices is not a sign of a subsidy either. Electricity is vital to our life and very hard to store, requiring national demand and supply to be balanced at all times and with very high reliability expected. The industry is thus heavily and tightly regulated all over the world, for both economic and technical reasons.

The choice of the market mechanism to identify the price of electricity in the short or the long term will be biased towards some generation technologies over others. This can be explicit or implicit, but it is unavoidable. Markets that rely on procurements tenders, CfDs and long term prices favour capital intensive forms of generation like nuclear or renewables, whereas markets that exclusively focus on short term prices tend to favour technologies whose production cost is close to marginal price (most of the cost comes from the fuel, and is linked to actual short term production volumes).

CfDs actually combine the best of both worlds in that they offer long term price stability to generators while nevertheless submitting them to the discipline of short term prices (which, among others, help balance supply and demand on an ongoing basis), as producers still need to sell their power in the spot market (but then get or pay the difference to the agreed long term price) and contribute to the balancing of the system.

The choice of market mechanism to procure generation capacity is not (and should not be) called a subsidy, yet it certainly is a political choice and shapes the market accordingly.

CfDs are unquestionably different to subsidies. Next time you see an ill-informed commentator conflating the two whilst opining on the electricity market, feel free to point this out.