Blog post

Zero bid auction proves the need for a new support system

Energy Blog, 11 July 2017

Jérôme Guillet explains why fixed energy prices are necessary for the renewable energy industry.

As the renewable energy sector and its regulators grapple with the prospect of so-called “zero-subsidy” bids, as seen in the recent German offshore wind auction, here’s a suggestion to ensure that the renewable energy sector does not do anything counterproductive or even destructive in any of the upcoming tenders.

Merchant pricing is fundamentally unsuited to renewable energy, given the structure of its costs: with heavy upfront investment and low operating costs, the sector has high fixed costs but a very low marginal cost and requires long payback periods to be competitive. This makes renewable energy projects “price-takers” under spot price markets, subject to the vagaries of factors they do not control. Additionally, given their low marginal cost, the more renewables you have on the grid, the lower spot prices will be. With high renewables penetrations, we could end up with a situation where spot prices are almost permanently near zero, with a small number of very high peaks at times when there is not enough renewable capacity available.

This is why feed-in tariffs were designed – to offer a long term fixed-price structure to renewable energy projects and give them the adequate revenue visibility over the long term to cover their costs. That long term price visibility is critical, and indeed it was included in the design of most recent auctions, where projects bid for a long term price regime.

But the flaw of many of these auctions, like those in the Netherlands and Germany, is that the proposed tariff is not an actual price but only a floor price – projects can still benefit from a higher market price, if available, rather than earn the exact price they bid for. Changing this could lead to a more favourable outcome. Like in the UK, the tariff should be a strict fixed price, with the obligation for projects to pay back the difference when spot prices are higher than the fixed price level. Such a rule would ensure that bidders in auctions bid a realistic price, because their income will be strictly linked to that bid level. That way, projects would look at their return over the duration of the tariff, with no merchant price risk, and would focus on the best technical performance while knowing they can attract cheap capital to fund the project, in the absence of merchant risk.

Amongst the features to include in such tariffs, here are a few additional suggestions:

  • the duration of the tariff should be as long as possible, and match the economic life of the assets. Wind turbines are now expected to last 25 years or longer, and tariffs could match this, as it would allow to attract low cost capital over the very long term (in fact, pension funds and other similar investors would love such long term, low risk assets). Given how important the cost of capital is to the long term average cost of power from renewables, this extended period would allow for lower tariffs and would therefore be highly valuable for consumers;
  • it would also be better if the tariff was indexed to consumer prices. Retail power prices typically move close to inflation, so this provides a natural hedge to both consumers and producers, and would make investment in the sectors more attractive. Long term investors are wary of inflation risk, and being protected from it will also help raise cheaper capital. This also has the advantage that the headline tariff level (on day one) will be even lower;
  • current rules from tenders, in particular the “contract for difference” mechanism whereby projects sell their power on the wholesale market, and get a top up (or in the case of higher prices, need to pay back some amount), can remain in place. They work, are understood, and ensure that renewable energy projects are normal participants to wholesale power markets, subject to the rules with regards to curtailment, negative prices, etc., that apply to other generators;
  • it would make sense to include the cost of the grid connection in the tender price and, when possible from a grid perspective, let the project build the connection itself under its own responsibility. This provides comfort to investors that the grid connection will be ready at the same time as the project, and again, allows to attract cheaper capital as a timely grid connection is one of the critical construction risks. It also allows to give a more realistic view of the total cost of the electricity generated;
  • finally, it is important that tender rules do not unnecessarily favour utilities over independent players, or financial investors. While utilities will be natural contenders to win such auctions (given their technical expertise and their low cost of capital), independent investors and financial players have shown that they could competitively build renewable energy projects and they should not be discriminated against via subjective rules on “experience” and “capacity” or with unnecessarily high bid bonds. It is necessary to have thresholds and conditions to bid to avoid unrealistic bids by non-serious players, but it should not amount to a protection for incumbents, especially in offshore wind. A fixed price mechanism will be more likely to bring about a diversity of participants to the industry (which is for instance an explicit policy objective in Germany) than the current tender designs, without the requirement for artificial lowering of standards for smaller developers (like in onshore wind in Germany) which may lead to projects not getting built.

Developers may be unhappy to lose the potential upside from power prices going up, but that will not prevent them from bidding on the basis of very predictable future cash flows – in fact, it will favour the “boring” investors focused on operational performance and technical optimisation rather than those looking for speculative assets – as it were, these boring investors tend to be those with the lowest cost of capital, which will help bring prices down. From a societal point of view, this offers a long term source of electricity at a known, fixed price and will protect consumers from the volatility of the fossil fuel markets which have driven power prices in recent decades. While ensuring that low prices are attained, such auctions will also protect society from speculative bids that lead to projects going bankrupt and give a bad name to the industry.

Jérôme Guillet – Managing Director