A little under a month ago, I wrote an article based on conversations with an intelligent friend, who challenged some of my perceptions concerning the benefits or adverse consequences of the UK’s increasing reliance on renewable energy. We have continued a sporadic exchange of emails on the subject as and when interesting developments have generated renewed interest in continuing the discussion. A recent article by Gordon Hughes could be said to offer some support to my friend’s view that insofar as costs of supporting renewables are already locked in, it’s no use moaning about them – the intelligent way forward is to decide whether it now makes sense to carry on (because we’re in so deep and it will be cheaper and more beneficial to build on current developments) or whether doing so will only make things worse. One of Paul Homewood’s recent articles also triggered a discussion between my friend and me regarding Contracts for Difference (CfD) costs and generally how this aspect works.
The system strikes both of us as being bureaucratic, opaque and complex, but my friend took the trouble to spend some time investigating it and trying to understand it better. I was so impressed with his diligence, that I thought it worth sharing his findings. What follows are his words not mine, so this is almost by way of an anonymous guest post. I have edited it only slightly so that it makes sense as an article rather than as an email between friends. In its essentials, it is as he wrote it. I hope readers find it useful and of interest. Comments on his views are of course welcome.
I have been reading some of the stuff from epexspot website, the LCCC website (which does contain a dataset – see later) and the provision of the standard CfD terms, written by someone who seems to have missed the plain English lesson at law college.
Frankly it’s turning into a combination of Groundhog Day and peeling an onion. Each time I think I understand the mechanism better, but it doesn’t actually get closer to a clear answer!
So here goes – my understanding of the market in electricity and its application to the pricing mechanism for electricity generated by intermittent technologies
Epex conducts an auction process for every hour of every day. This operates like a book building exercise – consumers (i.e. networks and large customers) bid a price they are willing to pay for a certain capacity in that hour. Suppliers (wind, solar, gas, nuclear etc.) bid a price and quantity they are willing and able to provide capacity for in that hour. The market price (MCP) is a price at which every consumer who was willing to pay that price or higher gets what they want at MCP (but any consumer who was not willing to pay that price gets nothing) and every supplier who was willing to satisfy demand at that price or lower receives MCP (but any supplier who was only willing to sell at a higher price gets nothing): https://www.epexspot.com/en/basicspowermarket
So far not that different to what we discussed before, save that the mechanism is hourly, which is material.
The epex mechanism is designed to generate supplier bids on a marginal cost basis. It’s essentially a Dutch auction. The problem inherent in this is that any business which sells on a marginal cost basis will go bust. A business needs to cover its fixed cost base (and make a profit). So if the system stopped at the epex price then the number of suppliers would rapidly decrease and the market would fail. As such, two mechanisms are used to limit this consequence- the CfD strike price for renewables, and the capacity payment mechanism for gas. Basically renewables (when available) have much lower marginal costs but higher fixed costs, whereas gas is the reverse – lower fixed costs, but higher marginal costs. (You could argue that an hourly marginal cost-based market system unfairly benefits renewables over gas but that is the market model we have currently).
Importantly the strike price in the CfD contract is fixed (subject to CPI uplifts). Consequently, whatever price the epex auction generates, the renewables provider ultimately gets the same price – limited by reference to the lower of the amount of electricity they actually generate in that period and the maximum contracted amount, i.e. if they produce more than contracted they don’t get paid for the excess, but equally if they don’t actually generate the electricity – say because of lack of wind – they don’t get paid. (As we know they do get paid even if the electricity they generate within the contracted amount is actually unused because of transmission issues, which is important, but not directly on point here).
The nature of this epex mechanism is that whenever renewables are available in sufficient quantity for an hourly auction, the lower marginal pricing means they will knock gas out completely. But if there is insufficient quantity then gas will be the highest bidder, but still set the price. An important nuance here is that even within technologies the marginal pricing will differ. We know that newer more efficient gas generators will have lower prices than older models because they will need less gas to generate the same electricity. So in fact even when gas does “set the price” it may be the cheaper, newer, gas price rather than the older gas price. As such it is logical to conclude that whenever renewables are available in an auction they will always cause the MCP to be lower than if they were not available at all. It is inherent in the marginal cost base mechanism.
This is important because it affects how we view the sums paid under the CfD.
Let me give you some scenarios – these are illustrative only – though I will make a point on the data later.
Scenario 1
Renewable bid price: £30. Gas bid price: £80. CfD strike price: £100. The auction needs gas to satisfy capacity, so MCP is £80. Renewables sell at £80 and receive £20 through CfD mechanism. CfD cost is £20, and that represents real cost.
Scenario 2
Renewable bid price: £30. Gas bid price: £80. CfD strike price: £100. Auction capacity achieved without gas, so MCP is £30.
Renewables sell at £30 and receive £70 through cfd mechanism. CfD cost is now increased to £70. But that doesn’t reflect real cost, as the electricity has been bought more cheaply, thereby saving £50. So the net real cost of the CfD contract is still the same £20. The CfD payment is an overstatement of the true CfD cost.
Indeed the renewables impact on the MCP will always lead to an increase in the CfD gross cost, but this needs to be adjusted by the savings in order to establish the net CfD cost. In effect the amounts actually paid to renewable sources under the CfDs will always be an overstatement of the “subsidy”.
However, as long as the CfD strike price exceeds the gas bid price, the effect is that the CfD is a net cost. But if the strike price is below the gas bid price. then this changes.
Scenario 3
Renewable bid price: £30. Gas bid price: £110. CfD strike price: £100. The auction needs gas capacity, so MCP is £110. Renewable provider sells at £110, but under the terms of the CfD pays government £10, i.e. CfD is a net generator of government revenue.
Scenario 4
Renewable bid price: £30. Gas bid price: £110. CfD strike price: £100. Auction capacity met without gas, so MCP is £30. Renewables sell at £30 and receive £70 under CfD. This looks like a subsidy of £70. But actually the MCP is now £80 below the gas bid price so the CfD, whilst paying out, is in effect still a profit for the government!
Viewing the payments made to renewables under the CfD framework as a true cost or “subsidy” is therefore misleading, though it is not possible to say what the real cost or benefit is. Expressed as a formula the cost/benefit of the CfD is – CfD payment less aggregate reduction in MCP caused by renewables in auction plus related increase in capacity payment to keep the gas provider running.
This doesn’t tell you whether it’s positive or negative or by how much, but at least identifies false information.
All of this analysis leads us back to square one. Is the CfD strike price higher or lower than the equivalent gas price? That remains the key question. As before, the long term fixed nature of the strike price means it may not be the same answer all the time during the life of the CfD. The hourly nature of the market adds an extra layer as the renewables may save more money in some auctions and little in others -even on the same day!
Here it is interesting, though I accept not definitive, to look at the data set from the LCCC website.
You will see from this that the hourly auction MCP fluctuations are significant. Picking (for no good reason) 1st November 2025, the price in hour 2 is £9.01 and in hour 18 it is £98.19 (an 1100% increase on the same day). It is not unreasonable to assume that the capacity demand in hour 2 is very low and in hour 18 is very high, but it does suggest that the cheapest electricity is a lot cheaper than the most expensive electricity, on a marginal cost basis, and it is reasonable to assume that the former is renewables and the latter is not (whether it’s gas, nuclear or coal). Now I accept that still doesn’t mean that the renewables make financial sense, as again it depends on the volume from each auction and the CfD strike price and also the capacity payments to the non-renewables needs to be factored in. But at least the issue we are focused on is clarifying slightly.
Effectively, as we said at the outset, the ideal comparison is of a system with no renewables and simply long-term fixed price gas generator contracts with no CfDs or capacity payments but financially robust enough to take shocks such as the Ukraine war in its stride, without going bust or screaming force majeure.
Unfortunately this hypothetical comparison is simply not available. [Ends]
I found that to be an extremely helpful and fairly compelling analysis. Certainly it makes a reasonable case for suggesting that claims regarding CfD subsidies may be exaggerated, whilst nevertheless acknowledging that due to the opacity of the system, those of us who are not privy to all of its nuances are left simply not knowing one way or another. I did respond that there is a counter-argument of sorts, to the effect that while the marginal cost of gas may well be considerably higher than the marginal cost of most renewables most of the time, this is at least in part possibly due to the carbon pricing that is artificially loaded onto gas, and in part also due to the fact that gas is rendered more expensive by renewables being granted favourable status on the grid. This means that gas has to ramp up and down – often at short notice – due to the intermittency of renewables, and this is an inefficient and expensive way to run a gas-fired plant.
In fairness to my friend, our discussion was homing in specifically on the way the electricity market in the UK currently works, with specific reference to CfDs. However, outwith that discussion, there remain all the extra costs within the system, caused by renewables, but not taken into account above, which I outlined in Voila!
In any event, it’s good to talk. I will be interested in any comments regarding my friend’s analysis from those better qualified than me to comment on it. [With thanks to my friend for the time and trouble he has taken, and also for his permission to quote his words here].
Climate Scepticism 
I’ve read that paragraph 3 times, but it still doesn’t make any sense to me. I think NO – the cost to the user is £100, not £20 or £50. If the Renewables bid 1p they will still receive £100, therefore the cost is £100 – how it is split between a bid price and a CfD is totally irrelevant as the user has to pay both.
BTW the other elephant in the room is the carbon tax on the gas price, about 30% of the bid price of gas generation goes straight to the government.
John
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Hi Mark – thanks for sharing your friend’s considered thoughts on this opaque (to me anyway) subject.
To be honest my mind went numb about half way through the post trying to weight up the pro’s & con’s of this. Also had a quick look at “Epex” website, partial quote –
“EPEX SPOT’s coupled Day-Ahead markets have proven to be a key tool for limiting the potential price impacts of renewable energy. By fully optimising the use of interconnectors, national surpluses and deficits are mitigated in the coupled markets, providing more resilience against supply and demand disturbances. Day to day or seasonal variations in renewable production can be counterbalanced between zones, and converging prices smooth both positive and negative peaks. Besides Market Coupling, product granularity plays an important role in the integration of renewables. EPEX SPOT’s Intraday markets provide an effective solution for integrating intermittent supply, enabling producers and consumers to balance their positions close to real time. Electricity can be traded up to 0 minutes ahead of delivery, which provides a level of flexibility welcomed by market players who trade both renewable and conventional energy. On all markets, 15-minute and 30-minute contracts are available, providing greater flexibility to handle the daily ramping effects of renewable production and contributing to a more balanced market.”
I suppose the only comment I would have is, back in the day, before renewables entered the mix, was it straight forward, or always a bidding war with subsidies?
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koaladeepest (John),
Thanks for your comment. In fairness to my friend, his analysis is aimed (I think) at two things – first, trying to get to grips with and explain how the horrendously labrynthine and complex electricity pricing system in the UK works; secondly, to establish the correct level of subsidy involved in any given Contract for Difference, given that the system relies (to a degree) on “market” prices.
I think he makes a very valid point in claiming that the extent of CfD subsidies might not be so great as is sometimes claimed. As he points out, the marginal price of renewables is generally much lower than that of other forms of energy supply, but they have higher up-front capital costs, which is they their owners look for firm contracts at higher prices – to cover all their costs. I think (in principle – subject to the caveats below) he’s right to say that if the marginal cost to renewables is £30, the CfD strike price is £100, and the market price is £80, then the subsidy is not £70, but £20, since if one removed renewables from the equation, the market price would be £80.
But (as my friend acknowledges) because we don’t know have the benefit of a counter-factual world where the UK energy system has no renewables in it, we don’t know what the price of gas would be if it hadn’t been rendered artificially high by the impact of renewables. (However, this is where the Paul Homewood article I referenced in the article may be relevant). Then there’s your point – the price of gas is also artificially increased by a carbon levy.
Furthermore, there are all the other additional costs (grid extensions, back-up, grid stabilisation, constraints payments, etc.) that can fairly be (but usually aren’t) attributed to renewables.
Having said all that, my friend and I, in our discussion, were homing in on one (or two) specific topic(s) – how the pricing system works and how that relates to CfD subsidies. And in that respect, I think he has done an excellent job of clarifying things.
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dfhunter,
“…before renewables entered the mix, was it straightforward, or always a bidding war with subsidies?“
I believe the market-based system we are saddled with is the result of Thatcher’s privatisation of the energy system. The fact that it’s now so complex is certainly in part due to the introduction of renewables into the mix.
Personally, I hanker after the days when we had a nationalised energy system where all this bureaucracy and complexity played no part in the system, and the profits from the system didn’t disappear oversees to all the foreign owners of our energy infrastructure. It would also be good if renewables played only a modest role, rather than the expensive and de-stabilising one that they do now as the engineers how to work out how to keep the lights on while renewing primarily on an unreliable and intermittent energy source. Sadly, though, that ship has sailed.
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The electricity market mechanism rules seem to have been designed by characters from Alice in Wonderland & implemented by Sir Humphry Appleby
https://www.youtube.com/watch?v=NX45hc0aZt0
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There is also the point that – if memory serves, please correct me – the CfD only pertains between 7 a.m. and 7 p.m., so that the weather-dependent lot don’t get the top-up at night.
That said, the adjective “weather-dependent” is surely important – a system entirely reliant on such generators, without CfD etc, would provide at times far too much power, and at times far too little. (With necessary enormous overbuild.) Then the cost to a consumer would vary between nothing, and infinity. [Exaggerating slightly.] The more weather-dependent generators added, the more swingy the wholesale price gets.
It reminds me of the Victorian strawberry fortnight, and farmers from the south west rushing their gluts up to the capital to sell on the day (for the picked fruit only lasted a day). Then, a fortnight later, farmers from the north rushing their own gluts down to the capital. For some of that time, strawberries had a high value, at times near-zero value, and in December, infinity value. I think consumers prefer the modern year-round availability and stable cost – even if the fruit is drenched in 12 kinds of pesticide.
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Thanks Mark, I can see a little better the point you (or your friend) was trying to make, however I would say that I think it is still misleading.
How about out this scenario: Renewable aren’t paid any type of subsidy, they are just allowed to supply power whatever they bid. Would they bid at £30? Of course not, they would quickly go bust, they would bid at least the present CfD level. So this argument that the subsidy isn’t “as bad as it seems” is eyewash, renewable are paid far above the level of other generators whether or not they are the only bidders. The bid price of gas is irrelevant.
John
PS sorry about the name change, never allow WordPress to suggest a username!!
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Jit,
Please say it (CfDs applying only during the day) isn’t true. The whole wretched system is complicated enough. I confess your suggestion is a wrinkle I have never heard before.
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John P,
I think my friend is probably correct to say that the headline figures for CfD payments (and therefore the headline figures for CfD subsidies) probably overstate the extent of this direct subsidy.
However, this is only part of the story, since renewables are subsidised in many ways that their supporters never mention. They receive priority treatment on the grid, which assists them with the problem of their intermittency, while disadvantaging their competitors (primarily gas). They cause many additional costs, which they do not pay for, but which are borne by others (consumers and taxpayers) instead – balancing costs, grid extensions, back-up costs). They receive constraints payments. They enjoy the benefit of government contracts which, going forward, will give them certainty for 20 years.
I can’t yet say that I have no doubt that renewables are making UK energy more, rather than less, expensive, but I have little doubt that this is the case.
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After reading the explanation, I immediately thought of these lines from the Broadway musical Lil Abner- “The farm bill should be 89 percent of parity, Another feller recommends it should be 93. But 80, 95 percent, who cares about degree? It’s parity that no one understands. The country’s in the very best of hands.” For some amusement, watch the you tube video of the song- https://video.search.yahoo.com/yhs/search?fr=yhs-infospace-076&hsimp=yhs-076&hspart=infospace&p=lyrics+the+country%27s+in+the+very+best+of+hands&type=ud-c-us–s-p-uw5bbolv–exp-none–subid-fk6j226i#action=view&id=1&vid=59b42c645ebe6fb52c8ea086bf2d52cc
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Mark,
To my limited understanding, your friend has not quite got the whole picture. To be fair, I rather doubt if there is anyone who has a complete understanding outside those in the game and a few specialists like the commenter It Doesn’t Add Up.
Although described as an auction, it is probably more accurate to view the process as a method of matching supply and demand using a notional price as the mechanism. Since all of the CfD bidders are paid their strike price, whatever bids they put in will not change how much they are paid – provided, of course, they do not overbid. So the various examples are actually only differentiated by which pocket the money comes from. The true, all-in cost of power from any CfD supplier will be the same, whatever the “market price” turns out to be.
There is a wide range of CfD prices in play. Ideally the system would seek to maximise the use of the cheapest ones but it does not seem to work that way. Maybe if the bidders were limited to bidding their strike prices, it would work to minimise cost.
“An important nuance here is that even within technologies the marginal pricing will differ.” That is correct but ” We know that newer more efficient gas generators will have lower prices than older models because they will need less gas to generate the same electricity” may not be the case because older units may well have amortised their capital investment whereas newer ones will still be looking for a capital contribution.
There is a glaring omission: the suppliers which come under the ROC (Renewable Obligation Certificate) system. It covers virtually all onshore wind – approx. 15GW – and about 6 GW of offshore which amount to about two thirds of the total wind capacity. Unlike the CfD suppliers, the revenues of those under the ROC scheme are influenced directly by the market price since they are paid that price plus their ROCs. Onshore wind gets 1 ROC per MWh while offshore receives 2 ROCs per MWh. ROCs are worth about £75 each so they have a major impact on the cost of that power which, as with CfDs, is not accounted for in the market price.
They also introduce significant distortion because those suppliers can afford to bid negative prices so long as the sum of the market price plus their ROC allocation is positive. To add even more complexity, some older wind farms are now out of their ROC contracts and some new ones have declined to take up their CfDs so both types are working with just the market prices.
On top of all this, there are all the other additional costs which you have mentioned. It was very telling that a number of utility chiefs recently told a parliamentary committee that prices would still go up even if the cost of gas dropped to zero because of all the other factors.
I do not know how the payments for CfD top-ups and ROC are funded but their exclusion from the “market price” is highly misleading. Then, as others have said, it makes no sense for the carbon tax in gas pricing to be included.
The US Marines have a term “cluster****” which sums it up, imho.
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Doug Allen,
Profuse apologies for the delay in your comment appearing and for the fact that you had to make three attempts to get it through. WordPress can be very irritating.
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