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Cost inflation creates new bidding dynamic in UK renewables auction

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Wind turbines off the Essex coast in England. Britain has awarded contracts to 20 GW of offshore wind capacity since 2014.
Source: John Keeble/Getty Images News via Getty Images

Widespread inflationary pressure may reverse a yearslong trend of falling prices in the UK's renewables industry as developers line up to bid in the country's latest auction for green power contracts.

The fifth allocation round of the UK government's contracts for difference (CFD) program, which has awarded more than 26 GW since 2014, opened for applications March 30. The competition is set to attract power giants like Iberdrola SA, Vattenfall AB and SSE PLC, and is the first to take place since the government pledged to hold auctions annually.

But for the first time since the formation of the program, bidders must contend with a new dynamic. Rising capital expenditure and financing costs, and wholesale power prices sitting above the long-term average, present developers with an uphill task to continue the downward trend witnessed in every CFD auction to-date.

"In the outside world, we're seeing inflationary pressure, interest rates going up, cost of capital going up ... meaning the cost of developing renewables has gone up," Alon Carmel, renewable energy expert at PA Consulting, said in an interview.

Despite this backdrop, the government is continuing to push on prices, setting a bid ceiling for offshore wind of £44/MWh, based on 2012 currency. That compares with a £46/MWh ceiling in the fourth round in 2022, which ended up awarding projects at just £37.35/MWh.

"The current ceiling price proposed in [the fifth CFD round] is going to be tight for developers — given that regulatory barriers, global inflation and the very real prospect of supply chain bottlenecks, continue to drive project costs upward," Will Sheard, director of analysis and due diligence at consultancy K2 Management, said in an email.

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Bidders sharpening pencils

The inflationary forces at play are difficult to reconcile with the £205 million budget the government has set for round five, which industry participants described as low, especially considering the auction's tougher parameters.

CFD payments stem from the difference between the market price of electricity and a project's awarded strike price. For round five, the government increased its estimated future power prices compared with round four and also increased the assumed capacity factor of offshore wind projects, historically the biggest winners in CFD auctions. Offshore wind will also compete against onshore wind and solar in round five, after previously enjoying a ringfenced budget.

"The tight budget will mean bidders will be forced to sharpen their pencils and think creatively about bidding strategy," said Carmel, who has worked with companies competing in past CFD auctions.

Even with a supportive midterm outlook for wholesale market earnings, "I honestly can't see how strike prices can continue to go lower," Sheard added.

Along with the possibility of a slight price uptick, the government may also have to come to terms with the fact that round five may underwhelm in terms of the amount of capacity awarded. Every CFD auction so far has outdone its predecessor, with round four peaking at 10.8 GW.

Round five looks set to deliver much less than that, especially given the previous round only concluded eight months ago. According to lobby group RenewableUK, the £170 million portion of the CFD budget devoted to mature technologies would only secure 1.9 GW of offshore wind bidding at the maximum £44/MWh, assuming no bids from other technologies.

"The budget [for round five] looks like it may be enough to keep a steady pace, but not enough to accelerate deployment," Carmel said, adding that the government can still increase the size of the funding pot should it wish to do so.

At least 4 GW of offshore wind farms are eligible to bid in round five. That includes Vattenfall's 1.8-GW Norfolk Vanguard project, Iberdrola unit Scottish Power Ltd.'s 800-MW East Anglia One North and 900-MW East Anglia Two projects, and the roughly 500-MW Seagreen 1A project being developed by SSE Renewables Ltd. and TotalEnergies SE.

Beyond that, the UK's offshore wind pipeline starts to look a little uncertain. In the context of the government's 50-GW target for 2030, some 40% of that future project portfolio is yet to be identified, according to analysts at Aurora Energy Research.

"It's really important that government does all that it can to enable the pipeline to come forward," Carmel said. "There are still too many delays in consenting and grid connection that are holding projects back."

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Pressure on lowball CFDs

Renewables developers globally are grappling with rising capital expenditure costs. For UK projects, the cost of raw materials and labor have increased up to 20% since CFD round four, according to RenewableUK.

"This is particularly concerning as some of the projects which won contracts in last year's auction are now struggling to make their CFD strike prices work due to the huge rise in inflation over the last year," the group said.

Danish wind giant Ørsted A/S is among those to have said it is feeling the pinch of higher prices. The company won a CFD in round four for its giant 2.8-GW Hornsea 3 offshore wind farm, locking in a contract at £37.35/MWh — the lowest ever awarded in the UK. The company is yet to take a final investment decision on the project.

Some developers have called for additional tax breaks in a bid to offset the rising capital costs.

"That's not really a good situation for anybody either," Carmel said about the economic pressure on projects already awarded CFDs. "The government doesn't want prices to be driven down so low that projects don't make a profit."

Sheard said other remedies could include an upward shift in CFD strike prices or a new price support mechanism with a protected floor and some upside opportunity, instead of the two-way contract structure utilized today and recently endorsed by the European Commission.

Bidders could also opt for a hybrid strategy, entering just a portion of their project's total capacity into the auction and taking the market price for the remainder. With power prices still above the long-term average, "the non-CFD option looks more attractive than it has for a while," Carmel said.

One strategy that bidders will not be able to employ in round five, however, is to delay the triggering of their CFDs to temporarily benefit from the high market prices.

Ocean Winds SL's Moray East and Ørsted's Hornsea 2 projects, which won CFDs in round two in 2017, have both set expected CFD start dates in March 2024, yet have been fully operational since 2021 and 2022, respectively. This practice, known as the "merchant nose," has now been outlawed after attracting criticism from the government.

The CFD application window for round five closes April 24. After applications are reviewed, bidding will take place anytime between June and August, with the winners announced about a month later.

S&P Global Commodity Insights reporter Henry Edwardes-Evans produces content for distribution on Platts Dimensions Pro. S&P Global Commodity Insights is owned by S&P Global Inc.

S&P Global Commodity Insights produces content for distribution on S&P Capital IQ Pro.