Contract for Differences: the essential tool to manage revenue flow in green projects

The net zero 2050 objective mandates companies to decarbonise their business quickly and effectively. However, decarbonisation projects are usually complex and require high capital investment. Unlike in ‘traditional’ projects, project professionals must be aware of evolving net zero policies and should apply innovative ways to overcome technical and commercial challenges.

We have a significant role to play in successfully achieving net zero targets. As project professionals, we’re expected to create value for clients and remain profitable by overcoming financial uncertainties. One of our core responsibilities is to secure a healthy cash flow throughout the project life cycle. In recent years, several renewable energy projects have been awarded by the UK government, which are complex and developed on a design-build-operate basis. These projects often require us, project managers, to explore a new source of project funding during construction and manage a healthy revenue stream during operation. Also, unlike other commodities such as oil, gas and metals which have a relatively stable wholesale price, the green energy wholesale price is volatile. Project managers face the challenge of maintaining a healthy revenue stream to fulfil their financial commitments and remain profitable throughout the project life cycle.

Developed countries, including the UK, want to step up renewable energy projects without relying on government subsidies and grants. Evolving policy landscapes and changing energy market configuration add uncertainty to renewable energy projects without a clear price signal committed by the government. These compounding issues affect the bankability of renewable energy projects.

So, how do project managers overcome market uncertainty, remain bankable and make profits in a green transition project?

Contract for Differences (CfD) safeguards project developers from electricity wholesale price volatility. Under this mechanism, the government and developer have a contractual agreement for a strike price valid throughout the contract. When the wholesale price goes below the strike price, the government compensates the developer with top-up payments for the difference. On the other hand, when the wholesale price goes above the strike price, the developers pay back the price difference to the government.

According to the UK government, until December 2021, CfD contracts have helped award around 16 gigawatts of new renewable electricity capacity, including 13 gigawatts of offshore wind. The UK’s Department for Business, Energy and Industrial Strategy (BEIS) recognises CfD as the government’s main mechanism for setting up renewable energy projects by:

encouraging project developers who require high upfront costs, and
protecting them from volatile wholesale prices.

Large-scale decarbonisation is only possible when private developers find green energy projects profitable and are willing to invest in such projects. As project professionals, we need to explore new venues for project funding during construction and manage a healthy revenue stream during operation. And so, we must understand the critical aspects of the CfD mechanism to mitigate financial risk.

Multiple technologies

The CfD scheme was introduced to UK’s energy market in 2014 to support renewable energy projects to decarbonise the electricity sector. Initially, CfDs were primarily focused on solar and onshore wind farms. However, in the last two to three years, it has also been extended to support offshore wind and waste-to-energy projects. With net zero ambition in place, the scope of CfDs is expected to get more expansive to include low-carbon hydrogen, and carbon capture and storage. Building on the success of renewable electricity projects, in 2022, BEIS proposed a new low carbon hydrogen business model based on CfD mechanism.

Auction process

The CfD auctions are held every two years, covering a range of renewable energy technologies. During the auction process, project developers are required to provide the size of their project and the strike price (per megawatt-hours) of energy expected to be generated. The Government caps the maximum strike price that bidders cannot exceed. The successful project developer must be the lowest bidder to secure the CfD contract. In the UK, once a bidder is found to be the lowest, the CfD is signed between the bidder and the Low Carbon Contracts Company for a 15-year duration.

Securing project finance

Banks and financial institutions look for a profitable business case before confirming finance for a green transition project. The CfDs come in handy by providing long-term revenue visibility and safeguarding developers against wholesale price volatility. This mitigates financial risk and improves the bankability of the project. In recent years, many project developers have successfully secured financing for mega offshore projects through the CfD route in the UK.

Contract for Difference contracts are a new tool for project managers to secure and manage their revenue stream in green transition projects. Currently, CfD contracts are primarily used in the power sector. With a net zero objective in place, CfD contracts are also expected to be increasingly used for green hydrogen, and carbon capture and storage projects in the industrial sector. Although CfDs emerged in 2014, the CfD concept is still evolving, and managing contracts is vital to project management. For those of us working on green transition projects, we must understand CfD contractual terms to successfully leverage them in the project’s interest.

You may also be interested in: