As the energy transition continues, one issue becoming more prevalent is the lack of power capacity in times of peak power demand. Fortunately, this demand can be met through energy shifting, but it comes with its own set of challenges. One of the main challenges is the high price volatility in wholesale markets. It makes operating energy storage profitable but also brings uncertainties in terms of revenues. The mismatch between the social welfare gain of flexibility through energy storage and the unreliable estimable added value for the operator is a problem that needs a solution. Fluence, a leading energy storage solution provider, recently published a white paper highlighting ways to solve this issue. One of the proposed mechanisms is the Contract for Difference (CfD)
How does Contract for Difference work?
The Contract for Difference is a subsidy mechanism that guarantees reliable revenues for storage facility operators, making an uncertain investment into a reliably profitable one. It is agreed between the operator and a counterparty, and they agree on a price or price corridor guaranteed by the counterparty for a long-term period. If prices fall below the floor price, the counterparty pays the difference to the operator, but if prices rise above the strike price, the operator must pay the difference to the counterparty. For investors, the Contract for Difference means reliable revenues and a chance to make an accurate assessment of the storage facility's profitability. Additionally, it also ensures that storage operators do not excessively profit from rising power prices, unlike conventional subsidy mechanisms.
Does ‘Contract for Difference’ work in practice?
The UK was one of the pioneers in Europe to introduce the Contract for Difference mechanism in 2013 to promote renewable energy systems. Developers of renewable energy projects sign 15-year contracts with the Low Carbon Contracts Company (LCCC), a government-owned company. In an auction mechanism, the producers who offer the lowest electricity price receive the contract. That ensures that priority is given to profitable projects, making the expansion of renewable energies more efficient and faster. The subsidy partially refinances itself through a charge levied on electricity suppliers if prices rise above the strike price. Due to the increasing competitiveness of renewables and the resulting high demand, the UK even expects profits from the Contract for Difference in the near future. The DIW Berlin states that electricity customers would have benefited from 1.7 billion euros in electricity costs in 2021 if Germany, like many other countries, had chosen this effective mechanism instead of the sliding market premium (EEG reallocation charge).
To sum up...
It is no secret energy transition requires more flexibility in our electricity system, and Contract for Difference can provide the necessary planning certainty, especially for small plant operators, incentivizing them to invest in energy storage. The mechanism has already proven to be effective in the UK. It may be worth considering introducing Contract for Difference to promote energy storage through higher investment reliability for ensuring the success of the energy transition.