Why we need Contracts for Difference in Romania

Article supported by CMS Romania

Author: Varinia Radu, Partner CMS Romania

The last three years put Romania back on the map of the RES investments with an unprecedented appetite from global investors (independent power producers, private equity funds, infra funds, institutional investors, utilities and developers) accounting to more than 40 GW of projects under development, some being among the largest in Europe, in terms of planned size. This wave came on the back of an ambitious national plan (Planul Național Integrat pentru Energie și Schimbări Climatice - PNIESC) of Romania to increase the share of renewable energy in the overall energy mix, the natural advantages and regional interconnections, the availability of European grant funding schemes and a legal framework aligned with the EU common market.

Romania is about to launch a Contracts for Difference (CfD) scheme for low carbon technologies, with the first planned set of two auctions aimed to facilitate investment into at least 5 GW of wind and solar projects over the next few years. There are many opinions and commentators on the scheme, some celebrating its groundbreaking vision, while others questioning whether the scheme is needed. This article discusses some of the key considerations and explains why the scheme should be celebrated as a leap forward for the Romanian electricity industry.

Why do we need such a scheme in Romania?

Romania is ahead of the curve compared to other countries in the region in adopting two-way CfDs, which will become the standard approach to promoting such projects. 

On 19 December 2023, the Council of the European Union and the European Parliament published a Provisional Agreement on, among other things, how to support new power generating facilities based on low carbon technologies such as wind and solar. The Provisional Agreement states the following: “Where Member States decide to support publicly financed investments by “direct price support schemes” in new low carbon, non-fossil fuel electricity generation-facilities to achieve the Union’s decarbonisation objectives, those schemes should be structured by way of two-way contracts for difference or equivalent schemes with the same effects such as to include, in addition to a revenue guarantee, an upward limitation of the market revenues of the generation assets concerned.”

The expectation from the European Council and Parliament is that using CfDs or equivalent schemes to support new low carbon generation facilities will become more or less universal across the whole of the EU after three years. This three-year transitional period is to allow developers time to adjust to this new approach of promoting projects.

Why is the EU so fond of CfDs?

The Provisional Agreement notes that the revenues of renewables projects subject to two-way CfDs would become more independent from the volatile prices of fossil-fuels based generation which typically sets the price in the day ahead wholesale market. The connection between the two has been seen as largely indefensible, and an ever-increasing issue with the scale of renewables on the system increasing. Why should renewables projects earn more when the price of oil & gas goes up? The two are not connected. Accordingly, the Provisional Agreement recognises that such CfDs may be best suited for renewable energy sources with low and stable operational costs and technologies which typically do not provide flexibility to the electricity system. Such as wind and solar, as being promoted by the Romanian scheme.

The EU also appreciates the fact that two-way CfDs preserve the incentives for the generating facility to operate and participate efficiently in the wholesale electricity markets. Further, the Provisional Agreement anticipates that such contracts for difference should include penalty clauses in case of undue unilateral early termination of the contract, because many of the benefits of the CfDs are anticipated to materialise later in the term of the CfDs as energy prices are like to increase more than normal inflation.

Further, with the recent experience of the price rises following the invasion of Ukraine, the EU notes that two-way CfD schemes provide an additional source of revenue for Member States when prices rise. These revenues mitigate the impact of high electricity prices on the energy bill to consumers at times when they need it the most. The EU expects such revenues to either be passed back to electricity consumers or used to finance investments that would reduce electricity costs for such consumers (such as in new grids to ease constraints).

Can we not leave it to the market to deliver, without a CfD scheme?

Fully merchant renewables projects in Romania are seen as largely unbankable given the lack of sufficient long-term certainty in the power price. This means that while some local developers may be happy to progress their projects taking a view on their exposure within wider conglomerates that naturally hedge such risks, international investors looking to fund non-recourse ring-fenced single projects will not be able to secure financing without some certainty on their revenues. 

Of course, power purchase agreements (PPAs) can provide this certainty. To give the full picture, the EU also considers the role of PPAs in helping to provide the same price certainty to renewables projects. It notes that two-way CfDs and PPAs play complementary roles in advancing the energy transition and bringing the benefits of renewable and low carbon energy to consumers. However, for PPAs to achieve the same effect, there would need to be sufficient liquidity in the PPA market. There would need to be sufficient private off takers willing to lock in low and stable electricity prices over the long-term. The EU notes that in the absence of such liquidity, the CfD provides a means for public entities (on behalf of electricity consumers) to do the same. As a statement of fact, there is insufficient liquidity in private fixed price PPAs from credit worthy counterparties in Romania to cover the output of projects to achieve anywhere near the scale of deployment that is required to achieve the policy objectives of the Government. By way of background, some of the projects in ready-to-build stage have been actively seeking offtake arrangements in the last couple of years, however the local market has been slow in entering long term bilateral agreements (PPAs). On the corporate side, the local industry offers a limited number of buyers and also, such potential buyers have not been incentivized to look on a long-term plan as long as they are protected by the capping prices mechanism, which currently is in force until 2025. Most of the reported power purchase agreements in the last couple of years were virtual or financial PPAs, often with buyers from outside the local market. In addition to these aspects, PPAs are sophisticated commercial ad legal instruments that take significant resources and time from both negotiating parties to be concluded. Especially for large scale projects of several hundred of Megawatts, the investors need to secure at least half of that planned capacity with long term revenue stabilization instruments, often times a mix of PPAs and CfDs, to be able to obtain financing. 

 It is therefore a fallacy to conclude that the market in Romania has been delivering of its own accord and so does not need an intervention. For example, the number of projects in development (seeking consents or connection rights) is very large in Romania. This is undoubtedly true.  As confirmed by the EU Commission Decision on approval of the Contracts for Difference support scheme for the production of renewable electricity from onshore wind and solar photovoltaic, there are over 9 GW of solar projects which have secured grid connection permit and over 8 GW of wind which have the same. This means these are projects which have proven viable from the technical perspective. Besides these, there are more than double in earlier stages of development.  However, the percentage of such projects that are taking investment decision and committing to construct, without revenue certainty, is a tiny proportion. Most are going slow in anticipation of a support scheme such as the CfD that will allow them to secure the finance required to be constructed.  

Of course, some projects have progressed to date. However, many of these have either been small or have relied on other support such as government grants that have been available such as under the Recovery and Resilience Fund and similar measures. As of 2022 and 2023, from the public data issued by the Ministry of Energy, a little over 600 MW of new renewables capacities were commissioned, leaving aside those by prosumers. 

What lessons are there from the UK scheme?

Romania has looked at various other CfD schemes implemented in Europe and in particular, the initial feasibility study done in 2018-2019 had taken as a reference the UK model. The UK government evaluates its CfD scheme on a periodic basis. The UK Government’s findings are that, based on their modelling estimates, the CfD scheme will reduce the impact of renewables deployment on consumer bills in all of its scenarios as compared with the Policies that preceded it. The reduction in costs to consumers due from the first three CfD allocation rounds alone is estimated to be around £10 billion.

A key aspect of this saving has been the lower cost of capital for CfD supported renewables projects due to a lower hurdle rate of up to 2% for such projects. The main contributing factors to this lower hurdle rate are the stabilised prices, the main purpose of CfDs, which lead to more stable revenues. The UK Government notes that as investors face lower risks of revenue fluctuations, this lowers both the minimum rate of return required to make their investment and the interest rates charged by lenders. As a result, the lower cost of capital will allow generators to bid a lower strike price, in a competitive auction, finally resulting in the most efficient price discovery process and yield better power price in the market for the final consumers.

Of course, the strike prices in different countries are not comparable. The maximum strike price in Romania (of Eur 91/MW for solar and Eur 93/MW for wind) was set in consultation with EU authorities following a detailed analysis of the maximum price that an auction should publish, considering Romania specifics in terms of, among others, local development costs, grid connection cost and more notably, the balancing costs which are much higher than the EU average. The UK experience is that actual strike prices in the subsequent competitive auctions come in significantly below the maximum prices. The competitive pressures from the CfD auctions have been seen as an important driver for strike price reductions since the first CfDs were introduced in 2012, with a 70% reduction in prices since then. Before the CfDs were introduced, renewables investments fell into a higher category of risky infrastructure investments. Since the CfD scheme, investors now view new wind and solar generation projects as less risky assets, and this has helped to attract a wide range of potential investors to the sector.

How does a CfD compare to grant funding for renewables projects?

There are several significant differences between grant funding and the CfD which can operate to achieve an efficient use of money through a CfD. These include:

1. The CFD scheme will only take effect (in terms of payment flows) with projects that achieve commercial operation. No monies at all are paid prior to this, safeguarding the State from any lost funding for failed projects. The entire risk in development and construction of the project is taken by the generator, hence the CfD scheme comes in to provide a price stability once the power is produced and injected into the national power grid. 
    
2. The CFD scheme only provides revenue support to the actual electricity that is exported by the project. It is not related to the amount of capacity that is built. Since consumers are interested largely in the electricity and not in the size of the project, this avoids consumers taking risks on inefficient projects.
    
3. The CFD is focused on reducing the risk on revenues. Project financing is, by definition, a financing of the revenues of a project. If those revenues are not sufficiently certain, project financing will be either expensive or not available. Grant funding cannot, therefore, facilitate a non-recourse project financing of a renewables project. The only way to do that is for the State or private sector PPAs to provide sufficiently derisk of the anticipated revenues. This is why previous support schemes for renewables have been structured as premia or substitutes to the electricity price, in the form of certificates or feed-in tariffs.
    
4. In the event that electricity prices rise in future, for example due to another shock such as the war in Ukraine, grant funded projects will benefit from a windfall as their revenues increase. The CFD scheme provides consumers with a hedge against future increases in electricity prices. And so that also has a value which would need to be considered.

Romania CFD specifics

1. The first phase of the CfD mechanism will be rolled out until 2025 via two auctions, one in 2024 and the other in 2025. The total capacity envisaged by the first auction is 2 GW of renewables respectively, 1000 MW for onshore wind and 1000 MW for solar. For the second auction, there will be 1500 MW auctioned for onshore wind and 1500 MW for solar.
    
2. The CfD scheme is funded innovatively not by a levy to the final consumer, as the support schemes are usually funded, but by monies from the Modernisation Fund. The EIB approved a budget of Eur 3 billion to fund the Liquidity Fund which supports the payments which will be due to generators awarded the CFD contracts. With regard to the potential impact of the scheme to the final consumer, if any, in terms of raising their bills, it should be said that the Liquidity Fund supporting the payments under the scheme is not funded by the final consumers. There will be a levy instituted in order to cover the administrative costs of the scheme, i.e. the costs of Transelectrica running the auctions and the costs of OPCOM managing the CfD Contracts. It is fair to say that in the big scheme, these costs are insignificant.
    
3. The entities involved are: (i) the CfD Operator - Compania Națională de Transport al Energiei Electrice "Transelectrica" S.A. which, among other responsibilities, manages and conducts the CfD auction; (ii) the Ministry of Energy - which, among other responsibilities, ensures that the CfD liquidity fund has at all times sufficient funds to enable the CfD counterparty to discharge its payment obligations to CfD beneficiaries in full; (iii)  the CfD Counterparty - OPCOM, the market operator, which shall conclude the CfD contract with the generators, will manage the contracts and the Liquidity Fund and will operate the payments under the CfD contracts and (iv) Autoritatea Națională de Reglementare în Domeniul Energiei - which, among other responsibilities, issues secondary legislation in respect to the CfD, including the methodology used by the CfD counterparty to calculate the reference price.
    
4. The CfD contract is a private agreement between the generator and OPCOM, for a duration of 15 years, establishing a set of rights and obligations for each party, outlining the two-way support payment, referenced to the power produced by the generator, which will be the difference between the strike price and market reference price. It is important to note that the two-way CFD is a more balanced scheme, because in fact not only the generators may receive payments due to keep their revenues fix over the contract tenure, but depending on the evolution of market prices, the state, via OPCOM, may receive payments into the Liquidity fund from the generators. Each CfD contract will have its own strike price, as resulted under the competitive auction, which will be under the maximum established strike price for that particular auction. More precisely, the generator is paid by the CfD Counterparty when the market reference price is below the CfD contract strike price and vice versa, the generator pays the CfD Counterparty when market reference price is above the strike price. Total revenue of generators per unit of electricity is given by: Actual Sale Price + (Strike Price – Market Reference Price). The payments are done on a monthly basis and the Market Reference Price is established as an average price of the electricity sold in the Day Ahead Market for the technology subject to CfD contract.
    
5. The CfD contract allows for three years for the projects to reach production, with a two-year buffer for excusable delays. Any such delays are being proportionally deducted from the overall tenure of the contract.
    
6. The contract provides for a change in law provision, but it also allows parties to regain contract equilibrium in case there is a systematic over or under compensation.
    
7. Given the fifteen-year tenure of the contract, the strike price inflation adjustment is applicable only over each three-year interval, if the cumulated inflation rate in the EUR zone exceeds 10%, hence the inflation risk below this threshold is largely expected to be accounted for by the investors in their strike price bid level.
    
8. Generators benefitting from CfDs have to sell the output of the CfD capacities on the centralized markets in Romania and not via bilateral, freely negotiated PPAs, and in case additional profits are achieved in the sale of the physical power, there is a profit-sharing mechanism. The intention is that thid will disincentivize the producers from making speculative trades. 

 In conclusion

Romania is leading the way on CfDs. This is a moment to celebrate the vision and innovation of the sector. This important policy tool is meant to improve the overall business environment in the sector, to facilitate access to capital for investments and help accelerate the transition to a decarbonised economy, all of these being key recommendations for Romania’s accession to OECD, as per the latest OECD Economic Survey for Romania, 2024.

The first CfD auction offering 2GWs is eagerly awaited by the industry and based on its outcome, the future structure of renewables procurements will take shape in a way that will give investors and capital confidence to invest in large scale renewables projects in Romania without corporate PPAs. There are many points of detail in the CfD scheme which bidders will be poring over in the coming weeks. This is the opportunity to shape our renewables future, extend the CfD scheme to other low carbon technologies and make Romania the leading destination for renewables investment in the region.

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