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Spooked by Contracts for Differences (CfDs) ?

Following DECC’s announcement about the move from ROCs to CfDs, solar developers and investors alike appear to react in one of two ways; (i) rushing to meet the March 31, 2015 deadline with the very clear accent on ‘dead’ in this case or (ii) those slightly more relaxed feeling that markets have a tendency to ‘over’-react to the unknown. Whilst an untested new regime will always bring some discomfort Alpha-Financials’ team of Peter Harding and Matt Lomax feel that the second belief is more appropriate, as reflected in the company’s point of view on CfDs below.   In transitioning from ROCs to CfDs, three common concerns arise: –        CfDs will last only 15 years rather than the 20 under ROCs –        The upside benefits of continuing and substantial electricity price rises will disappear –        The risk of not securing a CfD is too high Let’s briefly address each of these in turn: 1. Reduced subsidy duration In comparison with many other industries, the discount rates and IRRs used to appraise renewables projects are relatively high, reflecting the greater perceived risk. This means that losing an income stream in years 16 to 20 typically has a small impact on overall returns. For a 20 year project, completely eliminating the last 5 years’ income would typically reduce a 20% IRR by only 1%. Since the ROCs form only a part of the total income stream, the loss of the subsidy would reduce the IRR by less than this. 2. Elimination of upside potential Whilst losing the upside on retail electricity prices, the potential downside risk is also eliminated. We’ve become accustomed to ever increasing electricity prices which have exceeded inflation rates since 2003. It’s easy to forget that in the preceding 8 years, prices actually fell 30% in real terms. The point is when undertaking a 15 to 20 year financial analysis, a lazy assumption of ever increasing RPI-plus electricity price rises is potentially dangerous and inaccurate. CfDs however make such assumptions irrelevant by removing the risk. An absence of volatility combined with higher assured revenues should a) reduce overall financing costs and b) improve the chances of raising debt. 3. Risks of failing to secure a CfD We’ve not yet experienced the bidding process so the risk of not securing a CfD remains an unknown. Clearly developers will need to put considerable thought into their strike prices. The route to managing this risk appears to lie with multiple bids for a single project and avoiding an excessive strike price which produces unnecessarily high returns. In summary, we believe that the concerns over CfDs have been exaggerated – driven mainly by a fear of the unknown – and that, overall, the changing regulations will prove desirable, even for developers. Feel free to share your views on this topic with us.
Movement in average UK business electricity prices (in real terms) - Ofgem Price Analysis 2014
Movement in average UK business electricity prices (in real terms) – Ofgem Price Analysis 2014