EU electricity market reform: What exactly is a contract for difference?

The European Union’s 20-year-old electricity market is heading for a revamp.

The market suffered its worst year on record in 2022 after gas prices spiralled out of control and pushed electricity bills to unsustainable levels, bringing enormous financial distress to European households and companies.

The upheaval was blamed on Russia’s invasion of Ukraine and the Kremlin’s manipulation of energy supplies, which created widespread volatility and rampant speculation.

Although prices have since then gone down, the crisis is still latent and plenty of question marks remain on the EU’s ability to cope with the next winter.

To avoid a repeat of the 2022 chaos, the European Commission has proposed a reform of the EU electricity market and asked legislators to treat the file as a top priority.

The reform, however, is not the fundamental overhaul that some countries, like France and Spain, have demanded and instead focuses on targeted changes to the current rules.

One of the main elements in the draft plan is the so-called contract for difference (CfD), a type of long-term contract that is seen as underdeveloped across the bloc.

By comparison, in the United Kingdom, CfDs have been allocated since 2014.

Unlike a commercial deal, a contract for difference is signed between an electricity producer and a state authority for a period of up to 15 years. The signatories negotiate a range – or corridor – within which electricity prices can freely fluctuate.

But here’s where things get more interesting: if market prices fall below the corridor, the state is required to compensate the producer, effectively paying out the commercial losses.

If, on the other hand, market prices exceed the corridor, the state is entitled to capture the surplus revenues earned by the producer and use the extra cash to support households and companies.

This is why the European Commission refers to these contracts for difference as “two-way” because they work both when prices go up and when prices go down.

Under the proposed reform, two-way CfDs will become mandatory for new projects in renewable electricity and nuclear plants – but only if subsidies are involved.

Renewables often require a big upfront investment to pay for devices, such as wind turbines and solar panels, and their installation on the ground. These lofty expenses can deter investors from going into the renewable sector, particularly if they feel their financial contribution will not pay off as expected.

The Commission argues contracts for difference can help convince hesitant investors by acting as a guarantee that revenues will remain stable and consistent over time.

But CfDs are not meant to artificially regulate electricity fees and simply provide redistribution tools to offset extraordinary price swings in the market.

“Only in times of energy crises you need extra protection,” said Bram Claeys, a senior advisor at the Regulatory Assistance Project (RAP), a non-partisan organisation dedicated to the green transition.

“(Two-way) CfDs can offer a source of income for governments to alleviate the impact on consumers when prices are high.”

Moreover, it’s important to note that CfDs constitute state aid because of the compensation that governments have to pay producers when power prices go down. If this compensation drags on, state budgets can come under pressure and challenge the viability of these special arrangements.

That’s why the Commission recommends member states design CfDs with an “upward limitation” that can prevent exorbitant compensation using taxpayers’ money.

Additionally, the executive urges “penalty clauses” for producers who, upon seeing their surplus revenues being captured by the state, wish to get out of the contract before the termination date.