The prices attained in recent auctions are influenced by several factors
The prices attained in recent auctions are influenced by several factors; some relate to the auction design and others to an enabling environment, including: 1) country-specific conditions and access to finance; 2) investors’ confidence related to the presence of a conducive environment; and 3) the presence of other policies aimed at supporting renewable energy development. Chief among the country-specific conditions that directly affect the winning auction price are 1) the country’s renewable energy resources and 2) the capital costs and operating expenditures that project developers face.
For example, adjusting the results obtained in Germany to higher capacity factors, from 11 to 25 percent (the norm in Latin America), could yield prices close to half of the actual results. The higher cost of labour and land in Germany (and other European countries) compared to Latin American countries also contributes to the price difference. Installation costs of renewable energy projects may be affected by policies adopted to support the development of renewable energy. In the United States, for example, investment tax credits have been offered to attract investments in solar PV projects, reducing investment costs by about 30 percent, a reduction that has been reflected in the price outcomes.
Access to finance considerations are largely related to the variations in the weighted average cost of capital, reflecting both the country’s financing conditions (the cost of debt) and investors’ perception of the risks of owning renewable assets in the country (the cost of equity). These factors explain many of the country-to-country differences in auction prices. Investors’ confidence can be strengthened by a stable, enabling environment that is conducive to market growth through a clear target backed by a strategy and policy actions.
For instance, the commitment of the Government of India to its ambitious solar target of 100 GW by 2022, coupled with strong policy action, has given project developers, financing institutions and other market participants confidence in the country’s solar programme, despite challenges faced in some states related to off-taker credibility.
Off-taker risks are common in emerging economies and they strongly influence the risk perception among investors. These risks can be mitigated by ensuring that demand-side responsibilities will be met by offering additional guarantees to back the contract, if needed. In Argentina, the government provides liquidity guarantees ensuring the continuity of cash flow to the developers as well as termination guarantees shielding developers from counterparty risks that are also backed by the World Bank. The impact of investors’ confidence on the price outcomes is mainly illustrated by countries where accumulated experience from recurring auctions has resulted in persistently lower prices (e.g., South Africa and India).
A long-term auction programme, with a predictable schedule of auction demand, and a high degree of transparency all contribute positively to the level of competition in the auction.
THE DESIGN OF THE AUCTION HAS A SIGNIFICANT IMPACT ON THE PRICE
The design features of auctions, namely the auction’s demand, qualification requirements, winner selection, investors’ risks and liabilities, all strongly influence the price outcomes. Across the different auction design elements, policy makers should carefully consider the inherent trade-offs between potentially the most cost effective outcome and other objectives.
Auction’s demand In defining the auction’s demand, ambition for a greater role of renewables in the energy mix must be weighed against cost-effectiveness.
When the objective is to develop a particular technology, a technology-specific auction can
be selected. If the goal is minimising costs, a technology-neutral auction can be introduced,
allowing competition between technologies (e.g., Brazil).
• When the objective is to meet urgent capacity needs while retaining flexibility in holding auctions, the total volume can be auctioned at once, through a standalone auction. If the objective is to further enhance investors’ confidence for a more cost-effective outcome, the total volume auctioned can be divided into different rounds in a systematic auctioning scheme. This facilitates long-term planning by policy makers, bidders, and equipment suppliers, which may be beneficial to the grid planning and to the country’s renewable energy industry.
• If the objective is to meet broader development goals, the auction design can include additional selection criteria. Local content requirements, for example, can support the domestic industry, job creation and other socio-economic benefits. Such requirements are most effective when aligned with other design elements, such as a long-term auction schedule, and applied with other supporting policies.
Qualification requirements are key determinants of the competition in the auction and the prices offered by developers. They can be focused on 1) ensuring that the project will deliver as per the contract by requiring bidders to conduct assessments and obtain permits as a prerequisite to be able to bid, and 2) ensuring the capability of the developer to successfully deliver the project through technical, financial and reputational requirements. Some of the trade-offs to consider in defining qualification requirements include:
• If requirements in terms of permitting and documentation processes are too demanding, the transaction costs incurred by developers can be reflected in higher prices. Transaction costs can be reduced through site- or project-specific auctions where the government (or another entity) takes on the responsibility of site selection, resource and impact assessments, grid connection and obtaining necessary permits. This approach is increasingly common in diverse contexts, including off-shore wind development in Denmark,
Germany and the Netherlands.
• Auctions can be designed in a way to attract large international companies and achieve the
lowest prices through strict qualification requirements. While the requirement for an extensive track record in the field, for example, can help ensure timely project completion, it may also limit the participation to traditional, large players in the sector, which in turn affects the overall development of the sector.
Qualification requirements can also be designed to meet broader development goals, related to domestic industry development and job creation, such as in South Africa and China. These goals are further supported by a winner selection mechanism based on criteria other than the price.
The winner selection process is at the heart of the auction. The criteria for selection, ceiling prices and limits on project size can significantly impact the price outcomes, with the possibility of facing the following trade-offs:
• While a simple winner selection process based solely on the price can improve cost competitiveness, other objectives can be achieved by incorporating non-monetary criteria, such as socio-economic benefits and project location.
Regarding the latter, location signals adopted in the first round in Mexico resulted in the selection of sites that are not optimal in terms of renewable resource availability. Adjusting those signals in the second round contributed to a price decrease of about 30 percent.
• When the main objective is to ensure cost effectiveness, a low ceiling price can be set, above which bids are not considered. However, there is a risk that a sub-optimal amount of renewable energy will be contracted, as it could lead to the rejection of some reasonable bids. Experience has shown that keeping the price ceiling undisclosed can help increase cost effectiveness, but at the risk of disqualifying potentially good projects that are just above the ceiling (e.g., early auctions in Peru). Disclosing the ceiling price in auctions where competition is not fierce might result in equilibrium prices right below the ceiling (e.g., the first round in South Africa).
A limit on the project size or on the volume that can be won by one bidder also impacts the price. Such measures were put in place in Zambia to diversify the portfolio of generators and reduce risks in case projects do not materialise. Auctions that have no limit on project size can benefit from economies of scale, as in the case of Dubai and Abu Dhabi in the United Arab Emirates, where 800 and 1,170 MW of solar was contracted respectively, at record-breaking prices.
Investor risks and liabilities
In determining the sellers’ liabilities in the power purchase agreement, there are various ways to allocate financial, operational and production risks between the project developer, the auctioneer and the off-taker. Trade-offs that need to be considered in the allocation of risks and liabilities to developers include:
• Auction design features can limit the developers’ risks resulting in lower prices, but these risks would then be passed on to the off-taker. Currency, inflation and production risks can be reduced through auction design. In Chile, contracts are denominated in U.S. dollars and indexed to U.S. inflation, protecting developers from currency exchange and inflation risks. In addition, the newly introduced hourly supply blocks protect generators from production risks, reducing exposure to spot energy prices in case of deviation from the contracted amount. This is one of the factors that led to the record-breaking solar prices in Chile’s 2016 solar auction.
• Liabilities can be reduced to encourage participation and increase competition, but at the risk of facing project delays or underproduction. Investor liabilities involve commitment to contract signing and project completion as well as compliance rules and penalties. These are important measures to ensure that projects are developed as per schedule to meet the capacity needs of the power sector. However, if these measures are too strict, competition in the auction will be reduced, leading to higher prices. There are innovative ways to address these trade-offs, as in the case of Germany, where bidders with building permits saw their bid bond and completion bond requirements reduced by almost half.