How financial engineering can help Europe go green

The financial derivative in question, as currently designed, will misdirect those investments and make prices even more volatile than they already are.

The European Union is betting that a bit of financial engineering can help attract trillions in much-needed green investment while shielding consumers from the kind of price surges that slammed the region after Russia’s invasion of Ukraine.

It’s a great idea, with only one problem: The financial derivative in question, as currently designed, will misdirect those investments and make prices even more volatile than they already are.

To reach its goal of net-zero carbon emissions by 2050, Europe will need a lot of new wind farms, solar arrays and other clean sources of power. These days, such projects are often profitable without government subsidies. But the required investment won’t happen on its own, due to a cash-flow problem: Renewables companies typically need to make large upfront investments, which means borrowing money and making regular debt payments that can be hard to meet with highly variable income. Without a reliable way to hedge this default risk — something financial markets don’t yet provide — private lenders won’t lend.

To address the issue, governments have increasingly favoured a derivative known as a two-way contract for difference. Under these contracts, each project has a target price, determined at a competitive auction. When market prices are lower than the target, the government makes up the difference. When the market goes higher, the producer pays the excess to the government. As of 2022, such deals had been struck for at least 40 gigawatts of renewable capacity, according to Bloomberg New Energy Finance. That was about 8 percent of the EU’s installed total, up from zero in 2016.

If the EU has its way, such contracts will soon be pervasive. As part of a broader electricity-market reform, it’s mandating that within several years, all new government renewable-energy deals must employ them or something equivalent. This could be beneficial: By ensuring steady income, the contracts allow renewable investments to attract financing on relatively favourable terms. During periods of high electricity prices, moreover, they generate funds that governments can use to ease the blow on the needy — a feature that should protect projects from unpredictable and confiscatory “windfall taxes.”

There’s just one critical flaw. The contracts typically calculate payments based on the quantity of electricity actually provided, a variable that producers can influence. Generating more when prices are low, or cutting back when prices are high, maximizes net payments from the government. This encourages all sorts of perverse behaviour, such as scheduling maintenance at times of high demand or eschewing investments in low-speed wind turbines and sun-tracking solar panels that can produce when others don’t. In one extreme case, a company in the UK idled a biomass generator amid skyrocketing prices during the energy crisis of 2022, thus saving itself hundreds of millions of pounds. The more capacity such contracts cover, the greater the potential mayhem.

The solution: Payments should be calculated based on quantities that no party to the contract controls — something other financial markets figured out a while ago. Experts have demonstrated how such objective benchmarks could be applied to renewables. Weather models, for example, could estimate how much a given solar array or wind farm should generate at any moment (akin to what electricity traders already do, to great profit). This would still provide an effective hedge for both producers and governments while keeping market incentives intact. Producers could benefit by selling more at high prices, or less at low. Investment decisions would be driven by consumer needs.

Why, then, aren’t governments already using such contracts? The charitable explanation is inertia: They’re stuck in the past, when the primary challenge was to get capacity built and renewables weren’t competitive without subsidy. They now need to update their assumptions to match the reality and goals of the green transition.

Bloomberg Editors: Views do not represent the stand of this publication.