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Are tenders creating unsustainably low prices?

WORLDWIDE: As growth in wind deployment in Europe and the US slows, the baton has firmly been passed to emerging markets like Brazil and South Africa. Surging demand for electricity in these markets sees state-dominated electricity sectors struggling to keep pace. The response has been to attract private capital by awarding contracts through competitive tendering of PPAs.

The ambition is remarkable. Brazil plans to install at least 2GW of additional capacity per year until 2020 and South Africa's revised integrated resource plan seeks to bring the share of wind to the grid to 9% by 2030.

If the sole intention of awarding contracts by auction is to foster competition, the Brazilian example must be viewed as a roaring success. Fierce competition between 240 participants in the August 2011 tender round saw 20-year contracts awarded to 44 projects. Prices sank as low as US$63/MWh for contracts starting in 2014.

Discovering the true cost of supplying a good or service through competition is widely used to reduce prices and the desire of governments to secure low-cost energy supplies vital to any economy is laudable.

However, the maxim 'if something appears too good to be true - it probably is' seems pertinent. Electricity costing $63/MWh from wind farms is lower than has been achieved in almost any other market and gives natural gas a run for its money. How are these extraordinary prices achievable in Brazil? Indeed, are these prices sustainable at all? The absence from recent tenders of EDP, IPR-GDF, Iberdrola and Petrobras is indicative of the view of some leading regional players.

The cost of delivering wind projects in Brazil does not appear sufficiently favourable to drive prices to the levels observed. However, the onshore wind resource in parts of Brazil compares favourably with any region on Earth. Capacity factors of 50% are thought to be achievable by upscaling turbine rotors and the development of new products for the unique conditions.

In a competitive process like that employed in Brazil, a small number of projects with overestimated energy yield can significantly influence the prices of contracts awarded to all projects. Bidders are forced to place uncomfortably low bids to win a contract or risk forfeiting the costs of developing the project and participating in the auction. There are no direct parallels with this uncertainty for conventional generation, which can enter into long-term fuel supply contracts to mitigate market risk.

An alternative explanation is that a frenzy of interest in the auction led to "winners curse", which defies the assumption that all participants are able to make purely rational decisions based on the information available. Empirical studies suggest that in competitive situations players systematically overestimate the value of what is being sold. This might be shown by commitments to generate electricity at unfeasibly low prices.

It could be the case that a structural over-supply of global turbine-manufacturing capacity means developers' costs are temporarily low. But this raises questions about the long-term sustainability of the prices once the supply chain rebalances.

As auction designers strive to accommodate the unique characteristics of wind power the process becomes ever more unwieldy. In South Africa, the challenge of designing a successful auction is seen by the absence of much developmental wind capacity from a recent tender round.

An onerous prequalification process muted competition and just 634MW was contracted. More than 1GW remains available for a second round in March. Pent-up demand and sufficient time for developers to prepare compliant bids presages an over-subscribed auction and cut-throat pricing here, too.

Recent history is littered with examples of sub-optimal outcomes from wind-power auctions. The UK's non-fossil fuel obligation tenders saw only a fraction of contracted plant ever completed. Denmark's 2009 offshore wind tender attracted just one participant.

Policymakers seeking to unlock the potential of markets like Brazil and South Africa face a dilemma. If administratively set tariffs risk over-rewarding and competitive processes risk unsustainable pricing, how should they respond? Is there a compromise?

Means of accommodating the uncertainties inherent in the costs and revenues of wind power should be sought. Mechanisms that allow the tweaking of tariffs as the understanding of costs develop between contract award and project completion would go some way to addressing this information gap.

Important lessons about the role of competition have been learned over two decades of progress. Emerging countries planning to harness the power of markets to reveal prices could do worse than to heed words attributed to Mark Twain: "History may not repeat itself, but it does rhyme."

Oscar Fitch-Roy is a senior policy consultant at renewables consultancy GL Garrad Hassan's strategy and policy unit.

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