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FSR

Generation mix

Written by Thomas-Olivier Léautier

This FSR topic of the month explores governments’ intervention in four aspects of the power industry: (i) generation adequacy, (ii) generation mix, (iii) organization of the transmission grid, and (iv) asset ownership. This week’s post discusses the role of governments in shaping the generation mix.

In planned economies, governments choose the power production technologies.  Civil servants examine the different technologies available at a given time, compare their costs, and determine the optimal mix.  In the vertically integrated and regulated monopolies of old, utility planners were performing this task, in cooperation with civil servants.

One of the main objectives of industry restructuring was to put an end to central planning, and let competing investors choose the technology mix. Market discipline is supposed to increase productive efficiency, hence net surplus: if a firm chooses an inefficient technology, its profits will suffer, and the technology will be abandoned, and the firm may go bankrupt.  Markets appear to have performed well in the 1990s: in Great Britain for example, high cost and polluting coal fired power plants were replaced by more efficient and cleaner combined cycle gas turbines.

However, since the mid 2000s, European governments are back in the business of choosing the power production mix. For example, the German government has decided to phase off nuclear production, while at the same time the British government has decided to launch a new generation of nuclear assets.  Meanwhile, all European governments have heavily subsidized Renewable Energy Sources, in effect administratively setting the generation mix.

The justification for these interventions is not completely clear.  It is not obvious that the specific choice of technologies is a political issue, which falls under the purview of elected officials.  Of course, safety and regulatory agencies are responsible to ensure that assets are operated safely. Of course, governments and law-makers should correct for externalities, for example by introducing a price for carbon and other pollutants. However, these legitimate interventions do not justify choosing the technology mix.

On the other hand, the problems associated with governments’ choosing the technology mix are quite clear. First, this creates uncertainty for investors.  Market prices are no longer determined by economic fundamentals, such as fuel costs, but by government fiat. Since the latter are much less predictable than the former, investors have difficulties anticipating them.  Regulatory uncertainty is an important driver of underinvestment in all industries, including the power industry.

Second, the winning technologies are these that secure more favorable treatment from the governments, not necessarily the most efficient.  Lobbying prowess, not technological innovation, is the key driver of financial performance.

Finally, decisions makers are not accountable.  If a corporation’s management team chooses an inefficient technology, chances are investors will request a change of team. Experience suggests that the public’s appetite to hold elected officials – and bureaucrats – to account for such mistakes is much more limited.  These lower incentives are unlikely to translate in better choices.

Read the previous article: Generation adequacy