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The silver lining of Renewable Energy subsidies

Claude Crampes and Thomas-Olivier Léautier

The subsidy programme introduced by EU Member States to finance Renewable Energy Sources (RES) will be remembered as a textbook case of a poorly conceived public policy.  However, it produced a significant side benefit: it contributed to RES competitivity in developing countries, where the battle against climate change will be fought over the next few decades.

1       The squandering of RES subsidies in Europe

The carbon market

As already explained in previous posts, the most effective way to reduce CO2 emissions is to put a price on them, either through a tax or preferably a market mechanism. When faced with the actual economic cost of their actions – including their impact on the stock of CO2 in the atmosphere – decision-makers tend to do the “right” thing, in this case invest in the most efficient low-carbon technologies. With this in mind, Europe made the bold decision of setting up a carbon market in 2005. [1] A brave decision which should be applauded. [2]

Unfortunately, although the market works correctly, political leaders are disappointed with the results; they were hoping for a much higher price for a ton of CO2.

Why is the price “too” low? Mainly because the economic crisis that has been crushing the continent since 2008 has reduced economic activity, hence CO2 emissions. Europe is meeting its emissions reduction target without really doing anything, almost inadvertently. The market price for a ton of CO2 is currently around €9,[3] which fairly represents the balance between the demand from firms that need to procure quotas and the available supply of those said quotas. Yet many observers have complained that the price was not high enough to induce low-carbon investments. The European Union is attempting to raise the price through a remedial instrument whereby a portion of the quotas would not be sold until the end of the decade[4]. The campaign, set to begin in 2021, is also expected to further restrict the amount of authorised emissions[5].

RES subsidies

Politicians added another initiative to the carbon market that is less economically effective, but much more politically astute: renewable energy subsidies.

What was the economic motive behind this? Like every industry, RES construction and deployment is characterized by learning curves and economies of scale. Building the first generation of wind turbines provided knowledge that reduced the cost of building the second. In the same vein, a plant making 1,000 solar panels will have a lower unit cost than a plant producing 100. So it is not unreasonable for governments to subsidise the first installed units to bring their cost down more quickly. But why subsidise RES and not mobile phone manufacturers or any other industry with a learning curve and economies of scale? Because taking the carbon out of electricity production is a crucial component of the fight against climate change, which justifies a targeted public policy. A more cynical answer is that RES are “dispersed,” in plain view and turning consumers into producers – features that political leaders find very attractive.

Even when subsidies can be justified in economic terms, they are difficult to set up correctly. Experience shows that the organising entity, in this case the government, often gets spun along by clever subsidy recipients and their suppliers, to the great displeasure of taxpayers – in this case electricity consumers. The primary beneficiaries are usually those companies that master the art of receiving subsidies, especially the legal and regulatory process of defining them, and not those that offer the most useful and innovative technologies.

Governments in the vast majority of EU Member States decided to set a guaranteed purchase price for kilowatt hours generated by renewables but not to put a limit on the volume of these kilowatt hours, thereby setting up a ticking time bomb. The price was defined administratively, using the estimated production costs of the equipment. But even the most devoted civil servant would struggle to get his hands on accurate figures from the suppliers. Even if he did, and the price reflected the actual cost on that particular, that same price then remained in force for many years, during which time the learning curve drove down the cost drastically, generating an economic windfall for producers. With their eyes on this risk-free profit-making opportunity, they stepped into the breach and the volumes skyrocketed. So the price calculated administratively was not robust to a drop in costs, which was the very reason for the subsidy in the first place.

Governments then reacted to this massive influx of RES by reducing the purchase price. This led to a race between subsidies and costs, a competition that the latter almost always won. Some Member States opted to revise the subsidy system and revert to calls for tenders, i.e. regulating RES volumes instead of purchase prices.

Assuming decarbonisation justifies promoting RES, the effective economic approach would be to (i) figure out the total multi-year budget that we collectively want to allocate to RES subsidies, (ii) determine the annual volume of RES to include so that the trajectory of the subsidies follows the multi-year budget, and (iii) open calls for tenders for those volumes. One could debate whether the calls for tenders should be technologically impartial or specific to each industry.

The collateral damage of the RE upsurge on the European electricity market

The massive influx of subsidised RES in the European power market has created unforeseen negative side effects. The first damage befell the “red-brick” electricity producers; with electricity supply rising significantly while demand barely changed, prices have plummeted, bringing the financial health of producers down with them. We could squabble over how much the producers were to blame since they continued to pour money into gas power plants in the late 2000s as they wrongly projected the implications of RES subsidies.  Regardless, they are dealing with significant and very real financial troubles. In order to get back on track,  they have persuaded the public authorities to in turn subsidise them with capacity mechanisms. [6] So after subsidising the RES developers and producers, European taxpayers now have to subsidise the “traditional” producers to make up for the damage caused by the first subsidy!

Ironically, the RES industry is the second collateral victim. Realising their mistake, many governments made an abrupt u-turn. The most striking example comes from the United Kingdom, which essentially scrapped its subsidy policy to the great displeasure of its renewable industry.[7] One could argue that there is nothing really wrong with this: a business founded on the basis of a government policy runs the risk of that policy being amended. That said, inconsistency in public policy is never a good thing.

The amount of unjustified transfers

European RES subsidies have therefore created unjustified wealth transfers from consumers to RES producers and developers.

It is hard to put an exact figure on how much has been transferred, but one can make a reasonable estimate. Every year, the Frankfurt School–UNEP Collaborative Center for Climate and Sustainable Energy Finance publishes statistics on the annual investments in renewable energies.[8] The 2015 report shows investments in Europe between 2004 and 2014. Over this 11-year period, the total investment was $870 billion with a peak in 2011 at $120 billion.

In April 2014, the French Energy Regulatory Commission (CRE) issued a report on the profitability of renewables in mainland France.[9] It found that the average return on capital invested for solar in calls for tenders is 2% below the return when the price is set administratively. Similarly, the return on capital for onshore wind energy seems to be an average of 2% higher than a just and reasonable rate of return on capital. Assuming that this extra return on invested capital represents an unwarranted economic rent, it totalled $82 billion from 2004 to 2014. This is merely an approximate calculation. But it does suggest European taxpayers may have transferred somewhere between $50-100 billion of unjustified economic rent to the RES industry during that time.

2       The upside: a steep drop in the cost of renewables

The subsidies generously granted by European leaders, and paid for by all electricity consumers, have helped trigger a sharp fall in the cost of renewables. This is important for Europe and even more so for developing countries where the battle against climate change will be fought over the next few decades.

In some situations, RES are now an inexpensive alternative to conventional electricity generation. For example, in January 2015, the Dubai Electricity and Water Authority signed a 25-year procurement contract with Acwa Power for a 100 MW solar farm production at the price of $58.50/MWh (€53.63/MWh).[10] Inconceivable only two years ago, this price has now become the market benchmark. It is probably the best news for the climate we have had all year.

One could rightly object that solar electricity production is uncontrollable. Only available when the sun is shining, it does not always coincide with consumer needs. Concentrated Solar Power (CSP) is solving part of this problem by storing solar energy as heat to be used at night. The Swedish company Cleanergy has undertaken an ambitious CSP project in Dubai and thinks the technology could soon cost about $50/MWh.

This price drop is crucial. Over the next few years, the rise in CO2 emissions will mainly come from China and India. Thus, to prevent ballooning emissions, the demand for electricity in those countries must be met with low-carbon energy sources, including RES[11]. The International Energy Agency (IEA) predicts that electricity consumption in India will double by 2030[12] and the coal share will go down from 74% to 51%. This means the amount of electricity generated from coal, i.e. CO2 emissions and other residual pollutants, will increase by 45%. In 2030, India will be emitting 25% more CO2 than the European Union, and 25% less than the United States. If the cost of renewables was low enough that RES replace 10% of India’s coal generation compared to the IEA scenario , the country would reduce its emissions in 2030 by 250 million tons of CO2 per year, which is no mean sum.

The lower cost of renewables goes some way towards explaining why companies are “going green.” The White House recently announced that a long list of corporations, including Johnson & Johnson, Procter & Gamble and Nike, have signed pledges to take climate action, primarily to reduce or offset their CO2emissions.[13] Likewise, Apple recently announced that its supplier Foxconn will be producing enough megawatt hours from renewable sources to manufacture all Apple products.[14] We can always hope that the CEOs and board members at these companies have had an environmental epiphany. It is more likely that their decision was partly swayed by the low cost overrun of their commitment.

RES offer another advantage over conventional production: achieving efficient scale rapidly. People living in many rural areas of Africa still do not have electricity, and they will probably not be on the main grid by 2030. On the other hand, mini-grids supplied by renewables are expected to be able to provide them minimal access to the “electricity fairy” at a price they can afford. Africa generates barely 3% of CO2 emissions, so the benefit on global emissions will be slight. But the human benefit will be extremely high.

* * *

Renewables alone will not protect us from the risks of climate change. The only way to turn the tide is for public opinion to demand a firm commitment from governments and corporations. The incredible drop in the cost of RES, partially thanks to European taxpayers’ subsidies, makes this commitment more affordable, in particular for developing countries. Every cloud has its silver lining.

 


[1] ec.europa.eu/clima/policies/ets/index_en.htm

[2] The United States introduced the first market to regulate SOx pollution in the 1990s. The European CO2 market is more ambitious.

[3] www.investing.com/commodities/carbon-emissions-historical-data

[4] ec.europa.eu/clima/policies/ets/reform/index_en.htm

[5] ec.europa.eu/clima/policies/ets/revision/index_en.htm

[6] www.developpement-durable.gouv.fr/Regles-du-mecanisme-de-capacite.html

[7] “Energy groups axe UK renewable projects”, Financial Times, 20 October 2015

[8] fs-unep-centre.org/publications/global-trends-renewable-energy-investment-2015

[9] www.cre.fr/documents/publications/rapports-thematiques/couts-et-rentabilite-des-enr-en-france-metropolitaine

[10] “Cleanergy to unveil Dubai concentrated solar power project”, Financial Times, 20 October 2015.

[11] We should keep in mind that China also has a very extensive nuclear energy programme:www.world-nuclear.org/info/Country-Profiles/Countries-A-F/China–Nuclear-Power/

[12]www.iea.org/publications/freepublications/publication/WEO2015SpecialReportonEnergyandClimateChange.pdf

[13] “Global companies sign White House pledge on climate change action”, Financial Times, 19 October 2015.

[14] “Apple and Foxconn step up renewable energy push in China”, Financial Times, 22 October 2015.