conf talk apr5 combined

8/6/2019 Conf Talk Apr5 Combined

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Renewing the incentives to invest in renewables

Bruno Prior, Director, Summerleaze Ltd

AEP Seminar,Britain's 3 pin energy policy (5 Apr 2011)

Renewing the incentives to

invest in renewables

Bruno PriorDirector

Summerleaze Ltd

AEP Seminar, 5th April 2011

Britain's 3 pin energy policy:

Does the Electricity Market Reform plug fit?


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Good afternoon. Please forgive a brief initial discursion, but I want to begin by

asking: how should governments design policy?

There are two approaches to government and economics:

MECHANISTIC

INSTITUTIONAL

By mechanistic, I mean governments calculating what ought to happen, and

then designing schemes to try to make it happen. It's the lever-pulling school

of government.

By institutional, I mean

recognising the limits to central knowledge,

and maintaining the minimum apparatus of government necessary to

define and enforce the boundaries and remedies where one person's

freedom intrudes unacceptably on another's.

Within such a framework, we discover rather than calculate the more or

less efficient responses to evolving understanding and circumstances,

harnessing diffuse knowledge through the processes of voluntaryexchange and creative destruction.

You can see the attraction of the mechanistic approach, if only from the

simplicity and brevity of its exposition.

Indeed, it has proved sufficiently seductive for the mechanistic approach to

come to dominate our thinking over the course of the twentieth century, to the

extent that most people now take it for granted.

The need for governments to pull levers to correct any identified issue is

treated by many people as implicit in the identification of the issue.

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Yet I would argue that our prosperity and liberty in the modern Anglosphere was

founded on the institutional approach, and that many of the failings of modern

policy-making stem from our adoption of the mechanistic approach.

MECHANISTIC INSTITUTIONAL

ROUSSEAU LOCKE

NAPOLEONIC LAW COMMON LAW

EU ANGLOSPHERE

MERCANTILISM FREE TRADE

MARX SMITH

COLLECTIVIST INDIVIDUALIST

CALCULATION DISCOVERY

IMPOSED ORDER(TAXIS)

SPONTANEOUS ORDER(COSMOS)

KEYNES HAYEK

AGGREGATIVE ATOMISTIC

CORPORATIST ENTREPRENEURIAL

ECONOMIES OF SCALE COMPETITION

BAIL-OUTS CREATIVE DESTRUCTION

1848-20?? c.1700-1848 & ??

I could go on about the history and philosophy of this, but hopefully you can see

where I'd be going with that, so we'll press on with how this relates to energy

policy.

* * * * *

For a mechanistic approach to be justified, it is not enough for an issue to be

identified. The government must also have good enough information and

foresight to be able to work out what best to do about it. Otherwise, you end up

with the:

Something must be done. This is something. Therefore this must be done.

style of government. Sound familiar?

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Let's consider some examples of the quality of information and foresight

available to the government in the energy sector:

In the 2006 Energy Review, the Government produced the following chart,

showing historic and projected levels of fuel poverty in England:

In practice, the level of fuel poverty was projected to have reached 4.6 million

households in 2009.

Those tempted to blame the financial crisis should remember that 2.8m

households were in fuel poverty in 2007, and 3.3m by 2008.

* * * * *

How about prices and learning curves? Here are some estimates relied on by

British governments over the years for the anticipated costs of offshore wind:

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Year Source Price

2001 No.10 Performance and Innovation Unit (PIU) 20-30/MWh

2002 Interdepartmental Analysts' Group 20-30/MWh

2003 Oxera (for the 2003 Energy White Paper) 60-76/MWh in 2005,44-55/MWh in 2010,39-49/MWh in 2015,30-46/MWh in 2020

2004 Royal Academy of Engineering 55/MWh

2006 The Energy Challenge conclusion to 2006 EnergyReview

55-89/MWh (centralestimate: 82/MWh)

2007 Ernst & Young report for consultation on RO Reform 91/MWh (medium levelisedcosts)

2009 Ernst & Young report for DECC supporting theemergency banding review

144/MWh (levelised cost @12% return), and a rising, nota falling learning curve

Between 2001 and 2009, it went from being so cheap, it would need no subsidy

(but wanted it anyway), to more expensive than anticipated but with a steeply-

declining learning curve, to six times more expensive than originally thought,

and a rising learning curve i.e. the more we know about it, and the more we

deploy, the more we expect it to cost.

Yet we are asked to believe that the Government knows how much offshore

wind is economically beneficial for us, and is justified in providing whatever

level of support is necessary to deliver that amount.

Only a small fraction of the latest cost-estimate is justified by the value of the

avoided carbon emissions, so the vast majority of the subsidy must be justified

by the industrial-policy arguments.

But are those arguments credible in the face of such high and unpredictable

costs?

Why, at that level of escalating cost and uncertainty, would other countries

invest sufficiently in buying this technology from us to justify our initial

investment, particularly as the learning curve seems to be outweighed by the

cherry-picking effect?

How does government know this will turn out to be a technological winner?

Why is it the job of governments rather than entrepreneurs to pick winners?

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How long should governments throw money at winners before accepting that

they've picked a loser?

* * * * *

How about crude oil prices? Much of our energy policy is based on the

Government's projections for fossil-fuel prices. Here are some of their recent

projections:

DTI 2006 projections Low scenario Central scenario High scenario

2006 $55.0/bbl $60.0/bbl $65.0/bbl

2007 $46.3/bbl $55.0/bbl $65.5/bbl

2008 $37.5/bbl $50.0/bbl $66.0/bbl2009 $28.8/bbl $45.0/bbl $66.5/bbl

2010 $20.0/bbl $40.0/bbl $67.0/bbl

2011 $20.0/bbl $40.5/bbl $67.5/bbl

BERR 2008 projections Low sensitivity Central case High sensitivity

2010 $25.0/bbl $56.9/bbl $70.0/bbl

2015 $25.0/bbl $50.0/bbl $75.0/bbl

2020 $25.0/bbl $52.5/bbl $80.0/bbl

Oops.

One could do a similar job on most government projections.

* * * * *

The consequence of government ignorance has been seen internationally in mis-

priced Feed-In Tariffs.

Spain set the pace, but the UK's PV fiasco set the standard.

The Czechs have also pulled their scheme, and the mis-pricing of the French PV

scheme is costing EDF tens of millions of euros.

PV contributed less than 1% of the electricity produced in Europe in 2010, and

less than 0.2% of our final energy consumption.

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So what are we being offered in the latest market disruption... sorry, in the

Electricity Market Reform (EMR) proposals:

A bigger, badder Feed-In Tariff (FIT).

* * * * *

EMR aims to reduce the cost of financing the enormous investments that the

government (with its extensive knowledge and foresight) has decided are

necessary for us, by supposedly reducing the risk to investors.

Businessmen are in the business of taking risk. We don't mind commercial risk.

That's what we do. We should succeed or fail according to how well we do it.

What we can't easily cope with is political risk. And what creates political risk?

Targets.

Because governments never have good enough knowledge and foresight,

mechanisms designed to achieve targets in a given timescale to a given budget

rarely succeed.

If they are under-shooting or over-shooting the target or budget, the government

feels obliged to modify the mechanism to try to bring it on target or within

budget.

When they continue to be off-target, the government quietly forgets about the

old target and sets a new one.

The one thing you can be sure of in a targeted mechanism designed with

inevitably inadequate knowledge is that the mechanism will be subject tofrequent change.

EMR is intended to achieve:

incredibly ambitious targets

in a short timescale,

at a cost to be imposed on people whose budgets are already stretched to

the limits.

* * * * *

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A Contract for Differences (CfD) is supposed to give the long-term certainty that

investors need.

That may work for technologies with high capital costs and low running costs,

but for technologies with significant, variable input costs (like fuel), a CfD

offers fixed income to set against costs that may well be driven upwards by the

additional demand for the fuel generated by the scheme.

For most renewable fuels, it is very difficult to secure long-term supply contracts

to insulate against this risk.

And all technologies are exposed to the risk, as in Spain, that the mechanism

runs up against the ability of the economy and the willingness of the populationto keep funding an exorbitant mechanism.

Does anyone really believe that a government faced with the economic and

political consequences of having over-committed under EMR, wouldn't find

ways to claw back some of the cost?

A windfall tax or stabiliser springs to mind.

And what are the chances that the government won't impose new costs throughregulation, costs that are not currently anticipated in the economic models for

the various technologies?

The other problem with a CfD is that it requires a reference price that is a

reasonably-accurate reflection of the wholesale market, and we don't have a

liquid, traded wholesale market from which to extract such a price.

The Government is well aware of the problem of liquidity, but we have yet to

see if they have the nerve to implement an effective solution, or whether they go

for a kludge.

My bet is on the kludge, because there are only two effective solutions, and one

of them isn't good.

The bad solution is to reinstate a Pool in which all wholesale electricity must be

traded.

The good solution is to reverse the integration that was always incompatible

with the New Electricity Trading Arrangements (NETA), and

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DIS-INTEGRATE

the

Vertically

Integrated

Large

Energy

COMPANIES

It is unlikely that the current government will have the nerve to do that, in which

case the CfD proposal will become another opportunity for corporate gaming

created by the delusional pursuit of unrealistic targets.

* * * * *

It is far from clear that what the electricity market needs is a set of changes thatintroduce yet more upheaval and complexity without resolving any of the real

structural problems in the market.

As usual, the targets drive the changes, so the best way to minimise political

risk, reduce the cost and (counter-intuitively) increase the scale of delivery, is

for governments to abjure targets.

This is not only pragmatic, it is also good economic principle.

No sensible economist would argue that we must achieve climate targets at any

price.

Our targets are calculated (badly) on the basis that the present cost of mitigating

the risk is less than the Net Present Value of the harm that might result from not

mitigating the risk.

There is a cost of present action at which it is better to adapt than to mitigate.

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This is one of the few issues in economics on which there is almost universal

agreement.

Sensible climate policy would put a price on carbon, and leave it to the market

to discover how best to respond to that, in terms of behaviour modification, as

well as investment and innovation.

That is one example of the difference between the institutional and the

mechanistic approach.

* * * * *

If an unwise government still wants to pursue industrial policy, it can do so more

effectively through grant schemes.

After all, revenue support is a bad way to encourage investment in projects

whose success and eventual output is unpredictable. If the objective is financial

efficiency, grants are the answer for industrial policy.

Not that I want to encourage industrial policy.

And not that politicians would do it that way, because it would make it far tooeasy to identify what a waste of money most industrial policy is.

As industrial policy is really political, not economic, it has to be wrapped up in

mechanisms with multiple objectives, so arguments about its purpose and

effectiveness can easily be obfuscated.

* * * * *

The previous points about targets and carbon pricing are some of the manyreasons why the European Union Emissions Trading Scheme (EU-ETS) is a bad

scheme, and a carbon floor-price therefore an attempt to fix something that

shouldn't be fixed.

To set a target and then try to discover the price at which that target can be

achieved has it exactly back to front.

We should set a price and discover what level of delivery on carbon abatement,

and other responses, are justified by that price.

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Other failings of the EU-ETS, like:

the competitive advantage for incumbents (sorry free allocations),

its focus on only certain sources of certain greenhouse gases

the short-termism

the susceptibility to political gaming

the arbitrary nature of the national and sectoral allocations

its tendency to penalise European industry and to offshore, rather than

reduce, carbon

the irrationality of a mechanism that can swing from very low to very

high prices, depending on whether performance is marginally over or

under an arbitrary target

and so on, don't help, but the fundamental problem is that it is simply a bad

concept.

A carbon floor-price mitigates some of the failings, but exacerbates others (like

the offshoring effect).

The reason for the floor-price is the recognition that the EU-ETS simply isn't

designed to deliver, in which case why keep the complexity, bureaucracy, and

partiality, rather than scrap it and replace it with something more fit for purpose?

What we really need is a mechanism that discovers rather than calculates the

present value of the risk of future harm, and apportions the cost positively or

negatively in proportion to people's contributions to exacerbating or mitigating

the risk.

* * * * *

The pretext for targets is that they drive delivery, and it's vital that we deliver

on our environmental and security objectives.

Let's see how well the targeted, winner-picking schemes of the UK have done

compared to the untargeted Swedish regime of carbon and energy taxes(following two charts prepared using Eurostat data):

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Ah, but Sweden has all that natural hydro-electric potential, people say. So

let's take the legacy capacity out of it.

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Sweden introduced its carbon tax in 1991. The UK introduced NFFO in 1990.

From then until 2007, the share of renewables within gross inland energy

consumption (not just electricity) increased by around 8 percentage points in

Sweden, despite hydro's share decreasing by about one percentage point.

The share of renewables in the UK increased by less than 2 percentage points in

the same period.

And by the way, have a look at Finland, which introduced a carbon tax one year

before Sweden.

This is a little out of date, and compared with gross rather than final energy

consumption. Here is the latest chart of the renewable share of final energyconsumption across Europe (from DECC'sEnergy Trends, December 2010):

One would think Sweden had plucked all the low-hanging fruit by now, but

renewables' share of final energy consumption increased from just under 40% in

2005 to nearly 45% in 2008. And that is despite declining hydro output.

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Notice again that Finland is 2nd and growing rapidly, while the FIT countries,

like Spain and Germany, which received-wisdom believes have done

exceptionally well, are actually exceptionally mediocre.

Targets and FITs don't look like such a good bet for delivery, do they?

* * * * *

The Swedish combination of energy and carbon taxes provides the incentives for

everyone to minimise their consumption of fossil fuels in the most appropriate

way for their circumstances. It works a lot better than a central agency deciding

what is right for everyone.

With this sort of incentive, what would you do? [The following four charts are

from European Commission, DG TREN Staff Working Document,Report on

Progress in Creating the Internal Gas and Electricity Market, SEC(2009) 287]

For all the complaints about the cost of domestic heating, only 6 former-

communist countries had cheaper gas than us.

Or at least, on an exchange-rate basis, they did. By purchasing-power parity:

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Those poor British households.

Think how easy it would be for Sweden to make itself dependent on Russian gas

if it wanted. It doesn't want it.

The pattern is similar for electricity.

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Without taxes, Swedish electricity would be 25% cheaper than in the UK. With

taxes, it is nearly 20% more expensive.

And yet we have millions of households in fuel poverty, and the Swedes don't

even understand the concept, and when you try to explain it and our approach to

it, they first frown in confusion and then laugh at our stupidity.

* * * * *

There is no more poisonous and perverse concept in energy policy than that of

fuel poverty.

These people aren't short of cheap energy, they are short of money and good-

quality housing.

By keeping energy as cheap as possible, we make it impossible to justify the

cost of the changes that would be the real solution to their problems, and a huge

benefit to our economy, energy-security and the environment as well.

And as we've learnt recently, it doesn't even work, because you can't take

artificially-low taxes below zero, so when your waste-stimulating policies result

in excess demand and high global prices, you have no way of insulatinghouseholds against the effects.

They will pay for inefficiency one way or the other.

It's just a question of whether they should pay it to Arab Sheikhs and Vladimir

Putin, or to the exchequer, which could use part of the revenue to fund welfare

for the poorest households to mitigate the effects, and the balance to reduce

taxes on things like employment and productivity, promoting a higher-

employment, higher-efficiency economy.

In practice, our failed policy of trying to hold down the cost of domestic energy

is not only the main cause of fuel poverty, it is also a badly-targeted subsidy

from taxpayers, rich and poor, to people with high energy consumption, rich and

poor.

If you think this is just theory, compare the efficiency of British and Swedish

households. In a climate with double the heating degree-days of our climate,they use only a little more domestic energy per person than we do.

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In other words, their properties are nearly twice as efficient, and the little energy

they use is mostly renewable or nuclear. Because it's worth it.

* * * * *

Unlike domestic, commercial and public-sector energy, if you put heavy taxes

on industrial energy, the business will simply go abroad, probably to countries

that will be less clean and efficient. So what do those clever Swedes do? They

exempt their industry from 100% of the energy tax and 50% of the carbon tax.

Consequently, the Swedes have a strong industrial sector and a resurgenteconomy against a difficult economic backdrop, while we have a dependence on

financial services and a spluttering recovery.

Swedish Industrial Value Added per capita is more than double that of Britain,

their domestic efficiency is 80% better than ours, renewables' share in final

energy consumption is around twenty times higher than ours, and their GDP per

capita is 25% higher than ours. Which approach to policy seems to have worked

better?

* * * * *

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Others will point at Sweden's high nuclear capacity, and that is also an important

part of the story, but let's get it into perspective.

Nuclear electricity provides around 44% of their electricity, but around 17% of

their final energy consumption.

It is matched to high hydro capacity, which is a vital partner for its load-

balancing capabilities where nuclear capacity exceeds baseload demand. Hydro

provides another 44% or so of their electricity (i.e. another 17% of final energy

consumption).

We don't have that hydro potential, so we don't have the potential to replicate

this approach.

However, although nuclear and hydro account for nearly 90% of Swedish

electricity (but only around one-third of final energy consumption), other forms

of renewables contribute over 50% more to final energy consumption than either

nuclear or hydro.

It's not wind, which they haven't bothered with much until they caught a mild

dose of the European madness recently.

It's biomass.

But their biomass resource is bigger than ours, people object.

Sweden's biomass resource is bigger than Denmark's too. 14% of Denmark's

landmass is forested, compared with 12% of the UK's landmass.

Nevertheless, if you look back to the earlier charts of the contributions of

various renewable technologies to gross energy consumption, you can see that

the Danes have increased their overall renewable share by nearly 12 percentage

points since 1990, and three quarters of that was biomass of one kind or another.

Once again, this was driven by a carbon tax (less well-designed than the

Swedish, but better than the UK's mess). Native resource is a red herring for

biomass. Biomass is a globally-tradable commodity.

You can tell from the fact that nuclear and hydro supply most of Swedishelectricity that they aren't wasting much of this valuable resource on burning it

at 20 to 40 per cent efficiency all year round in power stations.

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They use it mostly in either heat-led CHP units or for heat-only systems.

That way, they make the most of the resource, not only in terms of efficiency of

conversion, but also in terms of using one of the few renewables that can easily

be stored long-term for the part of their energy demand that is strongly seasonal.

That's rather more sensible than the conventional wisdom in the UK:

even as we improve energy efficiency, demand for electricity may need to

double by 2050 as decarbonisation of the economy means that

electricity provides more of our heating and transport needs

-- The first bullet point of the Executive Summary of the

Electricity Market Reform consultation document.

Already, most of the seasonal variation in electricity demand is attributable to

the use of electricity for space-heating (total demand from National Grid data,

annual demand for electric space/water heating from DECC,Energy Trends,

Sept 09, distributed on assumption demand roughly mirrors LDZ SND for gas).

This seasonal variation is responsible for a material proportion of our capacity

requirement.

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Of the 39 GW or so between the highest half-hourly period of demand during

the year (around 59 GW) and the lowest (around 20 GW), daily variation

accounts for around 23 GW, weekly variation for around 6GW, and seasonal

variation for around 10 GW.

Because of the disparity in scale between electricity demand and heat demand, a

small electric contribution towards our heat supplies has a significant impact on

our electricity systems.

We could go a long way towards solving the supposed capacity gap if we got rid

of as much electric space-heating as possible.

Conversely, imagine the effect on our electricity systems if we followed the

received wisdom and tried to significantly increase electricity's share of heating.

Let's imagine a case where electricity's share of our heating supplies increases

by around 20 percentage points.

We would need to produce an extra 162 TWh, almost half as much power again

as we currently produce.

On apro rata basis, over half of that would be used for space-heating.

Using the Government's figure of 1,314 full heating hours per year, you would

need around 67 GW of capacity to supply the space-heating component, plus

another 10 GW for the rest of the heat demand, if that part is spread evenly over

the year.

In other words, increasing electricity's share of the heating market by 20

percentage points would increase by about 130% the dispatchable generating

capacity needed to meet peak demand.

It would have an equally dramatic and negative impact on levels of capacity

utilisation.

And it would require investment of tens of billions of pounds in the transmission

and distribution network.

That's a triple-whammy on the costs of electricity supply.

And this is mostly additional to whatever vandalism we might do to our

electricity systems in the name of stimulating intermittent renewables.

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Although increased electric heating is being mooted partly because intellectuals

are trying to figure out how to absorb all the unpredictable power that they want

to foist on us, in practice the coldest periods would often have minimal output

from intermittent generators, and there would be plenty of times during ourmilder periods when space-heating demand was limited while output from the

intermittents was high.

* * * * *

Some wind advocates pin their hopes on demand management. And it is

certainly important to encourage demand-side response as far as practical.

That is why it is important to expose consumers to the full reality of balancingcosts, and why a capacity mechanism, which dampens that exposure, would be a

mistake.

It is better for standby capacity to be rewarded through higher peak prices than

through a capacity mechanism, particularly given the risk that that capacity

mechanism will end up with the same failings as it had under the Pool.

But demand management is of minimal use for the problem of the mismatch

between intermittent output and cyclically-variable demand.

It is likely that domestic and commercial consumers will adapt to reduce their

consumption during relatively short periods of very high prices.

But it is unlikely that households or industry will find many ways to adapt to

patterns of intermittency that will last, both in the peaks and the troughs, for

several days.

And it is unlikely that new uses will be found for the output during those peaks

at a price that pays anything significant to the generator.

Indeed, there is wide expectation of negative prices during these periods.

That should be an indicator of the inadvisability of stimulating that level of

intermittent capacity.

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The reality remains the same as it ever was. We are likely to bankrupt the

country in pursuit of an impossible ambition if we aim for much more than

around 20% intermittents within our electricity mix, and boosting demand

through increased electric heating will only exacerbate that reality.

* * * * *

The mechanistic mind thinks it can pick another winner to solve that problem,

and proposes spending billions more on a massive HVDC network across

northern Europe.

Except it turns out that weather systems can sometimes affect most of northern

Europe.

So the mechanistic mind comes up with an even grander scheme a network to

link the whole of Europe and North Africa, relying on concentrating solar power

in the Sahara to provide a substantial proportion of Europe's electricity.

Great idea: making Europe's energy-security dependent on generators in the

Sahara and a couple of cables routed through the Maghreb. What could possibly

go wrong?

But that's where the mechanistic approach always leads you: to over-

sophistication and under-valuation of the risk. The issues have been assumed

away, along with the Government's ignorance.

* * * * *

Sub-prime was the result of investors under-estimating risks in the pursuit of

better returns, stimulated by government and central-bank policies that gave the

false impression that the risks would be managed away, in pursuit of well-meaning but misconceived objectives.

Want to see the next sub-prime?

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-- Financial Times, 4th Apr 2011

Offshore wind is not low enough risk to be an appropriate investment for

pension funds, especially when the reward is a measly 3 percentage points above

the relative security of 10-year government bonds, which themselves are paying

negative real rates of interest, making this a risky investment for the sake of a

real return of a couple of percent.

That's what you get with mechanistic attitudes to policy. You'd think there had

never been a financial crisis (and dot-com before that) for all that we've learnt

from it.

EMR isn't a renewal, it's a reformulation of the same old mistakes.

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If we really wanted to renew policy, we'd stop mechanistically picking winners,

scrap all the existing energy and environment interventions, and go instead for

an institutional approach that encouraged discovery of the best set of solutions

for our circumstances:

A carbon tax to internalise the risk of anthropogenic global warming.

Maybe a fossil-fuel tax if we want to discourage too much reliance on gas

as well as coal and oil.

Exempt industry sufficiently to enable them to compete internationally.

Use the revenues to (a) improve welfare for the poorest decile, and (b)reduce taxes on employment and productivity.

Dis-integrate the VILE companies to regenerate a liquid traded market

Maybe some diversity constraints if one doesn't trust the market to deliver

the necessary diversity to ensure security.

And otherwise let people get on with it.

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