Response to the House of Lords Economic Affairs Committee Inquiry into the Economics of UK Energy Policy:
A Focus on Electricity
Contributors
Cameron Hepburn is Professor of Environmental Economics at the University of Oxford at the Smith School and at the Institute for New Economic Thinking at the Oxford Martin School, where he is Director of the Economics of Sustainability Programme. He is also Professorial Research Fellow at the London School of Economics (Grantham Research Institute), Senior Research Advisor at the Oxford Institute of Energy Studies, and a Fellow of New College, Oxford.
Professor Hepburn has published widely in peer-reviewed journals on energy and environmental economics, across several disciplines including engineering, law, and economics. He is also a co-founder of Aurora Energy Research, an Oxford-based firm providing independent data-driven modelling and analysis for the energy sector, and Vivid Economics, a consultancy working with private and government clients on the economics of resource and environmental issues. Cameron has served on several government panels including the Economics Advisory Group to the UK Secretary of State for Energy & Climate Change, and has advised various other governments (e.g. China, India, Australia) and international institutions.
Jacquelyn Pless is a Postdoctoral Researcher with the Institute for New Economic Thinking at the Oxford Martin School, University of Oxford, and an Oxford Martin Fellow of the Oxford Martin Programme on Integrating Renewable Energy.
Jacquelyn is an applied microeconomist who studies energy and environmental issues related to innovation, market structure, and public policy with a particular focus on electricity. Prior to joining the Oxford Martin Programme on Integrating Renewable Energy, Jacquelyn worked as an economist and policy analyst in the United States at the Joint Institute for Strategic Energy Analysis at the National Renewable Energy Laboratory, the National Conference of State Legislatures, the Pennsylvania House of Representatives, and the World Bank. She has also worked as an independent consultant for public, private, and non-profit sector entities in the United States on energy and environmental policy. Jacquelyn received her B.A. degree in economics and political science from the University of Vermont and M.S. and Ph.D. degrees in Mineral and Energy Economics from the Colorado School of Mines.
Alexander Teytelboym is the Otto Poon Research Fellow at the Institute for New Economic Thinking at the Oxford Martin School, University of Oxford, and Associate with the Oxford Martin Programme on Integrating Renewable Energy.
Alex is an economist who works on market design and networks as well as their applications to energy and environmental economics. Prior to joining the Economics of Sustainability programme at the Institute for New Economic Thinking at the Oxford Martin School, University of Oxford, Alex was a Postdoctoral Fellow at MIT. He has also consulted the European Bank for Reconstruction and Development. Alex sits on the editorial board of the Oxford Review of Economic Policy. He got his BSc in Economics from the London School of Economics and his MPhil and DPhil in Economics from the University of Oxford.
This submission reflects thinking within the Oxford Martin Programme on Integrating Renewable Energy, within which issues of market failure and innovation related to large-scale integration of renewable energy sources are particularly prominent and studied. However, opinions and conclusions expressed here are solely those of the authors and do not necessarily reflect those of the programme participants as a whole.
Disclaimer
Table of contents
Summary of the submission
Market Failures in the Electricity Market
Reducing carbon dioxide emissions
Insufficient provision of system capacity and infrastructure fit for purpose
Insufficient research and development (R&D) support for innovation
Priority Recommendations
Extend the Carbon Price Floor to the broader economy, as far as possible, credibly increasing over time, incorporating border adjustments
Redesign capacity and infrastructure provision systems to ensure that they deliver adequate clean generation capacity and critical grid infrastructure at the lowest cost
Ramp up energy sector research and development
Abbreviations
1. Our energy system was designed for a different age in which most of the electricity was supplied by a few, large, polluting power stations. The current electricity market is failing to deliver the energy system fit for the 21st century. The most significant market failures are associated with climate change, energy security, and innovation. Addressing these challenges will require a fundamental long-run transformation of the British energy system. In this submission we focus on electricity markets, which are a key component of the energy sector.
2. Existing electricity market structures and policies do not provide appropriate incentives for building clean capacity, maintaining flexibility, and spurring innovation in the British electricity systems. While the costs of clean energy technologies for electricity generation continue to fall, they are not falling fast enough to ensure timely replacement of polluting generation capacity. In the meantime, security of supply is being challenged, with the capacity margin of the electricity grid now at historic lows, due to inadequate incentives to invest and uncertainty in the direction of travel of energy policy.
3. The Committee has correctly identified market failure as a key theme for its investigation, and the three main market failures that require attention are:
4. In addition to describing these market failures in greater detail, this submission also presents three policy priority recommendations that directly map to the identified market failures:
5. While we do not provide explicit responses to the comprehensive list of questions posed by the committee in its inquiry, we would gladly provide further evidence of support at the Committee’s request.
7. Carbon dioxide emissions must be reduced across the entire economy, especially in the energy sector, to reduce the risks associated with climate change. Well over half of the world’s entire carbon budget associated with a 2oC temperature increase has already been exhausted. More worryingly, any fossil fuel capacity installed by 2017 in the power sector, if operated for its usual economic life, will use the rest of the global budget, taking temperatures above 2oC with 50% probability.[1]
8. The Climate Change Act (2008) legally commits the UK to cutting its greenhouse gas (of which carbon dioxide is the main one) emissions by 80 per cent from 1990 levels by 2050. The UK is currently outperforming its second carbon budget (which runs until 2017), is on track to meet the third (2018-2022), but not on track to meet the fourth (2023-2027).[2] Economists have long argued that carbon pricing is the most efficient way to addressing the climate change externality. However, implementing appropriate carbon pricing at a stable level at the “right” social cost of carbon has so far proven difficult.
9. In April 2013, the UK put in place a Carbon Price Support (CPS). This supplements the EU Emission Trading Scheme when the price of tradable European allowances (EUAs) is below a minimum price on carbon, termed the Carbon Price Floor (CPF). The measure was intended to ensure that there was always a minimum financial incentive faced by generators in the UK to reduce their pollution. The CPS was to be calculated each year to be the supplement require to the EUA price in order to deliver a CPF of £16 per tonne of carbon dioxide (t/CO2) in 2013, rising to around £70 t/CO2 by 2030.[3] However, the CPS has been frozen from 2016-17 until 2019-2020 at £18 t/CO2.[4] While CPS still significantly bolsters the current EUA price (€4.3 t/CO2 or £3.8 t/CO2), the CPF is substantially below any reasonable estimate of social cost of carbon.[5]
10. The CPS was envisioned to encourage a switch from coal to less polluting gas by discouraging coal power stations from meeting EU air quality standards and encouraging them to close instead.[6] Since all coal power stations are due to close in 2025, its role in the future is unclear. With increased interconnection across European countries and without appropriate border adjustments,[7] the CPS will simply serve to discourage domestic gas generation and import coal-fired generation from abroad.[8]
11. If the carbon price is below the social cost of carbon, polluting electricity generators emit too much carbon dioxide at the margin. The 2014 freeze in the carbon price also represented an unanticipated change in UK government policy, suggesting that further changes are possible and increasing policy risk. The reduction in clarity and confidence in stable policy reduces the appetite of potential investors in the renewable energy industry. This is likely to have long-term effects on renewable energy deployment, innovation and UK-based cost reduction.[9]
12. A large number of power stations, including all coal power stations, are set to close over the coming years creating a potential supply gap of around 40%-55% by 2025.[10] Their capacity will need to be replaced to ensure energy system security. Furthermore, the increasing integration of variable renewable energy creates new challenges for balancing supply and demand on the electricity grid. These challenges could be overcome through the deployment of a combination of technologies—demand-side measures, energy storage, interconnection, and flexible backup generation. But current market arrangements will not deliver the optimal combination of such solutions because they send inconsistent signals to investors. The patchwork of markets that has been used to run power systems in the UK over the last few decades is increasingly not fit for purpose.
13. Today’s capacity market (CM) design in the UK creates an incentive structure that focuses solely on procured megawatts. This would be perfectly sensible if the other market failures (such as decarbonisation) had already been internalised. However, since they have not, the CM as currently designed procures plants, such as diesel generators, which increase local pollution and which are inconsistent with ultimate decarbonisation objectives. The current design is providing a lifeline for old coal-fired power stations, for example, which have received £373 million in subsidies through the auctions thus far. 650 MW of new diesel generators have been subsidised as well, with a £176 million of support in 2015. [11] This cannot last much longer. Lastly, notwithstanding declines in wholesale prices, consumers now actually face higher energy bills than prior to the market’s inception.[12]
14. While it may not be surprising that the CM is inconsistent with decarbonisation objectives, it is notable that the two CM auctions to date have also procured relatively little new capacity. It has largely subsidised existing capacity. For instance, existing nuclear power plants have received payments totalling £153 million for delivery year 2018 (compared to just £3 million for demand side response) and £136 million for 2019 even though they were highly likely to remain open during those years anyway, without the additional subsidies.[13] These power plants did not require a subsidy to stay online and were not built with CM revenue streams in mind. CM revenues therefore represent windfall gains, even adjusting for the corresponding decrease in revenues from the energy market.
15. Since renewable generation is variable, it can create large supply-demand imbalances in the electricity grid in the short run. Colocation of renewable generation exacerbates this variability. Therefore, mechanisms to support investment in new capacity need to ensure that not only is more generation procured, but that it is also located in such a way that it reduces total variability. In other words, pricing for new capacity might need to vary by location.
16. All of this points to the reality that the CM design is not fit for purpose and requires reform. Incentives need to better align with decarbonisation, security, and affordability objectives. The UK has had years of underinvestment, which makes the electricity sector particularly vulnerable to upcoming plant closures. New clean capacity needs to be built now to ensure near-term energy security. As noted above, research shows that new power sector investment must be zero-carbon globally by the end of 2017 for a 50% chance of limiting warming to 2oC, to avoid subsequent early asset stranding or additional carbon capture and storage (CCS).[14]
17. One key conclusion from this analysis is that the UK should not be building new fossil fuel assets in the power sector without a clear plan to close them early or to require the retrofitting of CCS. This follows from the global decarbonisation requirement, the fact that the Paris agreement sets a target of maintaining temperature increases “well below” 2oC, and the fact that, as a rich country, the UK should be leading rather than following poorer countries in decarbonisation. Furthermore, as noted above, the UK is not on track to meet its own legally mandated emissions targets for the mid-2020s.[15] Immediately banning any new fossil build in the UK would be expensive and create security risks. A target of stopping any new unabated fossil-fuelled power plants being built from 2020 should be seriously considered. It is possible to ensure system security by extending the lives of old plants (which is preferable to building new fossil plants, only to see them prematurely scrapped), new renewables, storage, demand-side response (DSR), interconnection, and planned new nuclear capacity.
18. One additional key element in meeting joint decarbonisation and security concerns is the Levy Control Framework (LCF). The LCF currently caps the total annual amount of government support for low-carbon generation. This not only includes renewables, but also nuclear and CCS. It is not clear how LCF will operate after 2020. If it continues in the current form after 2030 then the subsidy offered for construction of Hinkley Point C would directly take large amounts of funds away from subsidising renewables and deter investment. If the LCF cap remains at its current level, the total amount of procured renewables generation would likely be below optimum since there would be limited funds in Contracts for Difference (CfDs)[16] mechanism that serves as the main support system for renewable electricity.
19. Finally, it is noted that current piecemeal interventions such as CfDs, LCF, interconnection and closed-door nuclear deals often contradict and undermine each other. As noted, nuclear undermines renewables with the LCF in place. Interconnection, without a border carbon adjustment, can increase emissions, lower domestic UK wholesale prices and raise CfD payments.[17] In general, the operation of each of these mechanisms affects the others, so their combined impact needs to be thought through.
20. Costs and performance of renewable energy technologies are improving rapidly, but still not fast enough. No matter whether temperatures are stabilised at the Paris agreement aim of 1.5oC, or 2oC, or even 3oC, atmospheric physics requires net emissions to be zero eventually.[18] Renewable energy and zero-carbon energy technologies will therefore be critical in meeting future energy supply and environmental needs. Reducing costs – including integration costs – is vital, yet support for research and development (R&D) and innovation is inadequate to accelerate the integration of renewables into power systems.
21. It has been shown that R&D tax incentives and support schemes have significant effects on innovation outcomes (such as patenting) as well as firm R&D spending. For example, recent work finds that aggregate business R&D would have been about 10% lower in the absence of the UK’s R&D tax relief scheme over the period of 2006-11.[19] Furthermore, clean R&D generated by such policies creates much greater positive spillovers on the clean innovation of related firms.[20] Because of knowledge externalities, social returns on R&D exceed private returns, and thus public subsidies are justified. Currently, the six largest EU economies spend around 150 times more on deployment of renewables (e.g. through feed-in tariffs that spur learning-by-doing) than on R&D.[21] Most recent analyses indicate that optimally governments should allocate deployment and R&D spending roughly equally for renewable technologies, such as wind and solar PV.[22] While further research is needed in this area, it seems clear that there is a prima facie case for significantly more early-stage innovation support.
22. Directly mapping on to the three identified market failures, there are three policy priorities that must be addressed immediately to avoid significant threats to the UK power system’s security and affordability.
23. The carbon price is too low, is not economy-wide, and does not have a border adjustment.[23] The consequence is that emissions are not being cut economy-wide at the lowest cost. Moreover, electricity coming through the interconnectors (often coal-fired at the margin) has an unfair advantage against domestic production.[24] Without border adjustments and in the presence of interconnection, the Carbon Price Floor simply discourages domestic electricity production, especially gas generation, and leads to the import of more high-carbon electricity. Nevertheless, the Carbon Price Floor is essential for long-term incentives for renewable generation, especially if the UK were to leave the EU ETS following Brexit.
24. The electricity system needs to be reconsidered as a whole during reform. Piecemeal interventions in the various parts of the system are likely to undermine each other. This needs to take account of the potential for additional demands on the sector with the potential for the partial electrification of transport and also some degree of electrification of heat.
25. In particular, mechanisms to purchase capacity – CM and CfDs – must be redesigned in a way that guarantees security of supply today with existing capacity and but which also provides incentives for clean new-build at least-cost to ensure adequate capacity in the future.
26. A thorough economic examination of interconnection requirements is needed. The EU is aiming to have 10% interconnection capacity by 2020 with a view to extending this 15% by 2030.[25] The UK must increase its interconnection capacity from around 6%. But most of the current projects under consideration are unjustified from an (admittedly narrow) economic perspective.[26] Interconnection might undermine both the Carbon Price Floor and renewable incentives under CfDs and LCF, therefore interconnection decisions must be taken with the view of the whole system. Once interconnection needs are determined, significant zero carbon power, storage, and DSR resources must be procured. A central buyer model is increasingly essential because of the economic structure of generating capacity.[27] Given this, capacity auctions should be used to create as much competitive pressure as possible, but these auctions must generate incentive structures that lead to the procurement of zero carbon power and appropriate integration solutions (such as storage and DSR) at the lowest cost.
27. There is no room in the carbon budget to procure any new fossil power. Additional incentives may be necessary to extend the lives of current fossil fuel generation capacity (even for coal). For example, CM could be redesigned to offer only 1-year contracts for fossil-fuelled generation in place of current 15-year contracts that attract new fossil power. Future capacity auctions should be used to procure the infrastructure and generating capacity that is appropriate for the long run. We recommend disallowing any fossil-fuelled generation without CCS to enter capacity auctions from 2020. Renewables with storage and nuclear should compete on a level playing field. Capacity payments and the higher carbon price floor should ensure that retiring fossil fuel capacity is replaced sufficiently quickly by renewables, demand-side response measures, and storage. Policy must be flexible and respond quickly to changes in grid capacity margins and the rapidly declining costs of storage.
28. We recommend retaining and reforming the current CM, various fast-response markets, as well as CfDs for the moment. However, given the different functions and economics of DSR and storage from new generating capacity, it appears likely that different mechanisms will be required for these complementary resources. For example, a bespoke capacity (MW) – energy (MWh) auction might need to be designed to procure energy storage to ensure they supply adequate power for enough time. If separate auctions are designed for capacity, DSR, and storage, they should be linked in a way that is consistent with correcting all market failures.
29. The LCF should be adjusted to factor into account payments for nuclear or CCS beyond 2025 and the necessary support for renewables and storage should be removed once costs have declined to competitive levels. Nuclear power (large or small scale) should not be ruled out. CCS deployment should be assisted, as CCS technologies could well become a major British export in the future.
30. Carbon pricing is the most efficient mechanism for moving towards reducing the world’s reliance on fossil fuels and transitioning to a zero-carbon economy. However, history also suggests that technology advancements will continue to reduce the cost of extracting dirty fuels, making the market shift towards renewables unlikely without even lower costs for a broad range of renewable energy and storage.[28]
31. To drive down the costs of renewable energy technologies and to advance mechanisms for efficiently integrating renewables into power systems at a large scale, significant research and development (R&D) support is needed. Price signals alone will not achieve this outcome within the urgent timeframe required to avoid detrimental climate change impacts. Public spending on low-carbon technology may need to be tripled in order to limit global increases in temperatures to no more than 2oC.[29] Further research is required to determine exact R&D support requirements in the UK, but without doubt, energy sector R&D should ramp up at least as agreed by the UK as part of the Mission Innovation commitments. Funding should be allocated competitively wherever possible. If the current level of deployment subsidies were economically sensible and the most recent economic analysis is broadly correct, there is a case for the government to allocate a hundred times more on clean energy R&D than it is at present.[30] We are not recommending this level of increase, for various reasons, but there should be little doubt that spending between deployment and R&D should be much more balanced.
32. Spending on R&D should include a focus on integrating renewables, including bringing costs of storage down rapidly, along with improving performance, to truly transform the grid. Near-market storage technologies could deliver some high-value services (mainly ancillary services), operating from seconds to hours. But seasonal storage technologies, such as power-to-gas, H2O electrolysis and high temperature electrolysis, as well as potentially NH3-based solutions, still require substantial technological improvement.
33. Public R&D support should remain as technology-neutral as possible. While it is tempting to pick winners, remaining technology-neutral in R&D support may help to maximize the potential for game-changing technology innovation as opposed to incremental innovation that improves the performance of existing technologies without making an impact on the emission reduction goal. It is, of course, difficult to remain technology-neutral when making very early-stage public R&D investments.
34. Our carbon budget position means that it is very likely that some form of CCS, carbon dioxide removal or negative emissions technologies will be required to meet a 2oC, let alone a 1.5oC, target. Public R&D support would also make these technologies cost-competitive sooner.[31]
29 September 2016
[1] Pfeiffer et al. (2015), The ‘2°C capital stock’ for electricity generation: Committed cumulative carbon emissions from the electricity generation sector and the transition to a green economy, Applied Energy, 179, pp. 1395-1408.
[2] See the statement by the Committee on Climate Change: https://www.theccc.org.uk/tackling-climate-change/reducing-carbon-emissions/how-the-uk-is-progressing/
[3] See this Parliament Brief Paper (Figure 6): http://www.parliament.uk/briefing-papers/sn05927.pdf
[4] See this HMRC briefing: https://www.gov.uk/government/uploads/system/uploads/attachment_data/file/293849/TIIN_6002_7047_carbon_price_floor_and_other_technical_amendments.pdf
[5] The consensus estimate from the suite of models used by the United States Environmental Protection Agency (EPA) is around $57 t/CO2 (£44 t/CO2) in 2016 at a 2.5% social discount rate. See Appendix A of the recent EPA report: https://www.whitehouse.gov/sites/default/files/omb/inforeg/scc-tsd-final-july-2015.pdf
[6] See report by Sandbag (page 2): https://sandbag.org.uk/site_media/pdfs/reports/Comparing_carbon_price_instruments.pdf
[7] Helm, D., Hepburn, C. and G. Ruta (2012), Trade, climate change, and the political game theory of border carbon adjustments, Oxford Review of Economic Policy, 28(2), pp. 368-394.
[8] See report by Aurora Energy Research, What is the Carbon Price Support supporting? An assessment of the impact of CPS removal post 2025, August: https://auroraer.com/files/reports/Aurora-ER-Carbon-Price-Support-Aug2016.pdf?platform=hootsuite.
[9] The UK has slid down to an all-time low 13th place in the EY Renewable Energy Country Attractiveness Index in 2016. See EY report: http://www.ey.com/gl/en/industries/power---utilities/ey-renewable-energy-country-attractiveness-index-our-index
[10] See Engineering the UK Electricity Gap Report by the Institute of Mechanical Engineers: https://www.imeche.org/docs/default-source/position-statements-energy/imeche-ps-electricity-gap.pdf?sfvrsn=0.
[11] This is according to the analysis conducted by Sandbag: https://sandbag.org.uk/site_media/pdfs/reports/Capacity_Mechanism_analysis4.pdf.
[12] See the following IPPR report for more details on auction outcomes to date: http://www.ippr.org/files/publications/pdf/incapacitated_March2016.pdf?noredirect=1
[13] For more details on the auction outcomes to date, including capacity and subsidy totals, see the following IPPR report: http://www.ippr.org/files/publications/pdf/incapacitated_March2016.pdf?noredirect=1.
[14] Pfeiffer et al. (2015), The ‘2°C capital stock’ for electricity generation: Committed cumulative carbon emissions from the electricity generation sector and the transition to a green economy, Applied Energy, 179, pp. 1395-1408.
[15] See the statement by the Committee on Climate Change: https://www.theccc.org.uk/tackling-climate-change/reducing-carbon-emissions/how-the-uk-is-progressing/
[16] The CfD mechanism competitively allocates 15-year payments to (or from) low-carbon generators and covers the difference between their costs (“strike price”) and the electricity price.
[17] See the report by Aurora Energy Research (paragraph 4.5): https://auroraer.com/files/reports/Dash%20for%20interconnection%20-%20Aurora%20Energy%20Research%20-%20February%202016.pdf
[18] Allen et al. (2009), Warming caused by cumulative carbon emissions towards the trillionth tonne, Nature, 458, pp. 1163-1166.
[19] See a recent working paper by Dechezleprêtre et al. (2016), Do Tax Incentives for Research Increase Firm Innovation? An RD Design for R&D, http://cep.lse.ac.uk/pubs/download/dp1413.pdf
[20] Clean energy patents receive 43% more citations than dirty energy patents. See Dechezleprêtre et al. (2014), Knowledge Spillovers from Clean and Dirty Technologies, http://cep.lse.ac.uk/pubs/download/dp1300.pdf
[21] See Figure 2 in Zachmann et al. (2014), When and how to support renewables? Letting the data speak, http://bruegel.org/wp-content/uploads/imported/publications/WP_2014_01_renewables_.pdf
[22] See Figures 4 and 5 in Fischer et al. (2013), Environmental and Technology Policy Options in the Electricity Sector, http://www.rff.org/files/sharepoint/WorkImages/Download/RFF-DP-13-20.pdf
[23] Helm, D., Hepburn, C. and G. Ruta (2012), Trade, climate change, and the political game theory of border carbon adjustments, Oxford Review of Economic Policy, 28(2), pp. 368-394. It is as yet legally uncertain whether border adjustments within the EU would be acceptable, or indeed whether they would be justifiable under WTO Law, following one possible Brexit model. Certainly, strong justifications and evidence would need to be found under the EU and WTO regimes.
[24] For recent analysis on this, see the following report by Aurora Energy Research: https://auroraer.com/files/reports/Dash%20for%20interconnection%20-%20Aurora%20Energy%20Research%20-%20February%202016.pdf.
[25] See Communication From The Commission To The European Parliament And The Council Achieving The 10% Electricity Interconnection Target Making Europe's Electricity Grid Fit For 2020 (Com/2015/082) http://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX%3A52015DC0082
[26] For a recent study on the impact of interconnectors on the GB market, see this report by Aurora Energy Research: https://auroraer.com/files/reports/Dash%20for%20interconnection%20-%20Aurora%20Energy%20Research%20-%20February%202016.pdf.
[27] This also shows a clear need to revisit the EU (and thereby, currently, UK) law requirements concerning TSO (ownership) unbundling in a more comprehensive manner.
[28] In the United States, wind and utility-scale solar PV already have the lowest levelised costs of energy (LCOE) across all energy technologies even without any subsidies. See this annual report by Lazard from November 2015: https://www.lazard.com/media/2390/lazards-levelized-cost-of-energy-analysis-90.pdf
[29] More details can be found in the International Energy Agency (IEA) Energy Technology Perspectives Report 2015: http://www.iea.org/newsroomandevents/pressreleases/2015/may/clean-energy-innovation-essential-to-meeting-climate-goals.html.
[30] See Figures 4 and 5 in Fischer et al. (2013), Environmental and Technology Policy Options in the Electricity Sector, http://www.rff.org/files/sharepoint/WorkImages/Download/RFF-DP-13-20.pdf
[31] For example, see this recent news about CCS costs: http://www.bloomberg.com/news/articles/2016-09-11/carbon-capture-seen-competitive-with-offshore-wind-in-u-k.