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Competition and the renewables

Reconciling the twin imperatives of injecting healthy competition into the bloated electricity industry and boosting the use of renewables is proving horribly complicated. Policy makers around the globe are considering pioneering laws under a barrage of criticism from lobby groups with a multitude of agendas. The experience of the past decade provides some useful pointers for moving beyond the current impasse.

Governments around the world are now wrestling with the question of how to merge the dual goals of vigorous competition and a strong, market based renewable energy industry. Wind power is fast becoming the test case for whether a technology that is ready to compete economically with traditional power sources can get a firm foothold in the marketplace. Wind energy is already the world's fastest growing energy source and its costs are drawing even with fossil fuel based plants. But solid, commercial markets for wind power exist only in four nations, and outside of these countries the industry has virtually no political or economic base.

More competition should be good for wind power. After all, the industry has not fared well in most of the world's traditional power markets, dominated as they are by monopoly suppliers who are resentful of the competition. Moreover, wind energy is proving popular with many consumers who for the first time will be able to choose their electricity supplier. And even in pure economic terms-without accounting for wind's environmental savings-wind is broadly competitive with fossil fuel plants.

But creating a strong, stable market for wind power is far more complex and difficult than most policy makers seem to realise. Many policy documents, including the recent Working Paper of the European Union (Windpower Monthly, May 1999), underestimate the challenge in translating binding targets or goals for renewable energy into stable markets that will allow the kind of steady growth, ease of financing, and reinvestment of profits that are needed to make the new industry thrive.

Simply throwing the wind industry onto the "free" market without first removing a thicket of obstacles that currently exist could well lead to a setback rather than the great leap forward that so many hope for. Even at $2.5 billion a year, the wind industry is hardly a global business. In fact, it barely exists in most countries-including many of those with the greatest potential. It is only by addressing the myriad details required to make monopoly power markets open and competitive that policy makers will find workable strategies for integrating wind power into increasingly competitive but still diverse turn-of-the-century electricity markets.

Understanding markets

No matter how low its cost, wind power does not integrate easily into electricity markets that were designed with large suppliers and baseload thermal plants in mind. One hurdle is that when compared to combined-cycle gas plants-the current industry favourite-wind projects cost four times as much per annual kilowatt hour to build, which means that even if all else is equal, the developer has far more capital at risk.

In addition, wind power has the disadvantage of being intermittent, which raises thorny questions of grid access and pricing-problems that are magnified in the minds of utility engineers who are educated in the norms of large baseload plants, and tend to spurn generators that are not "dispatchable." These barriers are compounded by the fact that wind technology is still in its early adolescence. Although reliability has steadily improved, the current generation of machines only has a few years or less of operating experience, which makes investment financially risky for owners and lenders.

Moreover, the scale of wind technology is one for which today's power markets are poorly structured. With individual modules generally sized at 500-1500 kilowatts, wind plants can be installed at a wide variety of sizes, with only modest cost advantages in building larger installations. In recent years, most wind projects have ranged from 1 MW-30 MW in size, compared to the 50-500 MW that is typical for combined cycle projects. Electricity lenders are accustomed to the larger projects, and generally charge much higher interest rates for smaller ones. The experience of the home mortgage industry shows that it is possible to have simple, low cost financing for investments under $1 million, but a large organised market is needed.

The potentially small scale of individual wind projects is particularly important in the initial stages of market development, as the experience of Denmark and Germany shows. With early costs and risks being high, investors prefer to start with small projects rather than large ones. But the market conditions established by government policy in some countries, such as the UK, have precluded the orderly development of a first generation of small projects, which may be the main reason so few countries have a market today.

The wind industry is changing with the entry of large conglomerates such as Enron and Babcock Borsig, but the relatively small scale of most wind energy companies is another unique feature of the industry and arguably one of its chief advantages. Smaller firms are generally more entrepreneurial and innovative-the personal computer revolution would not have occurred had it been left to IBM-but small companies have their own vulnerabilities as well. They lack deep financial pockets, and can be quickly driven out of business if markets dry up or they have to wait long periods due to regulatory delays or difficulties in financing. Renewable energy policies that shift wildly-as in the United States-and those that make it hard for small firms to compete-as in the UK-often lead to early and frequent bankruptcies.

Despite expansive hopes for a liberalised free market in electricity and the work devoted to bringing it about, most governments are on a pace of reform that will not yield a truly open market for many years. Some barriers are relatively obvious-discriminatory pricing and unnecessary interconnection requirements, for example-but many are subtle or deeply rooted, such as the historic subsidies that have put existing baseload coal and nuclear plants in position to dominate electricity markets for decades into the future. The vested interest of the traditional power suppliers in keeping these barriers in place will inevitably delay their removal.

Lessons of the nineties

As governments in Europe and around the world look to build a legal regime that will support rapid development of wind power within the context of increasingly competitive power markets, they will need to understand the reasons that certain policies have worked well for wind power while others have not. The "electricity feed laws" introduced to stimulate a market for renewable energy, now in effect in Germany and Spain and previously in California and Denmark, have played a role in over 80% of the global wind capacity installed to date. These laws are often characterised by their system of premium prices, but they have structural characteristics quite apart from their price levels that have proved supportive of wind energy.

In Denmark and Germany, standardised interconnection requirements for renewables and stable prices have minimised transaction costs and lead times and allowed developers to easily and quickly obtain bank loans without spending years seeking a power purchase contract. This has made it easy to develop small projects and has lowered the risk to the small and medium sized firms and small investors that have dominated the industry to date. The electricity feed law (EFL) system has also been easy to integrate with a systematic planning permission process, in part because it reduces the number of variables the developers must face.

The German EFL is criticised for its failure to push wind energy prices down when advances in wind technology have cut the cost of wind power. This portrayal of a lazy, subsidy cuddled industry does not hold up under close scrutiny, in part because it fails to distinguish the impact on developers from that on manufacturers. A recent study by the Institute for Solar Energy Technology in Kassel shows that the German market is characterised by vigorous competition among manufacturers who must compete for wind contracts from developers. As a result, the cost of wind turbines has fallen steadily in Germany since the early 1990s-though not as much as in other countries (Windpower Monthly, April 1997). This is in part because federal and state subsidies have been reduced or eliminated in the last five years, even as the feed law price has fallen to DEM 0.16/kWh.

The German EFL not only created the largest wind power market so far-over one-third of the world total in the late 1990s-but it also stimulated a burst of entrepreneurialism and a market place that is far more diverse than the rest of the German power industry. Wind power in Germany is a dynamic and rapidly evolving industry, with a wide variety of business structures and financing mechanisms-unusual in a country where it is sometimes said that the most a German Bill Gates could hope for is to become a mid-level engineer at Siemens. Other countries have benefited from the German wind locomotive, which has allowed manufacturers throughout Europe to move further down the learning curve, and improved the economics of wind technology globally.

In Spain, a similar law, enacted in 1994, has resulted in a similar rapid market take-off, but with a very different market structure. The Spanish wind industry is characterised by hybrid public/private development companies with strong links to the utilities, and indigenous manufacturers that build factories in each region with a sizeable wind market. The market is not a particularly competitive one, but it has given the wind industry another strong economic and political base-one that is fuelling steady advances in the technology. If it weren't for its local roots-and jobs-it is unlikely the Spanish industry would ever have got off the ground.

Fixed supply quotas

The other main approach to creating a market for renewables in the last decade is the quota model developed in the UK. Under the Non Fossil Fuel Obligation (NFFO), introduced in the early 1990s, regional power suppliers are required to buy fixed amounts of renewable energy. The contracts for this supply are allocated via an auction that is administered by a government regulator. The premium payments to the generator are funded by a fossil fuel levy that is paid by all electricity users.

The UK's NFFO has led so far to a series of five competitive auctions. The prices of the winning bids have steadily fallen, but less than one-third of the winning wind projects-just 334 megawatts-have actually been installed. This is just one-tenth the pace of development in Germany, not terribly impressive given that the UK has Europe's richest wind resource. Efforts to fine tune the auction system have so far had little effect-just 10 MW of wind were added in 1998. The meagre market has meant tough sledding for the British wind industry, and has driven most of its manufacturers out of business.

Studies by Catherine Mitchell of Sussex University in England show that the NFFO's failure is linked to fundamental structural flaws. The UK auctions, carried out by the government on behalf of the regional suppliers, have turned into complex and lengthy processes with high transaction costs that largely preclude small projects. In addition, the peaks and lulls in wind energy development that result from the UK's periodic auctions have led to tight bottlenecks and managerial problems both for public officials and private companies. Finally, price competition has led wind developers to site their projects where the wind resource is best, on prominent hills and in scenic coastal areas where local opposition has prevented two-thirds of the projects that received contracts from being installed.

Even the main achievement claimed for Britain's NFFO-pushing down wind's prices-is said to be partly a function of gamesmanship by developers working to beat their competitors by low-balling their bids. Since the UK market has represented only 4% of the world market during the 1990s, it has done little to spur either R&D or scaled-up factories, the two main drivers of cost declines. To the extent that the UK's "virtual" prices reflect falling costs, those cost declines are in part a function of the booming wind markets in continental Europe, which are advancing the technology being deployed in the UK.

Which way forward?

Given the steady improvement of renewable energy technologies-and the rapid evolution of electricity markets-it is probably safe to say that none of the support systems in place today will continue unchanged for many years to come. The most immediate challenge is to reconcile the desire to increase competition in electricity markets with governmental commitments to dramatically increase renewable energy deployment in the next decade.

Analysts and policy makers around the world seem to agree that such goals-including the deployment of 40,000 MW of wind in the EU by 2010-will require government subsidies. This is true less because of renewables' lack of competitiveness against new fossil fuel generators, but because of the heavy subsidies that are embedded in existing fossil and nuclear plants. These generators, whose construction debts have already been paid, could go on producing pollution laden electricity at two to three cents a kilowatt hour for decades-unless there is some incentive to replace them. The challenge is to establish large, sustained markets for renewable energy, minimise the subsidies required, and limit the distortions to the competitive market place.

One approach to this dilemma is a new generation of policy being pursued both in Europe and North America. The governments of Denmark and the Netherlands, as well as several US state governments (page 35), have recently adopted or are considering a modification of the UK's fixed quota system: obliging electricity suppliers to include a certain amount of renewable energy in their supply portfolios, but allowing those obligations to be traded among the suppliers. This is the approach being taken by some of the states adopting "renewable portfolio standards" in the United States, as well as the European nations adopting "green certificate systems." Both are intended to create open, vigorous markets in green electricity, markets that are not controlled by monopoly power suppliers. The hope is that such a system will create an active secondary market and commodity exchange for green power.

How well these systems will work is uncertain. None have been in place long, nor have any yet created a significant wind power market. In principle, tradable obligations have many appealing characteristics, but new policy mechanisms rarely work as perfectly as planned. The relatively small number of prospective buyers in such a market, particularly in the early stages, could make it easy to manipulate. And given the tendency of commodity markets to swing wildly up and down, the lack of stability might make it difficult for small wind companies to survive or expand. These new systems will almost certainly require careful regulation-and repeated fine tuning-if they are to work effectively.

Having expanded fivefold in the last decade, wind markets are clearly ready to step up to a new level. But renewable energy policy making is unfortunately nowhere near as mature as the technology is. Some of the most popular policy options are largely untested, while those that have worked best so far are under attack for their incompatibility with competitive markets. And in far too many countries, including the US, the wind "market" still consists of one-off pilot projects and government mandates that do not provide the industry with long term stability.

Given this state of affairs, it would be naive to lay out a detailed global blueprint for the next generation of renewable energy policy. Governments that have not yet succeeded in creating sustained markets should be encouraged to try new policies. Those that do have functioning markets in place should reform their policy frameworks with care. The danger is that pursuit of free market purism will kill off the handful of thriving wind power markets before it is clear that policy makers have proved that a new approach will work. To navigate this minefield, some basic principles are needed.

Some guiding principles

¥ -----Regardless of the broad support system chosen, the devil is in the details. These details must be accounted for if the system is to work. For a start, standardised interconnection requirements must be established by regulators and enforced; planning and siting laws are needed so that projects are not considered on a piecemeal basis. Tax laws should be adjusted to encourage renewables-allowing rapid depreciation and reasonable credits.

¥-----One-size-fits-all approaches are premature. Different countries have very different electricity markets, industry structures, governmental capabilities, and levels of experience with renewable energy. A policy that works well in a country with an existing vigorous wind market or a strong economy might work poorly in a country that is starting from scratch with a weak regulatory system. It is notable that the United States, which has had a federal government for over two centuries and has recently opened the wholesale power market to competition, still allows-indeed encourages-individual states to promote renewables in their own way.

¥ -----Efforts to create a truly competitive market in renewable energy will have to be accompanied by disclosure requirements that ensure that all electricity suppliers inform consumers of the source of their power and the emissions that flow from it, as experience in several US states has shown. Without such requirements-perhaps via the kind of tagging system that has been agreed to by several US states-renewable power will be unable to fully distinguish itself from its more polluting competitors.

¥ -----Feed laws should not be abandoned until some other policy system has proven itself. As a study for the World Bank concluded last year, the feed law approach-which allows for easy market entry-may be most needed in the majority of countries that do not yet have a wind power industry and may find it difficult to start one without a system that allows easy market entry, with minimal bureaucracy and low transaction costs. By starting small, as a feed law allows, the wind power industry will be able to establish local economic and political roots, which have been key to the industry's entry into new markets in the last decade.

¥ -----Countries with feed laws should be encouraged to make them more responsive to market prices, however, perhaps by periodically adjusting them with reference to the wholesale cost of conventional generation, plus both the value of the small generator to the local distribution system and the avoided environmental externality costs. Alternatively, it might make sense to base a feed law price for small renewable projects on the auction prices for recently installed large scale renewables, plus a small premium to reflect distributed value. To minimise distortion of the larger electricity market, the renewables premium could be financed from a non-discriminatory levy on all electricity consumers, as the recent EU working paper suggests.

¥ -----It is time to move forward aggressively with the renewable portfolio standards and green certificate systems that have been adopted so far-and be prepared to modify them if they do not work. Countries that have chosen this route will need to work hard to ensure the systems are as efficient and non-bureaucratic as possible. It is essential that the market be truly competitive-large numbers of buyers and sellers-and that long term contracts be offered on a regular basis. It may also be necessary to segment the quotas, dependent on technology and scale, as regulators in California and the UK are now considering. If purchasing obligations are to be effective, and electricity distributors are to be motivated to make the systems work, steep financial penalties will need to be levied on those who do not come through.

¥-----Some governments may want to consider a hybrid approach: adopt auctions or renewable certificates for projects above a certain size, but allow access to the grid at a standard price for smaller projects that cannot afford delays or high transaction costs. Most governments will be pushed to develop such a system anyway-for the new class of micro-generators like fuel cells and micro-turbines that will enter the market in a big way in the next few years. These generate power economically at scales as small as 10 kW or less and will need some kind of standard pricing system that reflects their additional value in the low-voltage distribution system. It would make little sense to keep renewables out of such a system.

In light of these complexities and the many details that must still be dealt with, the decision of the EU Energy Council on May 11 to take a cautious and flexible approach to a Directive for a single market for renewables in the EU is laudable. Given the dynamic pace of change, and the many uncertainties ahead, strength will come from continued experimentation and diversity. Competition among policy makers may lead to as much progress in the wind industry as competition among manufacturers already has.

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