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Policy goals and market truths

This article, written by a market strategy theorist, looks at the pros and cons of the approaches to a pan-European support model for renewables in the context of a liberalised market. The author suggests ways of improving the proposal put forward by the European Commission, keeping in mind the truths of how the electricity market really operates.

The emergence from the bowels of Brussels of a pan-European support model for renewables, albeit in draft form, has split Europe's already divided wind lobby into two openly warring factions. On the one side, aficionados of support policies based on price regulation, such as Germany's Renewable Energy Feed in Tariff (REFIT), are aghast at the suggestion that their system, so successful to date, be scrapped. On the other side, backers of policies aimed at fully integrating renewables into competitive power markets are stunned by the force of the reaction against a model which they see as an eminently desirable step in the right direction.

The support model proposed by the European Commission (EC) calls for each country to place an obligation on its power sector to obtain 5% of national electricity needs from renewable energy sources by end 2005 (Windpower Monthly, December 1998). From that date, subsidy systems based on price regulation must be phased out in favour of support systems based on competitive markets, whether the competition be in the form of bidding for power purchase contracts, as in Britain, or trading green power credits to utilities on a power exchange, as in the Netherlands. Countries that meet the 5% target ahead of time must ensure the contribution of renewables to their energy supply is 3% greater than it was in 1996.

Europe has long been committed to a liberalised Internal Energy Market, the first phase of which opens on February 19, and the EC proposal is aimed at the integration of renewables into this market. Price regulation, where the state subsidises the price paid for wind power, is not seen by the EC as an option for the long term. The shunning of price regulation models, however, has struck fear into the hearts of wind associations representing many thousands of wind turbine owners. They see a system of relatively safe returns on investment being replaced by a model which opens the doors to market risk. They also argue against the replacement of a system which has proved so successful in catalysing markets, particularly in Germany and Denmark.

Economists and governments, however, are not enamoured by a subsidy system which represents uncontrollable, escalating and unnecessary costs for taxpayers. Other sections of the wind lobby recognise these arguments and support the EC's proposed alternative. As a result, the European wind community's heated discussions of yesterday have escalated into fierce and vitriolic argument. Emotions are running high, overshadowing facts and threatening reasoned argument. Challenge enough to take a closer look at the EU's intentions and the alternatives available.

Defining the battlefield

First, a look at the facts. Two types of market will continue to exist for wind: the value market, where customers buy wind energy at a premium mainly because of its environmental benefits; and the open energy market, where customers expect cheap energy anytime and anywhere -- and do not care where it comes from.

The accessible value market covers about 1%-10% of today's household demand in Europe -- and much less of industrial demand; in total, maybe 2-3% of the entire electricity market. This value market is already wide open for wind. No other renewable combines such favourable prices with ample supply potential; no reason, therefore, to set up specific programs to help wind to enter this market niche.

The real challenge is the open energy market. This is where the volume is; this is where wind energy has to become a competitive player. Despite all its impressive progress, wind energy has a long way to go to be on even terms with fossil and nuclear. It is still two to three times too expensive. True, the latest economic analyses of electricity costs (page 48) clearly show that the price of wind -- in a fair comparison but without accounting for its environmental benefits -- is on a par with that of fossil fuel and is cheaper than nuclear. But life in general, and markets in particular, are never fair. Arguments about scarce resources and external costs might be relevant, but they do not advance wind's competitive position in today's market.

Wind power will be bought on the open market only if its average selling price is lower than the marginal cost of an existing energy source. This means that wind must be cheaper than the cost of producing one more additional kilowatt hour from an existing power station. Not fair, but fact. And wind price estimates cannot be based on "good wind-sites." Wind as a volume resource has to include medium sites too -- and these drive the average cost up.

The good news today is that wind energy clearly has the potential to make it into the open market, even under such "unfair" restrictions. Wind's rapid fall in price is a reflection of not only the geniality of wind engineers, but also of the large and still untapped opportunities for further technology improvements. Achieving a price reduction of 50-70%, however, is a tough challenge indeed. Selection of the wrong support mechanism could end up prolonging the entry of wind into the open market, pushing it into a far distant and undefined future.

The pros and cons

Accepting that price is the fundamental parameter in an unfair world, the mandatory criterion for any support model is whether it contributes in a predictable way to bringing down prices. Improved interest rates cannot be relied upon to achieve this goal. They will remain high as long as the financial community remains unconvinced by the technical capabilities of the technology. If a support model does not fulfil the primary goal of reducing price through technical progress, achievement of secondary goals, like continuous growth of market share or protection of existing market players, is nice enough while it lasts, but fruitless for the long term.

The second important criterion of a support model is sustainability: it should put no undue financial burden on the public, it has to be compatible with accepted industry concepts, and it needs broad social acceptance.

Price regulated systems are characterised by fixed prices and no volume limitation. This makes them easy to administrate, nearly manipulation-proof, fully able to exploit any growth potential, and private investors are given a fair chance in an industry-controlled market. Due to their price fixing they create a protected market that allows for profit margins which cannot be achieved in a highly competitive environment.

Quota models -- where governments decree that a fixed percentage or quota of national supply come from one specified energy source -- are characterised by defined market volumes and by prices which are the competitive result of public tenders. Such models create considerable competitive pressure and are easy to budget, but they are complex to administer and control. A quota market is far easier to manipulate than one controlled by price regulation -- and market growth potential is restricted: all minimum quotas tend to become maximum quotas.

Weighing up the pros and cons of each support system is a matter of checking them against the two desired criteria: "price reduction" and "sustainability."

To REFIT . . .

Price regulation models may be appropriate in a relatively low volume environment, as has been proven in Germany. They provide great impetus to growth, manufacturers get reasonable margins, and this leads to constant development progress. It is an expensive way to promote wind energy, but most probably the easiest as long as the overall volume is small enough. But there is one critical Achilles heel: if the regulated price is too low, it offers no incentive and the support program fails; if, on the other hand, the price is set so it can be matched and even passed by decreasing production costs, the resulting exponential growth of volume and costs will cause the program to collapse under its own weight. What's more, the social consensus behind the model crumbles: "Why is wind allowed limitless growth in a protected environment when all other energy industries must fight it out in a relentless price battle?" Price regulation models do not fulfil the criterion of sustainability, not financially and not socially.

But what of price reduction in a price regulated environment? Is there an incentive to cut costs by improving the product? On the one hand, a number of turbine manufacturers are allowed to survive in the high margin haven of fixed prices -- as demonstrated in Germany. More companies mean more development resources, more variety and, potentially, more creativity and progress. Whether that potential is fully exploited is a moot point. There are indications that in a safeguarded price regulated environment manufacturers will primarily invest in new production capacity to keep their market share ( "more of the same" ) and are less inclined to take risks in new technology. This may vary in an environment where support programs are constantly at risk, as in Germany, where some manufacturers are preparing for the end of the REFIT-program by investing heavily in new concepts.

It can be argued that some of the drawbacks of price regulation models can be avoided by introducing volume limits through caps on market shares or specified maximum quotas. As soon as this step is taken, however, a price regulation model loses all of its advantages: easy administration, no manipulation, and fast growth potential. A price regulation model with volume limitations -- as introduced in northern Germany -- is a contradiction in itself.

The final word on price regulation in today's market is thus: an unmodified price regulation model is neither sustainable nor does it show special strengths in producing cheaper wind energy; regardless of all past successes, it is not a viable solution for making wind energy competitive.

. . . or to quota

Support models based on fixed percentages, or quotas, of renewables in the supply mix, appear nice and clear cut and have a proven track of returning low prices, at least in the UK. Sustainability is not a problem for any quota model -- the quota can be adjusted to match the available budget. The real goal of wind support, however, is not to gain a regulated small share of the energy market, but to make wind energy competitive; it has to be able to exist without subsidies. Under today's conditions, the use of the quota mechanism is only acceptable as long as it is a means to achieve the priority goal of increased competitiveness.

Quota models have one critical problem: public tenders favour the lowest price vendor and lead to a reduced market portfolio where "standard" turbines, without technical development potential, dominate. Price competition reduces the profit margins of suppliers, drives smaller producers out of business, and leaves less room for research and development investment by the survivors. In the past, high price markets (like Denmark or Germany) managed to offset the impact of low price markets (like the UK). In a unified European market, however, this option no longer exists. It is another important reason for why the wind business must adapt to tomorrow's world and can no longer trust in yesterday's prescriptions.

A standard quota market will thus be dominated by the most cost effective technology of today, but not necessarily of the future. It can be easily manipulated by cash-rich companies, who will push out other players. In its early days, any quota model will result in lower prices -- thus the perception of the model as the ultimate support instrument. But the longer term result could be a scenario in which an oligopoly of large utilities control the few remaining global wind turbine manufacturers; and where technology competition is not increased, but delayed. On closer examination, the unmodified quota model is clearly not as well suited to matching the criterion of price reduction towards full competitiveness as might be expected.

The EC support model

The EU Commission's proposal is based on a quota model. No outside executive could ever propose a regulated price proposal for national markets where expenses could rocket and blow any conceivable budget sky high. For wind energy, a quota model makes sense insofar as it is the easiest way to combine some minimum growth with limited spending (though it is not necessarily the right approach for renewables technologies further from the market, like photovoltaics).

The Commission's proposal emphasises competition, but within the confines of a protected market for the entire range of renewables. This focus on renewables obscures the real challenge of making wind energy competitive within an existing open energy market. The EC proposal's 5% goal for renewables deals only with quantity. It fails to specify the quality characteristics needed to meet the aim of cost reduction.

The draft Directive also lacks measures to alleviate the basic disadvantages of any quota model: as quota announcements come and go so does the market, in a never ending ebb and flow. This stop-go process puts the life of market players constantly in jeopardy. There are no long term prospects to make investment in technical advances worthwhile once a specific technology has surpassed its defined quota. And there are no in-built safety devices to prevent the misuse of limited quotas by a few influential market players. Skimming the cream off renewables orders became a veritable art form under some rounds of Britain's systems of non fossil fuel obligations.

A THIRD WAY

Neither the regulated price model in use today, nor the standard quota model are particularly well suited for driving wind energy price down by the factor of two to three necessary for it to compete under today's unfair conditions. The quota approach, however, is at least an approach which can be sustained over some time, whereas the regulated price model is suited only for small volumes and will collapse financially in a high growth environment. There are good reasons, therefore, to select a quota model as the basis for a future European support structure.

Any system which specifies the proportion of wind in the national power supply has to be considerably refined to match the real requirements of wind energy. One approach could be to combine a quota model (which guarantees the required volume yet limits the program costs) with a system-evaluation concept. The aim would be to construct a system of support which rewards innovation in areas where the technology needs improving. Definition of these areas would be the job of independent expert advisers who would summarise and assess them in generic catalogues updated each year. Not only would the catalogues contain specific technical product parameters, but also global system aspects, such as the total system availability or the total life cycle service concept of a supplier.

Once the specific goals to be achieved in each quota obligation had been closely defined, an evaluation factor could be assigned to the sought-after areas of technology development according to their importance (table). The more price-reduction potential is built into the concept for a renewable energy plant, the higher will be the evaluation-factor. Developers would be invited to bid with projects to fill the quota, and the selection of successful bidders would be based on the bid price divided by the evaluation factor. Such an approach would make even expensive systems eligible as long as they incorporated characteristics worthy of high evaluation scores.

The system sounds complex, and it certainly is. But it is the best choice from those available. The other choices are either to invest huge amounts of taxpayers' earnings and hope for the best -- the price regulation model; or to limit expenses at the cost of restricting growth and technological progress -- the standard quota approach. The failings of the standard price regulation and quota models in operation today are the cause of the bitter debate in wind energy circles right now. A third way has to be found.

A system which limits the cost of support, but at the same time achieves the goal of making wind competitive, requires tight control. Complexity is certainly nasty, but it is acceptable for combining conflicting goals, especially when the aim of the support model is to achieve a situation where it is no longer needed.

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