That was then - this is tomorrow

The political framework of Denmark's renewable energy market reform provides a fascinating glimpse of what could be the shape of the promised pan-European single market for renewables. This article gives a comprehensive look at how the market is expected to function, defining and explaining terms and providing several possible scenarios, along with charts and graphs.

It is ambitious, it is grand, it is new and it has to go fast. Civil servants at the Danish Energy Agency are racing against the clock these days to get a brand new competitive market for wind power on its feet by January 1, 2000. This is the deadline set by politicians for the end of the 15 year old system of fixed price tariffs for wind power in Denmark and the birth of a new market created by a national Renewable Portfolio Standard (RPS), facilitated by green-power credit trading.

Denmark's wind power producers will wake up New Year's day blaming their headaches on other things than an excess of alcohol. A completely new system for selling their wind power, consisting of exotic products with fancy names, will be the reality for wind turbine owners, provided the energy agency can sort out the many details still up in the air. Goodbye cosy world of fixed prices and security. Hello cruel, competitive, liberalised life.

Denmark's RPS was conceived on March 3 when a broad parliamentary majority agreed to liberalise the electricity market. At the same time, the majority set a goal for 20% of the country's consumption of power to come from renewable sources of energy by 2003. Currently some 14% of consumption is covered by renewables. The additional 6% will be reached by means of a purchase obligation placed on every electricity consumer -- represented by their chosen supply company -- requiring them to buy 20% of their electricity from renewables.

One of the principal contributing factors to Denmark's early transition from a fixed price regime to an RPS lies in Brussels. The European Commission does not believe that free trade in electricity -- a political goal agreed by the governments of the EU member states -- is compatible with the many different support schemes for renewables in the EU. The distortions have been tolerated so far because of the low level of renewable energies in the European electricity systems. But with renewable energy now seen as an important tool for meeting the EU's Kyoto commitments to reduce greenhouse gases, it is set for substantial growth. So too, therefore, are trade distortions if payment systems for renewables are not harmonised.

What Denmark hopes to achieve in the long run with an RPS-based market is a steady decline in the cost of wind power, as seen in countries where auctions models of support reward the lowest bidder, combined with streamlined rules and regulations for site permitting and grid access. This has not been done before and success is not guaranteed, but the theoretical justification for a true market for renewables is indisputable. The devil is in the details -- and these are still very much undecided.

Setting a standard

An RPS sets a standard -- or minimum limit -- for the amount of renewables power in a supply portfolio-governments simply decide that a specific and gradually increasing amount of electricity should come from renewable energy. With demand for renewables thus created, the market will set a price high enough to ensure continued development of new green power capacity.

The mechanism for recognising the "green value" of the power is green certificates, which are issued to renewables producers in proportion to the volume of green kilowatt hours they generate. Thus a "common currency" for trading renewables power comes into being and a certificate serves as evidence that a specific amount of green electricity has been produced and fed into the grid. The obligation on consumers, utilities or distribution companies to buy a specific amount of renewable energy, represented by green certificates, creates a market demand for them.

The supply of certificates depends on the volume of renewable energy produced. If demand exceeds supply -- which means the amount of electricity from renewable energy sources is not sufficient to meet the government's quota -- the price of certificates will rise. It will continue to do so until it satisfies investors' requirements for a decent return, whereupon new capacity will be installed to meet the quota. If supply exceeds demand, the price of certificates falls, making it unattractive to install new capacity.

In transition to the ideal market

The detailed structure of the future Danish market is still unknown. One of the most crucial aspects of a well functioning market -- the price structure -- has not even been examined yet. The success or failure of the market mechanism will depend on the decisions that are to be made before the market takes off.

The framework for a transitional phase is partly in place (fig 2). A price floor of DKK 0.10/kWh and a price cap of DKK 0.27/kWh on the certificates will be introduced until 2003. On top of that, wind turbine owners are certain to receive DKK 0.33/kWh for the electricity they feed into the grid over the next ten years. This means that all turbines will receive a minimum of DKK 0.43/kWh and a maximum of DKK 0.60/kWh in total. In today's fixed price system, the kWh payment is 85% of the electricity sales price in the utility region where the turbine is sited, a national average of about DKK 0.33/kWh (fig 1).

In the long run, however, there will be no floor and no cap on the certificates. There will, however, need to be a penalty for not complying. A high penalty is one of the contributors to the successful US sulphur dioxide market -- and it is one of the missing elements of the Danish reform so far. The price cap of DKK 0.27/kWh on Danish certificates was introduced as part of a political compromise and has been promoted as a penalty to be levied on consumers who fail to fulfil their renewables quota. But it is simply not high enough to be a penalty -- it is too close to the market price to be effective. So what is being promoted as a penalty is a price controlling factor, the result of a political decision to limit the total possible payment to 0.60/kWh.

The guaranteed minimum price owners receive for their electricity is also likely to be removed in the long run. Thus, turbine owners will receive the market price of electricity plus the market price of a certificate. The market price is the "present value" of expected electricity prices. Many Danish turbine owners undoubtedly dread the day they have to sell their electricity at the historically low market prices on the Nordic power exchange, the Nord Pool. This is currently around DKK 0.12/kWh. But if the market works, they have nothing to fear. If the market price (present value) of electricity drops, certificate prices will rise and if electricity prices rise, the certificate price drops. The electricity price could fall to DKK 0.01/kWh and it should not matter, in theory.

In the ideal market the price of the certificate and the expected price of electricity will always add up to what economists refer to as the "marginal cost" of producing wind power, that is the costs of adding one more unit -- one more wind turbine -- to the generating base. In reality, any change in costs associated with wind power production will be compensated for by an equal change in the combined income from selling the electricity and selling its accompanying certificate (fig 3). It works like this. If interest rates rise, so will the combined payment. If sites with poorer winds are used, the combined payment will also rise. And if technology improves the combined payment will fall. That way the RPS makes certain that new wind turbine owners with luck going their way do not reap excess profits. On the other hand, the system also makes certain that new turbine owners will be compensated if investment costs rise -- which will happen if interest rates start rocketing.

Driving down costs

But if an RPS is supposed to be a more cost effective way of adding capacity, surely someone must stand to make less money? True. The very idea of a market based system is to reduce the costs of expanding renewable capacity by introducing competition between producers of renewable energy and eliminating the potential for excess profits. Renewable energy producers with the lowest production costs will make the most money. Naturally, price competition will be transferred further down the system and renewable energy producers will seek to bargain with turbine manufacturers and land owners for lower prices to a larger extent than under the fixed price system.

Denmark's fixed payments for wind power supplied to the grid, combined with technology improvements, have undoubtedly added to the profitability of investing in wind turbines over the years. On the other hand, higher profitability has been offset by the increasing use of sites with lower wind speeds.

Another less spoken of contributor to improved profitability is the steady fall in interest rates in recent years. What if the interest rate had gone up instead of down? Under a fixed price system, turbine owners would not have received any compensation for the higher cost of finance -- and the outcome would have been lower profitability, unless the fixed price was adjusted upwards. With inflation adding further to the decline in profits, it would be questionable whether or not technology improvements and economies of scale in wind turbine production would have made up for that loss.

Under an RPS, all changes -- or rather, all expected changes -- in the cost determinants of wind power investment will be immediately reflected in the combined price of electricity and the price of renewable energy certificates. Likewise, a fall in electricity prices will be accompanied by an equal rise in the price of the certificate.

For this reason, investors should not care that the government has removed any of its production incentives, such as the DKK 0.10/kWh C02 tax compensation. The response of the market will be to increase the price of certificates by DKK 0.10/kWh.

Keeping price steady

The role of the market, as any other market, is to establish a price according to the laws of supply and demand. But economic theory tells us that determining a price is problematic when supply and demand are fixed in the short term (the problem of vertical demand and supply curves). A price cannot be determined if a situation where demand equals supply is an exception. The effect will be that the price will tend to be banging either against the price cap or the price floor (if there is one), and never floating in the mid-range.

In other words, if there is one certificate more in circulation than is needed to comply with the obligation, nobody would want to buy it and the price becomes zero. This is a problem arising from fixed demand; it causes price to become very volatile: it will nearly always be either zero or infinite (or zero and the level of the fine for not complying with the obligation).

In order to eliminate the price fluctuations caused by the fixed demand and to secure flexibility in payment, a system of "banking" must be available. It is an essential element of the market, so far missing from the Danish plan. Certificates will be issued at the time of production of renewable energy and will be destroyed -- in accordance with the requirements of the obligation-on delivery to an independent authority, in Denmark the Danish Energy Agency. But there will most likely be an imbalance between actual production of wind kilowatt hours and the quota obligation for any given period. The market must be structured to cope with the imbalance. A system of banking is the solution.

Such a system gives consumers the option of buying future production -- and wind turbine owners the option of selling future production by trading borrowed certificates. This stabilises fluctuating prices by creating a basis for long term certificate purchase contracts. The system thus allows participants in the market the option of hoarding certificates in the expectation of future price changes, and wind turbine owners the option of borrowing certificates in case their turbines do not produce electricity enough to meet their long term delivery contracts.

Because of the expected imbalances between actual production and the renewables quota, and the problems of volatile certificate prices, consumers -- bearing the weight of the obligation to buy renewables -- must be able to hand in contracts on future delivery by sending a larger number of certificates to destruction. This can be viewed as the "interest" on a certificate. With no interest element, the obligation will be met at the latest possible juncture, causing whirlpools of disturbance in the market.

Attracting finance

For owners of wind turbines -- and their sources of finance -- it is of paramount importance that any payment system allows a fair amount of certainty to be attached to cash flow projections. In support systems based on fixed price this is not a problem. But selling power and certificates on spot markets with fluctuating prices could become a problem. It increases the risk and thereby the price of investing in wind power. On the suggested spot market, the price of certificates would instantly hit the effective price cap -- the size of the penalty for non compliance.

"Banking" overcomes this problem and establishes a market for standard contracts in the form of futures or options. By selling electricity and certificates on long term futures or options contracts, the risk (and the price) can be reduced. Futures and options contracts make it possible to sell or buy certificates for delivery some time in the future at a price that is agreed upon today. Such a market would need an institution to facilitate trade and guarantee delivery if a wind turbine owner is unable to deliver. In the US, the Options Clearing Corporation serves this purpose, and similar institutions exist in other countries.

Competing renewables

Yet another aspect the energy agency has yet to pronounce on is whether all the renewables technologies in Denmark -- wind, biomass, solar -- should be included in a single "umbrella certificate" or whether a certificate for each technology is the answer. One certificate, however, only ensures development of the cheapest technology, while several certificates will result in a market with dangerously low liquidity.

One way to deal with the problem is to accept, say, that solar is 20 times more expensive than wind and issue 20 times the number of PV certificates. But there is no easy way of estimating the true production costs of the various technologies, which makes it difficult to determine the proportional relationship between the costs of wind and solar. And what if the cost of solar drops 10% from its current high level, and the certificate proportion is not changed politically to reflect the drop? Investment in solar would soar and nobody would invest in wind, even though wind is several times cheaper in real terms -- hardly a cost effective way of meeting renewable energy targets. Offshore wind, being more expensive than the onshore variety, also gives rise to the same problems and a way needs to be found of stimulating its development.

More importantly, such a system has absolutely nothing to do with markets. It requires constant evaluation of the costs of technologies and political intervention in the form of changed certificate proportions. The market would be politically driven rather than market driven. One certificate for all technologies will also make it impossible to determine the price of pollution abatement in relation to the individual technology and determine when a technology will no longer need support: an "umbrella certificate" will still have a positive value when the least costly technology becomes competitive. The risk is that support will be given to technologies that no longer need it.

The liquidity problem of having several certificates cannot be ignored. Low liquidity is a problem for efficiency in every market. There are compromise solutions, however. Certificates could be issued to different technologies in exactly the same proportions, with the less competitive technologies receiving separate subsidies. Or instead of granting direct capital investment subsidies, auctions could be held for subsidised contracts, to encourage competitive bids and provide an incentive to reduce costs, much along the lines of the British market, controlled by its Non Fossil Fuel Obligation legislation.

Green pricing

Meantime, there is "green pricing" to consider. The potential for a green pricing market, where green minded citizens and companies can opt to pay a premium to receive their electricity from a renewable source, has not truly arrived in Denmark. But that is not to say it never will. Consumers who want to buy renewable energy in excess of the obligation must have the opportunity of doing so without being cheated. So far there is no structure to allow for this.

Discussions so far, mainly among the utilities, have centred on offsetting electricity bought by consumers in excess of the obligation against the quota requirement. Should this be allowed, consumers would be foolish to buy excess certificates. Such purchases would not lead to more renewable energy being produced and these green consumers would be paying for those who declined to meet their obligation.

With no free electricity market and with a tradition of sharing social burdens across the entire rate base, the concept of green pricing has not attracted the attention of the energy agency's market planners. This is largely because a clean environment is considered a public good. If your neighbour buys it, he cannot prevent you from benefiting from his purchase for free. Pollution does not stop at the garden gate. An absolute free market for renewable energies creates free-riders and such a situation is not likely to be politically accepted in burden sharing Denmark. If renewables are to the benefit of all, then everybody has to contribute.

In the longer run, however, with a fully liberalised electricity market, there may be free-thinkers enough for green pricing to take off, even in homogenous Denmark. The challenge for the Danes in the short run is to reach their ambitious 20% goal while not preventing individuals and companies the opportunity of acting "greener-than-the-rest."

Hands off the market

Liberalisation and the creation of a market is not the same as "deregulation," the term used in America for the general loosening of regulative controls on its electricity markets. The two words are not interchangeable and liberalisation means just that; it does not mean a market with no regulation. Legislation is necessary if the market is to work properly. Just as it is on stock and bond markets. Legislation and rules create a framework within which the market can work. Once the framework has been established, intervention from lawmakers should be kept at an absolute minimum. Otherwise prices on the market will reflect expectations of political action rather than fundamental economic relationships.

Economic theory, however, is not the real world. When politicians get into the game of creating free markets, so do numerous opposing views and compromises. Wind turbine owners want one thing, electricity companies another and consumers (voters) a third. Senseless compromises can very well create disturbances to the market mechanism, and in the worst case make it useless.

Steering the needs of the brave new market through this minefield will take a cool head and a deal of nerve on the part of the Danish Energy Agency. The market is not a goal in itself. It is a tool to reach a political goal. Analysing whether the proposed market structure is a sufficient tool is an absolute minimum requirement for introducing an RPS. So far, not enough information is available to evaluate whether the proposed market can enable Denmark to meet its goals for renewables. In particular, details of the price mechanism and an analysis of its likely workings is desperately needed.

Whether the agency can have an effective market up and running by January 1, 2000, is highly unlikely. It took four years to establish a forwards market on the Nordic power exchange, the Nord Pool, and such a market will definitely not be in place within the next four weeks. A proposal for a transition model based on bilateral agreements is new. Nobody seems to know if it will satisfy wind turbine owners and their sources of finance. If they are not happy, there will be no investment in wind power development, and the ambitious Danish target of 20% renewable energy by 2003 will not be met.