In search of the perfect support system

With wind energy growing at an annual rte of around 30% in Europe, the pressing need for changing the current support systems requires a deal of explaining. This article examines in detail the pros and cons of four support systems: fixed tariffs, a renewables portfolio standard with credit trading, auctions of renewables contracts and price premium or energy tax.

Joint rules for an internal energy market in Europe were adopted in December 1996, the aim being to increase competition and thus the economic efficiency of energy supply in the European Union. Since then the EU states have been liberalising their markets. Renewables have so far avoided being drawn into the liberalisation process. Their contribution to electricity supplies has been so small that the subsidies awarded the various technologies have not been large enough to cause any serious distortions to the free market ideal.

But as clean energy sources grow in magnitude, so do the distorting effects of the innumerable different support schemes throughout the EU. These are simply not compatible with free trade, says the European Commission. Denmark is a case in point. Thanks to the success of wind power, renewables are contributing significantly to the national supply. The need to bring them into line with the EU's internal energy market has become pressing, implies the Commission, not least because an open market for renewables will considerably boost their growth potential.

Without special provision, however, wind power remains at a competitive disadvantage to fossil and nuclear sources. It does not have the benefit of decades of financial support behind it. When liberalisation is king, new wind power stations are required to compete with old nuclear and coal fired power stations producing at marginal costs, because interest and depreciation on investments has already been paid for by consumers. In other words, power prices today do not always reflect the full costs of traditional energy, and never reflect the full environmental benefits of wind and the other renewables.

For these reasons, all the EU countries have agreed that continued support of renewables is both necessary and desirable. Indeed, renewables are expected to contribute significantly to meeting the EU's commitment to reduce emissions of greenhouse gases in line with the requirements of the Kyoto protocol of 1997.

The trick is to find support systems which do away with the distorting effects of different levels of subsidy and incompatible subsidy mechanisms. The solution proposed by the Commission is the creation of an internal renewables market, one which will make international trade in renewable energies possible. Denmark is devising a support system suited to such a market.

Flaws and solutions

In principle, renewables subsidies based on fixed premium prices reflecting the external costs of conventional power generation could establish trade under fair competition. But attempts by the Commission to "harmonise" support systems have failed spectacularly over the past two years. Variations on three different models of support are in practice today: fixed price subsidies; auctions of premium price contracts to meet specific quotas of renewables; and renewables purchase obligations, facilitated by trade in green power credits.

Fixed price subsidies have been enormously successful at catalysing a wind market and are enshrined in law in Germany and Spain, as they were in Denmark before its electricity reform. Denmark's coming transitional market for renewables (previous story) is a variation on this theme. The disadvantage of fixed prices, however, is the difficulty of fixing the "right" price. Fixed prices will expand the supply of renewables as they become cheaper relative to conventional power generation. If the price is "right," that is if it is equal to the cost of conventional power generation, plus the external (pollution) costs of that generation, there is good justification for allowing profits to increase: they will attract further expansion of renewables energy generation.

When it is fixed, the price of wind power tends not to reflect the true costs of generating the electricity. Between 1994 and 1998, the minimum bid prices for contracts under Britain's auction model of support, the Non-Fossil Fuel Obligation, fell 40% in real terms, but remained stable in Germany and Spain. True, the fixed price can be lowered to better reflect the lower production costs over time, but it is difficult to compute what the "true" price -- the marginal long term cost per kWh for conventional power generation plus the external cost per kWh -- should be. For this reason the fixed price model tends to result in kilowatt hours more expensive than necessary.

In an attempt to solve this inbuilt flaw in direct price subsidies, the UK and Ireland adopted a market approach, based on auctions of contracts for renewables. Under the auction model, the government invites competitive bids to supply generating capacity for each renewable technology. The companies that bid to supply at the lowest costs win the contracts to do so. The difference between the price of these renewables contracts and the price of conventional energy generation represents the additional cost of producing green electricity, and takes into account falling production costs.

A major flaw with this model is that it encourages gaming of the system: the longer a prospective supplier waits to build a project to supply power at the contract price, the higher the likely profits because of the steadily falling production costs of renewables. Development of wind farms, partly as a result of this anomaly, has been slow in Britain. It is not a problem encountered with the conventional generating technologies because of the long construction lead-ins and the likelihood of fuel prices rising. The price of renewables will continue its downward spiral for some time to come.

Another basic flaw in the NFFO model is that it does not have a penalty if developers fail to install the capacity for which they have secured a power purchase contract. A prospective renewables plant developer is free to make an unprofitable bid, win the contract, and not build the power station. If there were a penalty, developers would only bid if they were reasonably sure of obtaining planning permission to build on the site. The quotas would be filled, but at a higher price.

In recognition of the shortcomings of the subsidy systems in use, Denmark is trying a third way. It is launching a renewables market based on an obligation on all consumers to meet a specific proportion of their electricity needs with clean energy. Every consumer must meet a minimum standard for the proportion of renewables in their electricity supply portfolios. In this Renewables Portfolio Standard (RPS) producers are issued with "credits" in recognition of the environmental value of the kilowatt hours they produce. It is another way of internalising external costs, in which the market decides the value of green power instead of governments setting an arbitrary price as with fixed tariffs or price premiums. These credits are then traded on an internal market -- and in time the market can be extended to stretch across Europe, with renewables feeding into the supply system wherever it makes economic sense to do so.

The wider picture

Economics are crucial. Wind and the other renewables are competing with alternative ways of reducing emissions, energy saving and nuclear power to name but two. The United Nations is considering so called flexible mechanisms as a way of reducing emissions. These include Joint Implementation (JI) and the Clean Development Mechanism (CDM), under which developed countries receive credit against their emission targets by investing in clean technology projects in developing countries. An international credit trading system will secure that developed countries can buy and sell emissions credits. That means they can buy their way out of their obligation.

An RPS is a far more effective way of meeting competition from other initiatives to lower greenhouse gas emissions than premium price subsidies, say promoters of the system. It creates a physical product-a green power credit, known as a certificate in Denmark, a green label in the Netherlands and a green ticket in California -- that is easier to market than an invisible product labelled "green."

Finally, a word on the much maligned British auction model, the NFFO. It is not the fault of this market model that so little wind power has been developed, as is so often claimed. On the contrary, there have been plenty of contracts to bear witness to the system's economic viability. The fault lies in Britain's unworkable permitting system, which has stifled a market that could have thrived. Had the UK planning system been applied in Denmark or Germany, little capacity would probably have been added, no matter how high the fixed tariff had been. On the other hand, it is impossible to know what effect introducing a NFFO in Denmark would have on future installation compared to the planned RPS system the country has chosen.

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