The UK government’s present policy position finds itself firmly skewered on the horns of a dilemma that the recent contributions by David Kennedy and Guy Newey illustrate all too vividly. That is, how to balance the delivery of low carbon energy with the need to keep the bill for customers (or taxpayers) as low as possible. Yesterday’s announcement that subsidies for onshore wind are to be cut confirms that overpaying on certain low-carbon technologies is a real risk. So why isn’t the government letting investors decide which technology will deliver its low carbon energy goals at least cost?
As explained in last year's Electricity Market Reform (EMR) White Paper, “introducing a carbon price support (CPS) mechanism could help the UK to meet its decarbonisation objectives.” Set at the right level, and with appropriate signaling of the long-term price level, the CPS could have supplemented the European Union Emissions Trading Scheme (EU ETS) and brought forth low carbon investment in what economists like to call the least distortionary way. No need to pick winners; just let all investors and developers optimise against a long-term credible price signal.
However, the EMR rejected this approach because it didn’t like the impact on customers’ bills of supporting a carbon price of, say, £50/tCO2 by 2020. It might also have added, but didn’t, that the CPS scheme could have created some very large profits for the cheaper renewable technologies.
Instead, the government has chosen to manage the trade-offs involved using a scheme called Feed in Tariffs with Contracts for Difference (FiTs CfD). Under this system, the government and operators agree a contract that contains a “strike price” for energy produced and risk sharing arrangements that differ according to the type of low carbon technology. This is a regulatory – as opposed to market based - approach to incentivising investment in the electricity sector and it places the onus on the administrators of the regime to set the instruments of regulation to achieve the right balance of objectives. Unfortunately, the lesson that we can draw from experience to date is that regulators don’t always set those instruments correctly, with many examples of regulatory rules leading to perverse or “unintended” outcomes that are scattered over the history of regulation in this country.
Whether the investment will be forthcoming under the government’s chosen system will depend on the credibility of the strike price and the contractual terms that define the balance of risk between the counterparties. Whether customers or taxpayers pay more than they should will depend on the level of understanding that those administering the scheme have of the cost of low carbon technologies and how learning over time feeds into future contract prices. And whether we get the most efficient mix of technologies depends on the headroom that exists between the regulated strike price and the cost of investing and operating the new technology.
It’s all rather uncertain, but one thing is fairly clear: if there is more money to be made out of expensive, but generously priced, technologies, then operators will be keener to invest in those technologies rather than in cheaper technologies where there is a smaller margin between the regulated price and the underlying cost. Experience from elsewhere in Europe where investors have gone for expensive photovoltaics rather than cheaper wind technologies should be a warning.
The challenge is significant; and the costs of errors on an investment plan of £70bn will be high. With typically long terms of FiTs CfD the legacy effect of wrong choices in the early years could be huge – another lesson from elsewhere in Europe. These errors will magnify if the policy design stage overlaps too much with the phase in which regulatory details are specified. Regulation works best when policy sets the limits and framework for regulatory design, but does not directly define detailed parameters. Setting the policy objectives whilst writing the rules for achieving them could result in an incoherent model that creates confusion and undermines the credibility needed to bring forth investment in the most efficient way.
The views and opinions expressed in this article are those of the authors and do not necessarily reflect the views of The Economist Intelligence Unit Limited (EIU) or any other member of The Economist Group. The Economist Group (including the EIU) cannot accept any responsibility or liability for reliance by any person on this article or any of the information, opinions or conclusions set out in the article.
