Minimum Electricity Prices

Proposal

A guaranteed minimum electricity price (indexed and time-averaged over each 5 year period, for the design life of each project) for long-term investors in carbon free (<50gCO2/kWh) electricity generation capacity.

Background

Our current energy system is dominated by fossil fuels. Coal Oil and Gas, make up (85%) of global primary energy supply and are available as respectively solid, liquid and gaseous fuels.All true low or zero carbon forms of energy produce electricity (and/or low-grade heat).

If we are to convert our energy system away from fossil fuels and towards less damaging forms of energy, we need to shift from fuels to electricity.

Electricity is the Problem

Electricity is the most carbon intensive form of energy at present (in terms of greenhouse gases released per unit final energy), so decarbonising the electricity sector is particularly effective at reducing carbon emissions.

Electricity is the Solution

All forms of energy that don’t produce greenhouse gases produce electricity and/or low grade heat. For example:

  • Hydro, Wind, Tidal, Wave, Photo Voltaic Solar: Electricity only
  • Concentrating Solar, Nuclear Fission, Coal with Carbon Capture and Storage: Electricity (plus some low-grade heat)

Our future low-carbon electricity needs are huge

In order to solve the climate problem, we will need to low-carbon electricity to convert not only the existing electricity sector (as Sweden and France have done), but also the energy sectors that currently use fossil fuels directly such as transportation (oil) and home heating (gas).

Some countries will decarbonise their economies more quickly than others. There is also the potential for a High Voltage DC Supergrid. In this case, low carbon energy produced in one part of Europe can help to displace carbon-emitting generation in another part of Europe. All low-carbon energy is helpful to reduce carbon emissions.

Investment is Needed

To convert our economy, we will need investment in low-carbon energy infrastructure – electricity generating capacity of the form of nuclear, renewable energies and perhaps coal with co2 sequestration. All these forms of electricity generation are capital intensive, that is the majority of the cost of a unit of electricity is the upfront investment cost, very little is paid in the cost of fuel and ongoing maintenance. In the case of renewable energy, fuel is free; for nuclear energy, fuel is very small part of the cost of electricity.

Current Policy is Inadequate and Costly

Present policy is dominated by costly direct subsidies to renewables (Renewables Obligation), and heavy direct subsidies to legacy nuclear generators.

Very little carbon reduction is bought for this substantial cost. There is a grandfathered cap and trade system (the European Emissions Trading Scheme), which does not aid long term investment and does not reduce carbon emissions

Changing Public Discourse

Public discussion is dominated by the notion that decarbonisation is difficult and costly. If this were true, it is unlikely that such policies would be adopted globally. But well designed policies need be neither difficult nor costly.

What are the guaranteed minimum prices for?

Full Scale Deployment Support

The purpose of this instrument is to encourage investment in electricity generation capacity which:

a) is economic; (has a positive net present value and costs less than the long-run price of electricity)

b) is capital intensive

c) is low-carbon

It is an instrument to encourage ‘mass-deployment’ of low-carbon technologies of a low enough cost.

It is not, in the first instance, an instrument to encourage less economic technologies to reach market.

Why encourage large-scale deployment of low-cost energy sources in addition to ‘learning support’?

Price support for already lower-cost energy sources is disproportionately effective at reducing carbon emissions for two reasons.

Firstly, given that electricity generation capacity is needed anyway, the net cost is small or even zero.

Second, if these technologies are already nearly-competitive with coal, it might take less investment to make them competitive or even lower cost than coal. Only then would

Other measures are for learning support

The basic scheme is not intended to be a method of reducing the cost of more expensive forms of renewable energy such as wave energy.

However, it is important that such novel energy forms are encouraged and brought to market rapidly.

The Renewables Obligation is set up to encourage the development of these forms of energy so as to reduce their cost. It has been recently banded to differentiate between technologies according to their level of market penetration.

Some have argued this method of support to be excessively costly. Greater direct research and development (R&D) support and feed-in-tariffs by energy type may be more efficient way to encourage these energy types.

How Would It Work?

There would be a long-term contract between the government and any investors that the time averaged electricity price over a certain period would not fall below a certain point. In effect this is an asian option on the electricity price. At the end of each time period the government would provide direct financial support in the event of a price falling below a certain level.

Contractual Arrangements

The government would write a contract for difference on the average price of electricity in each future 5 year period. So there would be CFD on the average electricity price in the period 2015-2020, and one for the period 2020-2025.

Who would qualify?

Initially, all ‘Zero Carbon’ electricity generators- ie those with emissions below 50g/kWh. It could be extended to all ‘Low Carbon’ electricity generators – those with emissions below 200g/kWh.

Why Not Just Impose a Carbon Tax?

A long term price on carbon should be the primary policy for carbon reduction. However, what determines low carbon investment is not the current price of carbon but the expectations of the future price of electricity. The effect of a carbon price is only in that expectations of a future carbon prices affects expectations of future electricity prices.

Economic costs of decarbonisation will be reduced if there already exists significant alternative energy when carbon prices are raised.

Relatedly, a significant carbon price may be being blocked politically by well-organised carbon intensive sectors such as fossil fuel extraction, coal electricity generation, aviation and heavy industry. It is necessary to create a significant well funded carbon-free energy industry before punitive levels of carbon taxes are imposed so that industry has alternative energy sources available.

Economic Justification: Discounting and Net present Value (NPV)

NPV Criterion

The net present value adds up the costs and benefits of an action. The NPV criterion is this:

An action should be taken in if it has a positive net present value.
Two examples are the following:

  • Social Planner (Economic Cost-Benefit Analysis): A policy should be adopted if it has positive NPV to society
  • Firm (Financial Analysis): An investment should be made if it has positive NPV to the firm.

Costs and benefits in the future are discounted using appropriate long-term discount rates. The net present value depends strongly on the discount rates used.

Discount Rates

The discount rate determines how much one should value future costs and benefits relative to current costs and benefits. If I receive £1 today, what is an equivalent amount that would be just as good to receive in 1 year’s time? If I beleive that £1.10 in 1 year is equivalent to £1 now, then I am implicitly using a discount rate of 10%.

What discount rate should be used for infrastructure projects such as investment in electricity generation capacity?

Public Discount Factors (Economic Cost-Benefit Analysis)

Economic and ethical arguments over discounting have been investigated extensively in the Stern review of climate change, and subsequent literature. Stern suggested a pure rate of time preference of 0.1%; the discount rate implied by this assumption depends further on assumptions over future growth in consumption. It approximately implies a 10 year discount rate of 3% falling to 2.5% over 40 years.

The treasury green book suggests 3.5% as a discounting rate for public infrastructure projects.

Private Sector Discount Rates (Financial Analysis)

However, the private sector is likely to use a much higher interest rate, than the socially optimal one. In general, the private sector will discount to take account of the risk in an investment. The riskier an investment, the higher the interest rate charged.

The discount rate used in the Energy White Paper cost benefit analysis is a 10%, close to a likely financing rate. The cost benefit analysis is therefore at least in part a financial analysis rather than an economic cost benefit analysis.

This means that less investment will take place than is socially optimal. It will therefore be useful to consider ways of reducing the financing rate.

So financial risk determines the financing rate, this leads naturally to the following question:

Risk

What are the sources of risk for an investor?

The following financial risks are generated by the sturcture of liberalised electricity markets:

  1. Policy Risk – that policy towards carbon or electricity may change
  2. Mismatch between revenue (electricity prices) and costs (fixed).
  3. Price risk – electricity prices in the future will be lower than expected, especially if investment is high.

Since these risks are largely the government’s responsibility, it is appropriate that the government should act to mitigate them.

The government should also provide assurances over the following:

  1. Regulatory risk – that regulations concerning the plant’s operation will change

The following sources of financial risk are independent of this policy:

  1. Construction risk – that the plant will cost more than expected
  2. Back end costs – for nuclear, decommissioning and waste disposal
  3. Operational risk – e.g. due to plant misfunction
  4. Risks due to financial structure and financial managment

These risks are largely the responsibility of the firm itself and therefore it is not the responsibility of government to intervene.

Moral Hazard?

A danger of insuring investors against loss is that companies are encouraged to behave recklessly. This is not a major danger here. In this instance, a revenue stream is being guaranteed, not the business. The businesses could certainly sustain higher levels of leverage against a certain cash flow, but in this case would clearly have to pay higher interest rates from investors.

Volatility Drivers

Electricity Price Volatility

A highly volatile electricity price will tend to suit low capital intensity (low fixed cost, high variable cost) electricity generators

Gas-Carbon-Electricity Correlation
In a spot electricity market, the price of electricity is determined by the ‘swing’ producer of electricity, usually gas. The price of this electricity is determined by the price of gas. Gas producers have a good deal – their revenues and costs move together. Capital intensive zero carbon energy (wind and nuclear) do not.
The market fails because it creates volatility and then passes it on to consumers.

Policy Uncertainty

There is considerable uncertainty over the future price of carbon. Whether there will be a systematic carbon tax or a cap and trade system. It is well known from real options theory that in these circumstances, investment is delayed.

We need guaranteed minimum prices to encourage investment in the midst of policy uncertainty. Minimum carbon prices will aid policy credibility.

Little Investment will happen without more certainty

At present the future price of gas, carbon and electricity are highly uncertain. There is likely to be little investment in either high-carbon choices such as coal (because of the danger of high carbon prices in the future) or low carbon choices such as wind or nuclear (because of uncertain revenues against a certain.

There is a danger of the lights going out.

Further Arguments

A policy measure to reduce emissions

The government has set strong goals for climate change policy, but at present does not have strong policies to acheive these goals. For example the UK government does not have control over the carbon price at present; this is set by the EU.

Reducing the Cost of Energy for Industry

By guaranteeing a minimum price for investors, large amounts of investment in low-cost capacity would be encouraged. By providing a floor on the price of energy, in the long term enough investment will be encouraged so that the potential

Carbon or Electricity?

A floor on the price of carbon has also been proposed as a measure to ensure greater certainty and to aid policy credibility.

A carbon floor or associated contracts for difference is a policy measure that would certainly be effective at locking-in committments to a carbon price.Electricity price support would support electricity investment. Carbon price support would support low-carbon investment. It would specifically support carbon capture and storage (CCS) technology. There are advantages in both strategies.

Auctioning Permits?

The current proposal is to give contracts away to low-carbon investors, on the completion of plant. An alternative proposal would be to auction the permits on the open market. Although this would not specifically support low-carbon industries it would still be a beneficial move and would actually raise revenue for the government.

What level to support prices?

  • A low price floor would provide little direct support but would nevertheless reduce downside risks.
  • A high price floor would provide considerable direct subsidy.

It is recommended that the price floor for the current period should be slightly below the current price of electricity. This should be indexed according to general inflation.

A policy with value but with little cost

An electricity price floor at or below the current price of electricity would have a relatively low cost.

Who Wins?

  • Planet Earth (fewer greenhouse gas emissions)
  • Renewable Energy Industry (more secure energy price)
  • Nuclear Energy Industry (more secure energy price)
  • UK Consumers (more security of supply and lower long-term energy prices)
  • UK Industry (more security of supply and lower long-term energy prices)
  • Investors & Banks (more secure cashflows)
  • UK government/ UK as a whole (security over future investment, lower financing costs for long term investors)
  • Pensioners (long term, secure assets to invest in for pensions)

Who Loses?

Nobody loses out directly. The policy is equivalent to a trust-building measure. Since the measure enhances trust, this is a positive-sum game where all can win without anyone losing heavily.

Banks are not able to charge such high interest rates, but this is reflective of the lower risk of the investment.

The government would in theory have to pay out in the future should the price fall below the floor level. However, since the government will have control over carbon policy such an eventuality is unlikely.

An Extension

In order to further encourage investment quickly it would be possible to give away a limited number of higher price contracts for those who are first to produce electricity. This might include renewable energy on a large scale and the first-of series nuclear and first full-scale Carbon Capture and Storage plants. The price would be declining in cumulative installed capacity.

An environmentally friendly option would be to offer 6p/kWh for first 10GW capacity, 5p/kWh for next 20GW, 4p/kWh for next 70GW.

This policy, when combined with an immediate carbon tax of 4p/kg CO2= £40/tonne CO2 (Stern – which would raise the price of electricity by 2p/kWh) could be achieved without initial cash subsidy.

Summary

Probable Effects

There would be strong investment in all electricity generating capacity with low or moderate cost. The basic policy would encourage nuclear, onshore wind. The advanced policy would also encourage other forms of renewable generation and coal with carbon capture and storage.

Economic Justification

  • Corrects market underinvestment arguably associated with liberalised electricity markets
  • Corrects market underinvestment due to policy uncertainty
  • Corrects a market failure by filling a gap in the market for risk instruments
  • Reduces the financing rate for long-term electricity investment to closer to the social discounting rate without market hazard
  • Provides an extra policy tool to reduce carbon emissions

Political Justification

  • Reduces carbon emissions
  • Encourages investment and thus keeps the lights on
  • Creates a low carbon industry thus providing impetus for a higher carbon price in the future

Extension

  • Provides incentives for first movers
  • Rewards social advantages of first-of-build (cost information revelation, cost and time reduction)
  • Provides credible signal that policy might be less generous in the future, thus further encouraging rapid investment.

Conclusions

In order to encourage sufficient investment to decarbonise our energy system, we need to promote a more long-term framework for investors. This can be done by means of price risk mitigation for long term investors.