The ‘Gold Standard’ market reform project has identified two key questions that need to be addressed when considering a market reform:
1. What market outcomes do we wish to determine – what level and over what timescales?
2. How does the Government ensure that these outcomes are delivered – who is responsible and what is the associated regulatory and governance framework?
The particular challenge that market reform needs to address is to attract significant levels of investment in certain technologies and to do so in a way that reduces overall costs. Financing costs will represent a large proportion of overall costs and, therefore, rebalancing risks between investors and customers should be the core objective of market reform. Investment risks will be most effectively reduced by ensuring that a long term market opportunity is available for the chosen technologies that cannot be competed-away by other technologies.
The challenge for renewables policy is to create a long term secure market opportunity for renewables, either for all potential technologies or a subset thereof, and to clarify the regulatory and governance framework which ensures this is delivered. In particular, it is important to recognise that supply chain investment has a market time horizon beyond one decade and, therefore, this market opportunity should be defined well beyond 2020.
The current RO arrangements do not fulfil these requirements:
There is no clear long term volume target for renewables in the power sector, although most people believe that the Government currently aspires to ensure around 30% of the market is delivered from renewable sources by 2020.
Delivery responsibilities and governance are not well defined. Despite the RO being an obligation on suppliers, the ability to use the buy-out mechanism does not create a responsibility for delivery. It is therefore assumed that the Government will use its powers to periodically adjust RO banding levels to meet volume aspirations.
The Government needs to clarify the outcomes it is trying to achieve and then ensure that there is a well designed delivery mechanism to achieve these outcomes. The choice between the RO and FITs should therefore be viewed as part of a process to ensure an optimally designed delivery mechanism to hit specified renewable generation targets. However, it must be emphasised that the establishment of these targets represents the cornerstone of renewable policy.
RO vs FIT
There is now extensive international evidence to inform the detailed design for renewable support mechanisms. The Government undertook a comparative analysis of renewable generation support mechanisms policies in 2008 . This report identified the key issues associated with a move from an RO to FITs:
1. Hiatus: There is a risk that changing the renewables support scheme would lead to a temporary pause in investment as investors understand and assess the new arrangements
2. Grandfathering: It is not possible to continue to operate the RO alongside a FIT scheme such that future revenues of historic investments remain unaffected. The simplest solution is therefore to transfer existing projects onto new FITs such that their revenues remain broadly as expected. It is likely that there will be a cost associated with this transition.
3. Market arrangements: FITs formalise the role of a central delivery agency charged with meeting Government targets. This agency will effectively buy all renewable output and then need to resell this to the market such that market participants can manage wholesale price exposure. This is likely to involve a series of auctions at various forward timescales.
4. Welfare allocation: A vintaged FIT scheme allows tariffs to be regularly adjusted such that they closely track renewable costs, thereby minimising the impact on consumer prices. FITs will not be able to perfectly track costs and, where projects are large and technically immature, there may be advantages in running auctions to aid cost discovery. RO bands, on the other hand, cannot be changed regularly and this significantly increases the likelihood that either investment will be insufficiently incentivised or renewable generators will receive significant welfare rents.
5. Financing costs: FITs remove future commodity price risk from renewable projects and, thereby, stabilise future revenue schemes. This can have a significant impact in reducing overall financing costs.
It is not possible to accurately quantify all of these effects. However, the previous work commissioned by the Government suggested a clear and systematic saving in both resource costs and consumer prices associated with a move to a system of FITs.
It is extremely difficult to imagine the RO system remaining politically robust far into the future, as volumes of renewable generation become significant, given the welfare allocation problem described above. However, a change to a well-designed FIT system is a major undertaking and will require significant political energy and regulatory effort to deliver the change. The longer it is left before a change is made, the more difficult it will become and the smaller the benefits that will be derived. This suggests that it is important that the change is made as soon as possible and certainly as part of the current package of market reform.