Briefings

Risk management, credible options and the future of European renewables policy

Share
Risk management, credible options and the future of European renewables policy

All long-term scenarios for Europe’s energy system involve considerable risks: the wrong decisions could jeopardise climate and energy security, damage human health and the environment, or lead to unacceptable costs for consumers. Recent events – including the sharp rises in fossil fuel prices accompanying the Arab spring, the nuclear crisis at Fukushima and the Deepwater Horizon oil spill – underline the profound unpredictability of future energy developments. At the same time, the opportunities associated with technological breakthroughs, such as distributed generation or thin film solar, could transform future energy outcomes.

When costs and potentials are not yet fully known, there is value in holding options open, to create a ‘policy hedge’ against future uncertainty. The European Union’s renewable energy policy has quickly become a key element of Europe’s strategy for managing the risks to the European economy associated with climate change and fossil fuel price swings. Though sometimes controversial, targets and subsidy mechanisms have served to drive development and deployment of key power technologies and widen the range of options available to deal with the challenges facing European energy systems. However, Europe is rapidly approaching the point where it must decide which potential energy pathways will be kept open and which will be foreclosed.

Renewables policy as risk management

The EU first adopted policies on renewable energy following the oil shocks of the 1970s. Since then, renewable energy policies have become increasingly sophisticated. All member-states now have financial support mechanisms in place, and the EU’s ‘renewable energy directive’, adopted in 2009, for the first time sets a binding target for 20 per cent of energy consumption to come from renewable sources by 2020. These policies have played two important roles.

First, renewables deployment has created an important buffer against the risk that the volatility of fossil fuel prices poses to Europe’s economy. Europe currently imports half of its primary energy and this figure is rising. Declining indigenous resources, combined with oil-linked pricing in the majority of Europe’s gas supply contracts, makes Europe increasingly vulnerable to shifts in international fossil fuel prices – often driven by political, economic and geological uncertainties over which Europe has little foresight or control.

When the 20 per cent renewables target was proposed in 2007, it was estimated that the policies to achieve it would add $26 billion per year to the cost of electricity by 2020 – under the baseline assumption of an average oil price of $48 a barrel.(See note 1 below) If the oil price averaged $78/bbl (the highest considered in the study), costs would drop to $0.2 billion per year. This suggests that if oil prices persist at current levels well above $100/bbl, the renewables targets may lead to net savings even without accounting for the carbon benefits.

The importance of this fuel price buffer is set to grow as Europe becomes more import-dependent and fossil fuel prices become more volatile. Analysis for the European Climate Foundation found that low-carbon technology pathways (involving significant levels of renewables) would prevent the loss of $300 billion in GDP in the event of a fossil fuel price spike lasting three years from 2020.(See note 2 below)

Second, renewables policies have allowed EU countries to gain experience of how low-carbon technologies operate at larger scale. From a very low base, renewable energy consumption has doubled in the last decade and, according to national plans, is on course to nearly double again by 2020 in order to meet the 20 per cent target.

Key technologies have moved from being theoretical possibilities to realistic options for the decarbonisation of Europe’s energy mix. As new technologies are deployed more widely, there is more solid evidence of their potentials and performance. In many cases the costs of technologies have also fallen. According to the European Commission, the costs of producing electricity from wind power have declined by 20 per cent over the nine years to 2006 and those of solar photovoltaic power by 57 per cent.(See note 3 below) Costs are expected to fall considerably further as installed capacity increases.

The experience generated by current policies has also made it easier to foresee the risks facing renewable energy in future. For example, the case of Spain shows that overly generous subsidies for certain technologies can create investment bubbles. These can just as quickly burst if policy is then changed and applied retroactively, as was the case in Spain where subsidies for already installed photovoltaic cells were cut considerably. The lesson is that drastic policy changes can damage the prospects for the whole sector. Another interesting example is the development of offshore wind farms in the UK. Large cost reductions were expected from installing such significant volumes of renewables. But experience showed that these cost reductions are difficult to predict far in advance and depend on a range of external factors, such as fluctuating exchange rates, the costs of steel and cement or the availability of cranes and ships.Greater understanding of these conditions will make risks easier to manage, but cannot remove them entirely.

The decision juncture

At low rates of penetration, renewable technologies can be incorporated into existing fossil based energy systems relatively easily. Existing grids can cope with the power flows; conventional generation can be ramped up or down to respond to intermittency. The key policies to facilitate the spread of renewables are subsidies for research and development and financial incentives for deployment.

To enable a move towards higher levels of renewables usage, however, the key policy challenge becomes one of adjusting the energy system as a whole rather than simply paying subsidies. Sufficient investment is unlikely to be forthcoming without confidence in the volume of future market opportunities; this in turn requires energy infrastructures, markets and longer-term policy frameworks conducive to renewable development. Europe faces key decisions in each of these areas over the next few years.

A strategic approach to infrastructure

The majority of existing power grids were built in an era in which electricity systems were predominately national, power generation was sited relatively close to the points of consumption, and power flows were uni-directional and more predictable. If the proportion of renewable electricity is to increase significantly, these conditions are unlikely to hold. Most of Europe’s large-scale renewable energy resources are located at its periphery (including wind and wave power in the northern seas and solar power around the Mediterranean), away from centres of consumption. Making best use of this potential will require greater volumes of electricity crossing national borders.

It is availability rather than demand that largely determines the use of renewables: turbines only turn when the wind is blowing. When such technologies represent a higher proportion of generation, supply and demand must be balanced either across larger geographical areas (the ‘super grid’ approach) or through using new grid technologies to shift generation and consumption profiles (the ‘smart grid’). Both options may offer associated benefits beyond renewables integration. Smart grids increase reliability and efficiency, and allow consumers to have greater control over their energy use. A super-grid could drive European market integration and increase security of supply.

However, such new grids will only be built if the EU adopts a more forward looking approach to planning and investment. Traditionally, investments in grids have followed the building of power plants and other generation, even though power lines take significantly longer to build than, say, wind turbines. This sequencing creates a vicious circle: delays in grid connection can undermine investment in new renewable generation; yet without the investment in new generation, the required grids will not be built. In Scotland for example, over 9 gigawatts (GW) of renewables is currently waiting for grid connection and much of this has a connection date later than 2018. (See note 4 below) This circle can only be broken if grid planning becomes anticipatory rather than solely reacting to where generation is already under construction, and regulators and transmission operators accept the risk that some lines will be under-utilised until new generation is built.

Some degree of predictability is provided by the new ‘ten year network development plan’ of the European Network of Transmission System Operators (ENTSO-E). The plan is an important starting point for providing more certainty for grid development. However, the current plan is insufficiently aligned with European decarbonisation goals and remains a collection of predominantly national plans. For future iterations, ENTSO-E must be empowered to address longer time horizons (say, 20 years rather than ten) and to push forward long-term transformational projects that could unlock significant volumes of low-carbon investments such as a North Sea grid for offshore wind or a Mediterranean grid for linking large-scale solar generation.

Public investment must support the construction of these strategically important networks where existing funding mechanisms are insufficient. The majority of new lines are expected to be funded on a regulated tariff basis, whereby the investment costs are repaid through tariff revenue over time. But public financing mechanisms will need to be employed to lower the cost of capital, to fund projects that are innovative or difficult (for example, offshore hubs for connecting wind farms) or where a project has strategic importance for energy security or decarbonisation.

Under the ‘energy infrastructure package’, the European Commission is currently developing proposals for infrastructure finance, including insuring project bonds via the European Investment Bank. However the European Council conclusions from February 4th 2011 appeared to prioritise infrastructure designed to meet security of supply and solidarity concerns. The package must be expanded to include the key investments that ensure Europe is able to meet its climate change trajectories.

Reoriented power markets

Current power market arrangements are designed to drive competition mainly among conventional power plants running on gas and coal. Wholesale electricity prices tend to be based on short-run operational costs and are largely driven by changes in fossil fuel prices. Most renewable power generation, by contrast, has high upfront capital costs but low ongoing operational costs. As the proportion of renewable generation within the electricity market increases, wholesale power prices tend to fall, and it becomes increasingly difficult for any investments to earn back their fixed cost.

In several EU member-states, these challenges have led to calls for electricity market reform, including the introduction of ‘capacity payments’ (mechanisms to remunerate the provision of back up capacity rather than electricity sold) to cover fixed costs as well as operational costs. Unless a co-ordinated approach is taken, however, these proposals may sit uneasily alongside the goal of European power market integration, as Georg Zachmann explains elsewhere in this report.

The underlying issue behind these dilemmas is the deep uncertainty about how future power markets will operate, and the barriers this uncertainty places on investments in both renewable and conventional generation. To answer both the investment and the integration challenge, European governments will need to develop power market arrangements capable of limiting costs to consumers, managing risks during the low-carbon transition and enabling the emergence of a single European market. An extension of the status quo would fail on each of these counts.

A believable story about the future

The final criteria needed to ensure the high renewables pathway remains a credible option is a more believable narrative about the future of European energy policies. As currently framed, European renewables policy effectively ends in 2020, a mere nine years away. Post-2020, there are no further renewables targets and no binding decarbonisation targets other than a general ambition to achieve 80-95 per cent carbon reductions by 2050 if other countries take similar action. However, the significant levels of investments in long-lived renewables manufacturing and installation capacity needed to deliver the 2020 targets (for example, the testing facilities, factories and ships needed for offshore wind) is unlikely to materialise without greater certainty over what will happen to renewables policy after the 2020 target date.

The European Commission is set to produce a ‘2050 roadmap’ for energy later in 2011, following on from the roadmap for a low- carbon economy published in March. The roadmap is an opportunity to limit this uncertainty and ensure that the high renewables option remains viable. This implies establishing a clear date by which the power sector must be decarbonised; developing new renewables targets for the 2025 or 2030 time horizon; or pushing forward plant-based emissions performance standards to ensure that more polluting coal or gas-fired power plants cannot crowd out cleaner energy from renewable sources.

From subsidies to systemic change

Like all evolving technologies, those needed for the use of renewable energy sources entail risks and uncertainty. The financial support schemes that EU governments have put in place for renewables represent a strategic investment to expand available options by driving forward technological development and accumulating experience on risk and costs.

Keeping the high renewables option open,[2] however, will require a widening of the debate from subsidising the use of wind and solar to adjusting the entire energy system to the widespread use of renewables. Investors in technologies and supply chains will require greater clarity on how big future demand for renewables will be. They need confidence that Europe’s energy infrastructure will be up to the task, that market arrangements will work efficiently and that policy frameworks will deliver the required decarbonisation trajectory. This requires the EU and its member-states to institute a more strategic approach to infrastructure planning, to reform electricity markets and to adopt longer-term carbon and renewables targets. Unless these decisions are taken quickly, the option of a high renewables pathway to a low-carbon energy system will be effectively foreclosed.

Notes

1. Fraunhofer ISI, EEG and ECOFYS, ‘Economic analysis of reaching a 20 per cent share of renewable energy sources in 2020’, August 2006.

2. European Climate Foundation, ‘Roadmap 2050: A practical guide to a prosperous, low-carbon Europe’, 2010.

3. European Commission, ‘Renewable energy: Progressing towards the 2020 target’, January 2011.

4. House of Commons energy and climate change committee, ‘The future of Britain’s electricity networks’, second report of session 2009-10.

5. The UK’s committee on climate change has proposed that power sector emissions should be no greater than 50g CO2/kWh by 2030.

This article was written for the latest Centre for European Reform report entitled: GREEN, SAFE, CHEAP: Where next for EU energy policy?

Related