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UK energy policy: radical reforms needed

August 4th, 2010 by Pierre Noël, University of Cambridge

The UK energy and climate change policy is failing, and failing at a high cost. Electricity bills are going up as consumers are asked to pay for ever increasing subsidies to renewable energy, the deployment of which does nothing to reduce greenhouse gas emissions. The situation will get worse as other low-carbon technologies ask for, and obtain, specific subsidy schemes based on the argument that they, too, are ‘needed’ to de-carbonise the economy.
These patchworks of support mechanisms are destroying the electricity market, creating unmanageable uncertainty for non-subsidised investments. The claim that ‘the market cannot deliver’ is a self-fulfilling prophecy: ill thought-out interventions destroy economic mechanisms, leading to major uncertainty and underinvestment, leading to more intervention.

If the current policy mess is not quickly addressed, the most likely outcome is that the UK will have destroyed one of its most brilliant public policy successes of the past 25 years — the creation of competitive energy markets, envied across Europe and copied the world over — face much higher energy prices, enjoy a lower level of energy security and at the same time fail miserably on its green targets. The voters’ backlash could be severe.

Now is the time for reform. What the new coalition government needs most is intellectual clarity about how to pursue the long-term public interest — getting as much de-carbonisation as possible at the lowest possible cost to the economy. Only clear principles will allow ministers to resist special interests and negotiate effectively within the European Union.

1. We need a high, long-term, economy wide carbon price

We don’t know how to de-carbonise at reasonable cost. Even if we could do it with existing commercially viable technologies, we can’t; there is no way governments can pick the efficient mix. Because of how much we don’t know, we need a mechanism to reveal the efficient solutions over time. This mechanism has to be a high, long-term carbon price covering the entire economy.

The historical evidence on industrial revolutions and energy transitions is clear: radical changes in energy production and use are associated with radical changes in the relative prices. When historians look back at the attempt to decarbonise our economies they will trace our success (or otherwise) to our ability to make carbon-intensive energy more expensive over a long period of time. All sectors of the economy must respond to carbon prices. A basic rule of thumb is that if we exempt half of the sources of emissions we double the total cost of climate policy.

The lesson for the UK is clear: either we make the EU Emission Trading System (ETS) work or we have to implement a national carbon tax. The ETS should be extended to cover more sectors of the economy. Its time horizon should be lengthened from the current ten years to, say, 30 years. Allowances should be 100 per cent auctioned to strengthen incentives to respond to the carbon price. Finally, a floor to price should be introduced; the coalition’s proposal for a ‘carbon correction levy’ is a way to do this, which could be made more credible if the government were to sign contracts for differences on the carbon price.

Carbon pricing implies that we accept a significant degree of uncertainty regarding the path towards decarbonisation, and how it will be achieved. One of the striking characteristics of the current climate policy discourse and practice is that this uncertainty is not tolerated. But the certainty that investors need is not about the long-term numerical target for emissions reduction; it is the mid- to long-term carbon price on which to base today’s investment decisions. Governments have to redefine what being ambitious means: moving the 2050 emission target from minus 75 per cent to minus 80 per cent is futile in the absence of a credible commitment to appropriately high price carbon for the long-term.

Governments will not be judged on how ambitious their long-term targets looked like. The real challenge is to put in place credible policies that are based on acknowledging our ignorance, have a serious chance of delivering and will preserve public support for climate change policies.

2. We must reform the our renewable energy policy

The way we support renewable energy is unjustifiable. It is very expensive, ineffective and damaging to the flagship instrument of our climate change policy, the EU ETS. It must be reformed.

The only economically sensible basis for subsidising renewable energy above the carbon price is the so-called learning effect. These are immature technologies, the unit cost of which goes down with the growth of cumulative installed capacity. Eventually some of them will be competitive with conventional generation, with carbon appropriately priced. Renewable support schemes must ensure that support per energy unit is targeted on to earlier stage technologies. Technologies such as nuclear, tidal barrages and co-firing biomass, where we cannot expect significant learning benefits, do not deserve any support if carbon is appropriately priced.

The current Renewable Obligation mechanism is not fit for purpose. It is currently costing electricity consumers around £1.4bn a year and grossly under-delivers. It compares poorly with other schemes around the world. The arbitrary banding where different technologies can get multiple ROCs cannot be justified. What we need is a lower cost scheme which incorporates a rational basis for the level of annual subsidy based on the maturity of the technology. A rational support scheme should also include a mechanism to remove support to a technology if it becomes clear that the learning rate is too low.

We also want to sort out the linkage between the renewable energy targets and the EU ETS. Under the ETS ‘cap’ the penetration of renewables does not reduce carbon emissions at all; it depresses the carbon price, reducing the pressure on coal. Emissions are moved around, not reduced. We must ensure that higher amounts of renewable electricity actually reduce the total amount of emissions allowances.

Finally, we should renegotiate our unreasonably ambitious EU renewable energy target (15 per cent by 2020, against an actual 1.5 per cent in 2005). Mandating the most expensive way to reduce carbon emissions is a recipe for a public backlash against climate policies. The new government should offer Brussels a deal by which we agree to a more ambitious carbon emissions reduction target in return for a much lower renewable energy target.

3. Energy security is not a problem

The idea that the UK faces an imminent energy supply crunch, is at risk of gas supply disruptions or risks mortgaging its foreign policy autonomy because of increased dependence on Russian gas is not grounded in reality. Britain enjoys a high level of gas supply security and owes this to its enlightened policy of building a competitive gas market that is the envy of every other country in the EU. This market delivers both long-term and short-term gas supply security. In response to the rapid run down of UK gas production, investors have funded new international gas pipelines and LNG facilities that offer ample import capacity from diversified sources. In-depth studies recently released by DECC show that under almost no credible scenario could the UK be left without gas. Last winter, despite some of the coldest temperatures in 50 years and supply outages from Norway, the market easily met demand at very reasonable prices.
The British gas market works so well it has become Europe’s western gas corridor. The UK is now the preferred entry point for LNG into Europe; while terminals in Spain remained idle during the recession, traders happily exploited the liquidity of the British market and the option to trade with the continent through the gas interconnectors. Continental gas companies stuck into long-term, oil-indexed contracts with Gazprom brought their Russian imports to a minimum and turned to the UK for spot-priced gas. If Europe has benefited from the over-supplied LNG market over the past two years, it is largely thanks to the UK market.

In turn, this new status as Europe’s western gas corridor brings additional gas supply security to British families and businesses. It creates incentives to add not only new import capacity but new storage as well. The worst possible policy move would be to regulate the freedom to trade gas between Britain and the continent.

There is a short-run issue about electricity supply security in the run up to the implementation of the Large Combustion Plant Directive which will see a significant chunk of UK coal fired generation capacity close in 2016. The best solution to this (apart from negotiating sensible transitional arrangements with the EU) is to let the market respond by building the necessary gas-fired plants to meet the demand. Nine gigawatts are under construction or advanced planning; more may be needed. This will have the added benefit of increasing the amount of flexible gas generation on the system to back up increasing amounts of intermittent wind generation.

The UK has some difficult energy and climate policy challenges. Thankfully energy security is not one of them.

4. Talk is cheap, decarbonisation is not — the public deserve the truth

Even with the right policies (let alone the current ones) delivering the low carbon economy will not be cheap. Suggesting otherwise does no service to the public and increase the chance of a later backlash against the effort.
The Stern Review, using favourable assumptions, suggested that the cost might be one per cent of global GDP per annum. Even if that were a correct estimate for the UK, we should keep in mind that political parties fight elections about transfers of less than half of one percent of GDP. The new government’s cuts of £6bn in the fiscal deficit were of this order. In the recent past, leaders and governments have fallen on the back of unpopular (i.e. expensive) climate policies in Australia, Sweden, Norway and New Zealand; president Sarkozy of France had to remove his flagship proposal of a national carbon tax in the face of public outrage.

The costs of the UK energy and climate policy are increasingly difficult to conceal (though we do a good job of trying). They are currently at least £4.5bn a year and rising. We need to have a grown up public debate about how much the policy is costing and may cost in the future. We must sort out the obviously publicly indefensible aspects of the policy, such as the fact that our expensive renewable electricity policy does not actually reduce carbon dioxide emissions, to maintain the credibility of the whole effort. Credibility with the public underpins the credibility of the policy with investors. Changing public behaviour in ways that reduce carbon emissions requires the public to believe the policy works and is financially fair. Public support and response will be essential if we are to fully and cheaply exploit new smart enabled demand side reductions, the installation of microgen and the adoption of more efficient boilers and insulation.

Green jobs are a fallacy. There is no reason to think that any subsidy creates any net new jobs in the long run; they only shift jobs around the economy. Subsidies are even positively dangerous if they suck highly skilled employees out of non-subsidised sectors and shift them from more productive jobs into less productive ones. More than this, subsidies to renewable energy are substantial. If the offshore wind industry were to employ 80,000 in the UK and if the subsidy level were £2,000m per year, that would work out at £25,000 per job per year, significantly above the outturn cost of jobs supported by regional development agencies in the UK. A more realistic figure of the final subsidy cost per offshore wind job per annum in 2020 is likely to be several multiples of this. In addition it is unlikely we will see any take-off in exports due to the established position of foreign incumbents — it will be these incumbent firms that will benefit from the profits created.

5. Only the market can deliver

It is fashionable, but dangerous to suggest that markets can’t deliver. Lord Stern describes climate change as the largest market failure ever and he is right. That does not mean we should do away with energy markets. We are faced with a huge problem of extreme complexity, involving not just energy but also water and land use; a problem of such complexity can only be solved with the help of well functioning markets. The trouble is that the market failure is not addressed because of the governments’ failure to properly price carbon.

There is a temptation on the part of climate scientists and engineers to approach the climate change problem as an optimal control problem which immediately suggests that it is amenable to a centrally planned solution. As governments try to second-guess the right mix of supply- and demand-side responses, and which technology mix to choose on each side, companies put in place massive lobbying campaigns to convince politicians that their solution is ‘needed’ if we are to decarbonise.

However, we simply don’t know the extent to which we need each technology and their true cost. We don’t know if new, game changing technologies, processes and business models are about to emerge. There is no way the government can decide on the correct mix. This is why we must go back to the spirit of our technology-neutral, market-based energy policy and radically simplify our approach to carbon emissions. We need to properly price carbon, establish the value of subsidising renewable technologies and then let the market reveal the best mix of supply side technologies and demand side responses. Bypassing the market’s discovery process in the name of urgency is the recipe for a costly government failure.

Pierre Noel and Michael Pollitt, Judge Business School, University of Cambridge. Both are researchers at the ESRC Electricity Policy Research Group. Pollitt is an external economic advisor to Ofgem.

P.S. This paper was issued in Parliammentary Brief (July, 2010)

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2 Responses to “UK energy policy: radical reforms needed”

  1. Paul Hunt Says:

    @Pierre Noel,

    This is a timely and persuasive clarion call for sensible policy and forceful implementation. I expect you are aware that it is being echoed by a growing number of people. But, politically (when public faith in market mechanisms has been dented) and in terms of the economic cycle (when governments in the developed economies are being compelled to close huge fiscal deficits), governments will require a lot of convincing – even if they know it is the right thing to do. For them, politically, the easiest thing to do is make grand declarations about targets, devise a plethora of instruments and hope to muddle through.

    The case for shifting taxes from a ‘good’ – productive labour – to a rent-generating resource – property and land – and to a ‘bad’ – GHG emissions – was never more compelling, but it is in the DNA of deficit-burdened governments to seek out ‘stealth’ taxes that will help to close the deficit (plucking the goose with the least amount of hissing).

    And I would be a little less fulsome in my praise of Britain’s achievement in establishing competitive markets in electricity and gas. Some of the seeds of the current problems were sown in the development of the current arrangements. The liquid forward markets required to secure investment in long-lived, specific assets have proved elusive. Yes, major investments have taken place in gas pipeline and LNG supply infrastructure, but all have secured various degrees of exemption from TPA, because the necessary long-term commitments are not forthcoming from market participants .

    The Entry-Exit (E-E) approach in gas (applied to national markets) requires enormous layers of complexity before it even comes close to supporting prompt markets in gas – not to mind liquid forward markets. The complexity increases as it is rolled out in contiguous national markets through-out the EU. The contrast with the US gas market could not be more pronounced. I have argued for a modification of the E-E approach that would incorporate key features of the US approach:

    Something similar is required in electricity. We need to solve the existing problems in the electricity and gas markets before tackling de-carbonisation. Bolting a plethora of instruments on to poorly-functioning markets is a recipe for disaster – and that’s where the UK is headed – with the rest of the EU not far behind.

  2. Alice Taylor Says:

    The way we support renewable energy is unjustifiable. It is very expensive, ineffective and damaging to the flagship instrument of our climate change policy, the EU ETS. It must be reformed.

    I agree with this point. Something must be done as we are still now in this situation.

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