Memorandum submitted by Dieter Helm, New
College, Oxford
This memorandum focuses on three issues: the
supply/demand balance in the energy sector; the linkage between
security of supply, investment and the climate change objectives;
and the energy policy framework required to promote low carbon
technologies. In particular, the option of using carbon and capacity
markets rather than planning and "picking winners";
and the issues surrounding investments in new nuclear power stations
will be discussed.
1. THE SUPPLY/DEMAND
BALANCE IN
THE BRITISH
ENERGY MARKET
Investments in the energy sector typically comprise
long-lived, capital intensive assets, which require a complimentary
network system of storage, transmission and distribution. These
investments have particular dimensions of risk: that the investments
ex post may turn out to be stranded by subsequent technologies
(and hence are technically "sunk costs"); that others
make investments which lead to excess supply; and that networks
are not developed consistent with particular investments.
These private investment decisions will
not necessarily produce the necessary level of capacity: for the
economy as a whole, a surplus of plants is necessary in case demand
turns out to be higher than predicted, since electricity cannot
easily be stored, and demand must equal supply if the lights are
to stay on. A slightly over-invested energy sector is required,
since energy is complimentary to the rest of the economy.
The last major investment phase in the energy
sector took place in the 1970s: since the investment decisions
of the 1970s, no new coal stations have been built, only one new
nuclear power station has been added (Sizewell B), and investment
has focused on gas and to a very small extent, wind power. The
primary focus in the 1980s and 1990s was to sweat the existing
assets, rather than invest. Networks have similarly focused on
cost-cutting, utilising the gas and electricity networks, rather
than replacing and adding significantly to them (Helm 2004).
The net results have been, unsurprisingly, that:
— existing coal and nuclear power stations
are almost all old, based upon old technologies, with high maintenance
requirements and lower reliability (particularly in the nuclear
sector);
— the supply/demand gap has closed
considerably, with security of supply a real concern; and
— networks are much more efficiently
operated, but replacement investment has become an issue, and
there have been notable power cuts (in London and Birmingham).
These developments are not confined to Britain:
trends in most developed countries have been similar. The 1970s
were a period of worldwide investment in energy, spurred on by
the combination of the OPEC price shocks, and the then conventional
wisdom that a given economic growth rate required increases of
electricity growth growing at about twice this rate. Most developed
countries de-industrialised in the 1980s, significantly reducing
the growth of energy demand and improving energy to GDP ratios.
In 2003, there were major power cuts in the north-east US, Switzerland
and northern Italy, and Scandinavia. Interestingly, almost all
were the result of minor accidents, indicating the fragility of
networks.
There are additional reasons for concern about
the supply/demand balance, notably:
— the impact of the EU Large Combustion
Plant Directive (LCPD) requirements from 2008, and the resulting
constraints on coal plant;
— the impact of the EU Emissions Trading
Scheme (ETS) phase II national allocation plans for 2008-12 on
coal plant;
— performance problems with nuclear
plant, especially the AGRs
— the infrastructure investment in
the gas networks;
— the growing inter-dependency of gas
and electricity developments in continental Europe; and
— the impact of intermittent generation
on networks.
The British energy system is therefore at a
stage when a major investment programme is required. This offers
an opportunity to ensure that the replacement of existing assets
is with lower carbon technologies, rather than more fossil fuel-based
technologies, notably gas, which is the default option.
The policy framework is however designed with
more emphasis on sweating assets rather than investment. In particular:
— The British style RPI-X regulation
is focused on fixed (short) periods, with fixed prices, which
encourages the primary focus to be on cost minimisation;
— there are few incentives for longer-term
contracts to match investment horizons, and in particular neta
has not resulted in longer-term futures markets; and
— there is no capacity market to ensure
that the quantity of supply meets predicted demand in cold winters.
Therefore, irrespective of the climate
change issues, there are significant obstacles in the current
energy policy framework to timely investment, whether of high
or low carbon content. Reforms that are required are:
— a longer-term regulatory framework
for networks; and
— a capacity market to augment neta.
2. THE LINKAGE
BETWEEN SECURITY
OF SUPPLY,
INVESTMENT AND
CLIMATE CHANGE
OBJECTIVES
The government has ambitious climate change
objectives. Two of these are short-term, shorter than the time
horizon for substantial investment in new generation, and much
shorter than the time horizon for newer technologies. These are
the 2010 domestic target for a 20% reduction in emissions, since
1990, and the Kyoto target for a 12.5% reduction of greenhouse
gas emissions. Only the 2050 target of a 60% reduction in CO2
covers the R&D and investment horizons, but this is in doubt:
the private sector has no guarantee that after 2012 there will
be any binding targets. The absence of binding post-2012
targets undermines the future development of the EU ETS and creates
considerable uncertainty about the value of carbon savings over
the investment horizon.
It is sometimes argued that security of supply
and climate change policies are coextensive. This is incorrect:
security of supply requires investment incentives (and the capacity
market recommended above is part of the solution); carbon policy
requires carbon incentives (to which we return below). Although
some low carbon technologies improve security of supply,
some do not. The key point here is that there must be at least
as many instruments as targets or objectives: therefore, there
needs to be specific and separate instruments to deal with security
of supply and climate change.
3. THE ENERGY
POLICY FRAMEWORK
REQUIRED TO
PROMOTE LOW
CARBON TECHNOLOGIES
There are two stylised models for relevant to
designing energy policy to achieve environmental objectives. The
first is the one which has dominated energy policy in the twentieth
century. The state, either directly or indirectly, decides
which technologies are consistent with its objectives, and passes
the costs through to customers via some form of vertical integration
and rate of return regulation (with, in some contexts, state subsidies
and guarantees too). Nuclear and renewables have traditionally
been addressed in this way.
The second—twenty-first century—approach
has been to use markets to deliver the objectives, either by changing
prices for carbon or energy (the Climate Change Levy (CCL) and
fuel duty are examples) or choosing quantities (the UK and the
EU ETS).
The efficiency properties of these two models
are well-researched: the second market-based approach is overwhelmingly
better than "picking winners". In the latter category,
the scale of costs in the nuclear programme and for wind power
would not have been supported in a well-designed carbon market.
In practice, interventions tend to be hybrid,
and there is a tendency to reach for as many instruments as possible,
without due regard to the overlap between them and the overall
efficiency of the totality of the interventions. The Renewables
Obligation (RO) is an example of an ill thought out hybrid: the
government has, in effect, picked wind technology and defined
a market share for it (given the time period of the RO, few other
technologies can compete and be brought to market). The result
has been very expensive investment. Note too that the RO has no
place for existing non-CO2 technologies, like nuclear (and plant
life extensions), and draws a sharp line between zero CO2 and
any other low CO2 technologies.
By contrast, a price or quantity market-based
instrument makes no distinction between any technologies, and
there is a gradient of cost imposed on carbon-based technologies,
incentivising not just zero carbon technologies, but low versus
higher carbon-based technologies.
At present the primary market-based instrument
is emissions trading. The EU ETS is the most significant carbon
market in the world. The problems are however considerable, notably:
— the time horizon is very short,
and has virtually no overlap with the investment and the R&D
requirements;
— there is limited coverage of sectors;
and
— it relies on hard targets,
and there is no strong expectation in the market that there will
be binding, credible targets after 2012.
The CCL has limitations too:
— it is not a carbon tax,
— it is not set at a high level; and
— it is not comprehensive in its coverage.
Assuming that the EU ETS is the main plank of
a carbon policy, there are a number of steps which might assist
in developing low carbon technologies, in particular nuclear,
wind, clean coal and other options.
The core requirement is carbon contracts beyond
2012. These longer-term contracts will not emerge without government
intervention. The government could translate its own objectives
for CO2 reductions (the 2050 soft target) into a trajectory of
CO2 savings, and then issue contracts, which the private sector
could bid for. Competing technologies would then be tested, and
the resulting investments would be determined by their bids.
The advantages of this approach would be:
— the government would not have to
"pick winners"; and
— the savings in CO2 would be guaranteed
in that the winning bidders would have the liability to deliver.
Although the Treasury would have to underwrite
these contracts, its liabilities would be limited to the difference
between actual targets which eventually emerge, and the ex
ante aspirations. The Treasury would, in due course, be able
to offload its financial liabilities into this carbon market—as
the auctioning of carbon permits requires polluters to buy carbon
contracts. There would be other advantages too:
— a long-term carbon contract gives
the government a powerful incentive to promote the development
of the EU ETS and subsequent traded markets; and
— a long-term carbon contract helps
to stabilise the existing EU ETS and anchor expectations.
The total carbon offered for auction need not
add up to the total savings required to meet the objective. It
could be part of the total.
The carbon contract concept is set out in Helm
(2005) and developed in Helm and Hepburn (2005).
4. IMPLICATIONS
FOR RENEWABLES,
NUCLEAR AND
ENERGY EFFICIENCY
The-old style energy policy approach to nuclear,
renewables and energy efficiency is for the government to estimate
the costs of these technologies, construct its predicted supply
curve of technologies, and then promote the "winners"
it picks.
Thus the DTI, Defra and indeed Select Committees
try to find out what the costs of alternative technologies actually
are. This exercise was again carried out in the Performance and
Innovation Unit Report (PIU 2002) and in the Energy White Paper
(DTI 2003). Such exercises are typically of limited value, and
often encourage government to rely on their conclusions for policy
design. The reasons are:
— The costs are complex, and often
the domain is not defined (for example, whether wind includes
transmission, distribution and back-up costs);
— The costs are strategic to
the providers—hence the wind and nuclear lobbies both have
incentives to understate the costs and over-state the benefits;
— Past evidence—on wind, nuclear
and energy efficiency—suggest considerable appraisal optimism;
and
— Government institutions themselves
have policy-bias incentives.
In the case of particular technologies, it is
important to disaggregate the components of costs and risks. Only
the carbon component of the project costs and risks are relevant
to a carbon policy.
Take a new nuclear project as an example. The
project can be disaggregated into the following contractual structure:
— The site (a land rental contract)
— The construction of the plant (a
nuclear plant contract)
— Plant performance (a performance
contract)
— Sales of electricity (a set of long-term
contracts, then disaggregated in the secondary market)
— Fuel supply (a fuel supply contract)
— Waste and decommissioning (a "pension
fund" and an NDA contract)
— Carbon benefits (a carbon contract).
Considered in this disaggregated way, only the
last two items depend on the government to a considerable degree.
None of the other components need to be estimated by the government—they
are market-determined.
A similar disaggregation applies to wind power
and energy efficiency.
The implications of this approach are quite
radical:
— A low carbon energy policy framework
should focus on carbon markets;
— A review of nuclear power should
not attempt to estimate its costs, but rather on the amount of
carbon to be saved and its value;
— There is no need for technology-based
obligations, like the RO, and before it the NFFO;
— There is no need for the Treasury
or customers to underwrite the full project costs of wind, nuclear
or other technologies, but only the carbon savings;
— The climate change and security of
supply objectives can be jointly met though a carbon contracts
market and a capacity market.
5. CONCLUSIONS
AND RECOMMENDATIONS
The conclusions are:
— The current British energy policy
framework is largely focused on asset sweating, with regulation
focusing on short-term cost cutting and with neta encouraging
short-term contracting.
— The energy sector is entering into
a major replacement cycle in power generation and networks, providing
an opportunity to move into less carbon-intensive assets.
— There are a host of competing technologies,
which offer carbon savings, all surrounded by lobbies and vested
interests.
— There are two clear models for energy
policy going forward—old style "picking winners",
and market-based approaches.
— Market-based approaches have major
efficiency advantages over "picking winners" and the
latter has been historically remarkably unsuccessful.
— There needs to be at least as many
instruments as targets.
— There is no need under the market-based
approach for government to estimate the full costs of alternative
technologies.
It is recommended that:
— the investment and security of supply
incentives are addressed through the development of a capacity
market;
— the carbon incentives are addressed
through longer-term carbon targets and markets;
and that:
— attempts by government to estimate
the costs of different technologies are abandoned.
References:
DTI (2003) Our energy future—creating a low
carbon economy. Energy White Paper.
Helm, D R (2004) Energy, the State and the Market:
British energy policy since 1979. Revised Edition. Oxford University
Press.
Helm, D R (2005) Commentary: Carbon contracts. www.dieterhelm.co.uk.
Helm, D R & Hepburn, C (2005) Carbon contracts
and energy policy. Mimeo
PIU (2002) The Energy Review. Cabinet Office.
25 September 2005
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