House of Commons - Energy subsidies - Environmental Audit Committee

Energy subsidies - Environmental Audit Committee Contents

3 The rationale for energy subsidies: supporting infant and low-carbon industries

30. Energy subsidies are often used as a means of promoting 'infant industries' (paragraph 12), and in particular renewable energy technologies. In this Part we examine two aspects: the UK's support for particular energies overseas, and the Government's support for renewables and other specific industries within the UK.

Subsidies, overseas aid and export support

31. In our 2011 report on Overseas Aid, we criticised DfID support for World Bank aid programmes which supported fossil fuel projects.[66] In our current inquiry, DfID informed us that the World Bank's approach to energy lending is now guided by its July 2013 Toward a Sustainable Energy Future for All: Directions for the World Bank Group's Energy Sector document, which allows "financial support for greenfield coal power generation projects only in rare circumstances. Considerations such as meeting basic energy needs in countries with no feasible alternatives to coal and a lack of financing for coal power would define such rare cases."[67] The Government's recent announcement about ending support for coal power plants abroad was couched in similar terms.[68]

32. The aid programmes of developed counties, sometimes involving renewable energy projects, may provide assistance for countries which are at the same time subsiding fossil fuels. Globally, fossil fuel subsidies are at least five times higher than the $100bn pledged to be made available in climate change finance at the 2009 UN Copenhagen climate change conference.[69] Shelagh Whitley of ODI identified five countries (China, Egypt, India, Indonesia and Mexico) which were among both the biggest recipients of climate finance and the biggest providers of fossil fuel subsidies to their consumers.[70] DfID told us, however, that the Government does not make the UK aid programme conditional on an absence of fossil fuel subsidies:

There is not a direct correlation between our support for climate finance and whether or not a country has fossil fuel subsidies or not. Having said that, all the programmes that we do support are to do with enhancing access for the poor and are based exclusively on renewables and other forms of non-carbon related energy. ... it is a series of programmes that are about carrot to help countries to work out how best to remove fossil fuel subsidies rather than stick in the sense of seeking to condition aid or support in some way to compel them to do so.

We make the assessment on the merits of the proposal for support and whether or not that meets the country's own stated objectives to decarbonise or seek a lower carbon, more climate resilient pathway. We do not ... make a linkage in any specific way to whether or not that country has fossil fuel subsidies.

When applications are made for support through our bilateral programmes and those we support through the World Bank then, yes, we do look at the programme as a whole to see whether or not that makes sense and whether or not it is indicative of a country making a serious attempt to move towards a lower carbon, more climate resilient development pathway. There is not, however, any explicit benchmark or algorithm that takes into account the fossil fuel subsidies or the extent of those which then conditions whether or not we provide that support.[71]

33. Our witnesses from Global Subsidies Initiative and Overseas Development Institute did not favour overseas aid being blocked when potential recipient countries had fossil fuel subsidies. Some subsidy might be justified where it is targeted at the poorest, rather than as blanket support.[72] Shelagh Whitley of ODI wanted greater transparency on where potential overseas aid is going to countries with fossil fuel subsidies, to help reduce cases which "are working full-time against you".[73]

34. In our 2011 Overseas Aid report we also criticised UK Export Finance's lack of support specifically for renewables rather than fossil fuel export projects.[74] The OECD and IEA regard export guarantees as subsidies.[75] Platform highlighted UKEF's support for oil and gas contracts in Nigeria, Russia, Urals and Brazil; and diplomatic and military support for Nigeria, Iraq and Russia, which they labelled as subsidy.[76] (UKEF provided us with a list of 'energy' exports and projects supported over the last 5 years.[77]) Oil and Gas UK, on the other hand, highlighted that UKEF are a net contributor to the Treasury.[78]

35. The Energy Minister told us that the Export Investment Guarantees Act 1991 does not allow UK Export Finance to discriminate in its support between different classes or types of export: "It would be unlawful for the Secretary of State simply to declare a blanket ban on certain types of investment. ... I think the objective is the right one, but we are constrained by the existing legislation."[79] David Godfrey, the UK Export Finance chief executive, assured us that a lack of green projects supported by the organisation was not the product of any discrimination on its part. The countries to which such technology is exported, he suggested, do not tend to require export support.[80] He highlighted that the OECD Common Approaches guidance, which the UK follows, requires export projects to be assessed in terms of their social and human rights, but also their environmental, impacts.[81] The Government's 2010 announced prohibition on supporting exports of 'dirty' fossil fuel technology[82] is defined in terms of meeting World Bank standards.[83]

36. DfID should make, and publish, an assessment that compares its aid expenditures and the extent of fossil fuel subsidies for each aid-recipient country, and UK Export Finance should similarly provide a comparative analysis of export finance support and fossil fuel subsidies. DfID should then include these analyses in a revision of its Environment Strategy, along with the two departments' assessment of why continued aid and export support in each case overrides the need for eliminating fossil fuel subsidies in those countries.

Renewables and the need for time limited subsidies

37. The main subsidy for large-scale renewable energy sources in the UK is currently the Renewables Obligation scheme which requires suppliers to provide a certain proportion of their electricity from approved renewable sources. Small scale generators receive a fixed price feed-in tariff for their generation. As a result of the Government's recent electricity market reform, large scale renewable and non-renewable generation below a certain carbon intensity will instead receive an overall reward for electricity generation based on a contract for difference that will provide variable payments, representing the difference between an agreed 'strike price' and an average 'reference' price representing what would otherwise be obtained by selling electricity at market rates. If the reference price exceeds the strike' price, the difference will be repaid by the generator. The strike price and the length of the contract will vary according to the type of energy technology.

38. While such renewables subsidies form part of a move to increase the proportion of energy from renewable sources and contribute to EU and national emissions reductions, the Government is resisting European proposals to increase the renewables targets. In our recent report on carbon budgets, we noted how the EU has agreed to raise its 2020 20% emissions reduction target to 30% if other developed countries and the more advanced developing nations pledged comparable emission reductions.[84] As we reported in October 2013,[85] the European Commission has been consulting on a 2030 Framework for Climate and Energy Policies, intending to publish at the end of 2013 new targets for 2030.[86] The Government wants the EU to adopt a 50% emissions reduction target for 2030 in the context of a global deal, or 40% without a deal, but it did not support a proposal for a separate EU renewable energy target because it believed that that would compromise member states' flexibility over how they secured a least-cost decarbonisation.[87]

39. Renewable UK believed that until there is a "correct" carbon price, subsidies to many renewable technologies will remain "necessary and indeed desirable".[88] However, different technologies, they told us, needed to be supported for different timescales:

For the time being, subsidies [for Renewables] remain essential, however our members are determined to reduce costs to a point where, in a market underpinned by a strong carbon price, no subsidy is required. However, it is important to understand that the varying technologies will achieve this on different time horizons.[89]

Subsidies for renewable technologies could potentially become harmful if these where pursued indefinitely and did not change to reflect the dynamics of the market. This is exactly what happened with feed-in-tariff for roof mounted PV systems in 2010 .[90]

40. Shelagh Whitley of ODI emphasised the importance of building-in processes to limit the duration of all types of subsidies:

What seems to be missing for existing subsidies and how they are structured is around this question of monitoring and reporting and around the question of exit and failure. I do not know ... what are the best ways to put in place sunset clauses, but planning for an exit, planning for flexibility, planning for modification, building that around a system where you have monitoring and reporting so that you can make decisions around milestones seems to make a lot of sense.[91]

Alan Simpson emphasised that "subsidies should be treated as transitional mechanisms rather than permanent support, addressing market defects and moving the energy market from its current structure towards the energy systems that will replace it."[92]

41. DECC calculate 'levelised costs' for each energy sector, representing the ratio of the costs of a generic power plant in that sector to the amount of electricity expected to be generated by it.[93] DECC expected the levelised costs of onshore and offshore wind and solar PV energy generation to fall, as "reflected in the proposed strike prices for such technologies", and that "we might expect some projects within these technologies to reach parity with wholesale electricity prices in the latter half of this decade or 2020s."[94] The Energy Minister noted that costs were falling for solar power and that:

we might have to ask why there should be any kind of supported strike price for it after the current levy control framework period. Almost all of [renewables], with the exception of biomass and energy from waste, show the prices digressing over the period of the levy control framework.[95]

42. Renewables energy has an important part to play in delivering the UK's emissions reduction targets, and allowing the UK to play a full role in tackling climate change. Subsidies for renewables are, in turn, an essential lever to provide certainty to industry and drive investment in those technologies. While the Government has a helpfully positive view on the need to increase the level of emissions reduction ambition in the EU, it should rethink its hostility to a separate continued target for the deployment of renewables. Even without such a continued EU target, however, the Government should be ready to fully use the scope for renewables subsidies to help meet our climate change obligations.

New nuclear

43. On 21 October 2013, the Government announced the parameters of a deal with EDF for the construction and operation of a new nuclear plant at Hinkley Point in Somerset, including the £92.50/KWh contract for difference charge for the electricity it would provide.[96]

44. Back in February 2013, the Secretary of State for Energy and Climate Change told the House:

... Under [the Electricity Market Reform], ... new nuclear will receive no levy, direct payment or market support for electricity supplied or capacity provided, unless similar support is also made available more widely to other types of generation. By similar, we do not mean the same. Whether similar support is being provided must take account of the material circumstances. It is not a mechanical exercise; it is a matter of sensible judgment. It is obvious that the characteristics of a small onshore wind farm are very different from those of a large offshore wind farm and, indeed, those of a nuclear plant. ... These different characteristics are likely to require differences in the support provided under our electricity market reform.

... It is right that new nuclear power will be entitled to benefit from Energy Bill measures such as contracts for difference and investment contracts. ...

... I do not think that what is needed is a line-by-line comparison of the terms of each contract. That is not what our policy says or requires. In fact, there are likely to be variations in CFD designs between one technology and another, and perhaps also between different projects within the same technology. What is important is that the terms agreed deliver a similar result across technologies and projects, and that they result in a proper allocation of risk. In addition, each contract will need to deliver value for money for the consumer and be compatible with state-aid rules. A contract with a nuclear developer that does those things would be compatible with our no-subsidy policy.[97]

Accordingly, DECC and the Treasury told us that:

new nuclear will receive no levy, direct payment or market support for electricity supplied or capacity provided, unless similar support is also made available more widely to other types of generation. New nuclear power will benefit from any general measures that are in place or may be introduced as part of wider reform of the electricity market to encourage investment in low-carbon generation. This is about creating a level playing field for all forms of generation, not subsidising nuclear.[98]

45. Dr William Blyth had a different view. He told us, before the Hinkley Point announcement, that the contact for difference would constitute a subsidy:

not only because of the raised price compared to market levels, but also because long-term fixed price contracts with reliable counterparties allow companies to borrow money at lower interest rates—a particularly important factor for capital intensive projects like nuclear plant.

It is likely that in the early years of operation, this market price support will constitute a substantial subsidy compared to the cost of the cheapest alternative (i.e. gas-fired plant), but in the long run, the subsidy element is not so clear.[99]

46. When we questioned the Energy Minister on 30 October about the Hinkley Point deal, he maintained that the project would not represent subsidy as defined by the Government, nor even that it would be subsidised on "similar" terms to the subsidies available to other energy sectors. Instead, the Government would provide the contractor with a "support mechanism"[100]

These are market based support mechanisms designed to facilitate the earlier introduction of high cost low carbon technologies that the market would not otherwise have been able to finance as quickly as we need them.[101]

The deal will now be scrutinised by the European Commission for potential state aid implications (paragraph 9).

47. The energy minister told the House on 23 October that:

... The Energy Act 2008 requires operators of new nuclear power stations to have arrangements in place, before construction begins, to meet the full costs of decommissioning and their full share of waste management and disposal costs.[102]

The cost of decommissioning, DECC told us, would not be subsidised by the Government because "the intention is that the decommissioning arrangements will completely fund all the waste that is created by that plant", for "the lifetime of the plant in terms of operation and decommissioning"—"the entire cost of decommissioning the reactor and dealing with the waste".[103] The Secretary of State told the House that the clean-up fund to pay for eventual decommissioning and a share of the waste management costs would account for around £2 of the strike price.[104]

48. The Energy Minister also stated on 23 October that:

... The waste contract will, at the outset, set a cap on the level of the waste transfer price ... The cap will be set at a level that reflects the Government's current analysis of risk and uncertainty around waste disposal costs and gives a very high level of confidence that actual cost will not exceed the cap. The Government accepts that, in setting a cap, the residual risk that actual cost might exceed the cap is being borne by the Government. Therefore the Government will charge the operator an appropriate risk fee for this risk transfer.[105]

Similarly, there will be a £1.2bn cap on the nuclear incident liability which, the Minister told us, was also not a subsidy because the developer will be charged a "risk fee" on "commercial terms" for the Government still having a residual liability. This arrangement, the Minister told us, was an "insurance policy" rather than a subsidy.[106]

49. The duration of the payments under the contract for difference for Hinkley Point will be 35 years, or 60% of its 60-year expected operating life. That, the Secretary of State told the House, would be "proportionally similar to the length of the [contracts for difference] that are being offered to most renewable technologies".[107] Gordon Edge of Renewable UK had a different view:

Government is taking a much longer term view of the nuclear side than it is for renewables. [Renewables] are being given some foresight at 2020 but they are signing deals for nuclear for 2023 and potentially beyond. So we think that is a bit of a mismatch in terms of commitment to the different sectors and we would like to see much more commitment to our sectors beyond 2020 in order to have parity.[108]

50. Although the scale and duration of the Hinkley Point project was "qualitatively different", the Minister told us, overall the support was "similar" to that provided for other energy sectors.[109] The Secretary of State said that "the price agreed for the electricity is competitive with the projected costs for other plants commissioning in the 2020s, not just with other low-carbon alternatives, but also with unabated gas".[110]

51. The Hinkley Point C deal will be scrutinised by the European Commission for state aid implications. It makes no sense to claim that a subsidy applicable to more than one technology therefore does not constitute a subsidy. It is already clear that new nuclear is being subsidised. The contractor for Hinkley Point will be able to use the guaranteed strike price for the electricity generated to raise capital at lower cost. It is debateable which of the various other Government-termed 'support mechanisms' and 'insurance policies' also constitute subsidy. Even in terms of the Government's 'similarity' definition of 'no public subsidy for new nuclear', there are aspects of support which are not 'similar' to that provided for other types of energy, notably on decommissioning and waste.

Contracts for difference and capacity payments

52. The regime established by the electricity market reform envisages a strike price (paragraph 37) and 'contracts for difference' for electricity produced by low carbon generators, alongside a 'capacity market' to provide guaranteed incentives for the construction of fossil fuel plants to bidders for electricity supply contracts. The Government's intention for the former is to move to a "technology-neutral competitive process as soon as reasonably practicable", with ultimately no need to issue contracts for difference: but in the meantime, with technologies at different rates of development, this would be "preceded by a technology differentiated competitive process".[111] The difference between the strike price and the reference price in the proposed electricity market system (paragraph 37) points to an inevitable but variable subsidy—the price the generator receives in excess of the prevailing market price—complicated only by the theoretical possibility that generators may have to pay back that 'subsidy' if the reference price exceeds the strike price. Renewable UK were content to acknowledge that the contacts for difference strike prices for renewables were subsidies.[112] Dr Blyth told us that for new nuclear whether the strike price represented subsidy would only be established with the passage of time.[113] There is no reason to believe, however, that the relationship of the reference price to the strike price over the long life of nuclear contracts for difference will be such that the principle of variable but real subsidy will not also hold as far as nuclear is concerned. The Nuclear Industries Association though saw the arrangements as addressing a market failure, providing "enablers to facilitate the UK's wider energy policy".[114]

53. The first capacity auction will be run in 2014, for delivery in 2018-19.[115] Whether the capacity payments regime would constitute subsidy depends on whether they over-compensate producers and whether they are fairly available for all appropriate types of energy. Dr Blyth told us that he would not regard them as a subsidy, but rather as "a pricing mechanism, ... a way of providing payment for services":[116]

If the market is competitive—and it is a big if—players in that market will recoup their costs either through the capacity payment or through the energy payment, or a combination of the two. In a competitive market, the combination of the two would cover their short-run marginal cost. ... Whether that works out in practice in a slightly less than competitive market is another issue, but that is not a subsidy issue.[117]

Gordon Edge of Renewable UK explained how any assessment of whether capacity payments would constitute a subsidy would not be straightforward:

In theory, it ought to be a zero sum game, in that what is paid out in capacity payments ends up lowering the wholesale price of power and therefore it is a recycling of money. I don't think that is entirely true. There will be some hysteresis in all of that and you will end up with more money going through the capacity mechanism than you save through reduction in wholesale price. But I think it could be seen as a cost of moving to a system where there is a high proportion of high capital cost, low running cost, low carbon generation sources that require a lot of flexibility at the margins in order to cope with their variability or indeed their inflexibility, as nuclear is. So we need to think of it as a system cost. Whether you regard that as a subsidy, I would have to go and think about the philosophy of that.[118]

The Government expected "the net cost to consumers ... to be lower than the gross cost of the [capacity] auction as the capacity market will result in lower wholesale prices than would have otherwise been the case."[119]

54. Where the capacity payment regime more clearly constitutes subsidy is in the restricted availability of the payments essentially to one type of energy. The Energy Minister considered that capacity payments would not be a subsidy because they would "not [be] a support mechanism for any one technology",[120] but he acknowledged that in practice the "majority" of the payments would be for gas-fired power.[121] Gordon Edge told us that "the capacity mechanism is too closely designed as a subsidy for new gas-fired plant when it should be thinking much more widely about how we provide flexibility and response to the system as a whole".[122] In practice, of the 'eligible technologies' listed in DECC's October 2013 Electricity Market Reform: Consultation on proposals for implementation,[123] it is clear that energy storage participation will be minimal because capacity payments will only be available to non renewable technologies not receiving Renewable Obligation or contract for difference payments, coal plants will not be able to participate since most existing plants will be required to close from 2016 under the terms of the Large Combustion Plant Directive, and it will not be possible to build new unabated coal plants because of the emissions performance standards set out in the Energy Bill. Demand side reduction measures have been excluded from the 2014 capacity auction, as have interconnectors. The capacity payments regime was another case, the Minister told us, of "an insurance premium" rather than a subsidy.[124]

55. The capacity payments regime will constitute a subsidy for gas-fired electricity generation because in practice it is the only technology that will be eligible for the payments when the capacity contracts are deliverable in 2018-19.

Oil and gas

56. Using the OECD 'producer support' calculation methodology, subsidy includes various tax allowances, such as 'field allowances', that can be set against petroleum revenue tax (although not tax allowances which allow exploration costs to be immediately offset against revenues).[125] There was some argument, however, about whether the generally higher starting rates of corporation tax and petroleum revenue tax levied specifically on North Sea oil and gas should be taken into account in calculating the net effect of field allowances.

57. Dr Blyth pointed out that all oil and gas producing countries levy taxes or royalties on production, to "gain value from the resources being extracted".[126] The tax system for the North Sea provides a mechanism for the State to "sell" the national asset to the extractive companies.[127] The standard rate of petroleum revenue tax therefore "defines the 'normal' baseline tax rate for oil production in the UK".[128]

58. The Government did not regard field allowances as subsidy:

In the case of oil and gas the Government has introduced field allowances for more challenging categories of field that are economic, but commercially marginal at the high rate of tax. Such fields are relieved of tax of 32% for a certain portion of their income—but they still pay ring fence corporation tax at 30% for this portion, higher than the mainstream corporation tax rate. Field allowances do not reduce the cost of oil to consumers; rather increase what is extracted from the UK continental shelf.[129]

This oil and gas fiscal regime policy ensures the Government maximises the economic production of oil and gas in the UK, without giving undue support to otherwise uneconomic production. For that reason, field allowances cannot be seen as a subsidy.[130]

The Minister told that "if [North Sea oil and gas companies] are paying a tax higher than other businesses are paying, it cannot be a subsidy. It cannot be both a subsidy and a tax, can it?"[131]

59. In a similar vein, Oil & Gas UK saw subsidy in terms of "the balance between the taxation collected ... and the amount of value that is transferred from the taxpayer back to these particular elements of the energy sector".[132] Accordingly, "allowances which reduce taxation rates to incentivise activity, and that remain set at such a rate that the effected sector remains a net contributor to the public purse, do not constitute a subsidy."[133] They considered that the higher starting point of tax for oil companies should be taken into account when assessing subsidy. Oil and Gas UK differentiated measures which underwrite the cost of an activity from a tax which is applied on profits "once all costs have already been paid".[134] Platform disagreed. They, like Dr Blyth, emphasised that "these [North Sea] taxes reflect the fact that the fossil fuel companies have been granted a right to exploit a resource that is scarce in the UK, for example, oil and gas reserves. ... These special taxes ... arise due to the special circumstances of natural resource ownership".[135]

60. Field allowances for North Sea oil and gas do not fully offset relatively high starting rates of corporation tax and petroleum revenue tax. The allowances nevertheless represent a subsidy because the higher tax rates compensate for the use of state-owned fossil fuel deposits.

SHALE GAS

61. The Treasury announced tax concessions for shale gas exploration costs in July, reducing the rate from 62% to 30%. There is clearly no rationale for subsidy on the grounds of supporting low-carbon technologies. Shale gas therefore provides a case study for whether subsidies are appropriate for supporting a new industry. The minister told us:

[Fracking] is new to this country. I think it compares much more readily with offshore exploration for oil and gas so the Chancellor is now consulting on a similar form of field allowance. Again, that would not bring it down below the tax rates paid by the rest of British industry.[136]

As the Energy and Climate Change Committee reported in 2011,[137] hydraulic fracturing and horizontal drilling are both techniques that have been present in the UK for many years. They are not new technologies. Fracking is not a technology warranting financial support to become viable and competitive, and on that basis it does not warrant subsidy through a favourable tax treatment.