House of Lords - Economic Affairs

The Economics of Renewable Energy - Economic Affairs Committee Contents

Memorandum by energywatch

energywatch welcomes the opportunity to respond to the issues raised in the inquiry. This response is non-confidential and we are happy for it to be published.

energywatch is the statutory independent watchdog representing gas and electricity consumers in GB. We help domestic and business consumers with their complaints against energy companies, provide them with advice and information about the market and act as an advocate for their interests to energy companies, government and regulators.

SUMMARY

The UK Government is committed to playing its part in achieving the EU's target to achieve 20% renewable energy by 2020. This includes electricity, heat and transport. It is likely that the UK's target will be 15%, or 13% more than we currently achieve. This 700% increase in renewable energy will be very demanding.

energywatch supports the EU's proposal. However, switching to renewable energy is relatively expensive in terms of £/tCO2. Therefore, energywatch considers it essential that the UK makes much more effort to reduce energy consumption, for example by ratcheting up its energy efficiency programmes, in parallel with the drive to meet the renewable target. It will be easier, and cheaper, to meet the target on the basis of reduced consumption.

energywatch considers it essential that consumers are provided with clear, accurate and real time information about their energy consumption. Smart metering and integrated real time displays, coupled with tailored energy advice, would provide consumers with this information and enable them to take greater control over their consumption and usage patterns.

energywatch also considers it essential that consumers are provided with greater transparency over the fuel mix of their electricity supply to enable them to play a greater role in driving demand for increased renewable generation.

Changes to the infrastructure and planning regimes are also required to meet the volume of renewable energy required.

Consumers will have to pay to meet the target either through their energy bills or through taxes. Assuming a cost of £28 billion for the banded Renewables Obligation by 2020, the cost to consumers by this year is expected to rise to £33 per household per year. However, existing policies are only expected to source 20% of electricity from renewable sources, that is only half the estimated 40% target that the draft Renewables Directive entails.

Given such high costs, energywatch considers it essential that mechanisms for subsidising renewables are as cost effective as possible. These costs will disproportionately impact on low income and fuel poor households. In the commercial sector, they will impact on small and medium-sized enterprises facing higher energy bills. It is therefore essential that measures are taken to mitigate these negative distributional effects.

energywatch supports the proposed reforms to the Renewables Obligation outlined in the Energy Bill, since banding will reduce the "deadweight" element of the subsidy and increase renewable deployment. However, we recognise that banding will also increase costs to consumers and again raise our concerns for low income and fuel poor households.

energywatch would like further debate on where the costs of subsidy should lie, for example, between energy consumers and general taxpayers. We consider there may be a case for some elements of the renewable subsidy being borne by taxpayers, for example research and development for newer technologies. This also represents a more progressive method of raising revenue.

energywatch considers that consideration of the cost of renewable energy should not be made in isolation. Comparisons should be made with fossil fuels and nuclear energy and greater account should be taken of the various externalities associated with other energy sources. Such externalities are mostly negligible in the case of renewable energy.

energywatch considers that the potential contribution from small-scale renewables and renewable heat and gas towards the UK target is currently not being realised. We consider new policies are required to stimulate this sector as a matter of urgency. energywatch therefore supports the introduction of a renewable energy tariff to support small scale renewables. This would also bring about a number of additional benefits, such as increasing energy security for consumers (generators) and allowing them to play a greater role in renewable policy.

BERR evidence suggests that renewable heat technologies, plus fuel cell micro-CHP, represent more cost effective means of meeting renewable and carbon reduction targets than small scale electricity technologies, such as PV and micro-wind. energywatch therefore suggests that the proposed small scale feed-in tariff should focus more on encouraging renewable heat than renewable electricity. This is also likely to have a greater impact on reducing fuel poverty (in that fuel poor households have a greater need for low cost heat than low cost electricity).

energywatch recognises that parallel measures are needed to encourage decentralisation of existing energy networks to facilitate the deployment of renewables.

THE COSTS OF MEETING THE RENEWABLE TARGET[70]

Poyry Consulting report

In March 2008 BERR published a report commissioned from consultants Poyry Energy Consulting into the costs of meeting the EU's 20% renewable energy target. Poyry concluded that there is sufficient resource in the EU-27 to meet the target on condition that:

— reported biomass potential is realised,

— sustainability and land-use competition considerations do not adversely affect assumed global biofuel supply volumes,

— all technologies are capable of implementing a step change in "build rate", and

— additional support is provided to incentivise investment above that in project baselines.

Poyry has estimated the resource cost to the EU-27 of meeting the 20% target. This is the cost to the economy from using higher cost renewable technologies in place of their conventional alternative. Their central case "least-cost scenario" gives the incremental annual cost of meeting the target in 2020 as €18 billion, and the lifetime costs of the project as €259 billion, discounted to 2006 prices. The resource cost is sensitive to the costs of the conventional technologies replaced as well as the overall renewable potential and the assumed costs of each renewable technology.

Poyry estimates that the incremental annual cost to the UK of meeting its share of the target in 2020 will be in the range between €5 and €6.7 billion. The lower end of the range will be achievable if trading with other Member States is a realistic option. If it is not, then more expensive domestic actions will be required. The lifetime costs will fall in the range between €59 and €93.1 billion, again depending on whether trading is an option.

Poyry estimates that meeting the target will achieve substantial CO2 savings. The annual savings in 2020 of meeting the target in the EU-27 will be 388 MtCO2 (32 in the UK), while the total lifetime savings are expected to be some 9,834 MtCO2 (1,034 in the UK). These figures assume that biofuels are zero carbon, which they may not be. Poyry concludes that these savings will be sufficient to meet around 45% of the EU's 20% reduction target.

Poyry identifies further research that will allow its estimates to be refined over time. These are:

— an audit of available biomass resource potential across the EU,

— detailed modeling of the global biofuel supply market,

— insight into the CO2 savings generated through biofuel use,

— review of potential supply chain constraints on increased renewable deployment across the EU, and

— assessment of missing or hidden costs, such as the costs of additional network investment or reinforcement and infrastructure costs associated with heat grids.

THE IMPACTS OF CHANGES TO THE RO

The Government intends that the Renewables Obligation (RO) will remain the principal instrument for delivering the required investment in renewable capacity, although it is exploring possible support mechanisms for renewable heat (see following section). Capital grants will no doubt continue to exist alongside the RO, but the level of these grants may decrease as the level of the RO increases.

The major regulatory burden imposed by the RO is that, in order to provide additional support for the generation of electricity from renewable sources, costs to all electricity consumers are increased. These costs are capped by the levels of the RO and the "buy-out" price in the RO. The RO also imposes some regulatory burdens on renewable generators and the electricity supply industry in relation to the administration required to benefit from and comply with the scheme.

From 1 April 2009 the RO will be banded: each technology will be assigned to one of four banding levels: 0.25, 1, 1.5 and 2 ROCs. The change will result in additional investment in renewables generation, in particular in higher cost technologies. The modelling indicates that under central electricity and central technology cost assumptions, the amended RO will deliver 8.6% ROC eligible renewables generation by 2010, 13.5% by 2015 and 13.5% by 2020. This is an increase to UK renewables capacity of 40% over 2009-15 compared to the existing RO.

The cost to the economy of producing renewable energy as opposed to conventional generation is expected to be £4.8 billion. However, the ability to target support in a banded RO, means that banding has the potential to significantly increase the efficiency of the RO (reducing the "deadweight" element of the subsidy) through providing support levels more closely linked to the needs of different technologies.

The precise outcome will of course depend on the impact of the changes on renewables generation, which in turn rely on a number of external market forces. Among those factors external to the RO are future electricity prices, future carbon prices, and future capital and operating costs for renewables. Sensitivity analysis carried out by BERR indicates that a 10% reduction in future generation costs has the potential to increase the level of ROC- eligible renewable electricity generation by 10-15% in 2015.

Ofgem estimates that the total subsidy will amount to £28 billion over the lifetime of the RO, which equates to £33 per electricity consumer per year by 2020[71]. This will save 103.1 MtC of Carbon over the lifetime of the technologies, an increase of 12.5 MtC over the existing RO. The figure for £/tonne of carbon is £188 higher than the existing RO. Introducing a banded obligation will increase the cost to consumers by an additional £1.4 billion, compared to the existing RO, over the lifetime of the RO. The out-turn will vary with the actual level of deployment—increased deployment will be accompanied by increased costs to consumers.


Option Three: Four Bands	Low	20151 Central	High	Low	Lifetime Central	High

Resource Cost £bn	1.1	1.1	1.1	19.9	19.4	19.1
Carbon Saved MtC	3.9	4.5	5.1	86.8	103.1	123
NPV Cost-Benefit £bn (cost+/benefit-)	0.8	0.8	0.7	14.4	12.9	11.5
Cost-Effective £/tC				229	188	155
RO Deadweight Cost £bn	0.2	0.3	0.5	3.8	5.7	9.5
Distributional Analysis
Exchequer Cost £bn	0.1	0.1	0.1	1.8	2.2	2.6
Firms Cost £bn	1.1	1.1	1.0	19.1	18.5	18.1
Consumer Cost £bn	1.3	1.4	1.6	23.7	25.1	28.6

Notes:
1. All costs are at 2007 real prices, discounted. Low scenario is modelled assuming technology costs are 10% higher in the central case, with a lower level of renewable generation. High costs assume technology costs are 10% lower than in the central case, with a higher level of generation, and therefore costs.

HEAT CALL FOR EVIDENCE

In the 2007 Energy White Paper, Meeting the Energy Challenge, the Government announced it would:

"...conduct further work into the policy options available to reduce the carbon impact of heat and its use in order to determine a strategy for heat. The work will look at the full range of policy options, including the range of existing policy mechanisms such as the EU ETS."

The Heat Call for Evidence, published in February this year, includes information on CO2 emissions from the generation and use of heat, assesses the potential for this to be reduced, and asks about the effectiveness of existing policies to bring this about. It also includes questions about whether further measures might be needed and what shape these could take. The document also includes consideration of the increasing role of cooling.

The Government has sought the views of stakeholders and heat users in industry and local government, NGOs, academics and energy companies. Existing practices in the UK and other countries have been reviewed and assessed, including the impact of policy and regulation.

Almost half of the final energy consumed in the UK (49%) is in the form of heat. Heat is generated by burning fuels such as gas, wood, coal or oil, or from electricity. Of this heat, 70% is used by households and in commercial and public buildings. The remaining 30% is used in the industrial sector. In total 907 TWh of heat was consumed in the UK in 2005.

Households use heat for space heating (69%), heating water (27%) and cooking (3%). The majority of household heat (81%) is met using gas, similar proportions are met from electricity (9%) and heating oil (8%). The remainder is from solid fuels such as wood and coal (2%).

Household demand for heat varies from year to year according to the severity of the winter. It has risen somewhat over the past 30 years from 400 TWh/y to a little under 500 TWh/y. This is despite the marked improvement in the energy efficiency of homes (SAP rating). Householders now enjoy much warmer indoor temperatures—the average internal temperature of homes has risen by 6°C since the 1970s.

The other reason for the growth has been the increase in the number of households which have risen by about 40%. Heat for the commercial and public sectors is mainly used in buildings for space heating (71%), water heating (13%) and cooking (15%).

The industrial sector uses heat for a variety of processes and at a range of temperatures. For example low-grade heat at less than 100°C is used for purposes such as drying, while high-grade heat at greater than 400°C is used for glass and steel manufacture. Industry uses a diverse mix of fuels to meet its heat requirement, including natural gas (47%), oil (26%), electricity (19%) together with other fuels such as refinery flue gases.

Generation of heat, including electrical heating, accounts for around 47% of UK CO2 emissions. The domestic and industrial sectors generate roughly the same level of CO2 emissions, even though domestic heat demand accounts for a larger proportion of final energy use. The reason for this is that industry uses a higher proportion of more carbon-intensive fuels or electricity to achieve the high temperatures needed.

The proportion of the UK's CO2 emissions from heat is forecast to fall as a result of changing patterns of heat use together with Government policies, including those announced in the Energy White Paper. It is possible to reduce the emissions from heating in several broad ways, which are not mutually exclusive.

— Another broad approach is to decarbonise the energy source, which means either making much greater use of renewable heat sources or heating from low or zero carbon electricity (which could be produced from either nuclear, fossil generating plants fitted with carbon capture and storage, or from renewable electricity).

— Finally, there is considerable potential to make use of surplus heat that is presently discarded from high temperature processes like electricity production. This would effectively displace other, more carbon-intensive ways of generating heat. Widespread use of surplus heat or other centralised heat production might widen adoption of district heating.

energywatch also argues that much more can, and needs to be done on engaging consumers with their energy consumption, both gas (ie heat) and electricity. Smart meters with integrated real time displays are one means of ensuring that consumers have access to meaningful information about their energy use. In addition, an integrated approach needs to be taken in relation to energy efficiency, fuel prices, and income so that consumers have easy access to comprehensible advice that is tailored to differing household's circumstances.

ELEMENT ENERGY STUDY

A study entitled "The Growth Potential for Microgeneration in England, Wales and Scotland" part-funded by many organisations, including BERR, was published in early June this year. The principal findings are:

— this expenditure would save 24 million tonnes of CO2 annually, which is about 4% of UK emissions (560 million tonnes). This is a high cost for a modest contribution to fuel saving and emissions reduction; and

— a rapid rise in conventional energy prices would render subsidy support needless, with a doubling in fossil fuel prices driving spontaneous uptake in 10 million homes by 2030.

Further details of the costs and benefits of the different subsidy options are set out below. The report included consumer research into attitudes to micro generation. The main findings among owner-occupiers were as follows:

— the majority are satisfied with their existing heating systems;

— there is high interest in purchasing loft/roof insulation;

— a minority claim to have considered purchasing micro generation;

— few of those who claim to consider purchasing micro generation actually go on to obtain quotes, and only a minority of these actually buy the technologies;

— respondents claimed the key driver for purchasing micro generation would be reduction in energy bills;

— among micro generation supportive policies options examined, consumers strongly prefer grants;

— consumers evaluate ongoing costs and benefits over a short time period;

— respondents strongly dislike maintenance costs, and especially additional maintenance costs;

— consumers strongly dislike inconvenience;

— there is little evidence of regional or income effects on consumer priorities; and

— of the roof-based discretionary microgeneration technologies, consumers significantly prefer solar technologies to micro-wind.

SUBSIDY OPTIONS CONSIDERED IN ELEMENT ENERGY STUDY

Annual subsidy

A £100 annual subsidy is sufficient to promote significant uptake of Combined Heat and Power (CHP) by 2020, with over 2.5 million units installed by this time. CHP systems are modelled as receiving between £200 and £500 under CERT or post-2011 supplier obligation, and a further annual subsidy is sufficient to drive high sales. When CERT ends in 2020, the unfamiliarity penalty associated with CHP has been reduced to zero, allowing them to compete well with gas boilers. Increasing the annual subsidy to £200 increases the microgeneration stock to six million in 2020 and nearly 14 million in 2030.

Feed-in tariff

A tariff of 40p per kWh degressed at 1% per year increases uptake of PV to 130,000 units by 2020 and 900,000 by 2030. The tariff is insufficient to stimulate micro-wind, which has similar costs to a 1kW PV system but a much lower energy output in most sites. The value of the tariff to a household with a 2kW PV system in 2008 is £680 per year. The same system installed in 2030 would receive £550 per year because of the low degression rate. A 30p tariff at 1% degression results in only 240,000 PV installations by 2030.

A 40p tariff is required to stimulate uptake before 2020, although technology cost reductions mean that at a 1% degression rate, the subsidy is equivalent to over 80% of capital costs by 2030. Paying a FIT every year, while ensuring that devices continue to operate in the future, requires a much higher tariff for a given level of uptake due to consumers' short time horizons. It should be noted that in Germany, where an ongoing FIT has stimulated installation of PV at a rate of 1 GW per year, uptake by domestic consumers was largely dependent on the availability of soft loans. This has the same effect as deeming in that it overcomes the capital cost barrier, and the value of feed-in tariff in Germany is sufficient to offset the loan repayments. Since soft loans were discontinued in Germany, purchases by domestic consumers have fallen significantly and most uptake is now by commercial and industrial consumers who have access to low-cost finance and probably longer time horizons.

Heat-based feed in tariff

Deeming the feed-in tariff for 10 years at the government discount rate of 3.5% leads to substantial uptake of air source heat pumps (ASHPs), with over two million units installed by 2030. Biomass boilers and ground source heat pumps (GSHPs) show no uptake since they are unable to compete with ASHPs which receive the same subsidy. Deeming at a commercial rate of 7% reduces uptake slightly to 1.8 million units by 2030.

At the support levels modelled, the non-deemed heat based feed-in tariffs can provide less support than the post-2011 supplier obligation, and so uptake is lower than in the baseline in 2020. This is particularly true for biomass, which receives favourable support under the CO2-based supplier obligation but receives the same subsidy as the lower cost heat pumps under the heat based FIT.

Solar hot water systems receive very little benefit from a 2p/kWh heat FIT. This is because a typical system installed in 2008 generating 1,500 kWh of hot water per year only receives £30 per year from the 2p/kWh tariff. Even when this is deemed over 10 years, it is equivalent to a capital subsidy of less than 10%. Therefore, to support mass market uptake of solar thermal using an energy-based subsidy, a higher p/kWh heat reward may be required than for primary heating systems.

A tariff deemed at 3.5% leads to annual CO2 savings of nearly 1.5Mt by 2020 and 4Mt by 2020. Over 15TWh of renewable heat are supplied in 2020, equivalent to 5% of the government's 2020 renewable energy target. This rises to 39TWh per year in 2030.

The cumulative cost of a tariff deemed at 3.5% is £2.6 billion by 2020 and £6 billion by 2030. This compares with a cumulative subsidy cost of £2 billion by 2030 for an undeemed tariff. This underlines the cost-effectiveness of deeming a feed-in tariff, as a tripling of the subsidy spend in the deemed case leads to over five times more renewable energy being delivered.

Heat and electricity tariff

The undeemed combined renewable tariff results in a total microgeneration stock of 4.5 million units and generation of 7 TWh of renewable heat and electricity in 2030.

Heat pumps and PV show much stronger uptake than in the baseline, with one device for every five homes in 2030.

The deemed renewable tariffs are much more effective and deliver microgeneration stocks of 2.8 million and nine million units by 2020 and 2030. These generate over 17TWh of renewable energy in 2020 and 45 TWh in 2030.

Despite the fact that PV has a higher stock than heat pumps, the contribution of electricity to the total renewable energy production is relatively small at less than 20%.

The costs of the deemed combined renewable subsidy scheme are high, with a committed spend of around £8 billion by 2020 rising to over £26 billion by 2030. Although PV and wind generate much less energy than heat pumps throughout the scenario, they receive the bulk of the subsidy, taking over £20 billion of the ca. £26 billion by 2030. This suggests that a heat feed-in tariff could contribute much more to overall renewable energy targets for a lower cost than a renewable electricity tariff can.

The final scenario illustrates that a relatively low level of support of 5p per kWh is sufficient to drive widespread uptake of CHP. This is because CHP systems, particularly fuel cells, generate much more electricity than a PV system costing a similar amount. Deeming the tariff means that the cost of a CHP system is reduced to the same cost as a condensing gas boiler, since the value of the deemed subsidy for a unit generating 4,000kWh per year is £1,600.

The cost of a CHP subsidy is very high, with a cumulative subsidy spend of £13 billion by 2020 and £44 billion by 2030. This means the total subsidy spend for all electricity and heat technologies is £21 billion and £76 billion in 2020 and 2030.

While the Element Energy study suggests that a feed-in tariff support mechanism does have considerable cost implications[74], energywatch supports the introduction of a renewable energy tariff for small scale renewables for the following reasons:

— It would lever in new sources of investment for renewable energy that are currently not being realised through the Renewables Obligation; for example in Germany, 90% of renewable investment comes from outside the energy industry.

— By encouraging micro-generation, it would change the balance between energy companies and consumers (who also become generators).

— If parallel mechanisms (eg subsidies for up-front installation costs) are introduced to make sure that low income and fuel poor consumers benefit from small scale renewable technologies, particularly heat, it could have a dramatic impact on reducing fuel poverty. Renewable technologies represent an effective solution, alongside solid wall insulation, for fuel poor households living in hard to treat properties (those off the gas network and/or built with solid walls), many of which are found in rural areas.

— Increased visibility and take-up of small scale renewables by consumers will also help stimulate energy reducing behavioural change and take-up of energy efficiency measures.

— It may help encourage new entrants to the energy market place, for example smaller companies able to offer energy service packages, and thus increase the competitiveness of the UK energy market.

FUEL POVERTY ADVISORY GROUP REVIEW OF MICRO-GENERATION

A recent report to the Government's Fuel Poverty Advisory Group[75] reviews the potential of micro-generation for tackling fuel poverty. The review was prompted by the problem of tackling fuel poverty among households living in "hard to treat" properties (those built with solid walls and/or off the gas network). The report argues that 50% of fuel poor households cannot be assisted by existing insulation and heating grants, in part due to limitations on the measures offered under conventional programmes (Warm Front etc).

The review examines a range of micro-generation technologies, including air sourced heat pumps, ground sourced heat pumps, bio-mass boilers, micro-wind, solar thermal, photovoltaics and micro CHP. It considers their suitability for inclusion in retrofit programmes aimed at the fuel poor.

The review argues that micro-generation technologies can play a role in tackling fuel poverty. However, policy should focus more on renewable heat technologies than electricity. This is because low cost heat has a much greater impact on reducing fuel poverty than low cost electricity (assuming initial capital costs are grant-funded).

CONCLUSION AND RECOMMENDATIONS

energywatch considers it is possible for the UK to meet the challenging target of providing 15% of its energy from renewable sources. However, this will require a number of new policy initiatives for ensuring the target is met:

— The introduction of a feed-in tariff to encourage the deployment of small scale renewable technologies, particularly heat. Parallel measures should be introduced to encourage the installation of such technologies in the homes of low income and fuel poor consumers.

— Renewables policy should address social objectives, eg increased efforts to mitigate the impact of higher fuel costs on low income households, as well as environmental (reduced carbon) and economic (increased security).

— A much greater policy focus on heat, particularly renewable heat, in general.

— Measures to address potential supply chain constraints on increased renewable deployment.

— Investment in grid and in network management to encourage decentralisation of energy networks and to transport renewable electricity to demand.

Meeting the target will entail increased costs for energy consumers, either through energy bills or taxes. energywatch calls for a debate on the most appropriate allocation of costs between energy consumers and taxpayers, given that the latter course represents a more progressive route for raising revenue.

energywatch also advocates a thorough analysis of the distributional effects of the measures required to meet the targets and the introduction of parallel measures to mitigate the negative distributional effects.

energywatch advocates the mandatory disclosure of the fuel mix of individual tariffs and contracts to all fuel consumers. We consider improved transparency will help drive consumer demand for increased renewable content of their electricity supply. This will also require the establishment of an independent accreditation body to verify supplier's claims and to assess any additional environmental benefits suppliers claim for "green tariff" products.

June 2008