Policy Sam Morgan - 05/March/2021

Metrics that inflate the cost of the energy transition are under attack

Put garbage into an economic model and garbage comes out. By using a discount rate that inflates the cost of the energy transition, the EU’s executive body is undermining the bloc’s new and more ambitious carbon reduction goal. Behind the scenes, however, method may lie in the madness. Officials working on legislative updates are suspected of holding a negotiating trump card up their sleeves

A 10% discount rate is increasingly being seen as too conservative a metric for dictating the scale and speed of the energy transition

OUT OF STEP The discount rate used to assess the cost of EU clean energy legislation is several times higher than that adopted by member country governments for their own models

PRECEDENT The EU Commission has once before lowered its discount rate during talks to win parliamentary and government approval for legislation to facilitate clean energy investment

KEY QUOTE The European Commission must not shoot itself in the foot now by artificially inflating costs

The cost of the energy transition may end up being a lot less than currently projected, with serious implications for today’s policymaking and spending decisions. If the metrics for measuring cost are wrong, so too will be decisions taken by governments, investors and industry on how fast to proceed with the transition. The higher the projected cost, the slower the rate of progress considered affordable, argues a growing body of opinion concerned that application of the wrong metrics is leading to wrong decision making. Unwarranted caution on energy policy today raises the future cost of the transition and reduces the chances of averting global climate disaster.

At issue is the discount rate being used by the European Commission, the EU’s executive branch, to review all of its energy and climate legislation. The ongoing legislative update was made necessary by the EU’s decision at the end of 2020 to cut net greenhouse gas emissions to 55% of 1990 levels by 2030. Current legislation would only enable emission cuts of 45%, insufficient for compliance with the aims of the Paris accord on climate change from 2015. The new target will bring the EU’s goal for climate neutrality by 2050 within striking distance.

Of crucial importance to the cost analysis the Commission is required to make for any new legislation is the discount rate it chooses for establishing the likely interest rates on money borrowed years into the future. As a metric, a discount rate can be adapted for various purposes, including accounting for the influence of policy decisions on the cost of future investment, where perceptions of the size of the risk being undertaken can amount to significant barriers. The nature of the energy transition requires an assumption of high up-front capital costs, with financial rewards coming further down the line. The cost of renewable energy lies primarily in the capital outlay, as it has no fuel bills to pay, and building renovations involve high upfront costs. In both cases, the discount rate helps modellers illustrate what is and what is not viable in a real-world scenario.

ROOM FOR MANOEUVRE

The governments of countries like the Czech Republic and Poland are more sensitive to the costs of the energy transition than richer EU members. Preparation of sound financial argument is a vital part of the Commission’s work. Stricter targets for renewables, energy efficiency, building performance and transport are on the legislative docket, but they all require cost-benefit assessments before being presented to national governments and the European Parliament for approval.

Changes to EU regulations normally require several rounds of trilateral negotiations between the Commission, Parliament and the Council of Ministers. Compromise is part of the process and leaves room for manoeuvre on the discount rate. The higher the rate, the higher the estimated costs and essentially the less attractive a policy will appear.

The Commission applies a 10% discount rate to its modelling and most recently used it to estimate the costs of the new 2030 emissions reduction target, eventually concluding that a 55% cut was as affordable—financially and politically—as 50%. Compared with discount rates used by member countries, however, the EU’s 10% is a high bar, even taking into account the risk of post-pandemic inflation. Most of central and eastern Europe, including Germany, as well as Scandinavia and the Baltic states, use a rate that is lower than 5%.

Use of a rate of 10% in the current round of negotiations has some senior officials convinced it is too late to tweak the numbers underpinning policies. The focus in the Commission’s climate department seems to be elsewhere, says one. Others are not so sure and argue that concerted pressure brought to bear on the issue could lead to a re-think.

BONE OF CONTENTION

Discount rates used by the Commission have long been a bone of contention. Ecofys, a Dutch climate and energy consultancy, warned in a 2015 report that the EU-backed rate was too high and would “have a significant impact” on what policies would be adopted. “Neither economic theory nor actual member states’ practice provide good reasons for the major differences between discount rates that we observe to be used in EU impact assessments and member states individual impact assessments,” the report warned.

“Using very high discount rates leads to the self-fulfilling prophecy that energy efficiency measures are an expensive way of meeting the EU’s climate goals,” argues Arianna Vitali from the Coalition for Energy Savings, an industry association. The discount rate used takes into account costs of capital and investment barriers, although the Commission does not comment on how those two are weighted in its calculation of the metric it uses to quantitatively assess the economic impact of energy transition legislation.

Nevertheless, the increasingly positive political will towards the energy transition and the resulting flow of helpful regulatory measures and monetary support are reducing both cost and risk barriers to investment. The European Investment Bank plans to dole out more than €1 trillion in green loans over the course of this decade, while the Commission’s Sustainable Europe Investment Plan—part of the European Green Deal—aims to mobilise a similar amount of cash. In 2021, the Commission will borrow €750 billion to fund its pandemic recovery plans, which will have to be geared towards sustainable investments. All told, the outlook for efficiency measures, building renovations and so on, should look bullish.

OUT OF STEP

But as Vitali points out: “In a world of near-zero borrowing costs, why would a 10% discount rate for renovating your house be justified?” Investors are currently accepting negative interest rates on EU bonds, making the high discount rate look even more out of step. Brook Riley, head of EU affairs at Danish insulation producer Rockwool, says the Commission has done a “great job” building political support for a more ambitious 2030 climate target. But he warns: “It must not shoot itself in the foot now by artificially inflating costs.”

Riley advocates the use of lower discount rates by the Commission to reflect the positive impact of new legislative decisions on the investment climate and put a distance between these measures and previous business-as-usual scenarios. “Otherwise they are basically saying that their policies will not have any impact,” he points out.

Given the scale of the transition required by the EU, which includes millions of building renovations and accelerated renewable energy generation rollout, it stands to reason that if those policies are successful, cost of capital will reduce and investment barriers will come down. Ecofys also recommends in its 2015 report that the Commission adopt a social discount rate of 3-6%, which would reflect the benefit to society in the future if investments are made in climate policies now. As costs have fallen over the last half-decade and climate policies have grown in importance, that reasoning has changed little in the meantime.

While building renovation work has high up-front costs, its positive impact on society goes beyond reducing carbon emissions to including benefits to human health through better air quality and general well-being. That nuance is lacking from the modelling. Social discount rates are still a contested field of economics for their reliance on too many subjective assumptions and data, but they have their supporters.

Wendel Trio of Climate Action Network Europe, an NGO, insists that all impact assessments are “full of assumptions” and the Commission must take into account the cost of inaction and cost to society. The EU executive’s joint research centre estimates that current climate policies would lead to annual welfare losses of €175 billion, due to factors like coastal flooding and heatwaves. This data is not reflected in the Commission’s latest impact assessments.

RENEWABLES MAY GET LUCKY

Beyond energy efficiency measures and building performance standards that may not happen in the mistaken belief they would be too expensive, use of the wrong cost metric could also be detrimental to renewable energy development. Renewables will form a major part of the Commissions’ review. Its 2020 offshore energy plan aims for at least 300 gigawatts (GW) of offshore wind power by 2050. The price tag it puts on the plan comes in at around €800 billion, sourced mainly from private capital.

The European parliament’s chosen point man on the legislation, Morten Helveg Petersen, believes a lower discount rate should be factored in by the Commission’s number-crunchers. “It’s a recurring discussion and polemic with the Commission, which in this context clearly disadvantages renewables so [there is] good reason to update and use a lower rate,” says Helveg Petersen, a Danish parliamentary member.

The renewables sector may well be in luck. Commission officials tasked with drafting proposals on clean energy deployment are pushing internally for a lower discount rate. Work is currently ongoing to prepare for the Renewable Energy Directive (RED II) review, which will be one of the main items on the EU executive’s summer update. Officials want the best possible hand dealt to them before it rolls around and have no interest in inflating the cost of renewables by applying above-market interest rates. For this reason, they are seeking to lower the Weighted Average Cost of Capital (WACC) applied to offshore wind development, either in specific scenarios that can be compared with the 10% discount rate or across the board. Senior managers in the Commission’s energy and climate directorates are open to the idea, given the crucial role reserved for offshore wind power in the EU’s climate plans.

PRECEDENT COUNTS

A precedent for lowering the selected discount rate, which the Commission set back in 2016, counts in their favour. Prior to that date, a 17.5% discount rate was applied. In its assessment of the Energy Efficiency Directive at the time, the Commission explained that better financing instruments and labelling requirements will, “Facilitate access to capital for investment in thermal renovation of buildings.” That allowed lawmakers to quietly phase out the old metric and apply the lower 10% rate in all of its modelling. The precedent makes a strong case for a new discount rate adjustment and applying it across the renewables, energy efficiency and building performance sectors today.

If the EC’s renewables unit is successful in its push, it could trigger a rethink in other departments. It could also be a trump card that the Commission could keep up its sleeve until later in 2021 when political discussions ramp up, particularly ahead of the UN’s negotiation of climate change actions at COP26 in November.

In 2018, when the EU institutions sat down to negotiate the current renewables law, talks were deadlocked between national governments and members of the European parliament, who disagreed about how ambitious the target should be. During one of the later negotiation rounds, the Commission ran the numbers again, taking into account the rapidly falling costs of renewables, which showed that a higher target would be possible for the same assumed costs as before. Officials then signed off on a 32% goal.

An established pattern exists of the Commission tweaking its calculations mid-talks to create space for a compromise on politically sensitive issues. The discount rate could yet prove to be a metric that gets tweaked late in the day. The outcome would be a big reduction in the calculated cost of the energy transition, providing reason enough to stamp on the accelerator.

TEXT Sam Morgan

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