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Why saying goodbye to subsidies is hard to do

Building solar and wind projects without subsidies is seen by many as the solution to the energy transition. But falling costs can create their own problems, especially without the right regulation and continuing financial support for fossil fuels

A growing number of renewable energy projects are being built without recourse to direct government subsidies. Many have greeted this news with open arms, but others insist that building the next generation of renewables is more important than ending subsidies, particularly when fossil fuels continue to receive large amounts of taxpayers money

For many renewable energy advocates, it’s the Holy Grail: the point where projects can be financed and built without government subsidies. Once that happens, they believe, renewable energy penetration will take off like a rocket, as economics overtakes environmental concern as the reason to invest in clean energy. For some, that moment can’t come soon enough. In Germany, renewable energy subsidies hit a record high in January 2018, with some €2.3 billion paid to network operators, 10% higher than the same month in 2017. Analysts expect that figure to continue to rise, peaking in 2020 or 2021. Even in the UK, which has dramatically reined in subsidies, leading to investment in onshore wind and solar to almost completely halt, spending on its Levy Control Framework, introduced in 2011 to cap the cost of low-carbon subsidies, will reach £8.6 billion, before starting to fall in 2025. Subsidy-free projects are beginning to proliferate. To cite just a few recent examples, Octopus Investments began operating five subsidy-free solar plants in Italy in June 2017. In February 2018, Hive Energy secured approval for what it says is Spain’s first solar farm to be built without subsidies. In the UK, Energiekontor reached financial close in May 2018 on a 8.2 MW extension to an existing wind farm project, which will be built without government support. In the same month, Finnish developer TuuliWatti announced it is to build a 21 MW onshore wind farm on the Bay of Bothnia without subsidies. In developing countries, meanwhile, wind and solar projects are being developed at lower cost than new fossil fuel generation. Winning bids in a tender for 1 GW of solar power capacity in India, for example, reached the equivalent of $0.04/kWh, below the cost of coal-fired power. And, perhaps most eye-catchingly, even relatively high-cost offshore wind projects are winning tenders without the need for direct subsidy. In 2017, Ørsted (then DONG Energy) and EnBW won tenders to build three wind farms off the German coast, without bidding for any of the available premium over the wholesale power price (although the projects, not due to be built until the early 2020s, will not have to meet the costs of grid connection). The reasons for falling costs are threefold, according to the International Renewable Energy Agency (IRENA): the move away from fixed-price subsidies towards competitive tenders; international competition between equipment manufacturers and developers; and improved technology.

Falling costs make renewables competitive

On the latter point, a recent IRENA report looked at the cost of renewables using a metric, the so-called levelised cost of electricity (LCOE), which provides a figure for the costs of power over the lifetime of a project and allows different types of generation to be compared. It found that the average LCOE of utility-scale solar photovoltaic projects commissioned in 2017 was 73% lower than those commissioned in 2010. Over the same period, the LCOE for onshore wind farms had fallen by 23%. Electricity from renewables will soon be consistently cheaper than from most fossil fuels,” it said. By 2020, all the renewable power generation technologies that are now in commercial use are expected to fall within the fossil fuel-fired cost range, with most at the lower end or undercutting fossil fuels.” Does this mean that taxpayers will be bearing lower costs in future? Up to a point, say renewable energy advocates. Michael Taylor, senior analyst at IRENA, says that it is a different story for countries with growing electricity demand, such as fast-growing developing countries, and more mature economies, where power demand is flat or falling. In the former, unsubsidised renewables can compete on their own merits and can often reduce the cost of power to consumers compared with that from fossil-fuelled generation. In the developed world, however, the competitive landscape is different. In Europe and, to a lesser extent, the US, we don’t need new capacity,” says Taylor. Instead, it’s about pushing existing [high-carbon] assets off the network to meet climate change objectives … It doesn’t matter how cheap renewables get … it’s about the cost of the transition to a sustainable energy system.” Despite the dramatic falls in renewable energy costs, the scale of the energy transition means that consumers or taxpayers are likely to continue to have to bear considerable costs for years to come, warns Frank Peter, deputy director of Agora Energiewende, a German energy policy think-tank. He notes that Germany’s climate goals require the country to move to a 65% share of electricity consumption met by renewables by 2030, up from around one-third in 2017.

Will renewable energy eat itself?

This, he says, has two implications: first, that wind and solar farms will have to be developed on sites with poorer renewable resources, making them less profitable; and that the merit order effect” of renewable energy will increase. Because most forms of renewable energy have, once built, low or zero marginal costs, and because most countries guarantee them access to the grid, renewables tend to reduce average wholesale power prices. This means that under the current market design those renewables exposed to market power prices will need greater subsidies to remain profitable. This is a risk raised recently by a number of analysts. Aurora Energy Research estimates that about 60 GW of renewable energy can be deployed subsidy free in Europe by 2030. A combination of factors, however, such as low fuel and carbon prices, high renewable energy build-out and poor system design, could undermine their economics. Another consultancy, Cornwall Insight, has modelled the cannibalisation effect,” whereby by the 2030s producing power from wind and solar could be so cheap as to significantly cut developers’ revenue streams and thereby make it harder to attract investment in renewables projects (see In search of a cure for cannibalisation’). It finds the former earning 34% lower revenues from the wholesale power market in 2031 compared to 2018, with solar plants earning 22% less. If subsidies or substituting revenues are not available to these projects, how will these projects be financed?” the report asks. We think it’s unlikely we will have a situation where renewables can be built only relying on market prices for a very long time,” says Peter at Agora Energiewende. We assume that the EEG [Germany’s subsidy regime], as it is today, will serve in the future as a hedging instrument against downside risk.”

When is a subsidy not a subsidy?

The debate around renewable energy subsidies is a complex one, with a large range of different types of support mechanisms in place, and little consensus on what is meant by a subsidy. Feed-in-tariffs
The clearest and most direct subsidies are guaranteed prices paid, usually through utilities, for power produced by renewable technologies. In Europe, many countries offered so-called feed-in-tariffs (FiTs) that paid set prices, often inflation linked, for a set period of years. Many of these programmes, however, failed to anticipate the speed at which technology costs would fall, leading to rapid increases in deployment, windfall profits for developers and large demands on the public purse. Green certificate schemes
Other countries have subsidised renewables by creating markets for trade of green certificates awarded to renewable energy generators for each MWh of energy produced. Electricity suppliers, again usually utilities, are obliged to retire to the regulator a growing number of green certificates, either by investing themselves in renewables or by purchasing them from certified projects. This creates an extra revenue stream for renewables projects, in addition from that earned from selling the physical electricity. Since these programmes are market-based, however, the value of green certificates can fluctuate wildly, therefore making them less attractive to many investors. Tax breaks
Renewable energy has also benefitted from a range of tax breaks. In the US, for example, wind farms receive a tax credit for each unit of power they sell, while other countries offer attractive depreciation regimes or tax advantages for research and development. Contracts for difference
More recently, contracts for difference (CFDs) have become a more popular means to provide renewables projects with revenue certainty, while sharing any potential upside. These involve setting a strike-price, set at a level — often via reverse auctions whereby sellers compete to obtain business from the buyer and prices typically decrease as the sellers underbid each other — high enough to allow a project to get built. If wholesale power prices are below that level, the project operator gets paid the difference: if they are higher, the operator pays the difference to the government.A growing number of CFDs are being struck without a premium to wholesale prices, leading to developers and observers describing them as subsidy-free”. Market purists, however, would argue that any revenue certainty reduces the risk faced by the developer, providing an implicit subsidy. Hidden subsidies
Renewable energy developers also benefit from other subsidies that are hidden to a greater or lesser degree. A number of subsidy-free” offshore wind farms will benefit from grid connections paid by governments, valued at around €10/MWh, for example, while the costs of balancing a variable supply of renewable energy with demand are socialised” — or borne by all electricity users.Of course, no discussion of renewable energy subsidies would be complete without a nod to the huge volume of taxpayer money that continues to be funnelled to conventional energy sources. Governments incentivise companies to extract fossil fuels, they pay the costs of treating those whose health is damaged by the pollution they cause, and they pay many billions tackling the waste caused by the nuclear power industry — not to mention the costs of the occasional nuclear disaster. The latest iteration of these subsidies to fossil fuels are capacity payments” made to keep open coal- or gas-fired plants in case they may be needed.

Leveling the playing field

It’s worth remembering why subsidies exist in the first place,” argues Taylor of IRENA. Renewable energy doesn’t face a level playing field. If the externalities of fossil fuels were accurately priced, we’d be having a completely different conversation.” These externalities include the health costs caused by the local air pollution from coal-fired plants, in particular, as well as the costs associated with climate change. In the US, the Obama administration calculated that each ton of carbon dioxide incurred a social cost” of $36. Renewable energy subsidies are correcting for a market failure,” Taylor adds. Renewable energy associations are, correspondingly, cautious about calling for an end to subsidies. Zero-subsidy bids are possible for certain developers, in certain locations and in certain conditions,” says Ivan Pineda, director of market intelligence at sector trade association WindEurope. But they aren’t the norm and they won’t be the norm before 2030.” Others point out that few, if any, sources of energy generation exist without any form of support. Fossil fuels get huge amounts of subsidy,” argues Joseph Dutton, a policy advisor at E3G, a London-based climate change think tank. Tax relief for fracking, the costs of North Sea decommissioning or capacity market payments may not be classified as subsidies, but they amount to the same thing.” Also, subsidies can take other forms aside from guaranteed prices or a premium over the market price for power, says Peter Atherton, an associate at Cornwall Energy. A truly non-subsidised world would involve generators selling power into an open market and taking wholesale price risk,” he says. Any arrangement that transfers risk away from the generator has a value and a cost that is borne by the government or the consumer, he adds. In the UK, there has not been a single megawatt of any type of capacity financed since 2012 that hasn’t been underpinned by some sort of government contract or guarantee,” he says. We’ve accepted that we have a managed market where the government effectively sets the price.” Gerard Wynn, a finance consultant with the Institute for Energy Economics and Financial Analysis, insists that what really matters in all this is how to get the next generation of renewables built.” He states that as long as developers can access long-term power purchase agreements (PPAs), renewables will continue to be developed. While the guaranteed returns offered by feed-in tariffs were great, asset managers and asset owners like pension funds are happy to fund renewables, including offshore projects, with long-dated PPAs giving 6-7% equity returns.” Elsewhere in the world, Wynn argues that the Indian government’s solar programme is showing great promise in bringing down auction costs, by removing risks faced by developers. These include providing a credit-worthy counter-party with which to enter into PPAs, and providing land in dedicated solar parks, with reliable grid connections. While he notes that most of the winning bidders have yet to construct projects, he says there has been astonishing growth” in the sector, and at incredibly competitive pricing.

A role for regulation

But regardless of where and how renewables are supported, there remains a need for regulators to manage their deployment. Benjamin Warren, global power and utilities corporate finance leader at advisory firm EY in London, argues that regulators must act to ensure that power markets aren’t flooded with capacity. It’s not sensible for governments and regulators to simply provide market access: it is incumbent on them to find ways to manage supply and demand.” Doing so will help to mitigate against the effects of price cannibalisation and ensure generators can earn a reasonable return. If part of the motivation for government subsidies is to bring down the cost of emerging technologies, should governments begin to redirect subsidies towards new types of renewable energy generation? Experts are cautious. There is a case for supporting new technologies that enable the cost-effective use of renewables,” says Warren, citing energy management technology and energy storage systems that would facilitate the greater penetration of renewables onto electric grids. However, for technologies such as wave or tidal, where the cost curve looks unlikely to come down over time to compete with wind or solar, it’s really challenging to make the case for subsidies,” he concludes.

Writer: Mark Nicholls