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Does renewable energy have a subsidy-free future?

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Green subsidies are getting trimmed but might outlast those for fossil fuels in the end.

As national leaders meet to thrash out what they are prepared to do to promote the growth of renewable energy ahead of fossil fuels, the reality is they have largely decided market forces will be used for delivery. Governments have been reining in the subsidies that have been used to encourage investment in renewables such as wind and solar as their operational costs begin to approach those of existing fossil fuels.

The good news for renewables is that subsidies for the competition look to be on the way down as well. Even excluding the externalities – the environmental costs – of fossil fuels that are rarely included in calculations, direct government subsidies to fossil fuels have long outweighed any others. A recent report compiled by the International Renewable Energy Agency (IRENA) estimated more than two-thirds of the $634bn (£458bn) spent on energy subsidies went into fossil fuels in 2017.

A quarter of the total energy subsidies worldwide were used for renewables; the remainder were for nuclear. By 2030, IRENA expects fossil-fuel subsidies to have dropped to 35 per cent of the total, but that is not because it expects renewables subsidies to surge. Instead, overall subsidy spending could drop below $500bn (£362bn), with renewables subsidies by governments rising just 15 per cent to around $200bn (£145bn). According to IRENA, the situation could stay like that up to 2050, with fossil-fuel support still accounting for almost 30 per cent.

Energy subsidies to 2050 infographic - inline

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Why has fossil fuel support been so sticky in an environment where governments are less than keen to turn on the money taps for cleaner energies? A closer look reveals the spending is not evenly distributed around the world. The country with the largest fossil fuel subsidy in 2020, according to the International Energy Agency’s figures, was Iran: spending close to 5 per cent of its GDP to keep fossil fuels cheap. China and India spend less as a proportion of GDP but each accounted for more than $20bn (£14.4bn). The stated reason for the subsidies in most of these countries is to help the poor, though a number of economists have questioned whether they are as effective for this as they are for helping richer business owners.

The growth in subsidies for renewables that these projections show are also misleading, experts claim. IRENA predicts Japan will be the only country where subsidies for renewables generation will grow. For practically all other nations, the subsidies are being redirected away from financing the installation of solar panels and wind turbines for grid generation. Instead, they support a transition to electrification in transport and industry. These are more difficult to decarbonise compared to electricity generation for domestic and office users. According to IRENA, around half of the industrial subsidies are being aimed at iron and steelmaking, with a third directed at cement production.

Instead of subsidies for renewables for power generation, the incentives now look to be shifting strongly towards carbon pricing while direct funding gets trimmed. There are two main reasons for this shift. One is that, arguably, the job of subsidies is now done. Unlike the fossil fuel subsidies that were ostensibly kept in place to support consumers, the payments for renewables were more about kickstarting an industry and getting it into a situation where it can compete directly with fossil fuels.

In principle, once the cost of generation using solar and wind, and perhaps later wave energy, falls below that of natural gas or coal, the thinking is that investment in renewables is the obvious choice. Carbon pricing should nudge this process along, something that is helped by the operating costs of solar and wind. Though they are relatively expensive to install, once they are active they cost far less than natural gas or coal. The resource you need to operate them does not need to be mined, it just turns up as long as the weather is favourable. In this environment, many governments are keen not to be seen giving money to businesses who are going to be making money anyway because their marginal costs are so low. Even with that in mind, is it really time to abandon subsidies? A lot depends on how fast governments want to move on decarbonising energy.

Measuring the effect of subsidies is hard, not least because every country has a different approach. One way to look at the effects is to see what happens when they are removed. The IEA’s latest outlook for renewables around the world points to the reduction of subsidies as being a major influence on investment in several territories, especially China, where the government is changing its approach to green energy, though with a stated continued commitment to hit net-zero emissions by 2060. The IEA expects growth to weaken in the wake of these changes.

Support in Europe has ebbed and flowed, as has the pace of installation, over the past 30 years. The German and UK governments were the first in the region to try what have become the main instruments for implementing subsidies. Germany opted for the commonly used feed-in tariff and the UK a green certificate in the form of the Renewable Non-Fossil Fuel Obligation. Since then, Germany and other countries have tweaked their incentive schemes multiple times. The Renewable Energy Sources Act of 2014 saw the feed-in tariff move aside in favour of auctions for long-term contracts for many renewables technologies, an approach the government said would control costs more effectively in addition to making it easier to tune how the deployment would proceed. In this case, it was designed to both promote wind-based generation in areas with good prospects for efficient generation as well as giving more parts of the country opportunities for hosting renewables.

According to a 2017 review performed by Marcella Nicolini of the University of Pavia and colleagues, payments in Germany alone had risen from less than €1bn (£853m) in 2000 to over €20bn (£17bn) in 2010. The UK lagged far behind how much it paid, barely rising beyond the equivalent of €1bn in any year during the same period. The UK had adopted a more stringent policy that kept tariffs below €0.05/kWh. They reached as high as €0.15/kWh in other European countries. By 2008, close to 20 years into its programmes, Germany had built up approximately twice as much renewables generation as a proportion of total capacity as the UK. In 2012, Germany hosted around 30 per cent of the photovoltaics for power generation installed worldwide.

In later research, Claudia Hitaj of the US Department of Agriculture and Andreas Löschel of the University of Münster concluded that the level of feed-in tariffs does help increase capacity. Their model estimated than adding just one cent per kilowatt-hour, on top of the average 15 cents, would have increased renewables capacity by close to 800MW per year up to 2010. Though capacity additions surged in 2009 through 2012 to more than 7GW, the average annual increase before then was around 1.5GW. However, the type of subsidy does also matter according to the Pavia team. Their model indicated that green certificates, even adjusted for the amount of subsidy, result in less of an incentive compared to feed-in tariffs.

In any subsidy environment, there are ever-present subtleties that distort how investments are made. One issue with the original model in Germany that Hitaj and Löschel found was that companies building the plants had to bear the cost of upgrading local grid transmission to support additional capacity. That in turn led to them being built in areas with good existing transmission infrastructure. When the German government shifted more of the cost to the grid operators, the generating companies started to look more widely for sites.

Another unintended consequence of the long-term nature of traditional subsidies can be seen in the German home-generation sector. Industry group Solar Power Europe expects significant growth in home battery storage in the coming years as prosumers who had been on generous 20-year feed-in tariffs retrofit their systems to store the electricity for later consumption rather than supply at market prices.

Fossil fuel consumption subsidies infographic - inline

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Will carbon pricing alone lead to continued strong investment in renewables? In an analysis of the carbon-pricing policies implemented in the past decade, Johan Lilliestam from the Potsdam Institute for Advanced Sustainability Studies and co-workers concluded that carbon pricing does help reduce emissions but that this tends to take place by swapping existing sources of energy for others rather than stimulating larger-scale technological changes. For those changes to take place, more active intervention such as subsidies for specific technologies may be unavoidable even with falling costs.

Professor Charles Donovan and colleagues at Imperial College, London warn that governments may be too optimistic about the willingness of private investors to finance further expansion of renewables simply on the basis of the average daily cost compared to gas or coal. Too much may be made of the averaged numbers, which do look good, when it is the vagaries of energy markets that influence the initial go/no-go decisions.

The Imperial work underlines a problem with renewables that more often crops up as an issue of energy security and the vagaries of the weather. In a particular region, if you are having a good day generation, it is likely so is everyone else around you. During these times, wholesale prices can drop sharply during phases of ‘price cannibalisation’. Conversely, when prices are high, this could easily be because the weather is unfavourable and there is no energy to supply.

A gas-fired plant on the other hand can, in economists’ terms, respond to market price signals. If prices drop it simply stops running and when prices rise, the plant ramps up its output and fuel consumption. The net effect is that the weighted average price for wind or for solar can easily drop well below the apparent average.

There is a longer cycle that the Imperial team sees as also having a major influence: the supply and demand for fossil fuels tend to fluctuate widely over long periods. The oil price, for example, fell from more than $100 (£72) per barrel to less than $30 (£22) in a matter of months in 2016, a crash that pushed many shale-oil producers out of the market. The price returned to around $60-70 (£43-50), though even that was punctuated by a few days in April 2020 when futures contracts for oil turned negative for the first time because refineries were sitting on full tanks for which they had no orders. As the balance between fossil fuels and other energy sources continues to shift, similar peaks and troughs are likely to form in the coming years. Though direct subsidies would help, one option for risk reduction is to use financial instruments such as contracts for difference, as these can iron out short-term fluctuations in price.

One developing sector that could change the viability of investments in the face of fluctuating energy prices is storage. If the problem lies in either being forced to sell electricity at a loss or even into curtailment by the grid operator, one answer is to move the supply closer to peak demand by storing the energy temporarily. So far, however, subsidies for storage have focused mainly on grid stability, which calls for short-term storage based primarily on batteries, or on the domestic batteries now used widely in Germany.

In their analysis of storage in Germany, Andreas Coester of the Vrije Universiteit Amsterdam and co-workers forecast the widespread deployment of batteries in what they call a “green maximum” policy could force fossil-fuel generation out of the German market they took as an example, albeit with a price tag of some €350bn (£300bn). Other, cheaper policies down to full free-market operation lead to slower rollout speeds for renewable energy and in full free-market scenarios to highly cyclical phases of building followed by decommissioning when installations turn out to be long-term unprofitable, a problem that historically has not been a big issue with renewable energy.

As the proportion given to renewables increases, the question of long-term profitability could lead to the transition seeming to stall or go backward. Though governments will try to lean on the market more to make changes happen, they may have to keep an eye on contracts to avoid heading in the wrong direction when it comes to low-carbon power.

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Subsidy options

There are plenty of variations in how subsidies are put together but they fall into three major classes, with most of those being used now designed to react to market prices.

Traditionally, the feed-in tariff was the most common option. In general, the feed-in tariff gives users with generating capacity guaranteed access to the grid over a number of years and pays for the electricity at a level that is also guaranteed.

Generally, there is a fixed premium payment made for each kilowatt-hour combined with a pricing that is set at a certain level over the regular electricity spot price. The feed-in premium variant just offers a premium on top of the spot-market price, making it less predictable for operators when determining their break-even level for investment but one that makes renewables more favourable to investors.

Another technique is the green certificate, an approach used in the UK for some years. With this, a government sets targets for the amount of energy that needs to be generated from renewables and agrees to pay operators if they fulfil the conditions of their certificate. One advantage of the green-certificate system is that it generally works out cheaper for a government to implement but also acts as less of an incentive than feed-in tariffs.

One technique that may prove to be more popular in the future is the Contract for Difference (CfD). Much like the futures contracts developed for crop and livestock farmers, these contracts give the operators a more secure base on which to base investment decisions and have already become part of the policy instruments used by the UK to promote some types of renewable. This need not be a full subsidy: much depends on the price. Its main aim is to provide pricing stability and, in turn, make it easier to estimate the break-even cost of an installation over many years.

The early CfDs employed in the UK were awarded for more than £100m/kWh, which at the time was more than double the wholesale price of electricity. However, governments with an eye on expenditure will likely look to much lower levels and use the CfD to overcome problems caused by oversupply when all the renewables in a region are active and demand is low.

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