Wednesday, October 26, 2016
HOUSE OF LORDS CONSIDERS MARKET FAILURES IN THE ENERGY SECTOR
Readers may be interested in two pieces of evidence recently submitted to the House of Lords Select Committee on Economic Affairs Inquiry on the Economics of UK Energy Policy and published on 12 October 2016. The main authors are both lead investigators within the Oxford Martin School Programme on the Integration of Renewable Energy – Dr John Rhys who is attached to the Environmental Change Institute, and Professor Cameron Hepburn of the Institute for New Economic Thinking (INET), with co-authors Jacquelyn Pless and Alex Teytelboym.
The theme of the inquiry is market failure in energy markets and the submissions address this issue from different but complementary perspectives. The INET team focus on two of the biggest sources of market failure – spelling out issues stemming from the absence of adequate carbon pricing, and the need to ramp up research and development expenditure on low carbon alternatives. They also remind the Inquiry of the carbon budget issue. The low carbon targets implied if we are to meet 2oC, let alone 1.5oC, mean that no new fossil generating plant should be built without a clear plan for early closure or required retrofitting of CCS.
John Rhys, in addition to addressing a number of specific questions posed by the Committee, also concentrates on some specific UK market failures, the core theme of the Inquiry, and argues that the combination of large scale infrastructure investment and the very different nature of low carbon technology present major challenges for the “system architecture” of the UK energy sector. He notes that most current market structures, wholesale and retail, were built around managing the particular technical characteristics of large scale fossil generation plant. They are intrinsically and increasingly unable to accommodate the technical and economic characteristics of low carbon generation, significant degrees of decentralisation in the power sector, and major changes in the “demand side”, the ways that consumers will need and want to purchase and use electricity in the future.
Taken together the submissions make a powerful case for policies to resolve these market failures, and therefore promote more effective action on decarbonisation. They indicate some important priorities.
The INET submission highlights some of the consequences of failure to deal adequately with the issue of carbon pricing. These include inconsistencies in policy and perverse incentives, both in a UK and a broader international (EU) context, that can both lead to higher current emissions and inhibit investment in development of new low carbon generation. Resolving these issues is a high priority.
Encouragement of Innovation
It has been shown that R&D tax incentives and support schemes have significant effects on innovation outcomes (such as patenting) as well as firm R&D spending. The submissions also draw attention to areas where innovation will be of fundamental importance to the achievement and efficient functioning of a low carbon economy. These include solutions (at acceptable cost) to the problem of seasonal storage, a role which batteries and hydro storage currently seem unlikely to fulfil. The most promising route may be chemical storage of energy, eg conversion of electrical power to hydrogen, or further conversion to liquid fuel or synthesised natural gas. This would resolve many of the real time balancing, seasonal and security problems, including the intermittency problem (for renewables), and make energy conform more closely to the model of conventional commodity markets.
The fundamental challenge for the energy sector is the scale of the transformative changes needed to meet low carbon objectives. This is true across different subsectors, including multiple issues in power, transport and heat. This requires a range of policies across the sector, and very substantial investment requirements. The scale and dominance of capital requirements make the cost of capital extremely important in making the necessary transition affordable. One key economic challenge is therefore creating the market, regulatory and institutional arrangements that provide confidence to infrastructure investors, as a necessary condition for adequate levels of investment from the private sector, and an affordable cost of capital. The central role of climate and energy policies implies key roles for government and regulation in this process.
Role of Government in Decision Making for the Power Sector
This leads to a continuing important role for government, and it will almost inevitably continue to get drawn into questions of technology choice and support for major investments. Capacity markets in the UK have the government acting as a de facto central purchaser, a role already implicit in its support for renewables and nuclear investment. This, taken with the INET criticisms of recent capacity auctions, suggests that a central buyer model is a necessity driven by technical and market fundamentals of the power sector. This should be a central purchasing agency at arms length from government, with a high degree of technical and commercial expertise. This could be given a formal remit embodying environmental objectives, ensuring at least some degree of insulation from political interventions and interest group lobbying.
“System architecture” is becoming an increasingly familiar term in examination of future energy policies. In summary it means the totality of technical, commercial, market and regulatory arrangements for all aspects of the energy sector, including production, wholesale markets, transmission and distribution, metering and final use by consumers, the role of competition, regulation and, where appropriate, policy interventions.
Particular issues highlighted in the submissions are the investment requirement discussed above, implications of central purchasing, the operation of wholesale markets, decentralisation and the demand side. The technical characteristics of low carbon generation force a re-evaluation of the current role of wholesale markets. Decentralisation undermines the conventional business model of network utilities (in distribution), and metering and control technologies enable a range of new approaches to the way consumers buy and use electricity. But the questions cannot be answered in isolation, as the answers will be highly interdependent.
In essence the overarching challenge is to find the right combination of regulated monopoly or public guarantee (to achieve a lower “utility” cost of capital), competitive markets and incentives (to promote efficiency and innovation), policy intervention (to meet climate or other social and political objectives), and technically competent institutions (to manage complex interdependencies). Implicitly this also includes a number of appropriate and consistent technical choices throughout the system.
The OMS Programme
The Oxford Martin School Programme on the Integration of Renewable Energy will be returning to these and other questions, not just for the UK but in a wider international context.