1. Theoretical Background
In 1972, The Limits to Growth book was first published; it aimed at simulating how finite resources will shape future economic and population growth. This was a time when the primary source of fuel, oil, was cheap and abundant. However only a year later in 1973, the first oil crises began. The Arab Oil embargo imposed by the Organization of Arab Petroleum Exporting Countries, triggered a massive shock in the price of oil. Governments started becoming concerned about energy security due to the reduction in the supply of oil and the ever increasing demand for energy. This newly found way of thinking coupled with the Oil shock placed an increased importance on energy. (1) Furthermore in the 1990’s a new theory on climate change and global warming started taking place, the implications of which were deemed profound in a global level. Think-tanks argued that restrictions on carbon-emitting land and cut backs in greenhouse gas emissions should be put in place. (2) Subsequently a focus on renewable energy started gradually emerging and with it an economic debate on the effectiveness and efficiency of it.
Renewable energy is needed to primarily deal with global warming, and the reduction of greenhouse gas emissions coming from unsustainable fossil fuels. This would slow down climate change but also reduce air pollution, an ever increasing problem especially in China. In principle renewable energy aims at internalising the external costs of energy production that conventional energy sources such as fossil fuel generate. Economic theory states that economic agents do not take into account external costs when making decisions. For example electricity generated from renewable sources has a higher price than that from fossil fuel, though prices are declining. The individual’s willingness to pay for renewable energy is low due to free riding behaviour. If one is willing to pay more for cleaner energy, then the marginal improvement in air quality would benefit everyone. (5) The question arises on whether the government should intervene.
With this in mind and considering renewable energy is a relatively new area, economists are discussing whether economic regulations should be in place and if yes what policies should be implemented. Neoclassical economists argue that renewable energy market failures arising from the presence of externalities, the monopolistic/oligopolistic nature of the market and imperfect information leads to an inefficient allocation of goods and services and on these grounds they support government intervention. The rational choice theory aims to develop economic policies in order to minimise these market failures and to define the role of the government in this area. While on the contrary there are economists opposing government intervention on the basis that information asymmetry leads to inefficient allocation of the taxes and subsidies collected or distributed by the government. (4)
The market for renewable energy, especially the one for electricity has certain supply and demand side restrains that differentiate it from other markets. Short run inelasticity characterises both the demand and the supply for electricity, whether renewable or not. On the consumer side, electricity substitution is infeasible due the high costs and long time frame needed. The supply side though is more complex due to a multitude of reasons. Installing new power plants has high costs and takes a long time to start producing energy, therefore only long term and large investments present, usually with high risks involved because of the difficulty in estimating future demand. (4)
Renewable energy especially has high generation costs, and even though the costs are declining, they are still higher than other traditional technologies. So the market barriers to entry are high, resulting in a concentrated market. Considering that the market is not mature, unlike the ones for fossil fuels, technological development through experience still has a long way to go. While the unpredictability of demand often results in shortage or excess capacity. Additionally certain types of renewable energy such as wind energy and solar photo-voltaic energy require certain whether conditions in order to generate energy, making it hard to adjust to demand necessities. The very short run on the other hand is very dynamic, supply and demand are balanced on real time due the difficulty of storing electricity. This not only puts pressure on the grid to deal with high peak demands but also on the operating system. (4)
All these elements, the free riding effect, where the willingness to pay of individuals is low, the characteristics of renewable energy industry including high generation costs, the early stages of technological development, infeasible storage and a need to instantaneously adjust demand and supply, prompt the intervention of the government. In case only market forces are in play, then the above mentioned benefits and positive externalities of renewable energies would not be taken advantage of. Therefore market failures in this market require government intervention. (4) In the following sections…
1.1. Market failure
Market failure, as defined by Bator (1958) is “failure of a more or less idealized system of price-market institutions to sustain “desirable” activities or to estop “undesirable” activities” This leads to an inefficient allocation of resources and a violation of Pareto Efficiency. The renewable energy market is characterised by three main types of market failure, firstly imperfect competition whereby the market is dominated by one or a few firms, secondly the presence of externalities, both positive and negative and thirdly imperfect information. (4) In the sections below the market failures and the reasons why will be discussed in more detail. However these failures are still present when the government gets involved, such as imperfect information. This could lead to government failures and potentially worse off market conditions.
1.1.1. Imperfect Competition
The energy sector suffers from various market failures, one of them being imperfect competition. Traditionally it was regarded as a natural monopoly, meaning that one firm can satisfy the entire demand of a market at a lower cost than in the case of more than one competing firms. (7) However as new players came into the market due to the technological progress, the market has become less concentrated. Nevertheless, imperfect competition is still very much a problem, too few firms do not guarantee efficient outcomes. In an oligopoly a few companies dominate the market and share a large portion of the industry. The two main features of an oligopoly that also fit in with the energy and electricity market are the barriers to entry and the interdependency of firms. Barriers to entry are particularly high in the energy market, high initial investment is required, economies of scale are large so a small company will find it hard to compete, other advantages that big companies investing in research and development have. (Sloan) In the energy market, even though there have been restructurings and liberalisations of the market in many countries, the energy industry is still dominated by a monopoly or cartel like formations. Theory shows that a few firms may decide to collude together and act as a monopoly in order to maximise their profits. (Sloan) A similar practice happens in the energy market. (7)
1.1.2. Externalities
The presence of externalities was first regarded as market failure by Arthur Pigou (1920). Externalities can be positive or negative, positive externalities are created by an economic activity that benefits third parties but not the producer of the goods, while a negative externality occurs when the economic activity creates costs to third parties and this is not reflected in the price. A classic example of externalities is pollution and environmental damage. Conventional energy plants such as coal production are associated with large negative externalities, due to the high emission of greenhouse gases. The environmental cost, and the cost of pollution that this causes to the residents near the plant are not taken into consideration. Renewable energies on the other hand do still produce externality costs but lower nevertheless. Hydropower plants have an impact an impact on marine life, wind power has an impact on the wildlife and causes noise pollution. (4) Pigou argued that since the price of the good does not take into account both internal and external costs, the market fails at creating an equilibrium between supply and demand. The supply of a good with high negative externalities will exceed the demand for the good, since not the full costs are taken into account therefore the price is lower. The opposite occurs with positive externalities, whereby the demand exceeds supply for goods that have high external benefits, the price is higher than it should be in equilibrium due to the extra costs. With traditional fuels, it is easy to see how the market fails due to externalities, however since renewable energy produces very little or no negative externalities it causes a strategic disadvantage. The price of renewable energy will therefore be higher than that of conventional energy due to the fact that it takes into account externalities. Since the price is higher, there will be less demand for it, even though it is better for the environment. In this case the government has to intervene in order to try to regulate the market and ensure the welfare loss is as small as possible. (4)
The graph below shows the effect of externalities in price and output demanded. Assuming this graph represents energy production, the market price at MP1 shows that when externalities are not accounted for, at price P1 there will be Q1 amount of energy demanded. Whereas taking into consideration externalities, the market price jumps up at P2 and the output demanded falls to Q2. (4)
1.1.3. Information Asymmetry
Another cause for market failure is information asymmetry, referring to the information is not evenly distributed between all partaking economic agents. One side has more information than the other, resulting in adverse selection or moral hazard. Adverse selection occurs when one party has more information on the characteristics of a good than the other party. A typical example arises in the insurance market where individuals that know they are high risk take more insurance, while the insurance companies can not distinguish between high and low risk individuals. Therefore, the high risk individuals end up paying less premium than they would under prefect information. Moral hazard on the other hand occurs when one party can not perfectly monitor the other’s behaviour, so there is an incentive for this party not to act accordingly. Taking the insurance market as an example again, individuals who have a full cover insurance on their assets, would have less incentive to be careful and protect the insured goods.
Renewable energy market suffers from information asymmetry, especially adverse selection. Both fossil fuel and renewable energy have a high market price volatility, renewable energy has has added risks regarding long term cost development of projects. Renewable energy has high investment risk and consequently the willingness to invest is reduced, particularly when investors compare it with conventional energy projects. Provision of information on renewable energy attributes and real risks would increase certainty and confidence in investors, therefore the investment’s risk premium would decrease.
The two methods, markets players can use to reduce information asymmetry are through signalling and screening. Signalling occurs when the party with more information identifies itself as better than the competition or with more attractive attributes. This initiative of differentiating from the rest is called signalling. (41) Whereas screening involves the party with less information performing tests or monitoring based on a set of attributes in order to select the best candidates. (41) The economists that disagree with government intervention argue that these methods are enough to correct information asymmetry and market failure.
On the other hand however, economists that believe in the role of the government to correct market failure, argue that government intervention is needed. Guidelines and laws that increase transparency are needed as well as ensuring the less informed parties have access to the same information as the better informed ones. Since information asymmetry acts as an entry barrier for an investment, reducing this effect would help investors evaluate risks correctly and it would increase market competition and decrease costs and prices. (4)
1.1.4. Government failure
Market failure as caused by imperfect competition, externalities and information asymmetry leads to an inefficient allocation of resources. Many economists use market failure as a justification for government intervention. But the 1970s brought a new focus on market failure and particularly government failure. In The Theory of economic regulation (1971), Stigler argued that the government faces pressure from both consumers and producers during the electoral process and this pressure is more intense when coming from the producers. This causes the government or regulators to act largely in the interests of firms rather than those of consumers. Of course this is done in a discreet way, through protectionism reforms or subsidies. Stigler criticizes the method of using regulation to correct market failure since it would lead to worsened market conditions and possibly even worse allocation of resources since the government itself faces information asymmetry and may have other intentions, hence leading to government failure. (43) In order to correct market failure, regulation should aim at doing just that, rather often it is used as an instrument by the government to redistribute income and resources. Therefore the government regulation does not act in the best interests of the whole public at large but rather in the interests of a certain group of individuals as suggested by the positive theory of regulation. Additionally Capture Theory suggests that the government as a regulator might pursue the interests of specific industries rather than use regulation in an unbiased way so as to benefit of the whole population.
Assuming the government is able to act impartially and does not give in to the pressures from consumers or producers, then the regulation of the market would still not be perfect due to information asymmetry. Part of the government’s role is to support the industries that have an overall positive economic impact; though selecting which industry or which firm to support is a hard decision to make considering the lack of information. Renewable energy market provides a particular challenge, since it is relatively new and not much information or experience from other countries is available on the different regulatory instruments used. So the risk of government failure is high.
1.2. Industrial Policy Approaches
In the last few years, governments have started to take more of an interest in providing support for new businesses and markets. Instead of following sectoral or vertical industry policies, which although are crucial to developing the economy, are also quite slow and expensive, they are instead following pragmatic industrial policies. These policies are mainly based on creating supportive environments which boost human development and encourage innovation, which are the pillars of our economy. The market of renewable energies is seen as a safe and profitable investment, which in turn is also greatly beneficial to the environment. Governments want to make the renewable energy industry more advantageous and investible in the global market, which brings to discussion two prominent issues: comparative advantage and competitiveness. Consequently the aim of export promotion and the concept of lead markets will be two of the lead topics being analysed.
1.2.1. The Competitiveness Problem
The meaning of the word competitiveness has always been vague, and open to personal interpretation, as can be seen in the meaning that it holds in micro and macro economy. Micro economy classifies it as the growth and profits of a firm in relation to others, whereas in macro economy it signifies the conditions of certain economic goals of a country in comparison to other countries. The latter is understood by many to be the goods a country a produces and the growth it experiences, while also managing to improve the quality of life of their citizens.
The traditional trade models function based on homogenous goods and returns to scale in production, which would effectively compare different markets and countries, but the comparative advantage theory has at its centre the different prices and production of goods in different countries. Countries are advised to trade at an international level, because it would invariably lead to creating specialised exports. The exported goods that are easier and faster to produce, will be more in demand in the international market, thus making them more advantageous for the country’s economy.
The finding of some authors, that developed countries are more likely to import and export similar good, contradicts previous models. New trade theories classify the main characteristics of trade flow as: imperfect competition which suggests that large firms may be able to have an effect of the price of goods; returns to scale which explains that with the expansion of a market, the firms involved will also experience an increase in returns; product differentials which consist of differentiating similar goods or services in order to avoid lowering their price or demand; and the timing of innovation which is important because it increases the demand of a good while being the sole supplier.
Research on comparative advantage showed that it is more likely reached by the ability to innovate, which gives said markets or countries an edge over the competition. This theory combines both the micro and macro concepts of competitiveness. Competitive advantage is characterised by 4 elements: factor conditions, which are divided into basic production factors and specialised factors, are the factors required for the production of a certain good; demand conditions which suggests that home demand puts more pressure on companies than foreign demand, since it based largely on quality than quantity; related and supporting industries which explain that technological innovation can be boosted by the exchanging of ideas and information; and strategy, structure and rivalry which include the conditions under which a firm is formed and developed, and the rivalries that it faces.
1.2.2. Infant Industry Argument
The Infant Industry Argument suggests that for new companies production costs will be higher at first, in order to allow them to develop, and compete with others. At the same time, the import for that product will be lessened until such time when the company is able to exist in the international market.
Economists have criticised this policy by saying that it will increase the domestic price of the imported goods, and suggest that all new companies will have higher costs due to less efficient production, and the purchase of technology and machinery. They also say that by making the protection of these companies a profitable venture, resources and reserves will be transferred to less productive activities. In addition it might cause a decrease and reduced efficiency in production.
This protection policy needs to be applied to companies that are predicted to be successful and influential in the long term, and the governments’ ability to determine them is put into question. The governments need to have extensive knowledge on the companies, but also in the markets that they are operating in, and even then mistakes would be probable. The Infant Industry Argument was at first only applied to companies in developing countries, which were trying to enter the international market, but they were not used in well developed countries. The reason why this policy has become so prominent is because it is believed to help companies to gain experience and allow them to compete in the international market.
1.2.3. First Mover Advantages
The First Mover Advantage suggests that the first entrant in a market may have an advantage over its rivals, and may maintain dominance over said market. Many economists have argued over whether it is better to entry a market first and benefit certain advantages, or to enter it later and thusly learn from the mistakes of the first movers.
This theory has applied extensively to the renewable energy market, with government regulation on environmental factors being in question. The backers of environmental regulation suggest that it provokes innovation in companies, and that the countries may benefit from two main advantages which are: increased export because of the first-movers advantage and decreased pollution. Some have argued that strict regulation in fact hinders innovation, from which we can conclude that it is difficult to determine whether regulation has an overall positive or negative effect.
Economists have questioned the constant promotion and support of renewable energy from the EU, which may be being done simply for an environmental purpose, or for increasing the advantages of the first-movers. Two types of first-mover advantages in the renewable energy market have been determined: the first exist only if the country has policies to encourage renewable energy or to reduce their carbon emissions; and second exist regardless of said policies being in place.
Along with research on the first-mover advantage, lead markets have also been attracting interest in the renewable energy market. Lead markets are markets where an innovative product is designed, developed and marketed, and afterwards is distributed to different countries. There are five key factors that contribute to the success of lead markets, which are: price advantages which usually result in the decrease of prices of certain innovative goods; demand advantages which come from the distribution of a good on an international level; transfer advantages which is when the national demand for a good is transferred globally; export advantages which is the increased global demand for an innovative product; and market structure advantages which include the rivalry between developed companies, and the entry of newer ones into the market. Many research on the lead markets have come to the conclusion that strict regulations and demand for the product, are crucial to their success.
1.3. Renewable energy policy instruments
In the early 1970s Alternative Technology movement first started campaigning for a more ecological and sustainable industrial society, they called out to industrialised countries to support the development of these new technologies. (9) That was the start of the renewable energy policies era. Initially the focus was on research and development as a means to develop new technologies and support their development. (10) However the relatively higher costs of renewable energy, meant that it could not quite take off without government intervention. (11) Considering that renewable energy is now becoming an increasingly significant area in both developed and developing economies, it is helping to reduce carbon emissions through greener development growth, it’s increasing technology diversification, consequently contributing to economic growth through industrial development and it’s creating labour market opportunities. It allows the governments to hedge against the price volatility of conventional fuel and it facilitates provision of electricity in rural areas where development is needed to combat poverty. The rise in investment flows and specific policy instruments with respect to renewable energy is showing a greater commitment from economies. (8) (statistics on global share of renewable energy)
Even though there is still substantial ambiguity on which policy is best to use, one thing is definitely true, market forces on their own do not encourage renewable energy and support is needed. Three main types of policies are observed throughout the different countries interested in generating renewable energy, firstly financial incentives such as tax-reliefs and lower interest rates. Secondly compulsory instruments that can be implemented on the price, quantity or through an auction. Thirdly other measures used may involve education on renewable energy, voluntary treaties and different research and development incentives. (4)
Designing a support instrument, whether it is price based or quantity based, the governments need to take into account various elements, though some of these elements may be better suited to one or the other type of instrument. In the sections below there will be a theoretical background on how the instruments are designed, starting from the determination of the support level, showing how the costs of renewable energy electricity production and how they are taken into account to establish the level of support needed. Examining the control of policy costs and how to adjust the price based instruments so that they fit the needs of the market. The government also needs to take into account how the instruments will affect the energy intensive industries in terms of competitiveness, so splitting the burden of the policies is an important factor. The industrial structure of the renewable energy market is also taken into account when deciding on a suitable instrument so differentiation between different types of technologies is needed. Not only instruments need to be differentiated but also they need to be flexible, stable, and predictable. Even though these attributes can be somewhat contradictory, it is important when considering investment risks. Then the final step is integrating electricity or energy coming from renewable energy into the market. (12)
The focus of the next three sections will be on the compulsory instruments, since they are the most widely spread and arguably the most successful policies in encouraging renewable energy development. Feed-In-Tariffs and Feed-In-Premiums are price driven instruments, whereas auctions and quotas are quantity driven. All four affect the market conditions in different ways and provide certain incentives to certain market players. The main factors that can determine the effectiveness of these policies are how the competition in the market is altered after the polices, does the supply of renewable energy increase and how easy it is to implement them.
1.3.1. Instrument attributes
1.3.1.1. Support level
Countries deploying renewable energy use various approaches to assess the support level needed, varying from estimating the foregone externalities as a result of using renewable energy, for example how much greenhouse gasses or pollution is avoided or estimating the decrease in energy import and increase in energy security that comes from using renewable energy. These approaches however rely heavily in assumptions and estimations; another method that aims to calculate the cost of producing electricity from renewable sources is called levelised costs of electricity (LCOE). The LCOE measures the net present value of the total cost of a renewable energy plant including the initial building investment as well as the operating costs throughout its financial life, then it converts this cost into equal annual payments. The LCOE enable governments to set support levels in price based approaches such as Feed-In-Tariffs and Feed-In-Costs while also acting as ceiling prices in auctions or in quantity based instruments. So the support level based on LCOE provides the renewable energy plants with the minimum income required over the investment lifetime. (12)
The levelised cost of electricity, initially requires the valuation of the investment costs then the operating and maintenance costs. Capital costs arise from capital expenditure on land, technology and equipment, construction, administrative costs such as permits and consultants and many more elements in the development of the plant. These costs are strongly dependent on interest rates, the time frame the debt and equity is needed, the debt-equity ratio, depreciation of the assets, the required return on equity. Investment risk, calculated as the additional premium paid on top of the risk free rate, has a significant impact on the weighted average cost of capital (WACC). It covers an array of risks ranging from the type of technology, the country the investment is taking place, policy uncertainty, and other investor related risks. (12)
On top of the initial investment costs, the operating and maintenance costs are estimated, they consist of a fixed and variable part depending on the type of costs. Maintenance, service costs, fuel and insurance are just some of the variables taken into account. Electricity coming from renewable energy has a high cost of capital ranging from 20%-50% of the whole levelised cost of electricity, however the operating costs can be relatively low especially in technologies such as wind or solar that do not require extensive fuel usage. (12)
After a certain period, once the investors start learning from experience in the market and using the technologies, the costs start to shrink. The learning curve is taken into account to define a degression curve whereby the support level starts to decrease by a certain percentage every year. The progression of revenues is based on the self consumption of electricity, the revenues from selling the electricity produced in the market or from the support from the government and other financial incentives laid out to encourage renewable energy production. (12)
Setting up the support level requires flexibility and ideally it should be paid out after the selling of electricity has taken place so as to take into account the revenue changes, however this is not always possible. The support levels should be carefully considered so as to still maintain the level of competition and technology and geographical aspects should be taken into account. (12)
1.3.1.2. Controlling policy costs
The promotion and integration of renewable energy entails policy costs, especially the technologies with a high cost such as solar PV. This is a particularly sensitive topic for the governments if they economy is not performing well and it can spark public controversies regarding the high policy costs during a recession. Though care needs to be taken when considering these policies so that it does not adversely affect the renewable and conventional energy market. If the investors do not trust the government to maintain the support levels on a long term, then investment risk increases and with it policy costs as well. Therefore political stability is key in the development of renewable energy. (12)
To control the policy costs, the government can opt to set a cap on the capacity and volume of electricity generated or directly capping the cost of the policy. Setting a cap on capacity however may be inaccurate and more difficult to predict since depending on the technologies the costs and generation capacity varies greatly. (12)
In auctions and quotas, so volume based instruments, the policy costs are controlled via an implicit cap set through the target, and it is generally determined in volume amounts. In such instruments uncertainties regarding certificate prices and the cost restriction as a result of the policy cap. When renewable energy companies do not meet the targets set out in advance, the supply is reduced, therefore the certificate prices increases. This also means that the policy costs increase. In order to mitigate this from happening and to incentivise companies to meet the set targets, the governments issue penalty payments. Grouping the types of technologies depending on the level of costs and uncertainties help to identify the technologies with naturally high costs. So that technology specific targets should be set out. Furthermore, penalties act as a ceiling price for the certificate prices and enable these technologies to compete in the market. (12)
Priced based instruments on the other hand require flexible support due to the ever changing operating costs and market conditions. Adapting the support levels to take into the account the reductions in cost due to the effect of learning, the changes in raw material prices and many other factors is crucial to provide the sufficient level of support but to also ensure that policy costs are not being excessively high. Bearing this in mind, for a successful support scheme, the government needs to provide a clear policy plan, under which conditions the policies can change and by how much would the support level increase or decrease. This transparency, reduces investment risks, premiums on the risks reduce as well and in turn decreasing policy costs. (12)
Another approach to control policy cost is setting the cap/limit on volume/price based instruments on a set time period. The governments can either choose a short term plan or a long term one, each having its advantages and disadvantages. Evaluating the policy costs on a short term basis, enables a more accurate forecast for the government and the project managers, however it can discourage investment in costly projects that take a long time to mature. On the other hand, revaluating policy costs on a long term basis, reduces uncertainty and risk premiums, thought from the government perspective it is harder to adhere to a policy cost plan. (12)
Regular monitoring of the budget as well as setting dynamic caps that automatically adjust depending on market conditions, can help keep policy costs under control as well provide the certainty that the renewable energy market needs. Therefore, when designing a policy to support renewable energy, there is a fine balance between providing predictability to the investors and providing flexibility as well. (12)
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