Designing Financing Mechanisms for Electricity from Renewable Energy Sources: The Role of the European Commission as an Agenda Shaper
Typical merit order of power plants. Source Transdisciplinary panel on energy change (TPEC), IASS Potsdam
When shaping national and European energy policies, the European Commission pursues the establishment of a text book model for liberalised electricity markets. Ultimately, all power producers should be able to refinance their investments via (spot) market sales of electricity and the achievable contribution margins (see Fig. 6.1). Ideally, this market (i.e. the spot market) would be a level playing field for all power producers—with externalities (e.g. carbon emissions and other environmental damages) being internalised via the European Emissions Trading System.
As indicated above, this leads to high investment risk for all power producers and potentially to high costs of capital. In addition, two other factors have to be taken into account in the case of renewable energy sources. First, their relatively high shares of capital expenditures in relation to operation expenditures. Second, the effect of an increasing share of wind and solar photovoltaics (PV) on spot market prices. Power producers need to refinance their capital expenditures (CAPEX) and their operating expenditures (OPEX) via surplus revenues from market sales, the so-called contribution margin. The share of CAPEX and OPEX differs quite considerably from one technology to the next (see Fig. 6.2).
The different share of CAPEX and OPEX leads to different levels of risks associated with investment in different power generation technologies—despite the fact that they are ideally competing on a “level playing field” in a common market. This is one of the aspects frequently overlooked in the debate on a level playing field. By definition, technologies with lower levels of capital cost face lower risk because their investment risk is primarily related to the cost recovery for the fixed capital costs. In other words, short- and long-term price volatilities of the spot market are a bigger risk for wind and PV producers than for gas-fired power producers. To put it simply: an operator of a gas-fired power plant can still decide not to operate the plant if market prices are below the costs for fuel (and CO2). Therefore, refinancing power plant via spot market sales creates a bias towards technologies with a low share of capital costs (and a high share of fuel costs). However, most low-carbon technologies have a relatively high share of capital expenditures.
In addition, an increasing share of renewable energy sources with very low marginal costs reduces the spot market price. This so-called merit order effect was observed in many countries with a high share of wind and solar PV in the system (Sensfuß et al. 2007; Sáenz de Miera et al. 2008; Ray et al. 2010). To put it in a nutshell, increasing shares of wind and solar PV on the market results in lower spot market prices and thus destroy the basis for refinancing themselves via spot market sales in the future.
6.2.2 Financing Mechanisms for Renewable Electricity in the European Union in the Context of Electricity Market Liberalisation
As indicated above, the European Commission is pursuing two partially conflicting objectives. On the one hand, it fosters the transformation of the European electricity sector and tries to enable investments in renewable energy sources and other low-carbon technologies. This requires investment security—especially because these low-carbon technologies are very capital intensive. On the other hand, the Commission wants to establish a common market, which is based on the concept of short-term trading on electricity spot markets. This creates a substantial amount of risk for power producers. In order to understand the ambiguous role of the European Commission as an agenda shaper for renewable electricity financing mechanisms, it is necessary to understand the debate of various financing mechanisms in the light of the ongoing electricity market liberalisation. How far are the different finance mechanisms able to allow for investment security and low capital costs? And how far are they compatible with the European target model for a liberalised market?
A number of different support instruments are applied in EU member states. Nonetheless, the debate within the EU context is primarily focused on Tradable Green Certificate instruments and feed-in tariffs. Recently, auctions have gained increasing importance in the European debate. Other support instruments, fiscal incentives, have played a minor role within the EU policy debate.
22.214.171.124 Quota Obligations
Under a quota obligation, the legislator requires electricity suppliers to provide a certain share of electricity from renewable energy sources. The supplier can either produce electricity itself or buy it from other green electricity producers. In order to increase the flexibility of the system, the supplier is also allowed to make up the required share by trading certificates in many counties, which serve as proof of compliance with legal obligation. Therefore, these mechanisms are called tradable green certificates (TGC) in the EU. The electricity supplier can obtain certificates either by producing renewable electricity or by buying certificates on the national certificate market. If suppliers fall short of reaching the required share, they must pay a penalty. Under this type of support mechanism, renewable electricity producers have two income sources. First, they sell their electricity on the spot market for electricity at the given (hourly) price. Second, they can sell their certificates on the national green certificate market. In theory, the certificate sales compensate for “greenness” of the electricity or the positive attributes of renewable electricity compared with conventionally produced “grey electricity” (Jacobs 2012a, b). This support instrument reflects the functioning of competitive spot market in liberalised power markets. First, the produced power is sold on a spot market—and the price achieved by the renewable electricity producer is the result of supply and demand. Second, the certificates received for each unit of renewable electricity is traded on a (national) trading platform. To a certain extent, this certificate trading platform reflects the functioning of an electricity spot market. In times of high demand, the power producer can achieve higher prices. And in times of low demand, the power producer receives lower prices. However, this support instrument has proven to be ineffective due to the high levels of investment risk resulting from the volatility with both spot market prices and certificate prices (Goldammer et al. 2012). As of 2013, six countries in the EU applied this type of support mechanism. Quota obligations were first implemented in the UK, Italy and Belgium in 2002. Sweden followed in 2003 and Poland in 2004. Romania was the last EU country to implement this support instrument in 2007 (EU Commission 2005; EU Commission 2008a, b, c, d; Resch et al. 2005). In 2011, the UK announced the replacement of the quota mechanism with a feed-in premium mechanism.
126.96.36.199 Feed-in Tariffs
Feed-in tariffs consist of three core design features: a purchase obligation, a predefined (fixed) tariff payment level per kilowatt-hour and a long duration of tariff payment. First, the purchase obligation forces the grid operator or utility to buy all renewable electricity—independent of electricity demand. Second, the renewable electricity producer is guaranteed a certain amount of money per unit of electricity produced. Third, this payment is guaranteed over a long period of time (usually 15–20 years), which increases investment security and ideally allows for cost recovery (Mendonça et al. 2009; Jacobs 2012a, b). This support instrument reflects the logic of price regulation under non-competitive markets. Renewable energy producers are exempt from price risk (volatility of spot market price) and volume risk (the risk of not being able to sell the electricity on the market). This finance mechanism delivers a high degree of investment security because power producers are able to predict their revenues over the lifetime of the power plant. Feed-in tariffs and feed-in premiums accounted for the majority of newly installed capacity from wind onshore and photovoltaics (93 % of all wind onshore capacity and nearly 100 % of all photovoltaics capacity installed by the end of 2010 in Europe) (Jacobs 2012a, b; Ragwitz et al. 2012).3 Besides this high degree of effectiveness, feed-in tariffs have also proven to be efficient since they were able to lower capital cost due to the high level of investment security. The great majority of EU member states use feed-in tariffs for renewable electricity support. As of 2012, feed-in tariffs were established in 24 out of the 27 EU member states. 20 member states use FITs as their main support instrument.
188.8.131.52 Feed-in Premiums
In the case of premium feed-in tariffs, the producer has to sell the renewable electricity on the spot market. As the market price of electricity alone will often not suffice to reach a certain profitability threshold, a reduced feed-in tariff is paid to the producer of renewable electricity. The premium payment usually depends on the technology-specific generation costs. The combination of these two payment components—the electricity market price and the reduced feed-in tariff—should suffice to operate renewable energy power plant profitably (Jacobs 2012a, b). As the premium feed-in tariff consists of both incomes from spot market sales and a “fixed or gliding payment component”, it can also be understood as a compromise between the proponents of feed-in tariffs and the proponents of quota-based TGC mechanisms. Premium feed-in tariffs are considered to be more ‘market-based’ than a fixed feed-in tariff and less problematic in the light of a common European market (EU Commission 2005; Klein et al. 2008). Therefore, the implementation of premium feed-in tariffs have often been considered as a means to overcome resistance to price-based support mechanisms in general (Mendonça et al. 2009). When assessing the risk of premium feed-in tariffs for renewable electricity producers, two design options need to be differentiated. First, a fixed premium payment on top of the revenues from spot market sales. Second, a variable or gliding premium payment, which makes up for the difference between the variable spot market price and a previously determined price that allows power producers to refinance their investment (Couture and Gagnon 2010; Ragwitz et al. 2012). In the case of a fixed premium, the power producer is subject to price risk that is variations on the electricity spot market—in the short-term (hourly, weekly and monthly) and on the long-term (over the period of years that are needed to refinance the initial investment).
In case of this financing mechanism, the responsible authority is usually auctioning a certain amount of capacity (e.g. 100 MW of wind onshore). Project developers will answer to this call for tender by offering a certain price per kilowatt-hour. Contrary to feed-in tariffs or feed-in premiums, prices are not set administratively but instead the result of competition between different market actors. This is more in line with the underlying idea of competitive markets than administratively set payments levels. In theory, auctioning capacity should guarantee power production at the lowest possible cost (see Rickerson et al. 2010; Becker and Fischer 2013). The risk associated with auctions depends on its design. Policy makers can either auction fixed tariffs, gliding premium payments or fixed premiums on top of the revenues from market sales. In addition, auctions lead to a higher risk during the project development phase because project developers cannot be certain whether their project will be selected or not. Auction mechanisms have been used in a number of EU member states, including the UK (until 1999) and Ireland (until 2005). As of 2010, this support instrument is still applied in Denmark for offshore wind energy. France also made use of this support mechanism from 1996 to 2000. Today, France still uses auctions for large scale solar PV, biomass, wind offshore and in exceptional circumstances for other technologies (Resch et al. 2005; Ragwitz et al. 2006; République Francaise 2010).
6.3 The Commission’s Positions Regarding Financing Mechanisms
In this section, we will elaborate on the position of the European Commission regarding different financing mechanisms for renewable energy sources over time. We analyse the Commission’s positions with regards to different legislative procedures and publications from 1995 to 2013. This includes White Papers, Green Papers, guidance papers and recommendations, best practise benchmark report, draft Directives and state-aid guidelines.
6.3.1 Early Commission Papers and the Directive 2001/77/EC
Although the first policy initiatives for the support of renewable energy sources were taken in the 1980s, the debate on the best financing instruments for renewable electricity was largely triggered by the liberalisation of European energy markets in the 1990s. First indications of a common European framework for the support of renewable energy sources can be found in the Commission’s White Paper of 1995 on an energy policy for the EU. The document stated that “certain forms of energy like renewables may need to be supported initially through specific programmes or subsidies in order for them to find a place on the market”. Nonetheless, support for renewable energies should be given in a way that is least harmful for competition. Consequently, “further policy development may need to be considered” and the organisation of national markets should be monitored closely (EU Commission 1995, p. 19).
In the following years, the European Commission and the European Parliament were looking for adequate financing schemes, which would eventually be applied for all European countries in a harmonised framework (Busch 2003). In its 1996 Green Paper Energy for the Future, the European Commission criticised the fragmented and rapidly changing nature of national financing mechanisms. The Commission also expressed a clear preference for quota-based support instruments by stressing the need to phase out and replace regulatory policies by “more market oriented measures” making explicit reference to the functioning of quota-based support instruments (EU Commission 1996, p. 34).
Even though the European Parliament does not have formal agenda-setting competences within the EU’s institutional framework, it soon expressed its opposing view reflecting the position of many European member states. In a report from 1997, Rapporteur Rothe from the Party of European Socialists called for the establishment of a European feed-in tariff scheme. Even though the term “feed-in tariff” was not explicitly mentioned, the report argued for a purchase obligation of green electricity and a “minimum payment by the utilities… which would at least cover all of the current costs of the producer” (EU Parliament 1997, p. 6). Despite this obvious disagreement on the most adequate financing instrument among the European institutions, the European Commission continued to push for an EU-wide quota-based support instrument and pressured several member states to adopt this type of support instrument by promising a first-mover advantage once this support instrument was introduced Europe-wide (Lauber 2007).
At the same time, the diffusion of feed-in tariff schemes slowed down because many legislators expected a change in the European framework and feared legal insecurity (Busch 2003; Bechberger and Reiche 2007). The European Commission openly criticised the German feed-in regulation, which granted high levels of remuneration for wind energy. And the German feed-in law of 1990 was referred to the European Court (Preussen Elektra vs. Schlesag) for its assumed incompatibility with the rules of the internal energy market (Jacobs 2012a, b). The European Commission’s 1999 working paper “Electricity from renewable energy sources and the internal electricity market” increased the pressure on feed-in tariff mechanisms. The paper found that, given the shift towards electricity market competition, a move away from a “fixed price tariff approach towards one based on trade and competition is at some stage inevitable” (EU Commission 1999, p. 17). In addition, the paper highlighted the distorting effects of a multitude of national support mechanisms on the functioning of a common European electricity market and criticised the limited competition between different renewable electricity technologies under feed-in tariffs.
In 1999, the energy commissioner, Loyala de Palacio, made one more push for a harmonised European support framework based on a quota obligation (Lauber 2007). However, this political initiative failed following criticism from the European Parliament, industry associations and environmental organisations (Jacobs 2012a, b). In other words, the co-decision-making process—and the opposition from the Parliament and selected European member states such as Spain and German—prevented the European Commission from enforcing their concepts of renewable energy finance mechanisms in a liberalised and common European electricity market. In the following years, Commissioner Palacio tried to take the concerns of member states and industry associations into account and allowed different financing instruments to work in parallel—at least for a certain number of years. After an interim period of 5 years, the European Commission planned to table a proposal for a harmonised support mechanism, which had “to be compatible with the principles of the internal electricity market” (EU Commission 2000, p. 18).
In March 2001, the European Commission had to cope with yet another indirect defeat as the European Court rejected the aforementioned complaint against the German feed-in tariff mechanisms of 1990. As a consequence, this judgement also undermined the Commission’s case against the German feed-in tariff of 2000 and the Commission’s intention to make explicit reference to state-aid provisions within the planned directive (Lauber 2007). Finally, the European directive of 2001 accepted heterogeneity of financing instruments—at least for the time being. The European directive fixed indicative renewable electricity targets for the European member states. But—in line with the principle of subsidiarity—national legislators were free to choose any type of financing instrument to achieve these targets. However no later than 2005, the European Commission was expected to table “a well-documented report on experience gained with the application and coexistence of the different mechanisms”, which might be “accompanied by a proposal for a Community framework with regard to support schemes” (EU 2001).
6.3.2 The Commission’s Assessment Reports for Financing Mechanisms
Under Article 4 of the directive 2001/77/EC, the European Commission was expected to assess the experience gained from the application and coexistence of the different financing mechanisms and possibly make suggestions for a harmonised support mechanism based on their effectiveness, efficiency, simplicity and compatibility with the principles of the internal electricity market. Assessment reports were published in 2005 and 2008.4 The 2005 assessment of financing instruments was first tabled in December 2005 (EU Commission 2005). The report was compiled by DG TREN—the department of the European Commission responsible for energy matters. The report stated that in most countries the support level had been insufficient to attract investment in renewable electricity generation plants.