The cheapest reserves of oil and gas are disappearing and continuing to use those fossil fuels which remain emits carbon is increasingly disrupting the global climate and economy. Older oil wells, such as those around the Persian Gulf, are economical with oil at $7 a barrel, but many of these retain just a third or less of their original reserves; while newer resources, such as the oil sands of Canada, are economical only with oil over $80 a barrel. At the same time, atmospheric carbon dioxide is now 37 percent above its preindustrial level, and average global temperatures are up by nearly a degree Celsius – enough to noticeably shift weather and agricultural patterns, but still only a fraction of what will follow if carbon emissions are not controlled.
The total energy available annually from renewable sources, meanwhile, is thousands of times what the world economy consumes and the engineering knowledge needed to extract it is largely in place. Physically speaking, it seems obvious that the transition to renewables should happen swiftly and immediately.
Economic and political factors, however, impede the transition. In both our infrastructure and our ideas, fossil fuels have the advantage of incumbency, making them harder to displace. The environmental costs of carbon emissions are not properly incorporated into market prices for energy, so private economic returns from fossil fuels remain higher than those from renewables. And escalating fuel prices resulting from tightening supplies will only stimulate development of new energy sources when it is already too late.
Systemic change is needed, and only government can break the deadlock. But which policies do we need? To answer this question, we must look at the current cost competitiveness of renewable energy and how policy can improve this. In doing so, I will look mainly at renewable energy in electricity generation.
For any power source, the principal economic considerations are the initial capital cost per unit of generating capacity, the rate at which this capacity is utilised, the operating costs per unit of electricity, the price of electricity, interest rates on financing and the project lifespan. Renewables tend to have higher capital costs than other power sources, often because the technology is not mature, and to have much lower capacity utilisation, because of intermittency of the resource. But they also have dramatically lower operating costs because no fuel is needed.
The total costs of generating electricity from different sources, taking all of the above factors into account, are as shown in Figure 1. This also shows the cost that would be incurred if a carbon tax at ¤25 per tonne of carbon dioxide were imposed on fossil electricity. The range of valuations that economists attach to the full social and economic costs of carbon emissions is ¤20-€30 per tonne, though even €30 may be an under-estimate.
The key point is that, because fossil fuels are much cheaper, energy firms will mostly put their money into these rather than renewables. So, without policy support, renewables cannot yet compete.
The costs of wind energy are unlikely to fall much. The technology is mature and whatever incremental cost benefits are realised from new turbine designs and materials are likely to be offset by the need to move onto less amenable sites than those initially exploited. In solar power, however, radical refinements such as ‘multi-junction’ cells that capture far more energy by having multiple layers that absorb sunlight at different wavelengths, or ultra-thin solar cells that use raw materials more efficiently, could make solar competitive without government support within a decade or two.
Until then, governments must intervene to level the playing field and make renewables competitive. The simplest way to achieve this would be a carbon tax on large emitters. If this reflected even a fraction of the wider cost of fossil fuels (reflecting the full cost immediately would likely be too disruptive and politically difficult), it would instantly make renewables more competitive than smokestack power stations.
Energy taxes, in some cases based partly or largely on carbon content, and often applying to transport and power generation in different ways, are in place in many European countries. Sweden has a carbon tax at up to ¤100 per tonne – albeit with several exemptions – and has experienced a substantial shift to low-carbon energy while suffering no economic harm. Denmark has a carbon tax at ¤18 per tonne. India introduced a carbon tax on coal power in 2010 but it is at less than ¤1 per tonne – potentially enough to finance research and development but enough not to affect the economics of power projects. State, provincial and local governments in the US and Canada have also introduced modest carbon taxes and other governments have considered them.
The European method
Another approach to achieve the same outcomes as a carbon tax is a system of cap-and-trade for carbon emissions. This involves selling permits to large polluters to emit carbon up to a certain quantity over a given period, and allowing them to trade these permits so that those emitters who do not utilise their full limit can sell permits to those who will exceed their limits. Companies who emit more than their permits allow face a fine per tonne of carbon substantially more expensive than the cost of permits. The result is that carbon emissions carry a price and, if the number of permits supplied by government is shrunk over time while the cost of their initial purchase and that of fines is increased, this price can be adjusted to exceed the ¤30 per tonne level deemed critical to fully reflect the damage done by carbon emissions.
The European Union introduced just such a system, centred on the European Union Allowance and the Emissions Trading Scheme in 2005. However, the initial issue of permits was free of charge and their quantity has not been sufficiently reduced over time. The EU carbon price currently sits around ¤17 per tonne but firms involved have paid much less due to the effect of free permits. Carbon prices under this system are also susceptible to arbitrary swings driven by sentiment and momentum, as happens in all financial markets, and the complexity of the system has permitted fraud. A simple carbon tax with appropriate indexing to inflation would be a better way to give firms a clear expectation of future carbon prices – making them frame their investment decisions accordingly.
More carrot, less stick
Feed-in tariffs are a different way to support renewable energy. These entail guaranteed access to the electricity grid, long-term contracts and a guaranteed price for renewable energy, often up to a certain maximum amount of power per supplier. Electricity distribution firms, be they publicly or privately owned, may then be obliged to meet this cost but can pass it on to consumers. Alternatively, the state may pick up the extra cost of renewable electricity through subsidies.
Rather than worsening commercial returns from fossil power, feed-in tariffs improve those of renewables – potentially making this approach more politically acceptable. Such tariffs have been employed in over 60 countries, mainly in Europe but also the US, Canada, Brazil, China and others. They were first introduced in the United States from 1978 but had limited impact there. It was in Germany, from 1990, that the policy was first pursued with vigour. Initially renewable energy producers were guaranteed a price of 65-90 percent of the final price for electricity from all sources. This resulted in 4400MW of wind power capacity being deployed in Germany during the 1990s and in renewables accounting for six percent of German electricity production by 2000.
German policy was reformed in 2000 with electricity prices paid by utilities to suppliers of renewable energy thereafter being based on cost of production in a manner that tended to offer investors a certain minimum annual return. This return was below what the technology can now achieve without state support but this was not the case when the policy was introduced, and putting a floor under returns is still effective in ensuring that renewables get a larger share in energy investment portfolios than would otherwise be the case.
Other countries have followed the German example, notably Spain and Denmark – with the former focusing on solar power and the latter on wind. Spain now gets nine percent of its power from renewables and Denmark 20 percent. The resulting increase in consumer electricity bills, meanwhile, has been modest; estimated at ¤4 per month for the average German household. Some cuts have recently been made to feed-in tariffs in the face of Europe’s sovereign debt crisis – a shockingly short-termist response. The UK, meanwhile, plans a minimum carbon price and feed-in tariffs for low-carbon energy but its policy outlook remains unclear after the recent austerity budget.
The path ahead
Many other policy instruments have been tried. Governments have set targets for the percentage of power they will get from renewables (15 percent by 2020 in the UK) and are using other policy instruments to meet these goals – with targets themselves also acting as signals when investors form their expectations. Building and vehicle standards for energy efficiency are being tightened and subsidies offered to refurbish buildings, with ¤20,000 refurbishments to old houses potentially cutting fuel bills and carbon emissions in half. R&D in new energy technologies is being financed. Installation of solar panels on houses in Germany has been subsidised – a policy that helped the global solar manufacturing industry establish scale, but which also inflated global prices for crystalline silicon and put many of the world’s solar panels in cloudy Germany.
Policymakers are looking to make electricity grids more amenable to renewables. Developments include lower electricity prices for certain domestic and industrial processes in return for halting when the supply of renewable power is low; long-distance power lines for exchanging renewable electricity over thousands of kilometres; power storage facilities to smooth supply intermittency and arrangements for feeding power generated by homes or businesses back into the grid.
Public policy has triggered flows of private capital into renewables. Total annual investment in new capacity (priced in constant dollars) rose from less than $10bn globally in 1995 to more than $150bn today. R&D investment has shown a similar trend. And major global players such as Suzlon and Vestas in wind power and First Solar and Q-Cells in solar have emerged. Eventually, as technology improves, such firms will be able to carry renewables forward without government help.
But we are not there yet. Renewables need state support and we know what works on this front. Governments need only learn the lessons and redouble their efforts.