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.

MARKET FAILURE AND ITS IMPLICATIONS FOR ENERGY AND CLIMATE POLICY

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 2^oC, let alone 1.5^oC, 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.

Carbon pricing

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.

Infrastructure investment

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

“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.

BREXIT BLUES. DEVALUATION WILL HIT DOMESTIC ENERGY CONSUMERS HARDEST.

For much of industry, the competitive benefits of devaluation will more than offset higher energy costs. The hardest effects will be felt by domestic consumers, especially the poorest. There are a few weapons that could be deployed to help the poor, but they will not reach everyone and are far from an ideal solution.

With the prospect of the UK leaving the EU, the slide in sterling was both predictable and predicted. It began on the night of the referendum and has gained more momentum with the growing belief, not only that exit is now very probable but that it will involve leaving the single market and the customs union, disadvantaging many of the UK’s key export earning sectors.

The calculus that underpins market sentiment on sterling is simple.  The UK currently runs a big current account deficit at around 7% of GDP. This has hitherto been balanced by foreign direct investment and borrowing.  The impact of Brexit has been threefold:

·         A severe threat to Britain’s service industries, especially financial services

·         The prospect of both tariff and non-tariff impacts on UK exports to its largest single market, the EU

·         Evidence that foreign firms, most notably Japanese companies, may hold back on investment in the UK and move many of their activities elsewhere

These factors together have the potential to make it substantially harder to balance the books, and this is now reflected both in sterling and in the slowly rising cost of government borrowing. A fall in the exchange rate both provides an additional incentive for UK manufacturers to export and acts as a major brake on UK demand for imported goods, as these become harder to afford. It is therefore a necessary part of making adjustments to the UK economy.

This will de facto mean a cut in living standards. That is unavoidable.  In current conditions the rising price of imports seems unlikely to set off compensating wage increases and an inflationary spiral, but the effects may be both severe and immediate, and the energy sector will be in the front line. The most clear cut impact will probably be through the impact on imports of gas. A 20% devaluation (around the level at the time of writing) means that imported wholesale gas will cost an extra 25% in terms of UK sterling. Given that wholesale costs account for about 40% of the retail price, this is likely to feed through as a 10% increase in prices to ordinary consumers. Other factors, not related to Brexit, will probably increase this figure further, to around 12%.  Effects on retail electricity prices are likely to be more muted but will still be significant.

Industry too will have to pay more for its gas and electricity, but for those who compete in international trade, this will be of much less importance than the competitive benefit conferred by devaluation. Inter alia, as I anticipated in an earlier comment, this could transform the prospects for Welsh steel.

Fuel Poverty

Inevitably fuel price rises, like food prices, bear most heavily on the poorest, for whom they are a much higher proportion of total income. This ought to be a major concern. Various approaches can be considered for alternative domestic tariff structures that avoid subsidies to utilities from the public purse, but they usually require a cross-subsidy between consumer groups.

One is the concept of lifeline tariffs, in which the first “block” of energy is provided either free or at a heavily discounted rate, but with a premium rate attaching to higher levels of consumption. Although this is superficially attractive there are some practical problems. One is that the correlation between income and level of consumption is far from perfect. Poorer consumers are not necessarily low volume consumers. Volume can depend on family size, fuel choice, nature of their dwelling, etc.  To illustrate the imperfections of what ends up a scattergun approach, a lifeline tariff is almost bound to benefit second home owners.

A more promising approach is the promotion or subsidy of energy efficiency schemes that will reduce consumption but this approach too may not be adequate for the problem, as it is neither an instant solution nor is it likely to cover all cases of fuel poverty. So there is no simple answer to the problem. At root it is a problem of poverty rather than a problem of energy per se, and we have to accept the fact that the costs of energy are likely to rise above current levels (from what is likely to prove to have been an unsustainable historic low), from devaluation and for other reasons. Lifeline tariffs may be worth an experiment, and energy efficiency is a good thing per se, but otherwise this suggests that the problems of fuel poverty have to be confronted at source, ie poverty, rather than through additional interventions in the energy sector.

A POST GEOGRAPHY TRADING WORLD? REALLY? AND SURELY NOT FOR THE ENERGY SECTOR.

CLIMATE ISSUES, AND ENERGY TRENDS, MAY PUSH US TO A MORE GEOGRAPHY CONSCIOUS WORLD

“Mr Fox believes the world stands on the verge on an unparalleled chance to liberate global trade, where technology means countries no longer have to find trading partners so close to them” according to Nathalie Thomas in the FT, 29 September 2016.  But how does this fit with a world of increasing pressure on physical resources, growing recognition of climate problems, and low carbon energy technologies that are intrinsically geographical in their application? The theory has all the hallmarks of the “weightless economy” that was so fashionable in the run-up to the dotcom bubble at the turn of the century. As so often, a small element of truth can be exaggerated to the point of absurdity and folly. Geography matters, and in few places more than in relation to energy.

Of course there are products, like software, financial products or computer games, which are close to being weightless, and whose transport costs are minimal. Many services, in principle though not in practice, can be delivered without actual travel. In practice they can also be culture, language and legal system dependent, with strong geographical features, and do require physical travel by either the provider (consulting services) or the customer (tourism). But these are not exactly new elements in trade, and the much larger volume of physical trade in goods and commodities of all kinds, including manufactures, energy and agricultural products, continues to dominate. WTO statistics place services at about 20% of world trade by value, with trade in services dominated by transport and travel.

There is also the unfortunate truth that political trends across the globe are becoming less favourable to free trade, not just because of popular reactions from those who do not benefit, but because the incremental benefits of further removal of trade barriers are in any case declining.

In reality the world has coalesced into regional units (EU, NAFTA, ASEAN etc...) and the scope for reducing geographic barriers seems to rest on cross-regional trade agreements, ( EU-ASEAN, EU-MERCOSUR), or with states such as EU KOREA, EU MEXICO, EU CANADA.  Countries on the margins of such regional trade blocs are increasingly isolated and underperforming (Japan, Russia).  This is a cautionary observation for the UK. These are political considerations, and no doubt if there were new and overwhelming technical or economic advantages, we might expect to see a change. So it is worth thinking about future trends.

The energy cost of moving goods and people.

What, other things being equal, would make trade in physical goods, or transport and travel, less dependent on distance and geography? The simple answer is a big reduction in transport costs, and an increase in speed of delivery, especially for perishable items. The costs of transport are not confined simply to the costs of operating aircraft, ships or lorries. They include, for example, the energy costs of refrigerating dairy and meat products. And the cost of transport has been falling, not least because of falling oil prices.

But a big part of the cost of transport is the cost of energy and this is far more likely to rise than to fall. Transport is particularly vulnerable to future energy costs because it will depend, in a low carbon world, on new as yet only partially explored ways of converting primary energy (currently mainly oil, but in future nuclear or renewables) into suitable transport energy vectors (such as batteries or hydrogen). In the absence of technology breakthroughs not so far on the horizon, this almost certainly implies higher transport costs. Alternatively, as suggested in the recent aviation agreement and my comment on it, fuel use for transport will need to be compensated by expensive means of offsetting its carbon footprint. In either case the cost of transport and travel, taking a medium or longer term view, seems set to rise.

The trade in energy matters too.

Historically the dominant energy commodities in a truly global energy trade have been oil and coal. Gas has also grown substantially, and should push out coal and oil to a significant degree, but apart from some LNG (with its high transport costs), is pipeline dependent. It is certainly not an emblem for a post geography world.

In future the most important growth areas for energy trade will arise through first, physical interconnection of power networks, and second the potential for trading in the scarce resource of allowable carbon emissions.  Physical interconnection necessarily involves “finding trading partners in close proximity” to paraphrase Dr Fox. More than that, the least cost and most effective interconnection investments for the UK will depend not only on protocols for trade with its closest neighbours in the EU, but also a highly coordinated approach to network design and most likely significant agreement over the sharing of costs. Long distance interconnection is a great idea in principle, particularly if it can move across time and climate zones, but it is in a more remote future and will depend on more local interconnection as a precondition.

On carbon emissions, there is at least a structure in place for EU carbon trading, even though it is one that has so far failed to prove itself adequate to the challenge of low carbon objectives. It is therefore a structure that could be expanded more widely to embrace a more global trade, and could be mutually beneficial to participants. Carbon trading transactions themselves may be weightless, but a market depends on a high degree of trust and common practice among the participants, exactly what is intended to be achieved within a single market. So carbon trading, for the moment at least, is confined by geography.

An unparalleled chance to liberate global trade?

Not quite. There will be plenty of global trade associated with energy, but potential rises in transport costs will continue to maintain or even increase the importance of geography.

TWO MILESTONES FOR CLIMATE POLICIES AND TWO CHEERS FOR THE AVIATION DEAL.

Major movements to ratify the Paris agreement in the last ten days include the EU and India. This gives us the prospect of the early entry of the agreement into international law. And we are starting to see movement towards more effective policies for the aviation sector. But 2016 is also likely to be the hottest year on record, the prognosis of climate science is still very worrying, and there is long way to go in making policies effective.

Ratification of the Paris Agreement.

The last few days have seen two major steps forward on climate policy. On Friday last EU environment ministers approved ratification of the Paris Agreement. The EU ratification process now implies means that the agreement is now likely to become international law in November. The decision on behalf of the EU’s 28 member states, including the U.K., adds 12% to the percentage of emissions covered by countries signed up to the agreement, which becomes law when 55 countries and 55 % of emissions are signed on. Given that the world’s fourth largest emitter, India, has also formally India formally joined the Paris Climate Change Agreement by submitting its instrument of ratification India formally joined the Paris Climate Change Agreement by submitting its instrument of ratification India formally joined the Paris Climate Change Agreement by submitting its instrument of ratificationsubmitted its instrument of ratification, this month can be seen as a major milestone in the long journey to effective action on climate change.

A more sombre note was struck by a new report from seven distinguished climate scientists led by Robert Watson, former chairman of the IPCC,[1] asserting that the opportunity to meet the 1.5 Celsius goal “has almost certainly already been missed” and that even a 2^oC objective would be infeasible without heavier emissions cuts under the Paris Agreement. Separately, 2016 continues to provide a string of monthly temperature record, and, barring a rapid dissipation of the el Nino effect, is likely to again set a new annual temperature record.

As I have noted previously the UK will continue to be bound by commitments made while it was still a member of the EU, even if it leaves the EU. There will however be serious climate policy questions to be addressed, both for the UK and the residual EU. The UK will have to decide on whether it continues to retain membership of the EU emissions trading scheme. Despite its flaws and past failures, any regional trading scheme should in principle be capable of delivering mutual economic benefits. The EU will have to face the fact that the UK has promised more ambitious targets than the EU average. The UK’s departure may mean that the residual EU will have to work harder to meet its commitments.

The Aviation Deal.

This had therefore already been a momentous week for climate policy. But this major milestone on the road to giving legal force to the Paris agreement has not been the only major event. The International Civil Aviation Organisation (ICAO) has promised that, from 2020, any increase in airline CO2 emissions will be offset by activities like tree planting, which soak up CO2.  Although aviation only accounts for around 2% of current global emissions, it would still, if it were a country, be the 7^th largest emitter. More importantly it is one of a small number of energy using activities where no clear route to a low or zero carbon activity currently exists, and it is also one of the fastest growing. The ICAO has previously predicted a threefold increase by 2050, at a time when other sectors are drastically reducing or even eliminating emissions.

As a result of these two factors, aviation is likely to be a rapidly increasing proportion of any viable global carbon budget consistent with Paris aspirations, and will be one of our major residual problems if and when other sectoral targets for low carbon are achieved. So we should, as one government minister has suggested, welcome this as “a clear message that aviation will play its part in combating climate change”.

On the other hand, the deal, while welcome, falls well short of what will ultimately be required. It says nothing about continued growth until 2020. The scheme remains a voluntary one after that. And the definition of how “offsetting” will work and be measured is far from clear. But at least this is a start.

Resolving the aviation and emissions conundrum will not be easy. We can hope for a technical fix, such as a practical means of synthesising airline fuel, and there is clearly scope to introduce regulations that encourage more progress in energy efficiency, an area in which the industry has achieved significant progress. But the likelihood is that we shall have to rely increasingly on a “market” solution, and one that is effective in reflecting the very high climate costs of GHG emissions.

One approach is, it can be argued, implicit in the agreement that any growth after 2020 will be compensated by “offsetting”. De facto this may ultimately correspond to the cost of removing CO₂ from the atmosphere, carbon sequestration. Current estimates of this cost suggest figures of several hundred dollars per tonne of CO₂. This may seem impractical, and is in political terms probably a non-starter. But we should at least start to ask the questions.

In many countries, domestic taxes on road transport fuels, for example, are already at much higher levels that are much closer to reflecting the costs of the climate externality (although that has never been a primary motive for their introduction). The parallels are close. Both forms of transport are highly valued “premium” applications of energy. As transport modes they are to a significant degree substitutes, and should be subject to similar taxation regimes that do not distort consumer choices. In each case the price to the ultimate consumer can have a significant choice on lifestyles, again with implications for energy use. The difference of course is the international nature of aviation, which makes the prospect of a common basis for taxation, or common pricing principles, much more remote.

I expect we shall hear more on these themes. In the meantime the ICAO agreement at least provides a first step.

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[1] The Truth about Climate Change. The Universal Ecological Fund.