Meeting the offshore wind target requires pragmatic policy

27 May 2021

Offshore wind and the green industrial revolution

At the end of 2020, the UK Prime Minister announced an aspiration to build 40 GW of offshore wind by 2030. With poetic references to the wind that puffed the sails of Drake, Boris Johnson placed offshore wind at the forefront of a ‘green industrial revolution.’

In the last 20 years, Britain has installed around 10 GW of wind around our shores – a remarkable achievement that places the UK at the forefront of sea-based renewable energy. However, to quadruple the amount of offshore wind in half that time will be no mean feat. To put it mildly, installing 30 GW of new offshore wind in 9 years is a significant challenge. It requires amongst other things the mobilisation of something of the order of £60 billion of investment.

Policy changes?

At the beginning of 2021 the UK government held a consultation on ‘enabling a high renewable, net zero electricity system,’ calling for evidence on a possible redesign of the electricity market in the UK[1]. So hot on the heels of the offshore wind target the Government then asked whether the principal support schemes used to promote low carbon energy need to be changed.

This rather arcane topic is hugely important to meeting the offshore wind target and to bringing forward all forms of low carbon generation. Reaching net zero will require a great deal of zero carbon electricity, over and above the 2030 offshore wind target, as we expand the use of electric cars and heating. That is why UKERC has embarked on a programme of research into electricity market design and meeting net zero.

Current policies have seen the prices offered to new offshore wind farms plummet from well over £100/MWh to below £40/MWh – making offshore wind cheap compared to most other forms of power generation. Onshore wind and solar can be even cheaper. The scheme that has driven the price reductions provides auctions for long term contracts to deliver green electricity. Introduced in 2013, these ‘Contracts for Difference’ (CfDs) have proved to be very attractive to investors and have attracted lower cost sources of finance such as pension funds, which is exactly what they were intended to do. The current scheme is working and experience suggests that as soon as a major policy review starts investors hang back to see what happens. Given the urgency and ambition of the 2030 target, even hinting at changes to policy now is a bit of a surprise.

What is the problem?

So why would the UK government want to change a scheme that is clearly driving investment and lowering prices just when we need to galvanise even more investment in renewable energy? The main reason is that we need to ensure that the electricity market provides incentives for the flexibility needed to complement variable renewables. Having lots of wind and solar power affects the wholesale markets for electricity. Power prices depend on whether it is windy or sunny as well as if demand is high or low. Yet the CfD insulates renewable schemes from much of these day-to-day fluctuations in electricity prices. The government is asking if this should change.

Some commentators also worry that the government, not ‘the market’, is responsible for more and more of the decisions about the electricity generating capacity installed in the British grid. Alongside the renewables support scheme the government also operates a ‘Capacity Mechanism’, intended to ensure there is always enough generation available to meet peak demand. The CfDs reward new low carbon generation and the Capacity Mechanism rewards generation able to provide peak demands (basically, all other power stations). The government has taken back the role of a central planner that was supposedly abandoned when the power sector was privatised in the 1990s – or so the argument goes.

One alternative approach is a low carbon obligation placed on electricity retailers, such as the low carbon ‘mandate’ recently proposed by the Energy System Catapult. Proponents of this approach argue it would minimise micro-management by government and ensure that the private sector delivers the carbon target as cheaply as possible. This is where alarm bells ring for me. Not because I am against private enterprise or hostile to using market forces. Well-designed markets can be a great way of allocating resources. It is just that we have tried all this before.

Back to the future?

Let me take you back to a previous debate. 20 years ago in fact. There are striking parallels. The then Prime Minister wanted to set ambitious climate change targets. Existing electricity market arrangements had been around a few years and had some problems. So back in 2002, following an Energy Review and White Paper, Tony Blair’s government announced a redesigned ‘energy only’ wholesale market and a Renewables Obligation to lift the share of renewable energy.

The Renewables Obligation (RO) was a bold policy experiment. It sought to provide market based and technology neutral incentives to build renewable energy. Then, as now, arguments in play focused on governments not ‘picking winners’ and the power of free markets. It stood in contrast to schemes operating in other countries known as Feed in Tariffs (FiTs) where government agencies set fixed power prices for renewable technologies. The proponents for the RO made great claims for the economic advantages created by their technology neutral approach over the ‘interventionist’ FiTs.

As a means of expanding some forms of renewable energy the RO was reasonably successful. In the early-2000s onshore wind expanded substantially, along with landfill gas. However, it became clear that the RO was less cost effective than the FiTs. It also appeared to be less successful at developing a home-grown wind industry and community-owned renewable schemes. There was a great deal of debate and discussion about this at the time, but the upshot is that the RO was rather complicated and quite risky for renewables developers. In contrast, Feed in Tariffs were simple and offered a secure revenue stream, attractive to both small and large investors and viewed as a low risk investment by banks and other low-cost lenders. In real-world conditions, the simplicity and low risk characteristics of the FiTs proved more important to delivering renewable energy at minimal cost than the theoretical economic efficiencies of the RO.

It also turned out that the governments of the day did not really want a technology neutral approach after all. Onshore wind was controversial and they wanted more offshore wind and rooftop solar, both of which were then too expensive to find favour under the RO. The RO was also administratively complicated. It required government to set the level of the Obligation, along with a price cap known as a Buy Out Price and a certificate-trading scheme administered by Ofgem. Perhaps a future scheme could be simpler, but any obligation needs a system to check compliance.

The RO was ‘banded’ to support a range of technology and a micro-generation Feed in Tariff was added in 2008, to offer small investors a less complicated means of support. However, by 2011 the government had embarked upon another full-blown review of energy policy. In 2013, legislation commonly referred to as Electricity Market Reform (EMR) scrapped the RO and brought in a new support scheme for both renewables and nuclear – the Contracts for Difference described above.

Lessons from the past: risk matters

The main rationale for EMR was that renewables, and importantly nuclear, needed to be de-risked more effectively. Low-carbon power sources are highly capital intensive – the fuel is free but they cost a lot to build. As a result, the rate of return sought by investors has a big impact on the cost of electricity. The risks EMR targeted are associated with wholesale prices for electricity, which can be volatile and move up down with the global gas price. Sustained low gas prices may spell financial trouble for low carbon investors because the power price could be too low for them to pay their debts. This happened in the early 2000s when record-low power prices resulted in nuclear power stations needing an emergency loan from the government. EMR deliberately set out to insulate low carbon investors from some of these price risks.

The CfD has another major benefit. It largely eliminates what financiers call counterparty risk. Under the CfD, the contracting party is a company owned by the government. Unlike individual electricity retailers, there is little chance of this company going bust or reneging on the contract. This combination of market and counterparty risk can have a profound impact on the cost of capital. It can also affect how much investment is available. Very large sources of capital such as pension funds need to find low risk investments to protect their members against the vagaries of financial markets. They call such investments ‘infrastructure assets’. In recent years, the UK’s low-risk policy environment has attracted these investors into offshore wind and other renewable energy schemes.

The architects of EMR appear to have been vindicated. The high prices provided under the RO gave way to CfD bids below even the average wholesale market price for electricity, ushering an era when renewable energy can be free of subsidy. The ability of the CfD to attract new categories of investor, such as pension funds, offering low cost finance has played a key role. CfD prices are set through auctions, so they have encouraged the private companies who build and run wind farms to innovate and minimise costs and maximise output[2].

Back to the future. Or not?

All this may leave the reader a bit perplexed as to why what sounds like a return to an abandoned policy from the early 2000s has even been discussed. This is partly ideological. For some, the first best solution will always be to minimise the role of government. As a result, any situation where it might be cheaper to have a government agency organise things than have a competitive market find a solution leads to hot debate. Similar debates run in other areas of policy, such as the railways, where policy has just come out in favour of more state coordination.

A more pragmatic argument is that there may be a trade-off between giving renewable energy investors a low risk environment and efficient operation of the grid. A low carbon obligation might be a better way to get efficient operation of the network, and cost savings here might outweigh any impacts on investment. This gives us a number of key propositions that we can evaluate through empirical and modelling analysis:

Can exposing renewable energy generators to wholesale price risk reduce overall system operation costs? How much does doing this increase the cost of capital? What is the impact of counterparty risk and is it possible to attract low cost sources of investment in the absence of a CfD or similar?

More detailed and complex questions follow but the principal point is to establish whether the benefits of changing policies outweigh the costs. Net zero is a very urgent challenge. There is no time to invent a clever free market solution just to see if it works.  We need to consider if the problem lies mainly with the CfD, with the capacity mechanism, or with the underlying market. Policymakers also need to assess whether changes should be radical or incremental, since a variety of adjustments to CfD arrangements could reduce system costs whilst maintaining the conditions needed to attract investment.

It would be very odd if the principal objective were merely to turn renewables off when demand is low. We will need all the low carbon energy we can get to power our electric cars and run our electric heating. Far better if we can make sure the renewable generators keep on running and then find clever ways to store power, or shift demand in time, and put all the clean power to use. The CfD treats renewables projects as low-risk infrastructure and requires other investors build storage or come up with smart demand-side solutions. A low carbon obligation would push renewable energy to behave more like conventional generation, requiring renewables to build their own back-up. But there are many other ways we could adapt or change policies in pursuit of more efficiency. Simply put, which approach works best?

This is why UKERC is trying to work out what mix of market rules and policies offer the cheapest and most effective way to incentivise ongoing expansion of renewable energy and the provision of smart and clever ways to manage demand or store energy. Quantifying any trade-off between operational efficiency and securing investment at low costs is essential. Rather than arguing from first principles, the analysis will engage with the messiness of the real world and learn from history, as well as experience overseas. The goal is to design a pragmatic set of policies that minimise costs all round so that the energy industry can get on with the hard part – building a net-zero power system.

The author is Director of UKERC. He was one of the authors of the Cabinet Office Energy Review of 2002. He was also Specialist Advisor to the Energy and Climate Change Select Committee scrutiny of the Energy White Paper of 2011 and Energy Bill of 2012, that led to Electricity Market Reform.

[1] More accurately in Great Britain since the island of Ireland has separate and integrated electricity trading arrangements

[2] The CfD has been less successful at attracting investment in nuclear power stations but we will leave that for another blog