Liebreich: Feed-In Tariffs – Solution or Time-Bomb?

By Michael Liebreich
Chairman and CEO
New Energy Finance

As the first of $163bn worth of promised stimulus spending starts to soak into the parched ground of the world’s clean energy industry, attention is shifting back to the perennial question of the policy mechanisms required to drive the roll-out of renewable energy over the longer term.

Momentum behind feed-in tariffs continues to build. They have without question proved effective at ensuring heavy investment in renewable energy capacity in countries such as Germany and Spain. By the end of 2008, Germany had 23.9GW of wind power installed and Spain 16.8GW, according to Global Wind Energy Council figures – putting the two European countries second and third in the world rankings.

Finland, South Africa, China and parts of Australia have launched or are launching schemes this year. Industry groups in the US, the UK, Brazil and some countries in Eastern Europe are calling ever more persistently for them to be introduced.

By contrast, no other type of regime can boast such clear success stories. The UK, for instance, with its Renewable Obligation Certificate scheme, had built just 3.2GW of wind capacity by the end of last year – despite its superb natural resources. Sweden’s Green Certificate system helped to produce just 1GW of wind by the end of 2008, while Belgium, with its green certificate system, had chalked up a paltry 384MW. The US combination of state Renewable Portfolio Standards and the federal Production Tax Credit worked well for a while – until tax capacity ran out.

So if feed-in tariffs have worked and other systems haven’t, why haven’t we here at New Energy Finance added our voice to the feed-in tariff choir?

We certainly agree that for distributed generation (residential, small and medium-sized businesses), the combination of net metering and feed-in tariffs is absolutely the right – possibly the only – way to go.

However, when it comes to wholesale power, we believe that the success of a country’s renewable energy policy has to be measured by more than just the GW column of the international tables. Spend enough billions, and you can green a few percent of any country’s electricity supply. After all, feed-in tariffs can hardly fail – as long as you are prepared to set them high enough.

But what are the costs of taking this route? What liabilities are created, over what period, and who will bear them? What do feed-in tariffs mean for the electricity industry, particularly when they grow to cover an ever-larger proportion of supply? What are the long-term implications for the economy’s growth and competitiveness?

These are key questions, and they are not being answered by the FiFs (Feed-In Fans).

A study by New Energy Finance, to be published in a Research Note in coming days, looks at the costs of feed-in tariffs and the liabilities they have created in Germany, Spain and Italy. It will make sobering reading.

The total cost of feed-in tariffs to be paid between 2008 and 2030 to existing renewable energy projects in Germany will be EUR 120bn. We estimate this to be EUR 55.7bn above the cost of generating the same power from other sources. The equivalent gross figure for Spain over the 25-year duration of the tariffs is EUR 53bn, or EUR 39.9bn net of the avoided cost of alternative sources of power. For Italy the figure, net of avoided cost, is EUR 6.7bn.

These are big figures and – let me repeat – they refer only to existing projects at the end of 2008. As renewable energy continues to scale, so they will continue to grow. Tariffs per kWh are set to drop, but volumes are set to increase, so the total liability will continue to build at about the same rate as the last few years.

In Germany and Italy, the long-term liabilities created by feed-in tariffs fall on the utilities, who in turn pass them through to electricity users via higher power prices. Existing projects covered by feed-in tariffs in Germany will drive up the cost of electricity by 1.1 eurocent/kWh for the next 22 years.

In Spain, the cost of feed-in tariffs falls on the government, where it forms a colossal off-balance-sheet liability. In 2008 alone, Spain installed 2.7GW of PV, resulting in payments by the government of EUR 1.5bn per year, index-linked for 25 years. The net present value of these payments is EUR 26.4bn, assuming inflation of 2% a year (close to the European Central Bank target) and a risk-free rate of 4.8% (the average yield for long-dated Spanish government bonds in 2008).

To put this figure in perspective, Spain’s national debt at the end of 2008 was EUR 328bn. So one year’s construction of solar power in Spain created a government liability equivalent to 8% of its national debt. Did the fans of feed-in tariffs warn of this before it happened? Of course not! And since the Spanish government implicitly allowed the national debt to increase by EUR 26.4bn to build solar projects, we also have to ask whether it got value for money.

At an average all-in system cost of EUR 7.5m per MW – the prevailing figure in Spain in 2008 – installing 2.7GW of solar projects should have cost EUR 20.4bn – 23% less than the EUR 26.4bn the government actually spent. Where did the extra EUR 6bn go? It represents a vast transfer of wealth from Spanish taxpayers to investors in solar projects. The average system prices, higher in Spain than in Germany, also represent a transfer of wealth to project developers, manufacturers and EPC contractors. Governments may not make good project managers, so public-private partnership structures of some sort almost certainly make sense, but how much was the capital of financiers invested in relatively low-risk Spanish solar projects really worth? Small wonder large segments of the industry are so keen to see feed-in tariffs rolled out worldwide!

Of course it could be argued that any excess cost of the Spanish, German or Italian feed-in tariffs is merely an artifact of overly-high tariffs, and these can be corrected. However, the fact is that there is no mechanism in a feed-in tariff system to ensure that progress down the cost experience curve– or indeed price spikes due to future supply-side bottlenecks – will be correctly anticipated. The history of government price controls suggests that mispricing will be the norm, not the exception.

In last month’s Briefing, I described how the development of the smart grid could herald either a new era of regulation or of deregulation: cementing incumbents in position, or opening the power sector to a period of unprecedented innovation. Similarly with feed-in tariffs. As renewable energy grows as a proportion of generation beyond 10% to 30%, 50%, 80%, feed-in tariffs have the effect of introducing price controls over electricity. This will have profound implications for industrial competitiveness and growth.

All this is not to say that any of the current alternative approaches are any better.

The UK’s system is probably the worst of all, combining a Renewable Obligation Certificate scheme which builds in uncertainty over future cash-flows with a planning process heavily tilted towards inaction. A study by the Council of European Energy Regulators, included in its December 2008 Status Review of Renewable and Energy Efficiency Support Schemes in the EU, the following conclusions. “The analysis appears to suggest that quota schemes are relatively more expensive but have facilitated less investment in renewable generation [than feed-in tariffs]”

The US system looks, on the face of it, like a contender. Renewable and alternative energy portfolio standards already in place in 32 states (or a national RPS, if one is passed) should on their own be sufficient to spur renewable energy growth – if the utilities believed they would be enforced. Then the federal investment and production tax credits provide a mechanism to transfer the extra cost of clean energy from state electricity consumers to the federal budget. But it has two fatal flaws: utilities simply don’t believe the regulator will enforce penalties under the RPS (particularly where these might drive them into bankruptcy) and the PTC/ITC system falls over when corporate and banking profits dry up. Even after they return, there will not be enough tax capacity for the PTC/ITC system to fund renewable energy on the scale needed in future. The American Recovery and Reinvestment Act has, for the foreseeable future, inserted the US government into the structure of every renewable energy financing, in the form of a grant or loan guarantee – hardly an efficient and scalable long-term solution.

China has tried a hybrid approach for wind. Between 2003 and 2007 the country used a competitive auction system in which developers bid for projects on the basis of long-term tariffs. The lowest bid didn’t always win: occasionally one was rejected on the grounds that it might put the success of the project in doubt, and in the final phase, bids closest to the average have been successful. The system was not entirely popular with developers and turbine makers, who complained that it caused uncertainty and was vulnerable to rogue bids but, the country did manage to build significant capacity in those years, with 12.2GW installed by the end of 2008. China has now switched back to a feed-in tariff system for wind, and has indicated it will do so for solar too, after a series of tenders for price discovery. China appears to have used a finite auction period to achieve price discovery, and then switched to the simplicity and scalability of the feed-in tariff.

State-run auctions wouldn’t necessarily work outside China. Any mechanism must be consistent with a country or region’s existing electricity market structure, regulatory framework and political philosophy. However, the bottom line is that it must be possible to design a set of policy mechanisms for each country to ensure rapid renewable energy deployment at a low cost, and without ceding the world’s electricity industry to central government price control.

A template solution might involve the use of auctions by utilities – mandated by government through a binding RPS or otherwise – combined with an averaging mechanism to provide sufficient medium-term price stability for supply chain investment. A central funding pool – grants, tax breaks and a loan guarantee scheme or the like – would reduce the apparent cost to electricity consumers to a politically acceptable level, at least until renewable energy becomes more nearly cost-competitive with other sources.

Phew, sounds complicated. Feed-in tariff, anyone?

Download the PDF here.

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