Energy policy circles have been abuzz for months over
proposed changes to the way renewable energy is to be supported, and the
government’s overall plan to balance the supply and demand for energy in the
years to come. The Department of Energy and Climate Change have recently
released details of the draft ‘strike prices’ for the Contracts for Difference(CfD) scheme,
marking an important step towards a radical change in the way renewable energy producers
are aided by the government.
Renewable energy producers are for the most part
private-sector, for-profit organisations. They need a financial incentive in
order to invest in our energy sector; at the very least, they need to avoid
making a loss in order to remain operating. I’ve drawn a very simple figure to
represent the profits and losses they can expect to make over the next couple
of decades.
What’s next for the Electricity Market Reform (EMR) bill?
Well, it’s currently under review by the House of Lords and is expected to be
given Royal Assent before 2014. EMR, for good or for ill, is coming soon.
As a mathematician working in the field of energy policy,
I’m keenly aware of the sheer number of complicated schemes, financial
instruments and legislative hurdles electricity producers have to face. At the
same time, the health of the UK’s energy generation and distribution system is
vital to every member of the population, not just the select few who understand
the intricacies of these new energy policy schemes.
I strongly believe that an intuitive understanding of how
energy subsidy really works must be spread beyond the corridors of Westminster
and Whitehall. A wider debate will result in more informed decisions from
policymakers, who currently lack a strong mandate for helpful policies and
accountability for poor ones.
In this blog post, I’m going to try to explain one half of
the Electricity Market Reform bill, namely the Feed-in Tariff with Contracts
for Difference (FiT with CfD) scheme. I’ll do this through diagrams and a
maths-free description of the way the scheme works, and the consequences for
customers like you and me.
Unfortunately, I can’t avoid making enormous
oversimplifications, but it should provide a basic sketch, accessible to
sustainability enthusiasts from all backgrounds.
Breaking even
Before we look at how the Feed-in Tariff with Contracts for
Difference (FiT with CfD) scheme works, let’s think about what would happen
without it (or some other equivalent subsidy scheme).
The horizontal axis in the
figure represents time; we begin on the left-hand side of the diagram, and time
continues as you travel to the right, with the right hand side being around 20
years from now. At the moment, the cost of producing most types of renewable
energy (the blue line) exceeds the price electricity producers would get for
selling it on the open market (red line). The red shaded area represents a financial
loss for the producer of the electricity, whereas the green shaded area is the
profit they can expect.
As time goes on, current
projections are for the cost of production to fall, and electricity prices to
rise. At some point, the cost of producing renewable energy and the money
producers get for selling it will be equal. This is the so-called break-even point, and is where the red
and blue lines meet.
The point of break-even is
extremely important to policy makers. So long as electricity producers think
they are going to make a loss, they have no financial incentive to expand the
UK’s renewable energy generation capacity. Once the break-even point is passed
the industry should grow, as potential investors see that the industry is
profitable. In order to meet the steep legislative carbon-reduction targets of
the UK, the government will want to reach this break-even point as quickly as
possible, as it promises a growing renewable energy sector for the years to
come.
So how do we get to the
break-even point more quickly? Well, that’s a question of how much money we’re
willing to spend, and the mechanism through which we support renewable
electricity producers.
A contract for difference, or CfD, is a financial instrument
that’s been around for many years. Until recently, CfDs were predominantly used
in commodities and stock trading. However, the last few years have seen CfDs
adopted as an instrument of energy policy, used by major renewable energy
producing nations like the Netherlands and Denmark http://www.publications.parliament.uk/pa/cm201012/cmselect/cmenergy/742/74208.htm.
The UK will soon be adopting a form of CfD scheme too, known officially as the
Feed-in Tariff with Contracts for Difference (FiT with CfD) scheme. Let’s take
a look at how it works.Contracts for difference
In the FiT with CfD scheme, the government enters into
contracts with electricity producers in an individual, case-by-case basis. They
agree a ‘strike price’, at which electricity generated by the producer is to be
valued for the duration of the contract. When revenues from selling electricity
at market prices (red line) are below the strike price (brown line), the
producer can ask the government to make up the difference (orange shaded area).
This effectively takes the place of subsidy in more orthodox schemes, and brings
forward the break-even point to where the blue line meets the brown line,
making the industry profitable sooner and attracting new investors.
When the market price of electricity exceeds the strike
price, the deal is reversed. Electricity producers must pay the government the
difference, shown on the diagram as the dark green shaded area. This allows the
government to recoup some of the money it spent on keeping the industry afloat
earlier. Producing renewable electricity still remains profitable though, as
shown by the light green shaded area.
What does this actually mean to you and me, the consumers of
electricity? Well, whatever the government spends on supporting renewable
energy will be added on to our tax bills, regardless of how much electricity we
might individually use. On the other hand, we will reach our carbon-reduction
targets quicker. It’s possible to balance the pros and cons of the scheme by
changing the strike price, but it’s not an easy problem given the politics
surrounding renewable energy.
As I’ve hinted before, things are much more complicated than
the explanation I’ve given here, and while I’ve tried to describe the scheme as
it is intended to work, we can’t be sure that it will behave as expected; we
haven’t reached the break-even point yet, so there’s little evidence to go on!
This blog is written by Neeraj Oak, from the department of Complexity Sciences at the University of Bristol.
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