Download Mandatory long-term contracts for renewable energy

2011 8th International Conference on the European Energy Market (EEM) • 25-27 May 2011 • Zagreb, Croatia
Mandatory long-term contracts for renewable energy: the best of both worlds?
Laurens J. de Vries
Faculty of Technology, Policy and Management, Delft University of Technology
Jaffalaan 5, 2628 BX Delft, the Netherlands
[email protected]
Abstract—Current renewable energy support schemes in
Europe either minimize investment risk, but in doing so rely on
administratively determined prices, or rely on market prices, but
in doing so create substantially higher investment risk. In Brazil,
an alternative market design has been pioneered, in which the
renewable energy policy instrument is part of a broader capacity
mechanism. This market design appears to be attractive for
Europe in the future, when the share of renewable energy has
grown, but does not solve the problem of how to maintain
efficient dispatch in case of transmission network congestion.
Some possible solution pathways are presented.
Key words: renewable energy,
electricity market, investment risk
policy
instrument,
I. INTRODUCTION
A wide range of renewable energy support schemes exist in
current electricity markets. In fact, no two countries have
identical support instruments and the instruments are
frequently adjusted. Apparently, it is not easy to design a
renewable energy policy that meets all policy goals.
Specifically, it appears difficult to balance the objectives of
stimulating investment in renewable energy technology and
achieving economic efficiency. Policy instruments that
minimize market intervention are less effective and do not
always provide certainty regarding the results, whereas more
intrusive instruments tend to be less economically efficient.
For example, feed-in tariffs have been successful at
stimulating investment, but may cause wind turbines to
produce electricity even when its momentary value is negative
(for instance if it causes network congestion). More marketoriented measures such as a renewable obligation with
tradable green certificates provide more efficient short-term
incentives, but are less successful at stimulating efficient
investment decisions [1].
Subsidy schemes are vulnerable to political changes. When
subsidies are curtailed and schemes are changed, market
parties lose their faith in future incentive schemes. The risk
that incentive schemes are changed adds to investment risk,
not only for the developers of renewable energy plants, but
also for the supply industry and for the network operators who
need to adjust their networks to accommodate these renewable
plants. A solution should therefore preferably be at some
distance from the government’s budget decisions.
The objective of this paper is to explore a different avenue
for stimulating renewable energy production that better meets
the various policy goals. We will focus on renewable
electricity generation, as much of the potential for renewable
energy concerns electricity generation, while the integration of
large volumes of renewables in the electricity sector is not
978-1-61284-286-8/11/$26.00 ©2011 IEEE
trivial. As the volume of renewable generation grows,
coordination issues with existing generation capacity. While
conventional generation capacity will remain necessary for
quite some time as back-up power, its business case will
deteriorate. Some of these issues can be alleviated by
expanding the capacity of the networks, but network
expansion is restricted by permitting limitations in many
countries. However, in the end, the question remains not only
how to stimulate investment in renewable energy, but also
how to achieve an optimal level of conventional capacity at
the same time.
In addressing this question, inspiration was drawn from
Brazil’s wholesale electricity market design, in which an
answer had to be found to the question of how to attract
sufficient investment in non-hydro sources of renewable
energy and in conventional power in a hydro-dominated
system [2]. While the intermittency of hydro plays out in a
period of years – there needs to be back-up capacity for dry
years – the fundamental issue remains how to achieve
adequate investment in generation capacity with a low load
factor. The elegance of the Brazil market design is that these
two issues – how to achieve investment in renewable energy
and how to achieve investment in back-up capacity – are
addressed together, as both concern investment in generation
capacity and the volume of renewable capacity affect the need
for back-up generation capacity.
II. OBJECTIVES
One reason for the existence of so many types of renewable
energy support schemes is that there are multiple objectives at
stake. As mentioned in the introduction, there is a trade-off
between the effectiveness and economic efficiency of
renewable policy instruments. This is well known, but less
commonly understood is that with respect to both these
objectives, there also is a trade-off between the short term and
the long term. Policies may be adjusted frequently in order to
achieve short-term goals in the most efficient manner (without
policy overshoot, for instance), but these changes may create
uncertainty for investors. This occurs when a support
mechanism is implemented with a finite budget and/or time
horizon: it may be effective at achieving near-term goals, but
leaves the future beyond these goals entirely open. The
resulting uncertainty does not only affect the developers of the
renewable energy projects themselves, but also in the supply
industry, who need to invest in factories, offshore equipment
etcetera. To maximize the economic efficiency of the
production of renewable energy technology, as stable as
possible a market should be developed so the supply industry
can optimize its investments. This means that the policy
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2011 8th International Conference on the European Energy Market (EEM) • 25-27 May 2011 • Zagreb, Croatia
€/MWh
should continue to work as the share of renewable energy, and
perhaps other energy sources with low variable costs such as
nuclear power, continues to increase.
Another trade-off between objectives is that effective
investment incentives may not always correspond with
efficient incentives in the short term. This is the case with
feed in tariffs that provide a fixed payment for unit of energy
production regardless of the current level of demand. Finally,
the objective is not only to stimulate the production of
renewable energy, but also to stimulate innovation in
renewable technologies. To achieve innovation in less mature
technologies, support schemes need to be differentiated to
avoid lock-in of the most mature technology [3].
To summarize, the goals for renewable energy are:
• effectiveness: quantity of renewable energy
• short-term economic efficiency: dispatch
• long-term economic efficiency:
o investment in renewable capacity,
o investment in the supply industry,
o innovation.
In addition, there are arguments for stimulating other, not
sustainable low-carbon options during the transition period to
a fully sustainable energy system, mainly because the buildup of renewable energy capacity will almost certainly not be
fast enough to meet climate goals. 1 Finally, in the interim
period, investment in fossil plant (especially efficient and
flexible gas plant) may still be needed, or at least there may
need to be back-up generation capacity for flow-based
renewable energy sources.
Db
price range
S
Installed Capacity (MW)
€/MWh
Figure 1: Sample supply function, starting situation
Db
Dp
price range
S
See for instance the scenarios that were developed by the
European Climate Foundation [3].
Installed Capacity (MW)
€/MWh
Figure 2: Sample supply function with additional wind
capacity
Db
Dp
S
price range
III. CHANGING MARKET DYNAMICS
Policy instruments for stimulating renewable energy are
often modeled and evaluated on their performance in a market
equilibrium. This implies the assumption that the instrument
that performs best in an equilibrium indeed is the best
instrument. In reality, energy markets never are in a long-term
equilibrium. To the contrary, the entire purpose of these
policy instruments is to stimulate a transition to a more
sustainable energy supply industry. Therefore, in designing a
renewable energy support scheme, this dynamic perspective
should be taken into account explicitly. This means that these
instruments need to achieve:
• investment in renewable energy;
• innovation;
• a sufficiently large and economically efficient
supply industry of renewable energy technologies;
• dispatch efficiency.
The problem is compounded by the fact that more
renewable energy will cause electricity prices to become more
volatile, which will further increase investment risk. This will
discourage precisely the type of capital-intensive investments
that are needed in the energy transition: most forms of
renewable energy are more capital-intensive than traditional
power generation technologies. The costs of wind, hydro,
1
Dp
Installed Capacity (MW)
Figure 3: Sample supply function with high gas price, no
wind
solar and geothermal power generation are largely fixed costs;
their variable costs are very low. Only biomass has a cost
structure that is similar to fossil plants, because it is processed
in a similar way.
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2011 8th International Conference on the European Energy Market (EEM) • 25-27 May 2011 • Zagreb, Croatia
If the goal is set more broadly to include all low-carbon
power generation options, then nuclear power and fossil plants
with carbon capture and sequestration may also be considered
as transition technologies. Nuclear power has the same cost
structure with high capital and low variable costs as most
renewable technologies, while carbon capture and
sequestration adds significantly to the capital costs of
conventional plants.
We may conclude that a low-carbon electricity supply will
involve a substantial increase in technologies with low
variable costs. The increase in intermittent sources of power
generation (mainly wind and solar) will cause the supply of
electricity from sources with low variable costs to vary
strongly. Consequently, power price will become significantly
more volatile. Figures 1 through 3 illustrate this. Figure 1
shows a supply function (based on the Dutch supply function)
with average gas prices. As the demand function shifts, prices
fluctuate between peak and baseload prices within the
indicated bandwidth. If a substantial volume of renewable
energy capacity (or nuclear power) is added and the resource
is available, the supply function shifts to the right, as indicated
in Figure 2. Prices drop and their bandwidth shrinks. However,
gas prices are volatile and may rise significantly. Especially
during times without wind, this will push up electricity prices,
as indicated in Figure. 3. Now the peak and baseload prices
have increased substantially. As the situations in Figures 2 and
3 may occur relatively shortly after each other (as fast as the
gas price may vary), this means that in a situation with more
renewable energy, the bandwidth of electricity prices is
represented by the combination of Figures 2 and 3. The price
volatility has increased significantly. Whether average prices
have increased depends on the average fuel prices and on the
distribution functions of the availability of the renewable
resources like wind and sun, and of the demand function.
In current electricity markets, relatively much power is
traded through contracts with a short duration in comparison
to the time horizon that an investor in electricity generation
capacity needs to contend with. Many forward and ‘long-term’
contracts only stretch several years or less into the future,
which is barely enough to cover the construction time of new
plant. If this relatively short-term pricing will continue to
dominate the electricity market, investment risk is bound to
increase as larger volumes of renewable energy become
available. The unpredictability of a market with even higher
price volatility than today will discourage the type of capitalintensive investments that are needed in order to reduce fossil
fuel consumption and carbon emissions.
As investment in low-carbon technology will discourage
further investment in the same technology, there is a
significant risk that the efforts to combat climate change will
stall and that an equilibrium will develop with a limited
volume of low-carbon technology and a stable and significant
volume of fossil plants.
IV. RENEWABLE ENERGY POLICY AND RISK MANAGEMENT
Given these dynamics, the challenge is to develop a policy
instrument that meets the public policy goals. In theory,
markets for tradable green certificates (in which demand is
created through a renewable energy obligation) should
provide optimal investment incentives, including incentives
for innovation. In practice, however, markets for tradable
green certificates may suffer from the same shortcoming as
carbon markets, in which the inelasticity of the statutorily
created demand causes the certificate price to be highly
volatile. Given that certificate markets tend to have an
inelastic target level, certificate prices may rise quickly if the
market is short. When the market is long, prices plummet,
leading to high market risks for investors. When renewable
energy faces high market risks, a higher level of financial
support is required to stimulate its development than in a low
risk environment [5]. Consequently, investments are not based
on average certificate price levels, but on much lower prices,
indicating the presence of a high risk premium.
The high risk premiums and/or low effectiveness of
tradable green certificates schemes are an argument for feedin tariffs or other subsidization methods that guarantee a
minimum level of revenue. Feed-in tariffs also have
drawbacks, however [6]. Firstly, in the absence of perfect
information about the long-run marginal costs of renewable
energy technologies, feed-in tariffs must be somewhat too
high if they are to be effective. (This effect will at least partly
be offset, however by the lower costs of capital that result
from the higher predictability of revenues.) Another issue is
that it has proven difficult to combine feed-in tariffs with
efficient operational incentives.
A theoretically elegant way of stimulating renewables is to
tax fossil fuels, or, even better, their externalities, such as CO2
emissions. Aside from the fact that Europe already has a CO2
policy (which is not providing sufficient incentives for
investment in renewable energy), there are two problems with
a tax. The first objection is that it is difficult to establish the
optimal tax level. This may be countered with the fact that the
tax can be adjusted over time. As the phasing in of renewable
energy sources inevitably will take several decades, there is
enough time to observe a tax’s effects and change the tax level
if necessary. The second objection is more pragmatic, but also
more difficult to remove: a high enough general tax on fossil
fuels or carbon emissions would probably not gain sufficient
political support, as it would raise the costs of energy
significantly. Finally, taxing externalities does not provide the
differentiation between support levels that is needed to foster
less-developed renewable energy technologies [3], [7].
Consequently, renewable energy policy options appear to
be limited to subsidy instruments (feed-in tariff, feed-in
premium or otherwise) or quantity instruments like a
renewables obligation. Or would it be possible to combine the
best of both worlds? The challenge is that (renewable)
electricity producers need to be exposed to an incentive to
make efficient use of resources, but too much market risk
deters investors, resulting in less renewable energy and/or a
higher cost of renewable energy (due to a higher risk
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2011 8th International Conference on the European Energy Market (EEM) • 25-27 May 2011 • Zagreb, Croatia
premium). Is it possible to combine the positive effects of
stable prices upon investment that is achieved with feed-in
tariffs with the economic efficiency incentives of a
competitive market?
From the above analysis, the outlines of an improved
renewable energy scheme become apparent. We would like
the market to set the price of renewable energy, but we would
like to limit price volatility. We would like to provide longterm stability to renewable energy producers, but at the same
time expose them sufficiently to short-term prices that they
make efficient dispatch decisions (in particular that they
reduce their output when network conditions demand this). In
addition, we would like to be able to coordinate investment in
renewables with investment in conventional capacity in order
to achieve a generation portfolio that not only meets
environmental goals, but also is sufficiently flexible to follow
load variations and that meets reliability standards.
Special consideration should be given to the role of
government. As a renewable energy market needs to be
created by the government – just like the general electricity
market – a certain degree of government involvement is
inevitable. However, we would like to limit this involvement
in order to minimize the risk of economically inefficient
decisions. Secondly, care needs to be given that the
government does not acquire a material interest in the market
for renewables, as this could distort future policy decisions.
Such an interest could arise in case of a tax, but also in case of
a subsidy, which would be an easy target when budgets need
to be reduced. Thus, an additional requirement is that the
government’s role is limited to setting the main parameters of
the policy, but that it should not be involved in economic
transactions.
V. MANDATORY LONG-TERM CONTRACTS
What is needed, is a kind of capacity mechanism that can
also be used to stimulate the development of renewable
energy sources. A wide range of capacity mechanisms exist or
have been proposed, but these penalize flow-based renewable
energy, because they have been designed with the objective of
stimulating reliably available generating capacity [8]. A
mechanism is needed that supports renewable energy,
including flow-based sources, and can also be used to ensure
an adequate volume of flexible back-up generating capacity.
Brazil has found a solution for a similar problem: it has a
large volume of hydro capacity and needs backup capacity for
years with water inflow, while this capacity is not profitable
during most years. Brazil implemented a system of mandatory
long-term contracts for different types of generating capacity,
such as new hydropower, existing hydropower, thermal power
and other renewable energy sources. The idea of mandatory
forward contracts is that the government requires large
consumers and retail companies to purchase a certain
percentage of renewable energy contracts for the future, for
instance three or five years ahead. This combines the
advantage of a renewable obligation, in which the price of
renewable energy is determined by a market, with the stable
revenues that are provided by long-term contracts. The role of
the government in this proposal is reduced to its core:
determining the renewables targets and enforcement of the
scheme. The government does not set prices or subsidy levels,
choose technologies or manage the renewable energy budget.
In Brazil, consumers, or their providers, are required to
purchase these long-term contracts at two-sided auctions that
are organized by the government [9], [10]. Contracts may be
for firm energy or may be option contracts that provide buyers
the right to purchase electricity at a certain price. In this sense,
this solution is related to the reliability options scheme for
generation adequacy that was designed by Pérez-Arriaga and
colleagues [11], [12], [13], [14]. Brazil’s forward capacity
auctions have proven successful in attracting sufficient
investment in generation capacity. Given the higher
investment risks in Brazil than in the OECD, a market design
that is based on the same principles should be expected to be
quite effective in stimulating renewable energy and backup
generation capacity in other countries.
The key difference between Europe and Brazil is that in the
coming decades, Europe will need substantial volumes of
flow-based capacity such as wind and solar power, without
having an equivalent volume of hydro capacity to back this up.
The cheapest, and therefore preferred way of integrating these
flow-based sources is by expanding the transmission networks
[15]. Spreading the variations in output from flow-based
energy sources, and in demand, over large areas, and
balancing the output of different flow-based sources with each
other (such as wind in northern Europe and solar power in
southern Europe) has been shown to lower the need for backup capacity significantly [4]. However, the necessary capacity
increases are extremely large, in comparison to existing
capacity [4]. Given the current barriers to transmission
network expansion in Europe (mainly permitting issues), it is
questionable whether the transmission networks can be
expanded quickly enough to accommodate the desired growth
in renewable energy capacity. Until that time, more thermal
capacity will be needed to back up flow-based renewable
energy capacity.
The nature of the mandatory long-term contracts is
necessarily different for wind and solar power. The output of
these flow-based sources cannot be sold through firm
contracts or options, as the owners cannot commit to any level
of available generation capacity. Therefore, in Brazil, owners
of these generation sources commit to producing a certain
amount of energy per year. This is more predictable and can
be influenced, for instance through the maintenance policy.
Brazil has the benefit of back-up hydro power; how would this
work in Europe? A second challenge is that in Europe this
type of decision regarding market design is taken by countries,
not the EU, which raises the issue of how to deal with border
effects when different countries implement different policies.
The government will need to create multiple markets for
different kinds of long-term contracts (like in Brazil). The
need for back-up capacity can be met by placing a
requirement on consumers to purchase call options for
electricity. It will be the task of the government to establish
how much back-up capacity will be needed to meet reliability
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2011 8th International Conference on the European Energy Market (EEM) • 25-27 May 2011 • Zagreb, Croatia
standards. The issue of compatibility with neighboring
countries is a more difficult one, because the practical
challenges will depend on the specifics of the market designs
at hand. The devil is certainly in the details in this case. This
is not an entirely new issue, however [16].
A system in which the government determines not only the
demand for renewable energy but also for conventional
capacity appears to represent a significant intervention in the
electricity market. However, in most countries the government
already is intervening strongly in the electricity market. In
addition to renewable policy, there are the Europe CO2 policy,
other emissions policies and nuclear policy (phase-out or the
reverse), while the development of coal and gas plants is
affected by the permitting policy. In addition, in some
countries shares of the power companies are owned by
government. Government already affects the generation mix
in many ways; in the proposal at hand, this intervention would
only be made explicit, more transparent and more systematic.
consumers (or their providers) to purchase contracts, which
would result in a bilateral market for long-term contracts. The
choice between the latter and centralized call options was
discussed in [17]. The centralized version may be difficult to
implement in a decentrally organized power market, in which
the TSO is not the market operator (as is the case in many
European countries).
VII.
OPERATIONAL INCENTIVES
An important challenge with all renewable energy policy
instruments is how to stimulate operational efficiency if the
renewable energy production facilities create congestion. This
may happen when there are large concentrations of renewable
energy in an area where demand can be relatively low, such as
wind energy in northern Germany. As long as the transmission
network has not been expanded to the extent that congestion
can always be avoided, there will be times where the wind
production needs to be curtailed.
Feed-in tariffs do not provide this incentive, which is one of
VI. DESIGN CHOICES
the main points of critique. In case of a feed-in premium or a
One of the main design choices is for which products renewables obligation, the incentive to produce would only
mandatory markets should be created. Should there be one cease (assuming that variable costs are zero) if the spot price
market for renewable energy and one for conventional power? was negative and larger in value than the feed-in premium or
Or are more markets necessary? The answer to this question tradable green certificate price. Only producers who have a
depends on the goals that are to be pursued and on the certain exposure to spot prices, in combination with spot
physical conditions. With respect to renewable energy, if the prices that may become negative, may have an incentive to
only goal is to obtain a certain volume, then one market may reduce their output in case of congestion. However, the
suffice, but if the goal is to stimulate different technologies, objective was to insulate producers from the risks of spot
the cost differences between these technologies will likely prices in order to reduce investment risks and hence
necessitate the creation of a separate market per technology. investment costs.
Separate markets may also be necessary in the presence of a
In a market with long-term contracts, allowing prices to
technology that is cheap but has a limited potential, such as become negative in case of congestion therefore is not a
hydro capacity or onshore wind. This technology would yield solution. Producers are being paid a fixed price per unit of
windfall profits if another technology would be marginal, electricity produced, regardless of the time of production, and
these windfall profits would not attract more investment if are therefore immune to spot prices. Drawing from
there were a non-economic (e.g. physical) constraint on its conventional congestion management mechanisms, there are
development. A third reason for creating multiple markets is two types of solutions. The first is curtailment by the TSO as
when old renewable energy plants, which have been paid off part of redispatching. This may be arranged as a purely
and therefore have low fixed costs as well as low operating technical intervention in the form of an order by the TSO
costs (like old hydro plants in Brazil), would also have reaped without financial compensation. However, as this would
windfall profits if they had been included in the same market increase the producers’ risk that they would not meet their
as new capacity (which would bid at long-run marginal cost).
contractual obligations for producing a certain volume of
For existing capacity, similar considerations need to be renewable energy that year, a kind of incentive scheme would
made. One possibility is only to impose an obligation on appear appropriate. The TSO could offer compensation for not
consumers to purchase call options, like they described in [11], operating; the producers who request the lowest compensation
[12], [13] and [14]. Producers would diversify their portfolio would be curtailed.
based on the frequency with which they would dispatch their
The other type of congestion management method is
plants. At the other extreme, the market could again be congestion pricing. The difficulty in the case of long-term
subdivided to facilitate fuel policy. An intermediate solution contracts for renewable energy is that the congestion is not
would be to impose an obligation to purchase options on related to the location of the buyer of the energy. He might
consumers, but allow producers and consumers to negotiate a even be located in the same node as the producers; in that case,
lower strike price than the one specified by the government. the congestion would be caused by the fact that he consumes
The lower the strike price, the closer the option approaches a the electricity at a different time. Still, one could conceive of
fixed contract for firm energy.
levying a congestion surcharge on producers in the region that
A second key design variable is whether to organize a causes the congestion. In case of congestion, the producers
central purchase of contracts, like proposed by [11], a two- would need to bid for the right the inject to the network, just
sided auction like in Brazil, or only an obligation on like they would bid for network capacity in an explicit auction.
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2011 8th International Conference on the European Energy Market (EEM) • 25-27 May 2011 • Zagreb, Croatia
VIII.
CONCLUSION
It is proposed to guide the development of renewable
electricity generating capacity through a system of mandatory
long-term contracts, not only for renewable energy but also
for the rest of electricity generation. Contracts for flow-based
renewable energy sources would specify the volume of energy
delivered per year, as the time of delivery cannot be predicted.
In order to deal with their fluctuating output, a certain volume
of option contracts for back-up capacity will be needed.
Contracts for conventional power will specify the time of
delivery.
This system combines market determination of the price of
renewable energy with low investment risk. Thus it combines
the main advantages of feed-in tariffs and tradable green
certificates. A second benefit is that this way, renewable
energy policy is integrated with a capacity mechanism. This
leads to a more coherent design then when each issue is
treated with a specific instrument.
An important challenge is how to provide incentives for
reducing output in case of network congestion to producers of
renewable energy who receive a fixed payment per unit of
energy produced, regardless of the time it was produced.
Variations of redispatching and of congestion pricing
(auctioning) both provide possibilities.
A key issue to consider in the implementation of mandatory
long-term contracts is how the market will interact with
neighboring markets. Implementation on a larger than national
scale is preferred.
ACKNOWLEDGEMENT
This research was supported by Delft University and the
Next Generation Infrastructures Foundation.
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