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Renewable cat out of bag

This entry was added to on 11 October 2006.

As foreseen in its 2006 energy review, the DTI has started a consultation on reform to the arrangements to support renewable electricity generation in the UK. The Scottish Executive also has a consultation on an additional aid scheme for wave and tidal power.

This article discusses the operation of buy-out recycling and some State aid issues.

Operation of buy-out recycling

The DTI paper's discussion of buy-out recycling (hidden in Section 3 "Obligation levels beyond 2015/16" under a subheading "Preventing ROC price crashes") rather lets the cat out of the bag as to the true nature of the renewables obligation.

Anyone who has studied the workings of the renewables obligation will already know that it is not all it seems to be. Under the disguise of a cap-and-trade scheme, the renewables obligation has been in fact, to date, acted as a production subsidy for renewable electricity funded by a tax on electricity supply. In the 2005/2006 financial year, the subsidy amount was nearly £600 million, shared pro-rata on a MWh basis between qualifying generators; and the tax rates borne by consumers were about £1.8/MWh in England, Wales and Scotland and £0.8/MWh in Northern Ireland.

To see why the this so, the workings of the obligation must be considered separately in two cases:

The UK renewables obligation has been in the second situation since its creation, and monies from the buy-out fund are a significant part of the economic value of renewables obligation certificates.

In these circumstances, a simple bit of algebraic analysis shows that the cost to consumers (£583 million in 2005/2006) is independent of the amount of renewable electricity generated, and instead simply the product of the obligation level (aggregate number of MWh, defined as a percentage of total supply; 18TWh in 2005/2006) and the Government-set buy-out price (£32.33/MWh in 2005/2006). The combination of the buy-out and recycling money flows ensures that all this money collected from consumers (by suppliers) is passed on to renewable generators or the suppliers to which they sell their certificates.

For example, if only 5TWh of renewable electricity had been generated in 2005/2006, the generator of each MWh would have collected about £116 (minus any costs of trading and amounts retained by middlemen) in exchange for its certificate (assuming competition between suppliers in the purchase of certificates). Of this value, £32 would have been in respect of the fact that the supplier that buys the certificate avoids a buy-out charge of £32 in respect of 1MWh of its obligation, and the remaining £84 would have been in respect of the supplier's entitlement to receive a share of the £420 million (=13TWh*£32.33/MWh) to be paid by suppliers (including probably itself) who are settling their obligation at least in part through buy-out — of the total obligation of 18TWh, 13TWh would be settled through buy-out if only 5TWh worth of certificates are available.

Leaving aside costs of trading, this is the same effect as would be obtained from levying the full buy-out charge on all suppliers and sharing the money between qualifying generators (or a supplier nominated by them), without any trading of any certificates.

The cliff-edge between the two cases outlined above is sharp (especially given that ex post trading is permitted so there is little uncertainty in the market for certificates about the aggregate outturn): the price of certificates would fall to zero if the obligation was exceeded, even by a small amount. Obviously when it comes to investment decisions, the effect is smoothed because what matters to investors is their ex ante estimate of the probability that the obligation will be exceeded.

This effect might reasonably be seen as a normal expression of the uncertainty associated with future prices in any competitive market at work (see Footnote: Brian Wilson quote). But the DTI appears to take the view that this cliff-edge is undesirable.

The DTI canvasses several proposals to address the cliff-edge. All have the same effect, which is to extend the formulae that work when the obligation is not met to cases where the obligation is met or exceeded:

The only differences between the three schemes are in terms of administrative and payment arrangements. And the second formulation removes any pretence that the renewables obligation is a cap-and-trade scheme, and instead reveal it for what it is: a tax-and-subsidy scheme.

In fact, these anti-cliff-edge schemes would even make the whole question of headroom and buy-out rate entirely irrelevant. Once the cliff-edge has been eliminated in this way, the only thing that actually matters is the size of the fund to be collected from all suppliers (in proportion of volumes of electricity supplied) and distributed between those who present certificates (in proportion of volumes of renewable generation). This amount is currently calculated as the buy-out price times the volume of obligation, but under the DTI's cliff-edge proposals it could simply be expressed as a p/kWh tax rate, with the proceeds from the tax going straight to renewable generators.

The fact that the renewables obligation is a tax-and-subsidy scheme is confirmed by the DTI's proposed approach to banding: the subsidy rate available will depend on the technology used according to multipliers to be set by Government, not on the outcome of any form of market competition between generators.

I have three questions left unanswered by the DTI consultation paper:

In support of my second point, I see that Ofgem's 2005 report on the obligation (98 pages, PDF) noted that

"The Renewables Obligation is complex and its administration continues to involve considerable resource within Ofgem."

"1.9. The current estimated annual ongoing costs to Ofgem of running the schemes are approximately £600,000. This includes staffing; technical, legal and IT support; audits of generating stations; audits of suppliers; systems support; and maintenance of the bank accounts. "

State aid issues

As a tax-and-subsidy scheme that discriminates between undertakings and ways of producing electricity, the renewables obligation is a State aid scheme for the purpose of Article 87.

DG Competition recognised this feature of the scheme from the outset.

Clearance was given under the State aid rules on the basis that it was an environmental State aid scheme, not an energy source "obligation" (which would have fallen outside the scope of Article 87).

DG Competition understandably did not seem fully convinced that the conditions for compatibility with the common market were met. In particular, it foresaw the risk that an administratively-set level of subsidy could be higher than is necessary (i.e. disproportionate) — "overcompensation" in the jargon.

The State aid clearance in 2001 was subject to some riders covering the problems that the Commission had noticed. As I see it, the latest proposals from the DTI and the Scottish Executive go straight against these conditions.

In relation to recycling, the European Commission said in 2001:

"The Commission notes that in the first years of the Obligation, supply of green electricity will probably not be sufficient to meet the demand created by the obligation."
" ... while the system will overcompensate producers in the beginning, the market mechanism will prevent in the aggregate of the duration of the scheme overcompensation. The Commission notes the undertaking of the UK authorities to review the operation of the buyout recycling mechanism after 5 years and considers this undertaking to be an important element of its assessment."
"Once sufficient capacity is available to meet the obligation, competition between generators should increase."

Against this, the headroom proposals for the UK and Scotland are designed to ensure that the obligation is not normally met, and the DTI's proposals to address the cliff-edge would ensure that if it ever is met then subsidy levels are not reduced too much as a result of competition between sellers of renewables obligation certificates. It looks like almost exactly the opposite of what the Commission considered necessary.

On banding, the Commission said:

"Competitiveness of green electricity generators should also be ensured as the UK authorities opted for the same treatment for all eligible sources of green electricity and thus did not create "niches" by a banded approach."

This concern about is probably most problematic for the Scottish banding proposals: at least the DTI's approach enables subsidies to move between niches according to the relative competitiveness of different technologies.

But in both cases the introduction of banding will mean that the government has to establish proportionality and the absence of overcompensation in respect of each individual niche, without being able to hide behind an argument about market mechanisms (which would be false anyway, but appeared to carry some weight in 2001).

There may also be some sort of problem about duration. In 2001, the Commission said:

"Although it is the intention of the UK authorities to continue the scheme for a longer period, they agreed to limit it first to 10 years and gave the necessary commitments to ensure the respect of this limit if the Commission does not approve a continuation of the scheme later on."

DTI now says:

"At present, the level of the renewables obligation is set to rise to 15.4% by 2015/16, and remain at that level thereafter until 2027 — the current end date for the Obligation in the legislation."

And Ofgem says (here):

"The target reaches 15.4 per cent in 2015-2016 and remains at this level until 2026/2027."

So is the UK making false promises to the renewable industry or to the European Commission? Or am I misunderstanding the meaning of "a continuation of the scheme"?

Given all these issues, and the ongoing Commission attempts at achieving mutual recognition of green certification between countries (so as to remove the barrier to trade that currently arises from the fact that UK renewable subsidies are only available to UK generation), I don't think that either the UK or Scottish proposals will have an easy ride in Brussels.

Expect trouble.

Updates since October 2006

January 2007: Ofgem also has serious concerns about the renewables obligation.

April 2007: My forecast about State aid was wrong, at least for Scotland. I am far from convinced by the Commission's reasons for considering the aid to be proportionate.

Footnote: Brian Wilson quote

Some readers might think that I am unfairly criticising the Government, and that it has never pretended that the renewables obligation was anything other than a tax-and-subsidy scheme.

This is how the scheme was explained to Parliament:

"Suppliers will meet their obligation each year by surrendering certificates to Ofgem. We have provided that surplus certificates that are issued in one year may be carried over to the next year. Suppliers may meet only a quarter of their obligation by using banked certificates. That will prevent any hoarding that could cause market distortions. Certificates that are issued under the Scottish order will be eligible under this order and vice versa, so there will be a seamless join between the two obligations.

Suppliers may meet all or part of their obligation by paying a fee to Ofgem. If there is a shortage of ROCs, suppliers may make up the shortfall. The buy-out fee is not a penalty or a tax. At the end of each year, Ofgem will redistribute all the buy-out fees for that year to the suppliers in proportion to the number of certificates that they surrender. In that way, suppliers will be encouraged to purchase ROCs rather than simply paying the buy-out price.

The market will operate to balance supply and demand for renewables around the level set by the obligation. Prices will rise if the market expects a shortfall, which will encourage new capacity. Prices will fall, and discourage excess capacity, if a surplus is foreseen. That shows market forces at work.

That mechanism will protect consumers from excessive costs. The maximum cost of the obligation each year is limited to the total obligation multiplied by the buy-out price. Initially, that is set at 3p per kWh, and it will rise in line with inflation.

Source: Brian Wilson MP, the then minister in charge, explaining the renewables obligation in the House of Commons on 6 March 2002.


Entry added by Franck Latrémolière on 11 October 2006

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Last changed by Franck at 6:10 PM on Thursday 31 May 2007.

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Reckon Open "Renewable cat out of bag | viewpoint: Franck" 2007-05-31T18:10:08