Je rêvais d’un autre monde

Decarbonising electricity production is an essential step in reducing our society's greenhouse gas emissions and limiting global warming.  Many countries have therefore engaged in the transition towards a new world in which the majority of megawatt hours are produced using renewable energy sources, mainly wind or solar energy.  To that end, they have distributed massive subsidies over the past decade: 101 billion dollars in 2012 alone, 57 billion of that in the European Union.[1]  A recent academic study using British data provides a clearer understanding of this "new world".[2]   This post presents two of the study's key findings: first, the difficult coexistence of renewable and traditional technologies, and second the need to maintain renewable energy subsidies.

1. Conflicts between nuclear and wind energy in the UK

Most observers and politicians agree that a decarbonised power sector will include both renewable and nuclear energy.  Some would prefer to see a higher proportion of renewables while others lean in favour of nuclear production, but the overall consensus seems to be that both will coexist by 2050-2100.

Surprising results

However, the study shows that a successful coexistence is far from being a given. More specifically, the analysis of the British system shows that nuclear power disappears from the economically efficient generation mix when production from on- and offshore wind power reaches 45% of demand. In other words, renewables completely replace nuclear production when they supply 45% of demand.

The underlying economic dynamics

Understanding these results requires using the peak-load pricing theory developed by Marcel Boiteux, with which readers of this blog are already familiar.

When renewable production capacity increases, residual demand, i.e. total demand net of renewable production, decreases. Conventional production technologies, mainly thermal and nuclear power, are therefore reduced, as is their installed capacity. This is, of course, the goal of the energy transition: more renewable production, less conventional production, more wind farms and fewer coal plants.

A simplified example illustrates this mechanism.  Suppose the year divided into two periods of 4,000 hours each.  One period corresponds to on-peak consumption, during which the hourly demand is 90 gigawatts.  The other period is off-peak hours, with an hourly demand of 30 gigawatts.  Total consumption is therefore (30+90) x 4,000 = 480,000 gigawatthours, or 480 terawatthours.

Two conventional production technologies are required: a baseload technology which produces during every hour of the year, and a peaking technology which produces only during peak hours.  If the price of carbon is very high in the power industry, then coal is the cheapest option and nuclear is the baseload technology.  It therefore takes 30 gigawatts of nuclear production to satisfy the off-peak demand and 90 - 30 = 60 gigawatts of peaking technology to satisfy on-peak demand.

We now introduce renewable production.  Assume that renewable production is constant during both periods: in technical terms, renewable production is not correlated with demand.  For example, the wind blows with the same intensity year-round, winter afternoons and summer mornings alike.  How do conventional production facilities adapt if renewable production is 10 gigawatts per hour? Residual demand is 30-10=20 gigawatt during off-peak hours and 90-10 = 80 gigawatt during on-peak hours. Nuclear capacity is therefore 20 gigawatts, and peak capacity remains unchanged at 80-20=60 gigawatts.

If renewable production rises to 30 gigawatts per hour, off-peak residual demand, and therefore nuclear capacity, disappears.  Residual demand during on-peak hours remains unchanged, however, at 90 - 30 = 60 gigawatts.  Renewables thus replace the baseload technology.  What production levels do renewable sources have to reach for this change to occur?  Renewables would have to produce 30 gigawatts per hour: 30 x 8,000 = 240,000 gigawatthours or 240 terawatthours. In this simplified example, renewables replace the baseload technology when they reach 50% of demand.

A similar dynamic is at play in the academic analysis of the British market.

Robustness of the initial results

Before discussing the implications of this finding, it is important to highlight that renewables are not always incompatible with the baseload technology.  The substitution depends on the correlation between renewable production and demand. Assume now that renewables produce only during peak hours.  This is the case of photovoltaic panels in areas where air conditioning accounts for a significant percentage of peak demand, such as the southwestern US: when the sun shines, the panels produce and the temperature rises, leading to high demand for air conditioning.

In the previous example, if renewable production is 30 gigawatts at peak hours and nil at off-peak hours, nuclear capacity will be unchanged. However, on-peak capacity will be reduced to 90 – 30 - 30 = 30 gigawatts.  Renewables replace the peaking technology, since they produce only during on-peak hours.

A similar example illustrates, that, if renewables produce only off-peak, then baseload capacity is reduced while peaking capacity increases.

Implications for national public policy in Europe

Germany. The results presented above partially justify the Energiewende, the German energy transition policy: if the correlation observed in the Great Britain applies to Germany, then wind will replace nuclear power.  Furthermore, Germany has made major investments in photovoltaic production, while its peak demand occur during winter evenings. There is therefore a negative correlation: off-peak residual demand decreases and peak capacity needs increase.  This suggests it is not unreasonable to close nuclear power plants as renewable production increases.

However, this argument constitutes only an imperfect justification for the policy: wind production is variable and impossible to control, which creates problems in adjusting supply to demand in the short term, hence requires the provision of significant reserves. Furthermore, the transition has been implemented very quickly. Certain nuclear plants have been closed before reaching the end of their economic lifespan, generating significant losses.

Great Britain. The British government, on the other hand, has decided to simultaneously encourage wind and nuclear power.  The findings discussed above indicate that it ought to have chosen between the two, since encouraging wind energy makes nuclear power less economically viable.  We will discuss this argument and the mechanisms used for encouragement a bit later in this post.

France. In France, the government and parliament have defined the market share of the different technologies by law.[3]  The authors of this blog are not opposed on principle to the use of legislation to define major aspects of energy policy.  However, a rigorous economic analysis and a transparent public debate on the cost of these objectives would have been useful.

2. Subsidies for renewables have 9 lives

The need for subsidies

Most renewable technologies are not economically viable in their early stages: the first megawatthours of wind or solar energy cost more than their market value.  To encourage renewables deployment, one solution is to price CO₂ emissions, thus increasing the cost of CO₂ emitting megawatthours, hence the value of renewable megawatthours. But even with a very high price of CO₂ emissions, the cost of the first renewable megawatthours remains higher than their market value. However, as in all industrial sectors, we can rely on the learning curve: producing today generates positive externalities in the form of a reduction in future costs.

While in other industries learning effects are integrated directly into businesses' financial calculations, in the energy sector, governments believe it is necessary to intervene and have decided to encourage the development of renewables in order to diminish their future cost.  European governments have forced consumers to buy renewable electricity at a price which covers costs, and is thus higher than market value. In this case, the subsidy for renewable energy is the difference between the purchase price set by the authorities and the market value.

A permanent temporary situation

This subsidy is often justified on the grounds that it is temporary: since the cost of renewable production is decreasing rapidly, it will soon converge with the market value of megawatthours, thus eliminating the need for subsidies.

The analysis discussed above proves this argument is false for Great Britain: based on a reasonable learning curve, subsidies for wind power never ends. The key here is the value of renewable megawatthours decreases as the installed renewable capacity increases.

An example illustrates this point.  Suppose that a single wind turbine is installed.  To simplify, assume it produces at 100% of its capacity for 1,000 hours per year and nothing for the remaining hours.  The average value of the megawatt hours it produces is therefore the average of the prices for these 1,000 hours.  We now add another identical wind turbine next to the first.  They both produce at 100% capacity for 1,000 hours.  During these 1,000 hours, demand does not change but supply increases, so the price decreases.  The same logic explains why the value of renewable megwatt hours decreases as installed capacity increases, as long as there is a positive correlation between the productions of the different units.

In short, there is a simultaneous reduction in costs and prices.  If costs fall faster than prices, subsidies will also decrease. This is probably the case in the early part of the learning curve.  However, once production capacities reach a certain level, the learning curve effect decreases and may not be able to compensate for the fall in prices.  In this case, subsidies increase.

This is what the study predicts for Great Britain.  Despite a very high CO₂ cost of £70/tonne, which corresponds to the government's objectives, the initial megawatthours of wind energy cost more than their market value to produce. Based on the British government's cost and learning curve assumptions, the analysis shows that the subsidies for onshore wind power will decrease very slightly as production capacity increases and that the subsidy for offshore wind power will decrease without disappearing as long as nuclear power is part of the generation mix. [4]

The inexorable rise of cumulated subsidies

We have been referring to subsidies throughout this post, but a more accurate term for the subsidies discussed above is "marginal subsidies," i.e. subsidies for the last unit installed.  Consumers (or taxpayers) are required to subsidise the entire installed capacity, and are therefore interested in the cumulative subsidies rather than the dynamics of marginal subsidies.

In the previous example, adding a wind turbine decreases the value of the megawatthours produced by both turbines. The cumulative subsidy therefore increases to cover not only the marginal subsidy for the second wind turbine, but also the increase in the subsidy for the original one.  This creates an explosive dynamic in consumers'/taxpayers' liability to wind power companies.

What are the implications for the British energy policy?  The government guarantees purchase prices for both wind and nuclear energy.  This encourages the development of more wind farms, thus reducing the value of existing turbines but also, as we have seen, of nuclear reactors.  Consumers will therefore pay to (i) subsidise the marginal wind turbines, (ii) maintain subsidies for existing wind turbines, and (iii) maintain subsidies for nuclear reactors.  We are not sure that the British authorities - and citizens - are aware of this dynamic.[5]

* * *

We understand it is essential to decarbonise electricity production, and are certainly not questioning the legitimacy of public policies designed to reduce greenhouse gas emissions.  We are, however, sceptical of the practical details of those policies.

In order to reduce the cost of the energy transition, and before investing tens of billions of euros, it is essential to conduct a dynamic analysis of this "new world" and the paths leading to it.  For example, revising the support mechanism for renewables, i.e., replacing the physical priority (the Transmission System Operator or TSO uses all of the energy produced by renewable sources) with a financial guarantee (the TSO buys all of the energy produced by renewable sources but only uses it if the price is positive) reduces the impact of renewable production on the baseload technology, hence the required subsidies.

Post-Script:

This is our last post for the 2014-2015 academic year.  We wish all of our readers a great summer, and we will be back in early September to share the highlights of the TSE conference on “energy economics and climate change”, held in Toulouse from 8 to 9 September.