On June 6th and 7th, TSE hosted the 14th Toulouse Conference on the Economics of Climate and Energy, bringing together 33 speakers and discussants from 28 institutions across 12 countries. As part of the conference, four distinguished economists, all with a foot in both the academic world and in public policy, participated in a roundtable discussing the public policies and market designs necessary to support the energy transition, moderated by Stefan Ambec (TSE).
Miguel Gil Tertre, Chief Economist in the Directorate-General for Energy at the European Commission, began the round table with an examination of the economic considerations regarding the energy transition, in particular for the EU. The EU has committed to become a climate neutral economy by 2050. Given that the power sector is the most cost-efficient to decarbonize, this would require a decarbonized power sector by 2040, as described in the Impact Assessment of the Climate Target plan. According to modeling done by the European Commission, this can be done most efficiently by electrifying as much as possible while decarbonizing electricity production. Even following this most efficient decarbonization pathway, it is still expected around 600 billion euros per year in clean-energy investments will be needed; this is significantly higher than the 330 billion euros per year that are currently being invested. Luckily, the transition will not just have climate benefits, but security and affordability benefits as well, helping Europe to indigenize its energy production, further justifying this increased spending.
Proponents of renewable energy often highlight its lower levelized cost of electricity than fossil-fuel generation technologies, but Dr. Gil Tertre pointed out that it is important to consider the full system cost of energy investments, as those levelized costs do not include the necessary backup generation and/or storage capacity as well as the increased transmission investments to address the increased electrification that makes up a large fraction of the estimated 600 billion euros. This emphasizes the need to consider the electricity holistically and to carefully calculate the most efficient decarbonization pathways so that investment can be directed where it will be most effective.
One way for governments to support these optimal decarbonization pathways is through the promotion of long-term contracts. There are two main types of long-term contracts, which differ regarding the need of government support. The revised Electricity Market Design promotes the 2-way contracts for differences. This provides investors with certainty about the profitability of their investments and also protects the public budgets (above a certain price, the investor pays back to the State, below a certain price, the State pays back to the investor), unlocking the private funds necessary to fuel the transition. The other type of long-term contracts are power-purchase agreements. These are also fixed price contracts for electricity supply, but instead of being signed between governments and producers, they are signed between private consumers and producers, giving producers the same certainty provided by contracts for differences while also providing price certainty for consumers. While in theory there is not a role for governments in power purchase agreements, in practice, the market for power purchase agreements is currently quite thin, and so government support in the forms of counterparty risk guarantees and standardization of contract terms is necessary to increase liquidity and so improve the competition and price signal quality in power purchase agreement markets.
Catherine Wolfram, the William F. Pounds Professor of Energy Economics at MIT’s Sloan School of Management and former United States Treasury Deputy Assistant Secretary for Climate and Energy Economics, brought the discussion across the Atlantic with an examination of the US policy situation, laying out several potential policy pathways following the critical US elections which will take place in November and the expiration of key US tax policies which will happen in 2025. Under current policies, particularly the 2022 Inflation Reduction Act (IRA, a misnomer curious name for a primarily climate-focused law), which she sees as the most likely outcome of what are certain to be tense negotiations, she estimated that US emissions will fall from just under 5000 Mt of CO2e per year today, to around 3500 Mt of CO2e by 2030, a significant reduction, but missing the Paris
Agreement commitment of reaching approximately 3000 Mt per year of emissions by 2030 In the event that Republican’s sweep both houses of Congress and win the presidency, there is a possibility that the IRA would be fully, or at least substantially, repealed. In that scenario emissions would still fall from where they are today because of a number of factors, including the low and decreasing costs of wind and solar making them competitive even without significant governmental support, but the rate of emissions decrease would be much slower, and would still be around 4100 Mt per year by 2030, far exceeding the Paris commitment. On the other end of potential policy scenarios, there is also a chance that Democrats expand their control of the US government in 2024 and use their increased power to expand the IRA, in this hypothetical increasing the subsidies by 50%. Despite the significant cost, this would have little additional impact on emissions reduction, as there are rapidly decreasing returns to the subsidies.
Prof. Wolfram’s favorite policy (which is also the favorite policy of the vast majority of economists) would be to supplement the subsidies for green investments in the IRA with a carbon tax. A tax of just $15 per ton today, rising slowly to $50 in 2035 and exempting gasoline and fossil fuel exports, would achieve more emissions reductions than the IRA alone, and would raise around $700 billion in revenue. While Prof. Wolfram acknowledged that this scenario is somewhere between a “hopecast” and a forecast, she thinks that is a reasonable possibility that such a tax could be a “2 am solution” to budget negotiations between more fiscally conservative and more environmentally conscious congresspeople, and she believes that the US will eventually implement some sort of a carbon tax, even if that doesn’t happen in the upcoming budgeting cycle.
Charles-Henri Weymuller, the Chief Economist at EDF, spoke next, bringing in the perspective of utilities. He began by discussing the demand side of the energy transitions. He sees demand reduction as the first step to be taken in the energy transition, as it can be begun almost instantly. However, he cautioned that demand reduction can only do so much. Behavioral changes, which are often favored because of their low or zero investment costs, are very difficult to force on consumers. While he supports promoting them, he believes that energy efficiency improvements will be the primary method by which energy demand is reduced. Electrification is a particularly important pathway by which total energy demand can be reduced, as it provides a double decarbonization benefit, with electrically powered products tending to be more efficient than their fossil-fuel powered counterparts, and the electrical power sector being particularly easy to decarbonize. Despite being more technologically complicated than other sectors, he sees accelerating the timeline on electrification as particularly important for industry, with large capital investments locking firms into their chosen power source for decades. That being said, electrification is not a panacea, and EDF estimates that around 40% of total European energy demand will be met from sources other than electricity even in 2050, highlighting the importance of improving technologies such as clean hydrogen production and synthetic hydrocarbons.
Returning to the electricity sector, Dr. Weymuller discussed the complementarity between intermittent renewables such as solar and wind and carbon-neutral dispatchable electricity sources such as nuclear and hydro. The costs of intermittent renewables has fallen rapidly and is expected to continue to fall, however, they are by definition intermittent, while nuclear and hydro have remained more expensive, but provide certainty that electricity will always be available. Batteries can provide that assurance for short periods of high demand or low production, but for low-probability high-impact events such as several weeks of light wind or cold snaps, sources like nuclear and hydro are necessary for grid stability. EDF modeling estimates that the lowest-cost way to decarbonize the European grid involves about ¾ of electricity coming from intermittent renewables, and the remaining ¼ coming from dispatchable sources.
Finally, Dr. Weymuller highlighted the necessity of strengthening pricing mechanisms for both electricity suppliers and consumers in order to align their incentives with the goals of efficiency and decarbonization. He emphasized the importance of creating complete electricity markets and encouraged policymakers to ensure that such markets are technology-neutral, allowing the free market to determine which decarbonization pathways are most efficient and ensuring that such markets have adequate size and liquidity.
Antoine Dechezleprêtre, Senior Economist in the Productivity, Innovation and Entrepreneurship Division at the OECD, discussed the importance of innovation in the energy transition. He began forcefully by stating that he sees the only good news on climate in the past decade to not be the signing of the Paris Agreement, but rather the stunningly rapid fall in the price of renewables and batteries. This is because he believes that for the transition to be durable, it must eventually be the case that clean technologies are preferred over their carbon-based alternatives even without further governmental support, and the only way to achieve that is for their prices to fall.
That being said, he sees an important role for governmental support in realizing these cost reductions, particularly in the form of research funding. In general, people like subsidies, and dislike taxation, so for political reasons, Dr. Dechezleprêtre believes that we cannot rely entirely on taxes and other market instruments. While we can keep dreaming about a sudden change of heart among global electorates, this means that some forms of subsidization and other non-market instruments for clean energy are necessary. He argued that R&D funding is a particularly overlooked form of subsidization, as one extra euro of R&D funding for emerging low-carbon technologies results in roughly six times larger cumulative emissions reductions by 2050 than if that euro had been spent on adoption subsidies. Yet, governments across the world subsidise adoption of commercially available technologies much more than they support R&D and demonstration activities. This means that R&D funding is significantly lower than is optimal relative to adoption subsidies. Indeed, R&D funding as a percentage of GDP has been approximately flat since 1990; it is critical that this changes to meet decarbonization targets efficiently.
Following the presentations from the speakers, there was time for four questions from the audience.
The first asked the panelists to discuss the trade-off between insurance and incentives in electricity markets, expressing concern about the loss of price signals as Europe contemplates a move towards contracts for differences.
Charles-Henri Weymuller answered, saying that price signals will become more necessary as the penetration of renewables increases, increasing electricity market volatility. However, he still feels that that is an important role for instruments, like contracts for differences and fixed-price electricity contracts, which provide certainty for risk-averse producers and consumers respectively. The more flexible a producer or consumer is, the more exposed they should be to price signals. This means that while it is important to move more flexible industrial consumers to things like real-time pricing, it might still make sense for residential consumers to remain on fixed-price contracts.
The next audience member asked the panelists to look back 10 years and remember the academics and policymakers who argued that we would move to fully flexible markets and that the invisible hand would solve everything. Now, however, even industry is concerned by high prices and variable prices, raising the question of what unanticipated market failure we are trying to address.
Miguel Gil Tertre answered that grid reliability will become more difficult to ensure as intermittent renewables have come to make up a larger fraction of total electricity production. Balancing a decarbonized grid with marginal prices will likely require occasional very high prices and introduce huge volatility, which is hard for industrial consumers to respond to properly. Additionally, uncertainty in profits makes long-term investments difficult for risk-averse investors. The key market failure is therefore that prices which balance demand and supply in the short-term might not provide the correct incentives for medium- and long-term decision making.
Following up on the importance of uncertainty, the next audience member asked the panelists to each state what they believed to be the largest cause of uncertainty for investors and to provide a potential way to mitigate that source of uncertainty.
Catherine Wolfram answered first, saying that policy uncertainty is the most important. As described to her by a CEO of a US power company “stroke of the pen risk”, i.e. policymakers unexpectedly eliminating a key subsidy, is what investors fear most.
Antoine Dechezleprêtre answered next saying that his research has shown that there has been a major increase in environmental policy uncertainty over the past couple of decades. He believes this to not just be the biggest source of uncertainty, but one which is on an upward trend. The EU benefits by implementing climate policy at the EU level, which is at least partially shielded from national politics, but even this is not enough. The problem with policy uncertainty is that there is no policy to combat policy uncertainty, and potential ways to remove policy decisions from politicians’ hands inherently conflict with democratic ideals.
Charles-Henri Weymuller added that technological uncertainty is also significant. It is very unclear to what extent consumers will choose to adopt electrification technologies such as heat pumps. Similarly, it is very uncertain the role which clean hydrogen will play in the energy transition. Both are driven by potential technological innovation which will hopefully drive down the prices, and also by energy consumers who are playing a massive coordination game about what sort of economy will be built. The combination of the technological and behavioral uncertainties makes it very hard to accurately predict the energy needs of the future economy.
Miguel Gil Tertre returned to the idea that policy uncertainty is key, noting that energy have very long investment cycles, and so if policies change every couple of years, very few investors will be willing to make the investments necessary for the energy transition. This means that it is important to take the time to get the policy as “right” as possible, and then to stick with that policy.
The discussion of policy commitment devices led another audience member to connect the problem of commitment to climate policies to the problem of commitment to monetary policies. He noted that because governments recognized their own inability to credibly commit to maintaining stable monetary policies they created semi-independent central banks, this raises the question of whether a central bank-like institution might be necessary for credible commitments to a stable environmental policy.
Catherine Wolfram, Charles-Henri Weymuller, and Antoine Dechezleprêtre all agreed that some stronger form of commitment mechanism for governments is necessary, that it is unlikely that governments will agree to bind their hands in such a way, and that more research is critical to determining what structure such a mechanism or organization should take. As an example of the difficulty of developing such robust commitments even in relatively small countries, discussed the case of the Dutch Climate Agreement, which was co-designed by the government and the most emitting firms in the Netherlands and combined generous support for low-carbon technology adoption with an ambitious carbon price trajectory to 2030, but the latter part of the policy package broke down in the face of the recent energy crisis.
Published in TSE Reflect, June 2024
See also: conference page and TSE Energy & Climate Center