It’s time to rethink incentives for renewables, and follow lead of UK

Popularised by the Germans in 1990, Feed-in-Tariffs (FiT) have been a driving force behind the adoption of renewable energy around the world. More than 40 countries have implemented some form of FiT scheme to provide financial support for the industry that not too long ago was considered too expensive or a technological dead-end.

Despite the enormous success of the FiT regime to date, the conditions surrounding the renewable energy sector are vastly changed which has led to the development of a new mechanism spearhead by the British, Contracts-for-Difference (CfD). We contrast each method below and conclude the time is right to start thinking about how we should encourage the renewable energy sector going forward.

FiTs are a cost plus approach

A FiT is essentially a cost plus approach where a particular technology determines a target price. The process typically starts with a government led team who determine what is the cost to produce electricity from a particular method and then an allowed rate of return over this cost is added to provide the developer an incentive to build the project. This method was very popular because it was relatively simple to determine and recognised that renewable energy was more expensive than conventional methods and needed incentives to get projects built.

If left to their own devices, no renewable energy projects would ever have been built because a conventional power station would always have been able to undercut the delivered price of electricity to the customer. The FiT did away with this problem as the financial incentive to build a project was divorced from market economics that dictated supply and demand.

Unintended consequences

While FiTs have driven the mass adoption of renewable energy, it came with a few unintended consequences:

1. A government review would typically set the FiT and then it was periodically reviewed to adjust for changed industry conditions. The biggest change has the dramatic fall in the cost of renewable energy over the past decade such that the assumed cost of delivery was substantially higher what it actually was costing developers to deliver viable projects. The application of “tariff degressions”, predetermined tariff reductions once certain conditions are met, has helped to limit the impact of this excessive financial support. However, they have proven to be clumsy as changing industry conditions are not as highly predictable as implied by a typical tariff degression formula.
2. FiTs do not necessarily promote the least expensive type of renewable energy. Since all projects receive similar rates of return on a given investment, project developers are more incentivised to build the easiest projects rather than deliver the best outcome for consumers.
3. Excessively generous FiTs have led to sudden, unexpected surges in renewable energy adoption such that the absolute level of dollars going into the FiT program far exceeded preliminary estimates. This resulted in a growing surcharge on consumers who provided the funding for the FiT program. Naturally, a program billed as good for the environment, and that would be relatively inexpensive because the cost would be spread across the nation suddenly become a political football amongst financially stretched households.

The UK is spearheading CfDs

The UK’s Energy Act 2013 became law on 18 December 2013. The Act contained a range of reforms for the electricity market with the overarching goal of decarbonising the UK power sector.  Contained in the Act was a new mechanism to support the development of low carbon generation called Contracts-for-Difference (CfD).

CfDs have continued in the same vein as FiTs in that they provide developers an incentive to build projects via a fixed, long-term payment structure. However, because a project is paid a FiT for every electron it produced whenever they produced it, CfDs have broken the payment mechanism into two parts. Projects under a CfD receive market rates for the electricity they produce plus a “top-up” payment from the government up to a certain price called the “strike price” over 15 years.

If market rates rise such that the project earned above the strike price, the project must refund the portion over the strike price back to the government. The strike price thus provides better value for consumers as projects are unable to earn excessive profits because of market movements. Also, what ensures better value for consumers is developers must bid for CfDs by tendering in a strike price they will accept. Naturally, the lowest bids will win. The “Administrative Strike Price” is also the maximum bid price the government will accept..

The Act also specified annual minimum and maximum outlays to ensure the cost on consumers will be more predictable.

CfDs have distinct benefits over FiTs

The results from the first round allocations under the new CfD regime are due imminently but for now there are clearly some distinct benefits of the new mechanism:

1. Competitive bidding for CfD’s will ensure the continuously changing dynamics of the industry get priced in each periodic auction. For example, if the cost of building a wind farm has fallen by 5% since the last auction, this new price point will automatically get reflected in a competitive bidding process. This is because no developer would risk being the only one who did not pass the savings on to the government. Competitive bidding is more efficient than the current tariff degression methodology that gets saddled with too many assumptions.
2. The strike price also ensures consumers get better value for their financial support as project developers will have to return excess profits.
3. The absolute size of the annual budget allocations has generally been well received by industry as it should support a reasonably sized local industry. The maximum budget also prevents the excessive build-out of projects and subsequently larger draw down on public finances due to unforeseen circumstances.

The UK is leading the world in its new approach to supporting renewable energy. It recognised that financial incentives need to be more responsive to changed industry conditions while continuing to provide financial incentives for developers to build projects. For CfDs awarded under the “Established Technology” pot, this method strikes a good balance between additional financial support and good value for consumers. Established technologies like utility-scale solar and onshore wind are nearing the point where they will no longer need financial support to be attractive to developers. As this happens, the budget will automatically get spread across a wider number of projects helping further accelerate the decarbonisation of the energy sector.

France, Japan and maybe Germany are already considering CfDs

Over the past few months, we have seen comments by regulators in Japan and France who are considering adopting their version of the CfD regime. Germany has already announced they will be moving to auctions for renewable energy by 2017 but have not yet specified the exact mechanism they will use. We suspect CfDs will feature prominently in this review.

Here in Australia we continue to debate the Renewable Energy Target (RET) and have seen our FiT decline substantially over time due to ad hoc, reactionary state-level change

Renewables will be stronger without the crutch of financial support

Far from being the technological dead-end forecasted by experts, renewable energy has evolved to become increasingly cost competitive against conventional power generation. To be clear, while unsubsidised solar and wind is cost competitive without subsidy in many places around the world, we are not calling for a total removal of all support. Rather, we believe the time is right to increase the market exposure for mature technologies like onshore wind and solar photovoltaic which can afford to reduce the financial inducements granted by the government without hurting the investment decision. We believe the CfD mechanism used by the UK allows the “right” amount of market exposure to enter the investment decision without totally removing all financial aid at this point.

Governments globally should accept that renewable energy will increasingly be able to stand on its own, and they should begin to craft policy that ultimately extricates them from the investment decision. In the long term, the renewable energy sector will be stronger and more sustainable if it eventually throws off the crutch of financial support.

Australia needs to follow the rest of the world and take a progressive approach to renewable energy policy.

Nathan Lim is portfolio manager at Australian Ethical Investment