How subsidised renewable energy undermines electricity markets

Can an intermittent source be integrated into a liberalised electricity market? It is technically feasible, but, if subsidies come into play, intermittent generation threatens to undermine the operation of the market. This is what happened in Italy with the solar power boom that in 2011 alone saw capacity increase from 3.47 GW to 12.75 GW, with the annual cost of subsidies increasing from 800 million euros in 2010 to 3.9 billion euros in 2011.

Very generous incentives have led to over-investment in solar power. This development had three major ingredients: 1) high subsidies; 2) unlimited demand (meaning that the power grid operator has a duty to dispatch any single ‘green’ kWh, regardless of both the actual demand and the deals that are made with conventional generators on the day-ahead market); 3) ‘implicit’ subsidies.

Implicit subsidies are the perhaps the key factor. They refer, in the first place, to the fact that unexpected variations in solar (and wind) production translate into imbalances that have a technical and economic cost. Under Italian regulations such costs are ‘socialised’, i.e. the end consumer pays for them and the intermittent generator has no incentive to make better forecasts or to adopt technical or financial instruments to cover itself for the risks associated with inaccurate forecasting. Moreover, local distributors are required to connect green generators to the grid and that cost is also ‘socialised’.

The combination of all the above will inevitably lead to over-investment and neglect of the problems that intermittent generators create in the grid in terms of imbalances. As a result, as Italians discovered in March, the average electricity bill for a household in April-June 2012 increased by 9.8%. Of that, 4% was attributed to the direct cost of incentives, and 2.3% was an estimate for the costs of imbalances.

Even that is only part of the overall cost of subsidised intermittency. Perhaps the biggest cost of all is that it makes competition less and less relevant, and top-down political decisions more and more decisive. The subsidy-induced growth of solar power in a moment of stagnating demand has the result of creating overcapacity in the conventional generation portfolio. This portfolio reflects private investments taken in the past decade under the assumption that the rules would not change (the main rule being, ‘each generator will gain or lose depending on its ability to be competitive on the market’). If some generators do not face price and volume risks, of course this will come at the expenses of other generators. This sort of ‘competition’ resembles the idea of socialism that George Orwell made famous: all competitors are equal, but some competitors are more equal than others.

As demand stagnates and non-market renewable generation increases, the size of the ‘contestable’ market – that is, that portion of the market where generators compete with each other – shrinks accordingly. Between 2007 and 2011, this part of the market fell from 292 TWh to 248 TWh (-15%), and it is likely to keep falling as the amount of subsidised production grows. At the same time, the amount of conventional, non-subsidised capacity has grown from 39,900 MW in 2000 to 53,700 MW in 2010. This means that conventional generators face growing difficulties in recovering their fixed costs. In a competitive market this would not be a ‘social’ problem – non-competitive generators would just fail. But in the kind of crony capitalism which is created when politics becomes the most influential variable, conventional generators also find it convenient to knock at policymakers’ doors: so they are calling for a ‘capacity payment’ scheme to be introduced, in order to maintain under-used, ‘reserve’ capacity at the expenses of consumers.

Italy’s experience is sad but it is also a telling case study for countries such as the UK that are now pursuing similar policies. Competitive markets are increasingly going to be disrupted by conflicting or concurring requests to get more subsidies (which, in turn, translate into a larger portion of the bill being determined by political or regulatory decision, and a smaller share depending on the actual supply and demand conditions).

Intermittent generation may be consistent with a liberalised market, as long as generators are required to bear all the direct and indirect costs of their production. If this is not the case, competition is doomed to become an irrelevant feature of a system that becomes more and more politically driven. The UK, which is debating its new Energy Bill, should be careful not to jeopardise the benefits of competition.