Chapter 4: Renewable Generation and Security of Supply

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Chapter 4: Renewable Generation and Security of Supply

  1. 1. 4 Renewable Generation and Security of Supply Boaz Moselle A key question this book seeks to address is what justification exists for the promotion of renewable generation over other forms of low- At the same time, a commonly voiced con- cern with renewable generation is that it will endanger security of supply by leading to exces- carbon generation—in other words, for policies sive dependence on intermittent sources such as that specifically promote renewable generation wind and solar power. To some commentators, rather than a technology-neutral approach such as this argues against the promotion of renewable a carbon tax or cap-and-trade mechanism. Simple generation. To others, it implies the need for sig- economics suggests that the latter approach would nificant changes in power market design to ensure be more effective in achieving carbon reductions that sufficient backup capacity is available over at lowest cost, through competition between dif- various time frames. ferent carbon abatement mechanisms and tech- This chapter therefore focuses on these two nologies (e.g., renewable energy, nuclear, carbon questions, examining to what extent security of capture and storage, reductions in non-generation supply concerns related to import dependence sectors, energy efficiency). warrant additional support for renewable genera- In the European Union (EU), one of the most tion relative to other forms of low-carbon tech- common responses is that renewable generation nology, and to what extent security of supply merits specific support because it enhances secu- concerns related to intermittency undermine the rity of supply by reducing dependence on case for supporting renewables at all or necessitate imported fuels. Concerns about import depend- major changes in market design. ence refer particularly (though not exclusively) to The focus is on the EU, where renewables dependence on natural gas imports from Russia deployment is most prominent on the policy and Algeria, which many observers view as poten- agenda and is explicitly linked to security of sup- tially unreliable because of political instability and, ply by policymakers. However, many of the in the case of Russia, a willingness to use energy conclusions—in particular, those relating to supplies as a tool of geopolitics.1 This concern has intermittency—can be applied to other jurisdic- been greatly enhanced by interruptions in recent tions as well. winters to the flow of gas from Russia into the The chapter begins by examining the issue of EU via Ukraine, as a result of disputes between import dependence. It assesses the extent of the Russia and Ukraine. problem and analyzes whether there are market or
  2. 2. 52 Boaz Moselle other failures that warrant intervention, and if so, ence is a problem for the main fuels used for whether the promotion of renewable generation power generation and whether the promotion of is the most efficient form of intervention to renewable generation is the most appropriate address the problem. It then focuses on the prob- policy response to any such problem. lems posed by intermittency, again assessing the problem and analyzing the case for policy inter- vention and the most appropriate form that inter- Current and Projected Levels of EU vention might take. Import Dependence As Table 4.1 illustrates, the EU imports a large proportion of its primary energy sources, includ- EU Dependence on ing the main fuels used for power generation. In Imported Fuels 2006, around 80% of electricity was generated from coal (29%), gas (21%), and nuclear sources The need to reduce dependence on imported (30%) (European Commission 2008b).2 fuels is used to justify a range of EU policies, Imports are very significant for natural gas, including not only the promotion of renewables, which, as explained below, is the main source of but also the promotion of energy efficiency and concern among policy makers. The EU holds just the provision by some national governments of 1.6% of the world’s gas reserves and currently subsidies to domestic coal production. In the past imports 58% of its natural gas demand, mainly decade, these themes have been developed in from four countries: Russia, Norway, Algeria, and numerous policy documents and pieces of legisla- Nigeria.3 Gas supplies 24% of total energy tion, including the European Commission’s 2000 demand and 21% of electricity generation (Euro- Green Paper on security of supply, the 2002 pean Commission 2008b). Gas import depend- Regulation on State Aid in the coal sector, the ence is set to increase, as EU indigenous produc- 2008 Energy Security and Solidarity Plan, and the tion is forecast to decline rapidly in the coming 2009 Renewables Directive (European Commis- decade, from 176 million tons of oil equivalent sion 2000; Regulation 1407/2002; European (Mtoe) in 2010 to 131 Mtoe in 2019 (IEA 2009).4 Commission 2008a; Directive 2009/28/EC). European Commission analysis forecasts net This section therefore presents evidence on imports of natural gas increasing from 257 Mtoe the extent of EU import dependence and the fac- in 2005 (58% of total consumption) to 390 Mtoe tors that have most given rise to concern with in 2020 (77% of total consumption) under a respect to power generation: the large and grow- business-as-usual scenario, without taking into ing dependence on Russian gas imports and the account the impact of the new energy policy effect of supply interruptions in recent winters. It adopted in 2009 (see European Commission also assesses the extent to which import depend- 2008b, Annex 2).5 Table 4.1. EU import dependence, 2005 EU primary energy EU primary Net imports Import dependence demand (Mtoe) production (Mtoe) (Mtoe) (percentage) Oil 666 133 533 80.0% Natural gas 445 188 257 57.8% Solid fuel 320 196 127 39.7% Renewables 123 122 1 0.8% Nuclear/ 257 8 249 97.0% uranium Sources: European Commission 2008b, 65; Euratom 2008 Note: Mtoe = million tons of oil equivalent
  3. 3. Renewable Generation and Security of Supply 53 Winter Supply Interruptions were characterized by low gas prices for Ukraine and low transit charges for delivery of Russian gas The heavy dependence of the EU on Russian gas to Europe.6 has been brought home to the public and In March 2005, Russia claimed that Ukraine policymakers alike in recent years by interruptions was not paying for gas and was diverting gas to the supply of Russian gas at the start of the intended for transit to the EU (BBC 2006). On calendar year, arising from disputes between Rus- January 1, 2006, Russia retaliated by cutting off sia and Ukraine. A number of such disputes have gas supplies passing through Ukrainian territory.7 occurred since the breakup of the Soviet Union as Russia and Ukraine reached a preliminary agree- a result of continuing difficulties in agreeing on ment on January 4, and the supply was restored. the details of a new gas transit and supply regime, The agreement provided for an increase in the as well as deeper underlying differences. The most nominal price of gas but did not provide an serious of these interruptions occurred at the agreed pricing formula for future years or a tran- beginning of 2006 and 2009. In January 2006, gas sition period to higher prices.The new agreement supplies to the EU were interrupted for one day; was set to expire on December 31, 2008. in January 2009, the interruption lasted 16 days The 2009 crisis began on January 1, when Gazprom cut off suppliers (again, it stopped sup- (European Commission 2009a). plying gas for Ukrainian consumption while the supply of gas that was theoretically to be transited Ukraine’s Role as a Gas Consumer through for European consumption continued). and Transit Country Initially disruption of supply to the EU was only minor, but by January 7, all supplies from Russia Ukraine is both a significant consumer of gas and to the EU were cut, and supplies were not a key transit country. Its daily consumption in resumed until January 20. This was the most seri- winter is about 300 million cubic meters per day ous gas supply crisis ever to hit the EU, depriving (mcm/day), and another 300 to 350 mcm/day of it of 20% of its total gas supply (European Com- gas passes through Ukraine to the EU (European mission 2009a). Within days of the supply disrup- Commission 2009a). Imports from Russia via tion, 12 countries were affected. They responded Ukraine constitute around 80% of EU imports of by drawing on storage, importing additional LNG gas from Russia and about 20% of total gas supplies, and fuel-switching by the use of fuel oil demand in the EU (European Commission and coal. Increased supplies were sourced from 2009a). The Ukrainian gas sector features below- Russia via Belarus and Turkey, as well as from cost pricing for domestic and government cus- Norway and Libya. Gazprom is estimated to have tomers, and chronic underinvestment in its oil lost sales of $2 billion (European Commission and gas sector, including the gas pipeline infra- 2009a). structure (Chow and Elkind 2009). Disputes between Ukraine and Russia over Is Import Dependence Really a Problem? gas supplies, transit, and payment for gas have Reliance on imported fuels is not, per se, a cause been a feature of this market since the early 1990s. for concern. For policy intervention to be justi- Ukrainian inability to pay for the huge volumes of fied on security-of-supply grounds, a number of gas contracted (despite the very low prices Russia conditions must be satisfied, including that: gave Ukraine) led to high levels of debt and unpaid bills on a continuous basis for many years • The reliance on imports creates a genuine (Stern 2005). The disputes remained unresolved security-of-supply risk. This is unlikely to be despite a series of agreements covering the gas the case for a fuel that can be imported easily volumes and prices, the price of gas transit across from a number of different countries that are Ukraine, and the level of debt owed to Gazprom politically stable, friendly, and geographically by the Ukrainian gas company Naftokhaz, which diverse.
  4. 4. 54 Boaz Moselle • There is good reason to think that the normal world, as Figure 4.2 illustrates. At the current rate market response will not efficiently address of consumption, this would constitute about 100 any security-of-supply risks and that policy years’ worth of supply. intervention can be expected to do better. Uranium’s extraordinarily high energy density makes it practical to maintain large stockpiles The first of these conditions is assessed below for (Euratom 2008), reducing the risks associated each of the main fuels used for generation: coal, with a short-term interruption in supply. This fac- uranium, and natural gas. This is followed by a tor and the diverse range of supply sources suggest discussion of the potential for market or other that dependence on uranium imports is not a sig- failures that might justify intervention. nificant security-of-supply risk for Europe, despite the high level of import dependence, una- Coal voidable given that Europe has less than 2% of the world’s identified uranium resources (European Globally, coal is much more abundant than oil or Commission 2008b). natural gas. There are proven coal reserves of 826 billion tons of coal, with a proven reserve-to- production ratio of 122 years (BP 2009).8 Coal Gas reserves are available in almost every country, with recoverable reserves in around 70 countries. Six The picture for natural gas is very different than countries together account for about 80% of coal that for coal or uranium. Prima facie there is good reserves, as shown in Figure 4.1. reason to consider that the EU’s import depend- Given that world coal reserves are spread ence does represent a potential threat to security across a politically and geographically diverse set of supply. As noted earlier, the EU imports more of countries, large in number and including some than half of its gas, of which a large proportion of Europe’s closest political allies, the prospect of comes from Algeria and Russia, and gas imports significant supply interruption seems relatively are predicted to increase in coming years (Euro- remote. It is therefore implausible to argue that pean Commission 2007) as output continues to dependence on coal imports is a significant threat decline in the main EU producing nations. to EU security of supply. Dependence on Algerian and Russian gas is of concern because of the absence or weakness of democratic institutions and transparent govern- Uranium ance arrangements in these countries. Algeria has The earth has 5.5 million metric tons of identified experienced recent civil war and ranks poorly on uranium resources, distributed widely around the international league tables in terms of democracy South Africa Brazil 5% India 7.1% 3.7% Namibia 5% United States 28.9% Australia 23% Niger 5% Australia 9.2% United States 6% China 13.9% Canada 8% Kazakhstan South Africa 15% Russian Federation Other 18.2% 19.0% 8% Russia 10% Figure 4.1. World coal reserves Figure 4.2. World uranium resources
  5. 5. Renewable Generation and Security of Supply 55 and civil rights (World Audit 2010). Russia also Nigeria 2.8% Venezuela 2.6% Algeria 2.4% has a low rank, and the poor climate for business United Arab Emirates 3.5% investment raises questions as to whether new United States Russia 23.4% investment required to maintain and increase gas 3.6% supply will be forthcoming. There is also a ques- Saudi Arabia 4.10% tion as to how far the supply of gas is a commer- cial decision versus an instrument to exercise geo- Turkmenistan 4.3% political influence. This means that the extent to which the supply of gas will respond to increased demand is unclear. Qatar 13.8% Iran 16.0% In addition, analysts have noted that Russia needs to replace declining fields with new pro- Figure 4.3. World gas reserves: top 10 countries duction from the Yamal Peninsula and offshore fields and to refurbish a large, aging high-pressure of-supply risk for the EU. It is possible that a pipeline network (Stern 2005). As mentioned combination of LNG imports and the arrival of above, there is also a need to invest in the Ukrain- unconventional gas (either in Europe or in the ian pipeline network or construct new pipelines United States but “liberating” LNG flows that to maintain transit capacity to Europe. could come to the EU) will mitigate the problem. Underlying these concerns is the absence of It is also possible that the risk is overestimated realistic alternative sources of natural gas. Relative because of the mutual dependence between the to other fuels, the ability to bring gas from differ- EU and its suppliers: revenue from gas sales is of ent sources is inherently limited by the more great importance to both Russia and Algeria, and costly, capital-intensive and inflexible means of indeed, they have been known to express concern transportation required, in the form of long- about “security of demand” from the EU, mirror- distance pipelines or liquefied natural gas (LNG). ing the EU’s concerns about security of supply Moreover, while gas remains abundant at global (see, e.g., Yenikeyeff 2006). Neither of these pos- level, with world proven reserves as of 2007 stand- sibilities can be viewed as certain, however, and ing at some 177 trillion cubic meters (tcm),9 the risk is therefore a real one, albeit difficult to equivalent to some 60 years of consumption at assess or quantify. current rates (BP 2009), those reserves are con- The problem is particularly acute for eastern centrated in a small number of countries, as Europe. Estonia, Latvia, Lithuania, Bulgaria, shown in Figure 4.3. Of these, just three coun- Slovakia, and Finland are completely dependent tries, Russia, Iran, and Qatar, hold about 53% of on Russia for gas imports, while Greece, Hun- the total. gary, and Austria are more than 80% dependent There is an unknown potential for European (European Commission 2008b). Among the seven domestic gas supply to be boosted by unconven- new eastern European member states, depend- tional or shale gas. In the United States, substan- ence on Russian gas imports averages about 77% tial discoveries of unconventional gas have been (European Commission 2009a). Eastern Euro- made.10 However, estimates of the potential for pean commentators point to the experience in unconventional gas in Europe are lower. One Lithuania—where oil supplies from Russia to the study estimates that Europe has 29 tcm, whereas Mazeikiu refinery were halted because, it is the United States has around 233 tcm of uncon- claimed, Russia objected to its sale to a Polish ventional gas (Holditch 2007).11 Moreover, the refiner, PKN Orlen—as a sign of the potential ability to extract the resources will depend on risks they face (Geropoulos 2007). The political environmental consents and the cost of extracting temperature is clearly at its highest with regard to unconventional gas in Europe. eastern Europe, given Russian resentment at its In conclusion, it seems that gas import loss of influence there since the breakup of the dependence is a potentially significant security- Soviet Union.
  6. 6. 56 Boaz Moselle The Case for Policy Intervention judgments and use them to implement better policies. A case may therefore exist for interven- Gas import dependence is therefore an under- tion on essentially paternalistic grounds. standable source of concern for European The second problem is the issue of politically policymakers. However, it does not automatically motivated supply interruptions. Arguably, the risk follow that policy intervention is warranted. Mar- of supply interruption by a hostile state actor is kets already provide strong incentives for market greater the more disruptive the effect of the inter- participants to appropriately ensure against unreli- ruption.13 Thus, although ensuring against low able supplies. Contracts between suppliers and rainfall in a hydro-dominated power system does consumers generally oblige suppliers to deliver not make rain more likely to fall, ensuring against energy, and suppliers that choose to contract with gas supply interruptions in the EU actually less reliable sources (in other words, are too reliant reduces the threat of interruption, because if such on gas from Russia and Algeria) will face what- interruptions are relatively painless, then a hostile ever penalties their contracts contain. These pen- state gets little strategic benefit from interrupting alties are negotiated on a bilateral basis and there- or threatening to interrupt supplies. If so, then fore represent accurately the costs to consumers of individual investments in supply security (e.g., loss of supply, or the trade-offs consumers are booking more gas storage or installing dual fuel willing to make between price and security of capability at gas-fired power stations) create a supply (for example, a consumer may be willing positive externality, and as with any such external- to sign a contract that has no penalties in the event ity, there will be an incentive to free ride: con- of supply failure, such as through the operation of sumers will spend less than is socially optimal, a force majeure clause, but in that case the supplier because they face all the costs but only a small part accepts a lower price in return). A similar logic of the benefits (the so-called “tragedy of the com- applies for consumers that choose to rely on mons”). Moving down the chain, it follows that short-term contracts or spot markets: they accept suppliers will not face appropriate incentives to the higher level of risk in return for greater flex- ensure security, and the market will under- ibility or an expected lower price. provide security. The key question therefore is whether these Third, experience shows that in conditions of incentives are sufficient to provide an efficient12 energy scarcity, regulatory or political interven- level of security—or, more accurately, whether tion will almost certainly prevent the market from they provide a more efficient level of security than functioning efficiently.The prospect of such inter- can be expected from policy intervention, bearing vention will therefore undermine investment in mind that real-world policy interventions and incentives. For example, a private investor might real-world markets are both inherently imperfect consider investing in a gas storage facility even if compared to any theoretical ideal. the market already appears well supplied with gas In that context, a number of problems could storage, on the basis that it would offer a very high undermine the ability of these market-based return in the low-probability event that a major incentives to give an efficient outcome. These gas shortage leads to prolonged spikes in spot gas include some market failures that typically provide prices. Experience in Great Britain suggests that the theoretical justification for policy interven- these spikes could involve prices many times as tions, but also other issues that are arguably more high as under normal conditions,14 implying important from both normative and positive per- spectacular returns to anyone holding gas in stor- spectives (i.e., they should be taken more seri- age. ously, and they have a bigger impact on policy In reality, however, the investor will be aware outcomes). that many regulators or governments have First, it may be that consumers (individuals arrangements in place that suspend the price and firms) are not good at making judgments of mechanism in such emergencies. Such an investor this kind, and that governments could make better will also be aware that even if those mechanisms
  7. 7. Renewable Generation and Security of Supply 57 are not yet in place, they could be introduced at supply. An individual consumer therefore has no short notice, and moreover, in the absence of incentive to purchase energy from more reliable price controls, they would be likely to suffer ret- sources, as the higher levels of security are spread ribution if they were judged to have profiteered or across all consumers. Purchasing from a more reli- “price-gouged” during a crisis.15 able source creates a positive externality but Conversely, market participants will also be almost no private benefit (see Joskow 2007). aware that emergency arrangements typically Again, this gives rise to free riding and involve the imposition of “shared pain” rules, underprovision of security by the market. which undermine private incentives to ensure against scarcity of supply. For example, scarce gas supplies might be allocated to all suppliers on a Assessment pro rata basis related to the size of their customer How material these problems are for security of load. Such an outcome would do nothing to supply is a difficult empirical question, both in reward the supplier who had purchased gas from a absolute terms and because assessment should be more reliable source. against a counterfactual that is based on a realistic Examples of these two tendencies— assessment of the likely intervention that the nonreliance on the price mechanism and a policy process would give rise to. Nonetheless, “shared pain” approach—can be found in the gas some simple observations are in order. “emergency cash-out” arrangements in Great First, the paternalistic argument that consum- Britain, which suspend the market-based deter- ers are unlikely to make wise decisions is at least mination of prices for the duration of the emer- plausible. Extensive research in psychology and gency (Ofgem 2006). The European Commis- behavioral economics shows that human beings sion’s proposed new legislation on gas security of have particular difficulty making decisions involv- supply provides for a variety of non-market-based measures including compulsory demand reduc- ing low-probability events that are well outside tion and forced fuel switching (European Com- their normal range of experience (Tversky and mission 2009c). Kahneman 1992). However, the claim that gov- A fourth problem is a more conventional mar- ernment intervention will lead to better outcomes ket failure: because security of supply is to some is more contentious (apart from any other consid- extent a public good, markets will tend to eration, governments are made up of human undersupply it.16 Specifically, the issue arises for beings subject to the same biases as others). natural gas and electricity because they are trans- Second, the argument concerning politically mitted via networks used by many consumers, motivated interruptions is also at least plausible. and most individual consumers cannot be The key question for EU policymakers to answer remotely interrupted when supplies are tight.17 is how likely Russia is to interrupt gas supplies for Domestic and commercial consumers generally political reasons. On the one hand, instances have do not have real-time metering and are not already occurred where Russia has cut off oil sup- exposed to higher spot prices when supplies are plies to an EU member state for essentially politi- scarce. There is therefore no incentive for indi- cal reasons. On the other hand, as noted earlier, vidual consumers to ensure against supply risks, profits from Gazprom are of great importance to for example by paying more to purchase from a Russia and members of its political elite, creating supplier that has more gas in storage.18 a relationship of mutual dependence between In particular, with electricity the absence of Russia and the EU. remote disconnection means that in the event of a Third, the combination of regulatory and blackout, all consumers will lose supply in an area, market failures described above seems to imply even though in general it would be possible to set that all but the very largest consumers are cut off a price—if all consumers were exposed to real- from any of the upside from investing in enhanced time prices—that would allow demand to match security of supply.
  8. 8. 58 Boaz Moselle Finally, whatever the objective merits, it is also able energy, with a binding target of 20% of final clear that governments are increasingly set on energy consumption; and reduce greenhouse gas intervention in this area, at EU and national lev- emissions, with a 20% reduction relative to 1990 els. In the context of this book, it is therefore levels. appropriate to ask whether, assuming that As the table shows, the combination of meas- policymakers are intent on intervention, the pro- ures is predicted to reduce gas imports by about a motion of renewable generation is the best form quarter, relative to business-as-usual. However, of intervention to address the EU’s concerns this analysis also raises a number of questions. about import dependence and its impact on secu- First, it is clear that much of the reduction in rity of supply. gas consumption reflects the impact of energy efficiency measures that reduce total energy con- Is Promotion of Renewables sumption, rather than the displacement of gas- the Right Intervention? fired generation by renewables. Indeed, one can see from the table (see the “Impact of new policy” It is natural to expect that the promotion of rows), that the predicted reduction in gas con- renewable generation will reduce gas consump- sumption induced by the new energy policy (sec- tion and hence gas import dependence, by substi- ond column) is much larger than the induced tuting away from gas-fired generation. Analysis increase in renewable energy (last column). carried out for the European Commission is con- Second, although the analysis does not allow sistent with this logic. Table 4.2 shows the pre- one to separate out these two effects, it is likely dicted effects of the EU’s new 20-20-20 energy that the impact of renewables on gas-fired policy adopted in 2008, whose main components generation is materially affected by the need for are commitments to achieve several goals by the continued use of gas to provide flexible backup year 2020: reduce demand, with an indicative tar- for intermittent renewables. Recent analysis by get of 20% reduction in energy consumption rela- Capros et al. (2008) suggests that the new energy tive to business as usual; increase the use of renew- policy will reduce coal-fired generation signifi- Table 4.2. Energy consumption and import dependence by 2020 Gas Gas con- Gas imports/ Solids Solids con- Solids imports/ Renewable imports sumption consumption imports sumption consumption energy (Mtoe) (Mtoe) (%) (Mtoe) (Mtoe) (%) production (Mtoe) 2005 257 445 57.8% 127 320 39.7% 122 2020 (oil $61/bbl) Business as usual 390 505 77.2% 200 342 58.5% 193 New policy 291 399 72.9% 108 216 50.0% 247 (20-20-20) Impact of new –99 –106 –4.3% –92 –126 –8.5% 54 policy 2020 (oil $100/bbl) Business as usual 330 443 74.5% 194 340 57.1% 213 New policy 245 345 71.0% 124 253 49.0% 250 (20-20-20) Impact of new –85 –98 –3.5% –70 –87 –8.0% 37 policy Source: European Commission 2008b, 65
  9. 9. Renewable Generation and Security of Supply 59 cantly more than gas-fired, both because of the imports of uranium or coal, I have argued above impact of carbon prices and because renewable that no significant security-of-supply issue should power requires extensive support by flexible arise from such imports. reserve power, supplied mainly by gas units. In conclusion, therefore, a policy that pro- Indeed, the analysis in Table 4.2 also shows the motes low-carbon generation in general would impact of the new policy on coal (solids) to be probably be more effective in addressing gas equal to or larger than the impact on gas. import dependency and enhancing security of Third, it is unclear which gas sources are most supply than the current policies that specifically likely to be affected by the reduction in gas promote renewable generation. imports. If the main effect of the policy is to dis- place imports of LNG from relatively friendly sources, then the effect on security of supply is small. However, this is likely to be the case. LNG Intermittency is often viewed as the marginal source of gas, Some of the most prominent forms of renewable because of the relatively high cost of bringing generation—in particular wind but also solar and LNG to the EU, and also because Algerian and wave power—are variable in output, with the Russian producers are to some extent captive sup- level of production determined by exogenous fac- pliers, given the high cost of attempting to diver- tors such as wind speed, and also unpredictable to sify away from their European customer base.19 a lesser or greater degree. “Intermittency” is the Finally, the analysis described above suffers term generally used to refer to this combination from a more fundamental flaw, in that the of variability and relative unpredictability. business-as-usual counterfactual is arguably some- Two concerns arise from the intermittent thing of a straw man. A more interesting counter- nature of renewable generation. A short-run con- factual would be a scenario with a policy that cern is the impact on “system balancing”— involves the promotion of all forms of low-carbon ensuring that supply and demand of power are energy on a technology-neutral basis: a carbon tax matched on a second-by-second basis. A long-run or cap-and-trade scheme (in this context, the EU concern is whether a liberalized power market can ETS with a tighter cap) and no policies aimed be relied on to produce enough investment to specifically at promoting the large-scale deploy- meet the much greater need for backup ment of renewables.20 generation—flexible capacity that will be used The effect of such a policy would be to pro- primarily when demand is high and wind output mote some combination of energy efficiency is low, and whose overall utilization will therefore measures, nuclear power, coal-fired generation be comparatively low. with carbon capture and storage (CCS), and renewables. The noteworthy point here is that of System Balancing those four classes of technology, renewable generation—at least in the forms of wind, solar, or The basic physics of electric power systems wave power—may well be the least suited to requires that production and consumption22 are enhancing security of supply, because as noted matched on a second-by-second basis. In any earlier many renewable generation technologies power system, a system operator (SO) is responsi- are intermittent and will likely be associated with ble for continuously ensuring this balancing. The continued extensive use of gas-fired generation as SO has short-term control of certain generating “backup”.21 It is therefore likely that they will dis- assets, which it uses close to and in real time to place less gas-fired output than equivalent correct any difference between the amounts of amounts of nuclear power or coal-fired genera- electricity supplied to the system and the amount tion (or investments in energy efficiency). being consumed. Although increased use of nuclear power or coal- Small deviations from perfect balance take fired generation would probably entail increased place continuously and result in fluctuations in the
  10. 10. 60 Boaz Moselle frequency of AC power. Certain generating units ter 2 and references therein. In brief, it is clear are configured to react automatically and instanta- that significant advances have been made in the neously to these deviations. This so-called “pri- ability to forecast wind speeds and the output mary reserve” acts as a first line of defense against from wind generation, such that while high levels imbalances. In case of larger deviations, after the of penetration of wind generation may add to the immediate response of the primary reserve, gen- cost of system operation, they need not under- erators providing the so-called “secondary mine system stability. Current evidence suggests reserve” increase or reduce injections within sec- this is the case at least for penetration up to 20% onds, following the instructions of a central (i.e., with up to 20% of electric power being gen- device in a process known as automatic genera- erated by wind). tion control. Secondary reserve is a scarce The issue is at present less clear for other resource, because it is provided by units with spe- intermittent sources, and in climates with cloudy cific technical capabilities. As soon as possible, skies, solar photovoltaic (PV) power may present therefore, typically with a lag of minutes, injec- greater challenges, as cloud cover means the vari- tions by units providing so called “tertiary ability in output can occur over seconds rather reserve” are increased or decreased, following the than hours (although geographic dispersion will instructions of the system operator, and secondary mitigate this to some extent). Nonetheless, Boyle reserve capacity is restored to the pre-deviation argues in Chapter 2 that they can probably be level. dealt with in similar fashion (for more details, see In a liberalized market, the SO generally con- also Boyle 2007). tracts with generators, and sometimes large con- The findings of a very comprehensive survey sumers, to procure these services.23 The nature of paper by Gross et al. are consistent with this con- the reserve contracts varies, but for the purpose of clusion: “none of the 200+ studies [we have] this chapter, it is sufficient to note that the SO will reviewed suggest that introducing significant lev- pay plants to be available to provide balancing els of intermittent renewable energy generation services, as well as for the provision of the services on to the British electricity system must lead to when called on. reduced reliability of electricity supply” (2006, Clearly the task of system balancing becomes iv). more difficult the greater the changes in the levels However, these conclusions do assume that of output, especially if those changes are advances in forecasting will be effectively incor- unpredicted or occur with only very short porated into system operation procedures. Chap- notice.24 The prospect of high levels of penetra- ter 11 notes the example of Texas, where a much- tion of intermittent generation therefore gives rise discussed emergency occurred in 2008 following to concern that the job of system balancing will a rapid reduction in wind output. The reduction become more costly and less certain of success: had been predicted by commercially available the SO will have to purchase more balancing forecasts, but the SO had not purchased those services, and if it fails to purchase enough, it could forecasts. find itself overwhelmed by unexpectedly volatile shifts in output from intermittent generation, endangering security of supply.25 Cost Implications The same survey by Gross et al. (2006) also System Stability Implications analyzes the cost implications of intermittency, looking at how much additional reserve capacity From a system stability perspective (i.e., in terms is likely to be required and how much this of the risk of supply disruptions), these concerns is likely to cost. The authors conclude that “for are probably exaggerated. The more technical penetrations of intermittent renewables up to 20% aspects of the system-balancing challenges posed of electricity supply, additional system balancing by intermittent generation are addressed in Chap- reserves due to short term (hourly) fluctuations in
  11. 11. Renewable Generation and Security of Supply 61 wind generation amount to about 5–10% of The size of this requirement will clearly installed wind capacity. Globally, most studies esti- depend on the level of penetration of intermittent mate that the associated costs are less than generation, the technologies involved, the specific £5/MWh of intermittent output, in some cases electricity system, relevant physical features (e.g., substantially less.” Of course, an additional cost of the geographic and temporal distribution of £5 ($7.50) per MWh is a material issue,26 but that wind), and many other factors. This has been the forms part of a larger set of questions about the object of many engineering studies. For the pur- cost-effectiveness of renewable generation and is pose of synthesis, it is convenient to summarize not really a security-of-supply issue. any such study in terms of its estimated “capacity All of this analysis assumes, however, that the credit,” which measures how much conventional necessary reserve will be there for the SO to call thermal generation is displaced by a unit of inter- on. This naturally leads back to the question of mittent generation. So, for example, a capacity investment incentives. credit of 20% means that adding 100 megawatts (MW) of intermittent generation would allow one to retire 20 MW of conventional generation Investment in Backup Generation while maintaining the same overall level of system Given the difficulty of storing electricity and the security. limited potential for shifting demand across time, A comprehensive survey of these studies can the use of intermittent generation means that a be found in Gross et al. (2006), whose summary large set of backup generation is required to of the estimates of the capacity credit from 19 of ensure that demand can be met at times when the the studies is shown in Figure 4.4. intermittent sources have low availability because Clearly a capacity credit in the range implied of a lack of wind, sunshine, and so on. This need by these studies would add significantly to the for spare capacity is not unique to systems with total capital costs of the system. With regard to intermittent generation: no type of generation is security of supply, however, the concern is that a available with 100% certainty, and conventional liberalized market will not have sufficient invest- units also close down for planned and unplanned ment to provide the required level of generation maintenance. Nevertheless, large-scale penetra- capacity. tion of intermittent generation gives rise to a much higher requirement. 40 intermittent generation capacity) 35 Capacity credit (% of installed 160 30 5 51 25 247 248 249 240 20 79 121 204 83 242 15 250 243 238 244 241 10 74 5 246 0 5 10 15 20 25 30 35 40 Intermittent generation penetration level (% of total system energy) Source: Gross et al. 2006, 43 Note: the shaded area refers to UK studies Figure 4.4. Capacity credit values
  12. 12. 62 Boaz Moselle Starting Point: Excess Capacity requirements of new environmental legisla- tion. So, for example, in the EU, the cost of In the short run, there may be little issue with the adding “scrubbers” to coal-fired units by availability of reserves and peaking generation 2015, to comply with the Large Combustion more generally, because as new intermittent Plant Directive, would have to be recovered capacity is added to the network, the existing through future profits, and this could be dif- conventional capacity remains available. Although ficult if utilization is expected to be very low. generators could choose to retire this capacity, the incentives to do so are relatively weak, because the investment is already sunk and profits from opera- Investment Incentives in Energy-Only Markets tion need cover only annual fixed costs (such as In the long run, however, there is a real question transmission charges or taxes levied annually) to as to whether energy markets will deliver the make it worth keeping the plant open. needed investment. This question falls into a Experience to date in Germany and Spain is wider debate as to the ability of liberalized energy consistent with these arguments. Sensfuß et al. markets to provide sufficient levels of investment. (2008) note that for Germany, “the development The issue has been extensively discussed in aca- of renewable electricity generation has had no demic and policy circles for some years (Cramton major impact on investments into new generation and Stoft 2005; Stoft 2002). This chapter can do capacity up to the year 2006. One reason is that no more than briefly sketch out the main posi- the period after the liberalization of the electricity tions taken. market was characterized by excess capacity and a The issue relates specifically to “energy-only” subsequent decommissioning of power plants,” markets, where generators’ only sources of rev- while “most of the decommissioned capacity was enue are the sale of electricity and the provision of decommissioned for economic reasons such as reserves, as described earlier in this chapter.27 low efficiency of the plant, need for repairs or Theoretical models suggest that although genera- inefficient use of expensive fuels such as oil and gas.” Chapter 15 in this book describes the evolu- tors in a competitive energy-only power market tion of Spanish capacity, characterized by high can earn sufficient operating profits to cover their levels of excess capacity due in large part to the cost of capital (i.e., the variable profit from selling rapid expansion of renewable generation, and as power can provide a sufficient return on invest- yet without any consequent retirement or ment), the requirements for that to happen are mothballing of plants. rather stringent and may not be met in practice in In some markets, however, this initial over- most real-world power markets. hang of excess capacity might erode relatively The problem arises because if such a market is quickly, for a number of reasons: competitive, then the spot price of electricity will approximate the marginal cost of the most costly • If there is too much capacity, then prices generator being called on—the “system marginal might fall to a level that induces plant cost”—at any point in time except hours when mothballing or early retirement. Chapter 15 demand (strictly speaking, demand for energy and indicates that this situation may be develop- operating reserves) exceeds available capacity. In ing in Spain. those hours, it is possible for price to exceed sys- • Generators with zonal or regional market tem marginal cost, for example if it is set by price- power might have an incentive to retire some responsive demand. The difference between price of these plants so as to raise peak prices and and system marginal cost is referred to as a “scar- the price of reserve. city rent”. • Incentives for early retirement may be exac- For peaking plants (the plants with the highest erbated by the costs of refurbishments, marginal cost on the system), these scarcity rents including those necessary to meet the are the only way to create a return on capital. It is
  13. 13. Renewable Generation and Security of Supply 63 possible to show that at least in theory, scarcity underinvestment, particularly in peaking capacity. rents are also necessary for plants with lower mar- This issue is commonly referred to as the “missing ginal cost, if they are to earn a sufficient return to money” problem. cover their sunk costs. It is therefore necessary On the other hand, proponents of a more that prices in those hours be sufficiently high to market-oriented approach argue or assert that in provide an appropriate return on capital, i.e., one the absence of price caps, the market can in prac- that will provide the right incentive for new gen- tice be expected to provide sufficient capacity, eration in peaking plants. theoretical models notwithstanding. In Great Prices at times of scarcity should generally be Britain, this view underlies the existing market set either by demand-side response or by actions design, the so-called New Electricity Trading of the system operator in its procurement of oper- Arrangements (NETA), which does not have any ating reserves (Hogan 2005). If those mechanisms price caps in place. Practical experience in the work appropriately, then it can be shown that in decade since NETA was put in place is somewhat theory, the level of scarcity rents will be efficient, ambiguous. Despite many claims of imminent in the sense of ensuring that generators earn their crisis, the lights have stayed on. However, this has cost of capital and have appropriate incentives for been achieved with very little new investment in new investment. generation, indicating that the system may have However, this outcome depends on the pres- enjoyed an overhang of excess capacity from the ence of flexible scarcity pricing mechanisms and preceding decade. the absence of market or regulatory imperfections In sum, there are theoretical reasons to believe that in the absence of some form of capacity that limit demand-side response or distort system mechanism, a competitive energy-only market operator decisions. In practice, such imperfections without efficient scarcity pricing mechanisms may are endemic: underdeliver on investment in reserve capacity (i.e., in flexible units that will experience low • The development of mechanisms to allow average utilization). Although the materiality of demand-side participation has been generally those concerns is open to debate, it is clear that rather slow in most electricity markets, limit- any problems would be exacerbated considerably ing the potential for demand-side response to by the much greater need for such units that set prices at times of scarcity. comes with high levels of penetration by renew- • The protocols followed by many system able generation. Moreover, in practice, concerns operators at times of scarcity do not lead to about underinvestment are likely to be well the appropriate level of scarcity pricing.28 founded because of the combination of explicit • The potential for prices to depart from gen- price caps and the implicit threat or shadow of erators’ marginal costs at times of scarcity is future price regulation in most or all liberalized often limited by administrative measures con- markets. Even in Great Britain, which until straining prices, to mitigate market power or recently was viewed as the paragon of energy for other reasons. For example, many cen- market liberalization, reregulation is now being trally organized markets (“pools”) have openly discussed (see, e.g., Ofgem 2010). explicit price caps in place,29 and some limit The example of Great Britain also illustrates a the offer prices as a part of the ex ante market deeper problem with investment incentives in the power mitigation process. In many markets, context of current energy policy, of which policy regulators monitor prices and perform ex toward renewables forms only a part. The nature post investigations of price spikes, with a of the policy response to climate change, particu- chilling effect on scarcity pricing. larly in the EU, means that all forms of investment in new generation capacity are heavily influenced It is therefore argued that in practice, imperfec- by government intervention. Thus renewables, tions in energy-only markets will lead to nuclear, and CCS each attract technology-specific
  14. 14. 64 Boaz Moselle forms of support, whereas environmental regula- high penetration of intermittent generation tion in the form of the EU Emissions Trading means that a number of EU regulators are likely to Scheme as well as non-climate-related measures30 be addressing those challenges in the coming affect the relative and absolute returns on different years. technologies. Investments are thus arguably sub- Finally I note one caveat: the picture may be ject to very high levels of political risk, and it is by somewhat different in countries where generation no means clear that markets are able to assess and investment decisions are more naturally influ- bear these risks. enced by informal ties between industry and gov- In conclusion, therefore, the possibility that ernment. For example, in Germany needed competitive liberalized markets will struggle to investments may take place as the outcome of provide sufficient peaking capacity to accommo- informal (or at least non-contractual) agreements date large amounts of intermittent generation is a between government and industry, rather than very real one, for a variety of reasons. The biggest being either a pure market outcome or one factor undermining investment incentives is the induced by regulatory mechanisms such as cap- high level of uncertainty and political risk, which acity payments. affects all generation investments to a lesser or greater degree, except for projects that can rely on explicit and iron-clad government guarantees. Conclusions The design of wholesale power markets may need to change to reflect these concerns, by pro- Dependence on imported gas gives rise to real, viding stronger and more reliable incentives for albeit hard-to-quantify, security-of-supply issues investment, such as in the form of capacity pay- for the EU, because of geopolitical concerns ments or similar mechanisms. Capacity payments around both Russia and Algeria. Those problems are widely used in the United States and have had are particularly acute for many of the new EU some application in Europe (in Spain, for exam- member states in eastern Europe, where depend- ple, as well as in England and Wales in the 1990s) ence is highest and relations with Russia are most (Perekhodtsev and Blumsack 2009). These are strained. Dependence on imported coal and ura- payments to generators that are additional to the nium does not give rise to such concerns, because revenue they receive from the sale of energy. Dif- of the number, diversity, and friendliness of ferent countries have taken alternative approaches potential sources. toward implementing such a mechanism. In Market outcomes may not provide an efficient Europe, the approach generally has been for the level of protection against the security-of-supply transmission system operator (TSO) to make pay- risks associated with gas import dependence, ments to generation on the basis of its availability because of a variety of market and regulatory fail- to generate, recovering those payments as a sur- ures. However, the promotion of renewable gen- charge on transmission tariffs. In the United eration is not the best policy response. Increased States, regulators have tended to place obligations promotion of all forms of low-carbon energy on demand-side participants to contract forward (including energy efficiency) would appear to be for capacity via organized “capacity markets”. The at least as effective in enhancing security of supply, level of the obligation then determines the at lower overall cost. demand for capacity in those markets, and that Security-of-supply concerns related to inter- combines with supply to determine a capacity mittency and its impact on system operation and price. In either case, the details of design (includ- grid stability are exaggerated. In particular, recent ing, for example, determining the appropriate improvements in wind forecasting mean that even level at which to place the price, or the quantity rather high levels of penetration for wind genera- associated with an obligation) are extensive and tion can safely be accommodated by an efficiently potentially challenging (Harvey 2005). For the run and appropriately regulated system operator. purposes of this chapter, it is sufficient to note that The impact is one of cost rather than a threat to
  15. 15. Renewable Generation and Security of Supply 65 stability. High levels of penetration of intermittent converted from billion cubic meters (bcm) to generation do, however, raise real questions about Mtoe using 1 bcm = 0.90 Mtoe (www.bp.com/ market design and security of supply—in particu- conversionfactors.jsp). lar, whether existing energy-only markets will 5. The 390 Mtoe figure assumes an oil price of $61 per barrel (bbl). A second business-as-usual sce- provide strong enough incentives for the invest- nario has an oil price of $100/bbl and forecasts net ment needed in peaking generation to cope with imports of 330 Mtoe (75% of total consumption). periods where high demand coincides with low 6. Some observers note that the actual price paid by intermittent output. Ukraine is higher than the contracted price In principle, market mechanisms are sufficient because of an agreement due to arrangements to to ensure the right levels of investment. In prac- provide free gas in exchange for delivery of gas tice, however, the absence in most EU power into Ukraine. However, even allowing for the markets of appropriate mechanisms for scarcity additional cost, the price remains well below pricing, combined with very high levels of regu- European levels. See Chow and Elkind 2009. latory uncertainty and risk, suggests that there 7. In principle, Gazprom did not cut off supplies to may be a need for some form of enhanced incen- the EU; it reduced the level of flows by the amount of gas that previously would have been tive such as capacity payments that reward genera- intended for Ukraine, while continuing to flow tion for availability, except in markets where the gas for transit across Ukraine to the EU. However, level of investment is strongly influenced by it was easily predictable that Ukraine would con- implicit regulation and consensus-based decision- tinue to consume gas, with the effect of reducing making involving industry, government, and transit flows significantly. other stakeholders. 8. Corresponding figures are 42 years for oil and 60 years for gas (BP 2009). 9. The corresponding figure for 1987 was 70 tcm. 10. The U.S. Energy Information Agency (EIA 2008) Acknowledgments has reported increases in the level of proven gas reserves as a result of the development of uncon- Thanks to Luis Agosti, David Black, Godfrey ventional gas resources. The Potential Gas Com- Boyle, Toby Brown, Guido Cervigni, Dmitri mittee (2009) reported an increase in reserves, (including proven, possible and speculative Perekhodtsev, and Dick Schmalensee for many reserves) in 2008 to the highest level in its 44-year helpful suggestions and input. All errors and omis- history. sions are mine. 11. Figures converted from trillion cubic feet (tcf) to tcm using 1 tcm = 35.3 tcf (www.bp.com/ conversionfactors.jsp). 12. Here “efficiency” refers to the trade-off between Notes cost and risk. Arrangements are efficient if the additional cost of investing to increase security 1. A parallel argument is made in the EU and the outweighs the additional benefit (and the saving United States about the benefit of renewable fuels from spending less does not justify the increased in reducing the risks arising from dependence on level of risk). imported oil for transportation. The focus of this 13. So either supply interruptions become more book, however, is on renewable generation. probable/frequent, or society pays a higher price 2. The bulk of the remainder was from renewables to avoid them, in the form, for example, of higher (14%). national security costs or unwanted changes in 3. Russia provides 42% of the EU’s gas imports, foreign policy to appease the potential interrupter. Norway 24%, Algeria 18%, and Nigeria 5%. This argument has been used in the past to justify 4. A more recent forecast is even more dramatic, the requirements for strategic oil storage. showing a fall from 166 Mtoe in 2010 to 14. For example, in 2005, a combination of factors 113 Mtoe in 2019 (ENTSOG 2009); all figures temporarily reducing supplies to the United King-
  16. 16. 66 Boaz Moselle dom led to price spikes of up to 500% between mittent generation will displace less gas-fired gen- February 23 and March 11 (Trade and Industry eration than will non-intermittent. Clearly this Committee 2005). would not apply to hydro generation or to 15. Some U.S. states even have legislation specifically biomass. The potential for new hydro is relatively prohibiting price-gouging. For example, Florida limited, however, and intermittent sources (in par- Statute 501.160 states that during a state of emer- ticular wind) are forecast to be the dominant form gency, it is unlawful to sell “essential commodi- of new installed renewable generation capacity in ties” for an amount that grossly exceeds the aver- the coming decade at least. age price for such commodities during the pre- 22. Including consumption in the form of losses aris- ceding 30 days. ing from transmission and distribution. 16. A public good is a good that is non-rivalrous and 23. With the exception of primary reserve, whose non-excludable. This means that consumption of provision is typically an obligation placed by the good by one individual does not reduce avail- administrative means on generators connected to ability of the good for consumption by others, and the system. that no one can be effectively excluded from using 24. An important distinction must be made here the good. between wind and solar photovoltaic (PV) power. 17. In other words, it is not possible for the system Wind variability occurs over a matter of hours and operator to cut off supply to individual consumers, is relatively amenable to forecasting. Except in cli- other than very large consumers (who often have mates with cloudless skies, solar PV can vary over “interruptible supply” contracts that allow for seconds and is therefore more difficult to forecast. such actions). 25. This account has greatly simplified the complexi- 18. Given metering technologies currently in place, it ties of running an electric power system. As well as is not possible to create such an incentive. For the need to match total supply with total demand, example, gas meters typically record only cumula- the system has a number of other technical tive consumption, and unless they were read on a requirements, including so-called “voltage regula- daily basis—which would clearly be impossibly tion”, and the need to respect transmission con- costly—there would be no way to know how straints. The latter task in particular is likely to much has been consumed by an individual cus- become more costly and challenging with the tomer on a day when supplies were particularly addition of large amounts of new intermittent scarce. generation, as discussed in a number of the case 19. This is a general analysis; individual import con- study chapters in this book. tracts can vary significantly. 26. As of February 2010, this is about €5.70 ($7.75) 20. Another interesting counterfactual, and one that per MWh. in principle should be the starting point for the 27. This is in contrast to markets where generators design of any intervention, would be to use taxa- also receive payments for being available to gener- tion to correct for any security-of-supply exter- ate, via “capacity payment” mechanisms or cap- nalities. In theory, this might lead to different lev- acity requirements and auctions, as discussed later els of taxation applied to gas from different in this chapter. sources, with Russian gas probably incurring the 28. Mechanisms allowing the scarcity of operating highest tax. In practice, this could create difficul- reserves to set the price in the energy market are ties with World Trade Organization (WTO) rules, not in place in most EU markets. Such mecha- and it would also raise difficult questions about the nisms require an advanced level of integration quantitative assessment of the size of the external- between the markets for energy and the markets ity. A more realistic approach would be to tax all for reserves, as well as between the spot and bal- gas. However, this would also be politically diffi- ancing markets. Market designs allowing such cult because of the aversion of key member states integration can be seen mostly in the United (notably the United Kingdom) to EU-level taxes, States. See, e.g., Kranz et al. 2003. and because the United Kingdom and the Neth- 29. For example, the markets in Alberta and Ontario erlands are both major gas producers. have price caps of C$1,000 ($979) and C$2,000 21. This is not to assert that intermittency per se is a ($1,958) per MWh (Adib et al, 2008), and Texas security-of-supply risk (see next section), but (ERCOT) has a price caps of $2,250 (ERCOT merely to observe that all else being equal, inter- 2008). In Europe, Nordpool caps the day-ahead
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