Case 6: Institutional arrangements of a green or fossil energy mix

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1 POLINARES is a project designed to help identify the main global challenges relating to competition for access to resources, and to propose new approaches to collaborative solutions POLINARES working paper n. 50 April 2012 Case 6: Institutional arrangements of a green or fossil energy mix By Stephen Dow (University of Dundee) The project is funded under Socio economic Sciences & Humanities grant agreement no and is led by the Centre for Energy, Petroleum and Mineral Law and Policy (CEPMLP) at the University of Dundee and includes the following partners: University of Dundee, Clingendael International Energy Programme, Bundesanstalt fur Geowissenschaften und Rohstoffe, Centre National de la Recherche Scientifique, ENERDATA, Raw Materials Group, University of Westminster, Fondazione Eni Enrico Mattei, Gulf Research Centre Foundation, The Hague Centre for Strategic Studies, Fraunhofer Institute for Systems and Innovation Research, Osrodek Studiow Wschodnich.

2 Case 6: Institutional arrangements of a green or fossil energy mix Stephen Dow University of Dundee The energy mix is a complex issue- it is fundamentally a policy choice as to whether the energy mix will be dominated by one source, or whether equality of diversity is sought, or whether domestic sources will be prioritised, or whether imports will be allowed (or relied on, or guaranteed). There are two basic methods of establishing a process for determining the energy mix. The first is that the government simply regulates it allocates the mix between different sources. The second is that the market gets to decide. In reality however, most countries prefer a controlled degree of liberalisation, which ultimately means that the choice is made by the market within the constraints set by regulation. Institutional arrangements are concerned with structure of markets, market abuse controls (regulation), instruments to deal with out-of-market sources which energy policy seeks to support, and the overall role of the regulator. A necessary prerequisite is that there is a degree of liberalisation. Where there is total state control (including but not necessarily requiring state ownership) there is no opportunity for the market to be involved in making choices about the energy mix. Most liberalisation schemes (at least in the energy sector) are designed to permit partial liberalisation of markets there is no intent to create full liberalisation, as governments want to retain a segment in which energy policy can be directly enforced. The classic EU example relates to renewable energy. Electricity markets throughout the EU are required to be liberalised to a certain minimum level, but beyond that level there is no competitive pressure and instead a regulated system to choose individual generators to meet demand. Qualifying renewable generators are treated differently from other generators who are exposed to market risks. Overall energy demand is met through determining the energy mix. There are clear implications for substitution / substitutability. Total energy demand is for oil, gas, coal (primary) and power (secondary energy). Substituting between primary sources is dependent on the appliance stock eg in the case of power plants, moving from coal to (fuel) oil or gas requires a dual firing capacity, or alternatively two separate plants on a system where only one is needed to meet overall demand. Where the energy mix is determined by the market, the price mechanism will drive substitution decisions where physical substitution is possible (it is for example currently difficult to substitute gasoline or diesel cars with electric cars). The role of energy policy and policy institutions is to adjust the choice made by the market where the government does not think that market result is appropriate. A government might decide to try to reduce dependence on imported oil the market may not necessarily make that same decision. To Page 1 of 5 Version: 1.00 Status: Released

3 reduce dependence, governments may seek to artificially bolster other sources e.g. gas (whether piped or LNG); nuclear power; energy efficiency; etc. Making such policy choices is ultimately the role of government, but its choice is informed by pressure groups (including NGOs eg promoting greater energy efficiency or particular health / safety / environmental / social goals); by consumer groups (primarily concerned with end-user prices); by producer groups (single industry representatives eg oil; gas; coal). The fundamental assumption is that the market makes the basic choice in the energy mix, and then regulation exists to correct market failures essentially any situation where the market does not deliver the energy policy goals without interference through regulation. Early examples of liberalisation of downstream gas and electricity sectors sought to bring market disciplines the primary goal was to utilise the overcapacity to drive prices down, and to permit fuel substitution (eg cheaper gas instead of relatively expensive coal) in power generation. In simplistic terms, the driving force was price reduction. The market was frequently able to deliver price reductions particularly across the EU as (cheap) gas became a significant part of the electricity fuel mix. The underlying circumstances were open to being exploited by the market to deliver the basic energy policy goal. Apart from affordability, the other basic goal of energy policy is availability. The initial downstream sector liberalisations were carried out in conditions of excess the entire point was to introduce competition, and allow different sources to compete against each other. It created an (electricity generation) market structure where coal producers competed to sell to coal fired power plants; gas producers competed to sell to gas fired plants etc and crucially where the coal fired plant competes against the gas fired plant to sell power to wholesalers and consumers. That institutional structure meant that the market was choosing the fuel mix, driven by the price signal. At the time of the early liberalisations (particularly in Europe) there was easy availability of relatively cheap gas. That underlying position created a deceptively simple story of success for liberalisation the narrative became that liberalisation itself could deliver lower prices. The true story is more complicated and more nuanced, in that the conditions in fuel markets were such that introducing competition between generators was rapidly able to deliver the desired result on prices. If (for example) cheap gas had not been available to substitute for relatively expensive coal, the price results of the liberalisation programmes would have been different. Where liberalisation has been introduced in conditions of shortage, the story is somewhat different. The institutional structure of the market requires to be different than where there are conditions of excess. The new entrants (and existing participants) cannot be allowed to use the price mechanism to choke off demand without adverse impacts on affordability and availability. Regulation therefore sets out to cap prices, or directly establish prices. The market does not set the price. The price signal for choice of fuel source is not a true market signal, but instead is a regulated price signal. It is of critical importance to understand how regulation establishes the structure of the market, and controls the activities of the participants. The institutional structure begins with the definition of activities through licensing of the individual activity. Activity in the gas sector is divided into production (see further below) or import; transmission; distribution; and supply. Separating activities in that way permits a regulator to decide whether an individual can be involved in only one activity, or whether vertical integration is allowed and individuals can undertake two or more activities. Page 2 of 5 Version: 1.00 Status: Released

4 Activity in the electricity sector is similarly divided into generation; transmission; distribution; supply (and metering). The licence issuing authority can again control the existence and extent of vertical integration, including allowing partial vertical integration through licence conditions regulating the relationship between linked entities eg the supplier s ability to purchase electricity from a generator in the same ownership group. Controlling the issue of licences is one thing, but to influence the market more is needed. The rights and obligations of the market parties the gas producer who sells to the gas supplier; or the electricity generator who sells to the power supplier are set out in the respective licences. One such condition is the obligation to trade in the manner specified in the specialised market. Market regulation is therefore built into the licence indirectly. The crucial institutions and instruments for a green or fossil energy mix surround the market. The market structures reflect the network-bound nature of gas and electricity. The market is played out between the producers / generators on one hand, and the suppliers on the other but always bearing in mind that the delivery mechanism (the pipe or wire) is essential. That essential nature of the network requires that it is operated in a manner which does not improperly impact on the transaction between the producer / generator and the supplier. Legal instruments to ensure the independence of the network are designed to ensure that ownership of the pipe/wire and ownership of the commodity are separated, whether through full ownership separation or separation of commercial interests. The unbundling debate is a familiar theme across EU liberalisation in particular. With the potentially adverse impact of associating networks and commodities out of the way, the institutional structure of the market can focus on the relationship between producer/ generators and suppliers. In the context of the fuel mix debate, the structure of the gas market aims to ensure the largest possible number of producers (or importers). The electricity fuel mix debate is more complicated, as it is difficult to make radical changes to the fundamental cost structure of a given individual source. There is a limit to how much more efficient a coal fired plant can be made in order to compete on price with a gas fired plant at some point, the difference between the two plants mainly relates to the fuel cost. The result is that competitive markets tend to create merit orders clustered round a single fuel source. That has obvious adverse implications for diversity. Accordingly, energy policy tends to intervene to support diverse sources either by structuring the market to limit competition; or through some outside support for (or penalty on) sources other than the market s preferred choice. Penalties on fuel sources are most obviously created by instruments such as taxation, or carbon penalties including emissions penalties. There are two basic forms of emission penalties. First there is a fixed rate option essentially a tax and secondly there is a trading scheme. Cap and trade schemes start from the simple premise of a maximum quantity of emissions from the parties or sources covered by the scheme, and go on to price out the most expensive polluter. Bigger pollution sources pay more than smaller pollution sources and as coal fired power tends to be a significant CO2 source, it is not particularly difficult to design instruments to target coal fired power. In cap and trade schemes, all that is necessary is to lower the cap to create greater scarcity of rights to pollute, meaning that the cost to major polluters rises. Page 3 of 5 Version: 1.00 Status: Released

5 The entire point of such instruments is to adjust the outcome of the merit order noting that the market has not delivered what energy policy wants. This is also the rationale behind non-fossil fuel (renewable) support schemes. Renewable support schemes are fundamentally designed to address the problem that current technologies do not produce power at a price which is sellable in the market. Simply put, the power is too expensive. Energy policy, whether driven by environmental concerns, or climate change concerns, or by a desire to create new industries and opportunities before other countries, creates a market share for renewable sources. The same structures can be used to promote any qualifying generator it is not the technology per se which is characteristic of the scheme. The unifying characteristic is that the cost is out of market. The consequence is that schemes can be used to promote any source which is out of market in the given circumstances for example, in many systems dominated by (old and amortised) hydro schemes providing cheap power, it can be advantageous to distort the merit order in favour of fossil fuels (usually gas). Renewables schemes come in two basic types. The first is the tradable certificate, in terms of which licensed suppliers must purchase their share (normally their market share) of qualifying power. There is a premium applied to that purchase. The premium in a tradable certificate scheme is ostensibly set by the bidders into the scheme, but normally subject to conditions set to ensure that the bid value does not go to zero as the total required volume of power becomes nearer. The supplier is permitted by the regulator to pass on that premium to consumers. It is a deliberate distortion of the market, but as all suppliers are affected, it is not a discriminatory distortion of the market. It also means that the consumers ultimately bear the additional cost, not taxpayers. The second basic type of scheme is a feed-in tariff, where the basic difference is that the premium is fixed by regulation rather than attempted to be influenced by any market forces. Such schemes are effectively a price AND volume guarantee for qualifying generators. The market risk is compulsorily transferred to the wholesale supplier, and passed on to the consumer. The result is that with appropriate levels of subsidy, investment in renewables outside the market becomes an attractive proposition. That instrument provides a route through which energy policy goals can be implemented. Renewables subsidies have the effect of raising consumer prices beyond that which the market would otherwise deliver. It follows that the greater the amount of renewable power in the energy mix, the greater will be the rise in consumer prices. As renewables targets are set in line with climate change obligations, both international and domestic, it is likely that the proportion of renewable sources within the fuel mix compared to fossil fuel sources will rise and continue to rise. The non-fossil sources also include nuclear power. Nuclear (discussed further elsewhere in the project) has considerable political hurdles to overcome. It is not generally regarded as a qualifying renewable source. It is however a low carbon source of power, and if the policy goal is truly about carbon targeting rather than merely promotion of renewable power, it is undeniable that nuclear deserves consideration, although such decisions are inevitably complicated by political pressures. Theoretically nuclear power could be supported in exactly the same way as renewable sources (as it is another source with typically higher costs than fossil fuel sources). It is unlikely that there is currently great public acceptance for price subsidies for nuclear power. It is also possible that market prices will rise to the point where the cost of nuclear is not far out of market, or even within the merit order. In Page 4 of 5 Version: 1.00 Status: Released

6 that event, nuclear could be supported by volume guarantees rather than both price and volume guarantees, in other words a form of compulsory purchase by suppliers, but purchased at the prevailing market price. Such an instrument recognises that nuclear power costs are lower across higher levels of output per plant, and provides a mechanism to force the purchase of sufficiently high volumes to take advantage of lower unit costs. The institutional structure to differentiate between volume guarantees and price guarantees does not yet exist in the EU. The overall role of the regulator is therefore to oversee the market, and take corrective measures in the event of market failure. Oversight of markets is ensured where the regulator is part of the design of the market and the trading and transmission mechanisms (as is the case for regulated terms or indeed terms negotiated between the parties). The regulator approves the terms and conditions of use of the wires, and also the structures of the wholesale trading regime. Market failures such as cartels, abuse of dominant position, price manipulation etc are the traditional concerns of competition law. The regulator simply becomes involved in their enforcement. The energy policy element to institutional arrangements of green or fossil energy mix is found in the ability to influence what happens outside the market. Most obviously seen in support schemes for renewables, the same ideas or parts of the ideas such as separating volume and price guarantees can be used for any source including nuclear power, or fossil fuels in systems which have a non-fossil dominant source. The institutional arrangements reflect the underlying position of the sector. In gas, the relative position of domestic production and imports is crucial. A system which is entirely reliant on imports also has security concerns, and the institutional structure usually seeks to create diversity to mitigate the potential risks. In power markets, an unregulated market will tend to drive towards one source and institutional arrangements seek to mitigate that security risk. Page 5 of 5 Version: 1.00 Status: Released

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