Is Small Beautiful? Making Sense of the Economics of Local Renewable Energy Adrian Winnett Department of Economics University of Bath

Acknowledgements The presentation draws on the work of those working on the EPSRC Supergen project on Highly Distributed Power Systems (HDPS) In this respect thanks are due to all the Bath team but most especially to Hassan Haralji who provided the thorough and detailed cost- benefit analysis (CBA) underlying the presentation

Economic appraisal Bath has conducted integrated appraisals of various microgenerators, including thus far solar photovoltaics and wind turbines (and also solar hot water) The economic appraisal begins with a standard financial assessment and adapts/supplements this with estimates of environmental benefits - especially those from lowering carbon in energy generation - to provide a full environmental CBA

Economic appraisal: headline results Highly sensitive to detailed specification, location etc But even allowing for environmental benefits, notably climate change impacts, returns are poor and microgeneration would not be a competitive investment This finding is robust

The basic figures The CBA shows a ratio of benefits to costs for both the microgenerators of the order of 0.4 to 1 Mid-range estimates, but over a wide range of assumptions on costs and benefits, gives negative returns NB this means they are absolutely non-viable, not just relative to other possible energy investments

Justifying investment in microgeneration Nonetheless there is strong political and public support for high levels of investment in microgeneration For individuals and organisations the financial payback period is typically decades, and this remains the case even if environmental benfits are internalised through e.g. proper carbon pricing The way microgeneration can be made to work for investors is thus only through some public support over and above this

Non-economic returns First, though, we briefly look at some other ways in which HDPS may work for investors in psychological/social ways, e.g. Feel good or warm glow Peer esteem and emulation Image, especially corporate (which may ultimately bring an economic return) Ownership of energy decisions

Some questions about CBA Not surprisingly requires sound estimates of bot costs and benefits, but these can be very problematic Also requires assumptions about how to assess costs and benefits spread over very long time frames - discounting

Revisiting the economics case CBA has many limitations The support for microgeneration explicitly or more often implicitly seems to rely on these limitations The bottom line is that CBA assumes, in some sense, that prices can be got right as a guide to decisions – this may not be so or, at least, they may need a lot of difficult modification

Some arguments: 1. fossil fuel supplies and prices Fossil fuel-based generation is subject to problems not easily encompassed in CBA First, (in)security of supply from volatile regions: again, not easy to quantify A case for home-grown generation? Second, fossil fuel prices are volatile in ways resistant to forecasting

2. Employment: a green new deal A fashionable argument: environmental expenditure as part of a job-creation fiscal package Has been widely adopted Lord Stern has recently done a quick appraisal Pragmatically, microgeneration does not score well on job creation in the short-run More basically, unemployment is a market disequilibrium phenomenon incompatible with CBA-type pricing assumptions (we believe)

3. The fat tail Climate change may have low but significantly positive (i.e. which do not decline smoothly to zero) probabilities of catastrophic costs Though familiar in much of the climate change debate, this type of probabilty distribution is very hard to reconcile with conventional CBA- type modelling of risk

Some more tractable arguments There are two arguments which can – in one case contentiously, in the other with difficulty – be incorporated into CBA They have direct implications for the design of incentives for customers to invest in microgeneration

1. Discount rates Nearly all the cost of microgeneration is up- front capital cost Note this assertion may need modification once the implications for grid management of large-scale penetration are considered Thus lowering the discount rate obviously improves the pay-off to investment in microgeneration

Discount rates (continued) The Stern Review chose a rate for appraising climate change policy of close to zero Also implicit in many environmental arguments The subject of heavy criticism But if something like this was accepted, how would it be reconciled with the way in which capital markets operate? Major implications for customer financing

2. Technology cost forecasting New technologies such as microgeneration have declining costs over time due to Economies of large scale production Learning by producers: modelled with experience curves – have large errors for immature technologies Customers may also learn to use new technologies more effectively over time (may be assisted by smart metering etc)

Technology cost forecasting (continued) Thus a case for subsidies to early adopters, declining over time But needs care Cost forecasting (and new innovations) create risk of lock-in to long-run high cost technologies Reinforced if there is complementary network investment in new types of grid

Design of customer incentives for microgeneration Have shown that a case can be established for public support, but that design and level of this needs care and could be difficult But this case lacks the apparent (spurious?) precision of CBA and is quantitatively shaky and sometimes advocated naively Early stages of discussion, e.g. DECC consultation on Heat and Energy Saving Strategy this year Two mechanisms actively under consideration: feed-in tariffs and new finance models

An equity issue Even with support, early adopters will still probably carry substantial costs Thus regressive: targets subsidy at better-off However, if support is income-sensitive, enormously complicates design of incentives Note: the simplistic argument that the pay-off to self-generation is reduced bills from external suppliers does not work: that is already allowed for in the financial return calculations cited

1. Feed-in tariffs Experience of these, especially from Germany, shows them to be effective drivers Complementary with smart metering Directly raises the rate of return on microgeneration investment Our discussion shows that this increase needs to be a lot more substantial than suggested by standard CBA, but difficult to quantify how much is justifiable

2. New financing models Is sometimes argued that this is unnecessary since the benefits of microgeneration will be capitalised in property prices Given the poor financial return this is obviously not the case A key problem is that the time-scales of pay-offs are much longer than typical tenure of properties

Financial decoupling This has to take two forms For energy suppliers, of removing incentives to supply more energy full-stop; in fact standard tariff structures reinforce the basic incentive to do this For customers, of replacing financing of microgeneration linked to ownership rather than the property These are major upheavals in long-established institutional arrangements

Energy pricing Suppliers need to be given incentives to supply less fossil fuel-based energy This is a regulatory issue One suggested mechanism is for regulators to set prices on a business-as-usual forecast and to allow price increases if this is bettered in fossil fuel generation In effect, energy suppliers than have an incentive to support or even operate as ESCOs who can manage the installation etc of microgeneration

Financing microgeneration The need is for financing, even if subsidised, to be tied to the property not the owner, given the discrepancy between payback times in microgeneration and average lengths of tenure The mechanism most discussed is for such financing to be accounted for in network billing procedures since these have permanent connection to the proerty, so it can be (simply?) passed-on at transfer of ownership

Some problems But we see two potential problems in all this from the perspective of supporting microgeneration If they are more cost-effective, large-scale renewables may crowd out micro-generation There are equity isues of the sort already discussed: less well-off households with less capacity to invest in micro-generation may be penalised by higher tariffs on conventional energy – and reduction of so-called fuel poverty is a policy objective

Complexities There are already a variety of mechanisms for supporting and incentivising microgeneration DECC is coy about whether or how these will be reconciled with any new initiatives Our view is that there is strong case, evidenced from much public policy, for simplicity to maximise take-up

Is there a case for regulation? What if pricing incentives do not deliver effectively, even if well-designed? This suggests much more direct intervention Not so much what can we deliver to customers? as what should they do to meet social objectives? An argument requiring much justification This is sometimes put in terms of the market transformation model – getting recalcitrant adopters into line at the end of the process

Is there a case for regulation? (continued) The scale and learning arguments suggest, contrary to this, that there is a case for pushing adoption early, albeit with the lock- in warning A possible example: in the UK the Zero Carbon Homes level 6 may, in effect, mandate on-site generation by 2016

Policies in summary These need to bring together tariffs and finance in a coherent, intelligible package with due attention to equity issues – a dimension often lost sight of in these debates This is the only way in which the economics of microgeneration can be made to work for customers -unless we are sanguine enough to believe in the potency of non-economic motivations

A vision of the future But do we want to go down the microgeneration road? A vision of large amounts of small generation embedded in the grid A decentralised, bottom-up energy system Would require complex and costly reconfiguration: a smart grid

Another vision Replace centralised fossil-fuel generation with large scale renewables To overcome intermittency and unpredictability of generation, need to be linked over wide areas: a DC grid? Again expensive Can we afford both visions or should we prioritise one?

Against easy assumptions The reason for supporting microgeneration is basically climate-change related However it is small, local and controllable by individuals and communities In much environmental discourse, theres been a (too?) easy assumption that these are per se environmentally virtuous: does this need to be questioned?