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Energy and power

Is the era of subsidies ending for renewable energy investment?

Subsidies have played a pivotal role in driving FDI into the renewable energy sector and remain an essential part of the market, for now.

Renewable energy is rising in popularity while its prices are coming down, but the industry will be reliant on subsidies for some time to come. (Photo by Charly Triballeau/AFP via Getty Images)

Governments seek to attract foreign direct investment (FDI) through the use of a variety of different incentives, such as targeted tax breaks, grants and loans, special economic zones, or regulatory changes that benefit the investor.

Subsidies have played a crucial role in the development of energy markets around the world and have been the most important incentive in the history of the renewable energy sector.

A developer of any type of power generation needs to be sure that the price he or she receives for selling electrons is greater than the cost of producing them, otherwise they are going to make a loss.

For much of its history, renewable energy has been more expensive to produce than other types of generation such as coal-fired, gas-fired or nuclear power stations. To make it worth their while, governments have subsidised renewable energy producers, shouldering some of the costs and allowing them to make a profit.

The cost of producing renewable power, particularly from solar and wind sources, is falling fast, however, and in some markets nearing grid parity. This is when a power producer’s levelised cost of electricity is less or equal to the price paid for electricity from the grid.

Grid parity is the holy grail for renewables and in some countries solar power is beginning to achieve this target. Highly competitive open auction tenders have led to zero-subsidy bids for some projects, even offshore wind, which has much higher costs and higher generating capacities than other renewable technologies.

These developments show how hugely successful renewable energy subsidies have been. Subsidies awarded ten years ago look very generous in 2020, given the significant cost reductions achieved over that period.

While subsidies are playing a less pronounced role in the global renewable energy market in 2020, they still play an important stabilising role.

Types of subsidy

Governments can support renewable energy assets through various stages of their life cycle, from research and development (R&D) through to decommissioning.

The subsidies that attract the most attention are those supporting the investment into and development of a renewable energy project and those supporting the production of renewables.

Here are some of the most widely used subsidies in the renewable energy sector:

• Tax incentives: These are a reduction in tax liability to incentivise a certain economic behaviour. For renewables they can include exemptions, reductions, tax credits for investment, or private R&D. They are particularly popular in the US, whose federal government has awarded production tax credits based on production volume and investment tax credits of up to 30% of capital costs for qualifying projects.

• Feed-in tariffs (FITs): A widely used incentive around the world, although they have been phased out in some markets now. FITs provide a cost-based price for electricity sold by renewable energy generators over a long-term contract. These prices are typically above market price, guaranteeing the producer enough revenue to cover costs. FITs are technology specific, dependent on an assessment of the typical costs for each, and tend to decline over time to incentivise efforts at cost reduction.

• Renewable energy certificates: These create an additional revenue stream for renewable energy generators and allow consumers to purchase and trade green energy. The producer is awarded a certificate for power sold to the grid, in addition to the market price of the units sold. The producer can then sell these certificates to power users, who can in turn trade them on the open market.

• Renewable obligations: These work in tandem with certificates by requiring power suppliers to procure a proportion of the electricity they supply to customers from renewable energy sources. Suppliers do this by buying certificates from generators or on the open market.

• Contracts for difference: These have replaced FITs in some markets, such as the UK, as the main mechanism for supporting renewable energy generation. Developers are paid a flat rate for electricity produced over a long-term contract, but this price is determined by the difference between the strike price (the set price reflecting cost of production) and a reference price (the average market price). When the reference price is below the strike price the generator is compensated accordingly, but when the reference price is higher than the strike price the generator pays back the difference.

Controversies in renewable energy

Around the world, all types of energy benefit from subsidies, as governments seek to protect companies or consumers from prices they would struggle to swallow.

Renewable energy subsidises have tended to attract more negative headlines than other types of energy subsidises, however. When any technology is in its early stages it is highly likely to be expensive to build and often to operate. The more a technology is used and the more companies that develop it, the greater the economies of scale achieved.

Subsidies have been essential in reducing construction and operation costs for wind and solar technologies over recent decades, to the point where they are beginning to be cost-competitive with conventional power sources.

Having more renewables in the grid reduces the cost of developing them, which should reduce energy bills in the long term, although bill payers have to pay more in the short term for that future benefit.

Since they began to be more widely developed around the world, large-scale renewable energy projects have attracted a range of criticisms. Some complain they ruin the aesthetics of the landscape where they are located or that they threaten wildlife. Some have criticised their intermittent nature, claiming they could never replace more conventional types of generation and are a waste of money.

Subsidies have often been criticised as overly generous or blamed for distorted power markets by rewarding supply rather than demand. The costs of subsidies are often passed on by government to consumers, which can lead to further opposition.

In countries such as South Africa, vested interests in the coal mining sector or rival power producers have successfully stoked resentment of high subsidies to derail a nascent renewable energy market.

The non-payment of subsidies can even create controversy. Spain was seen as a leader in solar power until the global financial crisis meant it could no longer pay for its FIT scheme. Between 2008 and 2013 it applied several retroactive cuts to its renewable energy subsidies before imposing a full moratorium on the issuing of any more FITs.

The popularity of the scheme was its downfall. With no cap on how many installations could benefit, it eventually became unaffordable for the government.

With sunshine and subsidies available in other countries around the world, the solar industry ground to a complete halt in Spain for many years. Auctions for new projects only began again in 2017.

Now many of the new solar power projects in Spain are being financed without subsidies, thanks to the cost reductions achieved in the intervening years. These zero-subsidy projects are also being seen in other countries.

The end of subsidies?

The cost of renewables has plummeted over the past decade, with the price of solar PV modules down 90% since 2009 and wind turbines down 55–60% since 2010, according to the International Renewable Energy Agency.

This has led governments around the world to start to reduce or remove subsidies, as the cost of producing renewable power becomes comparable with other types of generation.

The intermittent nature of renewable power remains a problem, however. While production can be ramped up for gas and coal-fired power at peak times and scaled back during periods of low demand, renewables are not responsive in the same way given that the wind doesn’t always blow or the sun shine.

This intermittency means renewables would likely receive a lower market price than other more responsive generation types in a completely open market, which would make these assets less attractive to investors, slowing the renewables roll-out and global efforts to reduce power-related carbon emissions.

That is why the removal of subsidies will need to be done in coordination with the development of battery storage, which should eliminate the problem of intermittency. Storage adds to costs, however, and appropriate market solutions that provide adequate revenues for storage are still to be perfected.

Another mechanism used in recent years to support non-subsidised renewables is corporate power purchase agreements. These are contracts between the power producer and an end user, often an industrial power consumer or large corporate. The producer receives a fixed price for power over a long-term contract, while the purchaser guarantees that the power is renewably sourced – an increasingly important aspiration for companies.

The pool of companies motivated enough by environmental considerations to fix their power prices long-term, instead of benefitting from fluctuations in market prices, is still not large enough, however, to support the volume of new capacity needed to meet national renewable energy targets.

Volatility in power prices due to the Covid-19 pandemic may make medium-sized corporates even less likely to want to sign long-term power contracts.

Market conditions mean renewables will continue to be subsidised in some form for some time. However, the strength of investor appetite for green energy assets suggests a market solution to the problem of intermittency may not be too far away.