Decarbonising our power system will require a careful mix of policies, regulations and incentives. Our current approach is piling on unnecessary costs, misallocating risk and causing unintended consequences.
Electricity systems around the world are in the vanguard of the net-zero transition. We are fast decarbonising our electricity grids, primarily in response to the climate crisis, and now with a tailwind from the energy crisis caused by Russia’s war on Ukraine.
This is an urgent priority. To address climate change, we will need to electrify large parts of the economy – transport, heating, industrial processes – that currently rely on fossil fuels. We will need massive investment in clean power generation, energy storage and power transmission and distribution.
Over the medium term, power systems dominated by wind, solar and nuclear generation will provide cheaper electricity than those based on fossil fuels. Eliminating our dependence on volatile, often expensive fossil energy, much of which is supplied by autocratic and unfriendly states, will have numerous economic, geopolitical and social benefits in addition to their environmental ones.
In the short term, however, the transition will be costly and disruptive. It is vital that we deploy the best policy, regulatory and market tools at our disposal to make accelerating the penetration of clean energy as cheap and painless as possible.
We have produced a short series of blog posts to explain the underlying issues we face and propose some solutions.
A new type of electricity system
The new power grids that are emerging have different characteristics than those which went before. Whereas grids used to be supplied by a relatively small number of large thermal power plants, generating predictable volumes of power as required, new grids are characterised by many thousands of generators, many of which are small solar or wind farms. Their supply is intermittent, meaning that the power market is exposed to novel risks.
‘Traditional’ approaches to remunerating operators and their investors are beginning to show themselves not fit for purpose as power systems change. Marginal pricing based on the merit order of available power plants is ill-suited to support capital investment in large volumes of intermittent capacity that has running costs that are close to zero.
To enable investment in new clean energy capacity, there has been enormous innovation in policy, regulation and market over the last three decades. The UK has been a leader in many regards, and some of its approaches have been copied elsewhere. These mechanisms have evolved to meet changing conditions, particularly in response to falling clean energy costs.
In a number of countries, including the UK, this evolution has been enormously successful. Supported by its Contracts for Difference (CfD) regime, the UK has become a world leader in offshore wind, second only to China in terms of installed capacity. From October to December 2022, renewables produced more power in the UK than gas.
But the proliferation of intermittent clean power, mostly with operating costs close to zero, has had a major impact on electricity pricing, threatening to discourage new investment through a process known as cannibalisation.
Clearly, the tools we need to deploy to meet our goal of a net-zero grid need to evolve further.
Incentivising the transition
To get clean energy projects built, there are broadly four options for developers. They can either be supported through subsidies like the Renewable Obligation scheme or with pricing support via CfDs. They can enter into long-term power purchase agreements (PPAs), either with power traders or suppliers (utilities) or directly with corporate or public sector consumers. Or they can trade as ‘merchant’ generators: selling power into the wholesale market on a short- to medium-term basis.
Each of these options have their pros and cons, their benefits and their risks. Some suit some actors better than others. Some are not delivering against their potential. None are perfect, and all give rise to unintended consequences – especially as the generation mix changes on the way to net zero.
For example, corporate PPAs should be a key tool to get new renewables built and help companies meet their net-zero commitments. But the current ad hoc approach to structuring corporate PPAs makes them expensive and time consuming to execute. And there is a mismatch between buyers and sellers. Because companies typically benchmark PPA pricing against the wholesale market, they are most attractive when wholesale prices are high – precisely when developers would rather sell into the wholesale market. Conversely, when wholesale prices are low, companies are reluctant to commit to PPAs.
The relative lack of corporate PPAs means that government-supported CfDs have been necessary to do more of the heavy lifting to reach net zero. But the complexity of managing the risk in these apparently straightforward contracts means most of the associated price risks end up being socialised across domestic and corporate consumers reducing the efficiency of the instrument, increasing overall costs and risking a backlash from some market participants.
Electricity systems are inherently complex. The net-zero transition adds to their complexity, requiring them to address climate impacts and dramatically increase in scale, while continuing to deliver reliable power at an affordable price.
This complexity means that there are no quick fixes to make the system work better while reducing unnecessary costs. Instead, what is needed are numerous improvements and refinements, alongside new products and market solutions, to enable the decarbonisation of our power supply as quickly, efficiently and cost-effectively as possible. In this series of blogs, I am applying more than 30 years of trading power, building and leading power market businesses, and advising on regulatory reform to set out the existing problems as I see them and suggest some solutions.