The Design and Sustainability of Renewable Energy Incentives: An Economic Analysis

CHAPTER 1

Introduction

Background

Rapid urbanization and economic growth, new demographic trends, and climate change are key challenges that developing countries must face as they strive to meet growing energy demand. These and other challenges call for an acceleration of public and private investment in renewable energy (RE).

The adoption of the Kyoto Protocol in early 2005 spurred exponential growth in mainstream RE investment around the world. In 2008, for the first time, RE—including large hydropower projects—attracted more power sector investment globally than fossil-fuel-based technologies (UNEP, SEFI, and Bloomberg New Energy Finance 2012). Contributing to this exponential growth was an alignment of global factors: rapid growth in energy demand in emerging economies such as those of China and India, increased competition for energy resources, geopolitical tension and energy security concerns, rising oil and gas prices, as well as the entry into force of the Kyoto Protocol, and the rise of climate change in the political agenda more generally.

The traditional functions of energy policy and regulation are to ensure access to adequate and reliable supply, protect consumers from high prices, and ensure that private sector entities will be able to recoup their investment. A fourth goal—decreasing environmental impact—is often added. These goals sometimes conflict with one another. Improved access to reliable, secure, affordable, climate-friendly, and sustainable energy can represent a formidable challenge.

Changes can be particularly costly if a move toward a low-carbon solution is implemented through an increasing proportion of RE. Most renewable sources of energy are more expensive than conventional ones; in most cases this is because of high capital costs, spurring changes in the level and composition of investment. In addition, most forms of renewable generation—though good substitutes for conventional sources of energy—are poor in providing capacity at peak time.

A recent review of private sector investment in RE draws several important conclusions about the effectiveness of incentive mechanisms:¹

• Developing countries that have introduced feed-in tariffs (FITs) are almost four times more likely to attract private investment in RE—resulting in about seven times more total investment—than countries where such support mechanisms have not been introduced.

• The introduction of FITs (and, more broadly, of other support mechanisms) is positively and significantly associated with the introduction of public-private partnerships (PPPs)² in renewable electricity generation, controlling for several variables (including supply and demand factors), economy-wide governance indicators, and sectoral controls. FITs affect both the entry and the level of investment in renewable-based energy, though they became much less significant when it comes to determining the amount of investment. This second point suggests the need to revisit the implied allocation of risks between the public and private sectors over time to ensure that FITs produce the desired volume of investment.

• In contrast, broader economy-wide governance factors, including the degree of corruption and political competition, are most often considered by private investors as they decide whether to invest in renewable-based generation. This reinforces the hypothesis that private investors seem to be adequately protected against risk: once they have entered the market, they can accommodate the governance environment.

• Countries that have enhanced transmission investment have also paved the way for attracting more investment in renewables. This confirms that attracting more private investment depends on the broad policy environment, and not just financial support or incentive mechanisms. Avoiding costly construction delays due to regulatory uncertainties, and lack of transmission and infrastructure access pose significant obstacles to timely, successful project development.

The effectiveness of FITs and renewable portfolio standards (RPSs) in deploying RE can be framed within the pioneering debate between the use of quantity versus price instruments. In the absence of market imperfections, both policies have the same welfare outcome (Weitzman 1974, 477–91). In the presence of market failures, however, each policy has its relative merits. The key advantage of a FIT is that it reduces investor risk by offering a guaranteed price. On the other hand, a FIT that is too generous can stifle innovation and unnecessarily increase procurement costs. The advantage of an RPS is that it typically stimulates cost-effective procurement by inducing competition between suppliers. On the other hand, such competition may deter the entry of risk-averse RE suppliers and limit the ability to foster technologies that require time to become more competitive. Functional form choices for the independent variable range from binary indicators (a policy exists, or it does not) to nominal measures (level of FIT or RPS target) to more nuanced measures that aim to better capture the incentives that the policies provide. Other dimensions, along which these regression approaches differ in scope (in terms of countries and years), are relevant to policy design and range-of-control variables.

Overall, there is still a lack of consensus among studies about whether, which, and in what way renewable policies have been successful in stimulating RE. Case studies and cross-sectional regressions typically find that FITs and RPSs are most effective in RE deployment (del Rio Gonzalez 2007, 994–1012; 2008, 2917–29; Haas and others 2011, 2186–93; Lesser and Su 2008, 981–90; Lipp 2007, 5481–95; for RPSs, see Allegappan, Orans, and Woo 2011, 5099–104; Menz and Vachon 2006, 1786–96). But econometric studies using panel data do not confirm these results. For example, in the case of RPS studies, the presence of an RPS has been found to increase, not affect or even reduce, RE penetration (Carley 2009, 3071–81; Shrimali and Kniefel 2011, 4726–41; Yin and Powers 2010, 1140–49). Some discrepancy between findings is due to the different methodologies that have been used. For example, between cross-sectional and panel data, the ability of panel data to control for time-invariant unobservables encourages greater confidence in the robustness of results. Another reason for discrepancy between findings depends on the different extents to which different studies take account of policy design and policy contexts. The many dimensions of policy design and context are difficult to capture by simple quantitative indicators.

Major progress may be observed in the econometric literature, however. Zhang (2013), for example, models several FIT design elements and finds that high feed-in rates do not necessarily lead to an increased uptake of wind power in European countries, but guaranteed grid access and length of feed-in contracts are crucial policy characteristics for RE deployment (Delmas and Montes-Sancho 2011). Several studies, including those of Delmas and Montes-Sancho (2011) and Zhang (2013), attempt to account for the existence of a lag between the enactment of policy and measured policy output. This lag arises because it takes time for investors to respond to incentives and is particularly relevant for technologies with high up-front capital costs, such as RE.

Existing studies focus almost exclusively on the United States and the European Union (EU). This focus undoubtedly reflects not only the prevalence and experience of RE policies in developed countries, but also the difficulty of assembling data for quantitative analysis in developing countries. There is limited understanding of renewable policy design considerations that are specific and important to developing countries.

Studies also focus on effectiveness as a measure of policy success, rather than cost-effectiveness or efficiency. For example, Zhang (2013) suggests that high subsidies in Europe’s FIT program may have driven up investment costs by allowing installation at low-wind-speed sites. Similarly, Menz and Vachon (2006) suggest that an effective RPS can facilitate the adoption of renewable capacity in states with low resource potential. These results are critical to ensure sound spending of public funds in support of RE generation.

Key Issues

From these general observations follow the main questions to be considered by the case studies included in this report:

• Effectiveness and efficiency of incentive mechanisms. What types of incentive schemes prove to be the most successful in attracting private investment in renewable-generated electricity? How do FITs compare with RPSs, quota systems, and auctions in terms of effectiveness and efficiency? How can the combination of different incentive schemes (see the taxonomy outlined in table 1.1) (Mitchell, Bauknecht, and Connor 2006; Rickerson and Grace 2007) be used to maximize effectiveness, while reducing the cost burden on the budget and on vulnerable consumers (Cory, Couture, and Kreycik 2009)?

• Details of tariff design. How important are the details of the FIT system design, which may include capping (government-established limits on installation); tariffs differentiated by technology; tariff inflation-indexation; duration; and the methodology used to determine tariff levels and to revise tariffs, purchase obligations, the introduction of tariff degressions, and the specific burden-sharing system? Which of these design factors will make the business environment for renewables more or less attractive to private investors?

• The broader energy policy environment. How effective is the deployment of RE in reducing the carbon intensity of developing country economies, relative to alternative options, such as eliminating subsidies on fossil fuels? What is the evidence from several of the case study countries that provide large subsidies to coal and gas generators (the Arab Republic of Egypt, South Africa, Indonesia, Vietnam)?

• Financing and affordability issues. What is the incremental cost of RE relative to that of fossil fuels? Who pays for it? Are donor grants, concessionary loans, and carbon finance provided by the global community, consumers, or taxpayers? What is the impact of RE support mechanisms on consumers? Is it equitable and affordable for poor consumers in developing countries to contribute? Can the costs be passed on to just large customers (rather than poorer residential customers)? Yet in some countries (including Germany), it is the large customers who are exempt from consumer levies to recover the incremental costs.³

Table 1.1 Taxonomy of Financial Incentive Mechanisms for Renewable Energy

Source: Authors’ elaboration.

Note: BNDES = Brazilian Development Bank; CDM = clean development mechanism; CSP = concentrated solar power; EU = European Union; IDA = International Development Association; PTC = production tax credit; PV = photovoltaic; VAT = value added tax. The taxonomy is not meant to be exhaustive, but to provide a few representative examples in each category.

Objectives

The main objectives of this study are to offer (a) a global taxonomy of the economic and financial incentives provided by renewable support schemes and (b) an economic modeling of the sustainability and affordability of such support schemes. Also included is operational advice on how the regulatory design may need to be modified to minimize budgetary impact and be affordable to the poor, with an aim to identify—and fill—the financing gap.

Why Is Renewable Energy Important for Poor Countries?

To date, few World Bank discussions about the need for increasing RE in developing countries have directly confronted one of the fundamental realities of the global climate change debate: governments in poor, developing countries believe that they should not bear the incremental costs of RE in the same way as the governments of, say, Germany, Switzerland, and Sweden. Such beliefs are fundamental to the question of who pays.

Everyone prefers to be seen as green, so there are countless examples of RE targets promulgated as political statements that have little realistic chance of being achieved, or of governments going through the motions of introducing RE incentive schemes that at first glance appear to be based on wishful thinking, but in fact are based on a great reluctance to do anything that results in increases of the electricity tariff.

An example from our case studies underscores this point. Vietnam has at best a modest wind resource, and what it does have is highly seasonal (and more seasonal than that of Europe or Latin America).⁴ Given that wind is very high up on the RE supply curve, and that Vietnam has significant small hydro and biomass resources that can be exploited at a much lower cost, there is no economically rational reason for Vietnam to pursue wind power. Only years of relentless donor advocacy have persuaded the government to introduce a wind FIT—but one set at such a low level (7.8 cents/kilowatt-hour, kWh) as to have no realistic chance of enabling any wind farms.

Understandably, the Government of Vietnam is reluctant to introduce a wind FIT at a level comparable to other Asian countries (16 cents/kWh in the Philippines, 19 cents/kWh in Sri Lanka). With inflation and already sharply increasing electricity tariffs being a real problem in Vietnam, the idea of imposing a consumer levy to recover incremental costs of wind power has been politically unattainable, with the result that the draft Renewable Energy Master Plan, which was submitted in 2009 and which proposed such a consumer levy, has little chance of eventual approval. Yet at the same time, Vietnam has implemented a highly successful small hydro program, with 800 megawatts (MW) enabled since 2009 through its avoided cost tariff (ACT) and standardized power purchase agreement (SPPA). The program has been successful precisely because one could demonstrate that small hydro was economically efficient, with costs at or below the avoided social cost of the thermal alternative.

This highlights one of the main themes of this report: namely, that economic rationality lies at the heart of any successful RE program, and that the single most important issue is the transparent recovery of incremental costs. We know of no successful RE program based on attempts to bury incremental costs in nontransparent subsidies. The most expensive RE program in the world—in Germany—has been achieved by a transparent consumer levy. In 2012 residential customers paid 25 cents/kWh for electricity, of which the surcharge for the FIT levy accounted for 3.59 cents/kWh, or 13.9 percent of the average bill (see box 1.1). This surcharge will rise to 5.28 cents/kWh in 2013 (excluding value added tax, VAT).⁵

Box 1.1 A Paradox in the Design of the Erneuerbare-Energien-Gesetz (EEG) Surcharge, German Renewable Energy Sources Act 2000

Renewable energy (RE) has had a price-curbing impact on wholesale prices in recent years, as additional supply has shifted the demand curve, particularly in the case of wind (Sensfuß, Ragwitz, and Genoese 2007). Because the surcharge is calculated as the difference between the feed-in tariff (FIT) and spot market prices, lower prices mean an increased surcharge (see the figure B1.1.1, panel a). Exempted industrial consumers are net beneficiaries: because of RE they pay lower electricity prices, and almost no surcharge. Households and other small consumers do not benefit from lower prices (due to the merit order effect), as these are not passed on to them (for lack of effective competition among distributors). By contrast, their surcharge payments are increased since they also pay for the extra cost share of the exempted industry (see figure B1.1.1, panel b).

Is it true that all costs are passed through to users? The answer is no, as there are other costs attributable to RE sources. These include, for example, the additional cost for basic and balancing energy that is needed because of the fluctuating input of electricity from photovoltaic (PV) and especially wind energy systems. Other factors are grid expansion due to the integration of power from renewables, and administrative costs incurred by grid operators for implementation of the EEG. These additional cost factors are difficult to quantify. They have been estimated to total between €300 million and €600 million, the dominant share of which is due to basic and balancing energy. On the other hand, the expansion of renewables also involves a number of beneficial effects that are not reflected in the operating cost factors so far considered.

Apart from the reduction in wholesale electricity prices effected by the EEG, the external costs of electricity generation from fossil fuels that are avoided by using RE sources are particularly important from a macroeconomic point of view. If these costs were allocated in strict accordance with the polluter pays principle, the price of electricity from non-RE sources would be much higher. In this connection a study for the Federal Ministry for the Environment, Nature Conservation, and Nuclear Safety of Germany (Bundesministerium für Umwelt, Naturschutz und Reaktorsicherheit, BMU) came to the conclusion that the external costs saved by EEG electricity, between €5.84 billion and €20.44 billion in 2012, were more or less equal to the additional procurement costs for the EEG.

Electricity generation from RE sources also results in a significant reduction in imports of coal and natural gas into Germany. In 2012 this reduced Germany’s bill for fuel imports by about €25 billion. One must also remember the positive effects of RE on growth and employment. The basis for this positive trend is the rise in domestic sales of RE that has been in progress for years and—to an increasing extent—the export success of the German renewables sector. The latter is profiting considerably from the fact that the EEG has set in motion a technological development that has given Germany a leading position on the world market in various fields in the renewables sector. The fact that the EEG itself is increasingly proving to be an export hit, reflects this trend and is one of its main driving forces.

Source: Lauber 2013.

Taxonomy of Financial Incentive Mechanisms

The economic rationale for RE lies at the heart of the design of incentive mechanisms. Our proposed taxonomy of incentive mechanisms recognizes four general categories:

• Price incentives, as when the government intervenes to provide RE generators with preferential output prices, with the result that the market determines the quantity of RE provided at the stipulated price (though in some countries a cap is placed on the quantity).

• Quantity incentives, as when the government sets a target for the quantity of RE to be provided, with the result that the marketplace determines the price (for example, through an auction for a given quantity of megawatt-hours [MWh] to be delivered some years hence).

• Direct support. Cash support is provided directly to RE generation projects, either as direct cash subsidies from governments, or as cash from the sale of carbon credits (clean development mechanism, CDM).

• Indirect support. Support is provided to developers through tax rebates and incentives, low-cost loans from government-owned development banks, or concessionary carbon financing.

Within each category there are many different specific mechanisms, as listed in table 1.1. Moreover, most countries have in place more than one such mechanism, which makes policy interaction and compatibility important issues, since the combined impact may result in inefficient outcomes.⁶

In some cases, who pays is defined by the nature of the incentive mechanisms. For example, a preferential rate of income tax is necessarily carried by taxpayers, and green tariffs are necessarily carried by consumers. But for those incentives identified in table 1.1 as a design decision, who pays must be decided by the government as a matter of policy design. The incremental costs of a FIT can be paid by consumers or from several different sources (as in the case of Vietnam’s wind FIT, by the utilities and the Vietnam Environmental Protection Fund, VEPF).

Table 1.1 lists the policies directly aimed at increasing RE generation. But this list excludes the policies that are not expressly directed at promoting RE, but which may in fact have a much greater impact on RE by removing the distortions that lead to the need for RE incentives in the first place. The two main policies in this regard are:

• Subsidies on fossil fuels, which make RE appear more expensive than it really is (as in Vietnam and Indonesia).

• Subsidies on the retail tariff, whose elimination would (other things being equal) reduce all electricity generation and greenhouse gas (GHG) emissions far more than is achieved by the policies listed in table 1.1 (illustrated by Indonesia, where the Ministry of Finance subsidy to the Indonesian utility Perusahaan Listrik Negara [PLN, or Indonesian State Electric Utility Company] runs to several billions per year).

These are important questions for countries whose subsidies are large: from both the Vietnam and Indonesia case studies it can be concluded that removing fuel subsidies would have a far greater impact on GHG emissions—and the amount of RE that would become competitive without subsidy—than the additional RE likely to be enabled by the proposed FITs.

Meanwhile, the removal of institutional barriers often unlocks much more RE than attempts to introduce price incentives. This is well illustrated by the Indonesian example: in fact the main barrier to achieving the geothermal targets is not inadequate tariffs, but the barriers faced by private developers in dealing with an often-dysfunctional permitting system in the provinces, and tender committees that lack technical capacity and have awarded tenders at unrealistic prices by developers who lack technical and financial capacity.⁷ On the other hand, in Vietnam, it is relatively easy to build a small hydro project (SHP), but provincial authorities’ capacity for reviewing SHPs is weak, resulting in widespread allegations of environmental damage and the perception that too many SHPs are being