Minimizing externalities

The electricity generation has important externalities issues. An externality happens when the price of a good doesn’t reflect all the costs that are generated in its manufacturing. That is because some of affections of the product manufacturing has no cost for the company because the price is zero, for instance, there are no price for the clean air or for a not-nuclear-risky generation. In the electrical generation, the product is very homogenous: electrical energy, measured in kWh. But, obviously, it is not the same for the planet how you obtain this energy. But the market, the wholesale market by own, doesn’t reflects all of these affections. So, in electricity markets, both negative externalities and positive externalities happen at the same time. In these two pages, I will analyze the two most popular methods of internalizing the benefits of the positive externalities of the renewable generation: Feed-in Tariffs (FiT) and Renewable Portfolio Standards (RPS), and I will focus on two country examples: Spain (FiT) and the US (RPS). There are also methods for internalize the negative externalities as the carbon cap and trade for CO2 emissions, but I will not consider them in this article.

So, the promotion of the renewable energy, as solar, wind or biomass, is an issue of how to internalize their positive externalities into the market. These benefits are well known. The clean or renewable energies, do not pollute, do not contribute to climate change, do not imply resources depletion, do generate local employment, do promote the national industry, do improve the energetic independence, and more. All of these benefits are not include in the Levelized Cost of Energy (LCOE) or the price of the electricity. Because of that, these technologies are not competing in the same conditions as the conventional generation. That makes that the price of them is above the average price of the electricity in wholesale market, and as a consequence, the utilities do not want to build this expansive plants or to purchase expensive energy to others. This is because the benefits of the renewable energy do not go to them, but to society. That is a market failure and that is because they need the regulation or the support from the Government.

In a market, even the Government can not control the quantity and the price of a product at the same time. If you fix the price for the renewable generation (as FiT does) you do not know what will be the amount of renewable generation that you will obtain. The same, if you fix the quantity you want (as RPS does); you do not know what will be the price for this generation. The price plus the quantity is the key point, because that will be the cost for the electricity customers who are also your voters. So you have to be careful with that because otherwise you can make your citizens to pay so much for the electricity if the price plus the quantity is too high or you can make them not to gain the benefits of renewals if the renewals were not developed due to low prices which do not make the investments profitable. The two methods are good if they are well designed, but that is not the common case.

The Feed-in Tariffs
In the Feed-in Tariffs option, the government decides what will be the price of the renewable generation. That has enormous advantages for developing the market because it is very easy for developers, investors and financial institutions to know what will be their retribution and the Internal Rate of Return (IRR) for their investments. It is easy to calculate the IRR and if the FiT is well calculated -the price will be a bit more than the cost of capital- then the development of renewable is smoothly and a reasonable cost for ratepayers, being the society awarded with the benefits of clean generation.
Spain has become a power in renewals thanks to FiT. The government support has been very strong and determined. Spain has been successful implementing some FiTs, for instance in the case of wind, but has made huge mistakes in solar PV. Spain started to use FiTs in 2000, and ten year later, the 35% of the total generation is using renewals (2010).

In the following graph you can see the average cost of electricity in the wholesale market (black line), the LCOE of wind power (blue line) and the FiT (yellow and red line). As long as the FiT is above the cost, the investment is interesting. This FiT was well calculated to make the investor obtain a 5-7% IRR.

Spanish Fit in wind

In the following graph you can see the objective in wind (red bars) and the actual development (blue bars). As you can see, the development has been constant and progressive.

Spanish wind development vs objective

That is the successful example. But what did it happen in solar? In the following graph you can see the average cost of electricity in the wholesale market (black line), the LCOE of solar power (red line) and the FiT (yellow line). As you can see, the FiT was much more than the cost, so the investors obtained more than 11% IRR.

Spanish Fit in solar PV

What was the result? An over investment in solar PV power. Government wanted 400MW and they obtain more than 3,000MW. That implied a huge cost for citizens, and, as a result, the FiT has been reduced dramatically.

Spanish solar PV development vs objective

Renewable Portfolio Standards
With this method, the Government fixes the quantity of renewable generation that it wants, but not the price. That makes that the developer, the investor, and the most important, the financial institution that is going to put the money on the table, they do not know what will be their IRR before they start to promote a plant. So they have to deal with a lot of risk if they want to build a renewable plant. That is crucial, because at the end, the development of the renewals results too slowly.

You can see the example of the US. The US was the first country in building renewable plants in the 80’s, but now, only the 10% of the total generation is renewable (being 7% big hydro). So they have thirty years of expertise in renewable and only 10% as a result.

The US uses the RPS. That is an objective that some states try to achieve. For example, California has a RPS of 33% renewable in 2020. This objective becomes an obligation for the utilities, which have to provide a 33% of their portfolio using renewals.

Not bad, but then why have they achieved so few renewable generation up to now? Because two things: first of all, they make auctions to know the price of generation (trough Request for Proposals) and due to the competition, many of the bidders offers a price below the real cost, thinking that when they will build the plants, the technological development will made the cost reduced. But that not happened, and now there are a lot of projects that will not be ever built because the developers offered a very low price. Second, because, in fact, the utilities are not penalized if they do not comply with the RPS. So they do not have real incentives to buy more expensive energy that will make their ratepayers to pay more. As a result, the real price of renewals is not revealed.

We have seen to examples of trying to internalize a positive externality. But it is not easy because it is extremely difficult for a legislator to put a price for all of these things that are not in the market. Nevertheless, from the errors, we learn, so, these experiences will improve Government thinking. Benchmarking is also good thing to do for legislators to learn from the errors of the neighbours.

2 thoughts on “Minimizing externalities”

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