This five-part series dives deep into the economics of electricity markets and the role that markets can and must play in the decarbonisation journey. But in reality, do they? And what can be done about it?
In this fourth part, Is the commodity wrong?, we scrutinise electricity markets under a fundamental microeconomic lens and discuss the suitability of electricity as a true commodity. Given the inadequacies of electricity markets in enabling so, we explore a few avenues (some involving uncomfortable truths) to help renewable projects take off.
Read previous parts: Part I, Part II, Part III
In Part II and Part III of this series, we looked at the cost and revenue side of renewable energy projects in detail, highlighting the market developments that create roadblocks for successful renewable energy projects. We covered how energy markets are posing more risk than reassurance to project developers, thus acting as detractors rather than drivers for renewable projects.
In this fourth part, we will explore the microeconomic theory behind electricity markets in an attempt to seek answers to the above. We will question the very fundamental pillar that upholds energy markets and discuss possible solutions to mitigate their deficiencies.
Given the inadequacies current energy markets exhibit in fulfilling their role in the clean energy transition, Brett Chistophers concludes his book, The Price is Wrong (read Part I for details), with a radical claim.
Brett claims that, in fact, electricity as a commodity is wrong. He refers to (and extends) Karl Polanyi’s argument around fictitious commodities introduced in The Great Transformation.
Brett argues that electricity, in addition to land, labour, and money as identified by Polanyi, is a fictitious commodity. This argument is based on the fact that electricity traded (in its current form of MWh of energy) has been forcefully commoditised to fit the liberalisation and marketisation agenda in the late ’80s and early ’90s. The main propeller behind this agenda being the neoliberal reforms pushed for by economists in financial institutions such as World Bank and International Monetary Fund. Whereas, electricity, in fact, exhibits properties of a necessity good, one which must be delivered to the public, irrespective of the cost involved, and is therefore, naturally suited to be delivered by tightly-regulated, vertically-integrated suppliers owned by governments.
Therefore, Brett concludes that deep and ongoing financial involvement by governments in the energy sector around the world is the only way to decarbonise it at the scale and pace necessary to mitigate climate change.
The way I read this conclusion is that it leaves two viable options on the table: either (i) ramping up of the subsidies and other support mechanisms for renewables (i.e., deliberately and continually overriding the free market dynamics), or (ii) a complete overthrow of the current liberalised energy markets by nationalised, vertically-integrated utilities.
Interestingly, there are some merits to both these options. For the first option, if not for any reason other than the fact that the classical competitors of renewables, i.e., fossil-fuels, have typically enjoyed (and still do) decades of direct and indirect state subsidies around the world. So why shouldn’t the same courtesy be extended to renewables?
To justify the second option, one need only consider the reality of how electricity markets truly work in practice. To trade electricity effectively, we must have an intricate and complex structure of regulations governing a multi-layered market structure (involving a combination of futures, spot, balancing, and capacity markets) in place.
Looking at such complexity, it would be naive to not question whether all this orchestration reflects our futile attempts to tame an untameable beast.
Ensuring a safe and reliable supply in a complex, interconnected physical system, which does not obey any human-enforced laws for fulfilment of transactions and where physical laws govern the instantaneous flow of the commodity (electricity), raises credible questions of whether we are asking too much of the electricity markets.
That is, irrespective of any shape or form of the market orchestration itself, is it the commodity that is indeed wrong?
One must ask, where does that lead us?
Is re-nationalisation of our energy system and perennial government subsidies the only way forward to save the warming planet?
On the other hand, the industry has expended (and is still expending) massive amounts of resources since the 1990s to prop up a mostly-functional system to organise market-based energy transactions.
Is it time to pull the plug on it?
Not necessarily, at least, in my opinion.
I believe, there is a middle ground where free-market capitalism and calls for more regulation can and, I argue, must co-exist (and cooperate) to make energy markets fit for the purpose of accelerating clean energy transition.
First, there must be a fundamental rethinking about what does it take for renewable energy projects to take off the ground in a market-based environment. With that comes the need to assess and communicate the true-cost of a failed renewable energy project.
Let me clarify.
Hopefully by now in this article series, I have convinced you that profit (and the perceived certainty of it) governs the growth of renewable energy projects, not the low costs of renewables.
From an individual project perspective, therefore, we must get rid of the current thought process around “cost of energy”. While analysing financial feasibility of projects, LCOE must be replaced by a metric that represents the “cost of energy delivery”. We need to leave behind the zealous excitement over the cost-competitiveness at point of generation to adopt a more pragmatic and self-reflective view that focuses on ensuring value-competitiveness at the point of consumption instead.
This implies looking beyond the sheer number of MWh produced, rather focusing on the value that each MWh produced brings at a low risk.
This could, for instance, be achieved by extending the conventional revenue streams available to renewable projects (i.e., participation in volatile energy markets or low PPA price lock-in) to provide grid services and adding behind-the-meter assets.
This strengthens the revenue prospects significantly, as renewable energy projects are no longer passive, non-dispatchable price-takers in the market. Rather, they earn additional revenues as active, flexible market participants who actively contribute towards strengthening the electricity grid.
Figure 1 below illustrates a few examples and lists the pros and cons of such value-based de-risking pathways for the development (augmentation) of new (existing) renewable energy projects. As evident from this list, achieving a successful value competitiveness of renewables is a multi-faceted challenge which needs a similar response to address it.
Another critical pathway to increase value competitiveness of renewable energy projects is through energy trading. Energy trading is expected to play a key role, given the headwinds faced by renewable energy projects due to the various geopolitical and regulatory bottlenecks we have discussed in Part I and a shift away from long-term PPAs (refer Part III).
Short-term energy trading, both asset-oriented energy balancing and profit-oriented proprietary kinds, can become effective mechanisms to maximise and stabilise operational revenue from energy assets and provide confidence to potential investors on the value of supporting new and operational renewable energy projects.
This could be achieved by, e.g., revenue stacking across markets and products, adopting risk-adaptive trading strategies built upon a foundational understanding of energy markets, and making robust data-driven decisions considering uncertainty and risk.
It is, therefore, exciting to see so much innovation happening in this sphere, spearheaded by startups and small companies, see here for an example list.
Hopefully, short-term trading will eventually achieve its full potential in de-risking renewable energy projects, beyond price arbitrage and liquidity provision, to support the clean energy transition.
Zooming out from individual projects and adopting a systemic perspective, it is crucial that energy academicians and practitioners weave a public narrative that acknowledges and publicly admits the challenges that a renewable-based energy system entails.
Some of these challenges, I have discussed in this series, e.g., ensuring adequacy of available energy, controllability of generation for a continuous supply-demand balance, and above all, the requirement of a massive, expensive build-up/upgrade of grid infrastructure, supported by short- and long-term energy storage, to deliver clean energy to consumers all year round. This recent IEA report further highlights these challenges, dividing them into 6 phases of integration of weather-dependent renewables. (See infographic)
However uphill a task it may seem, we need to hold constructive dialogues to convince decision-makers and more importantly, the general public to whom they’re answerable, that these are existential challenges that we must overcome by making massive meticulous strategic investments in R&D, public infrastructure projects, and targeted financial support aimed at climate change mitigation.
Because, contrary to popular belief, doing so makes economic sense right now.
And the cost is not just about the cost of renewables, rather the cost of not investing.
Not in the short- or long-term, but in the now!
And it is less relevant a question what form this targeted and country-specific investment (and the regulatory framework underlying it) takes.
Needless to say, it does matter whether this support takes the form of direct or indirect capital subsidies (e.g., in the US and the UK), an extension of feed-in tariffs (e.g., in China and Germany), double-sided contract for differences or CfDs to hedge market price risk (e.g., in the UK and soon in DK), socialisation of grid costs (e.g., in the Nordic countries), preferential treatment while integrating renewables to grid (e.g., in Spain), favourable land leases for large-scale renewable projects (e.g., in India and China), research grants to academia and industry for CleanTech breakthroughs, and so on.
The investment mechanisms must be designed to fit the specific needs of individual countries and regions. But the fact that we need this investment must no longer be debated. Above all, it provides the confidence to all market participants involved that their long-term interests are protected, thus, enabling them to make the “riskier” bets necessary for climate change mitigation!
As a concrete example, one model could be to design incentives for large electricity consumers, e.g., metal and steel industries, data centers, etc. to procure their energy demand from renewable energy projects through (long-term) corporate PPAs, as hinted in Part I.
Such a policy framework when implemented with a requirement for “additionality” — i.e., demand must be met with new (greenfield) energy projects, will give a massive impetus to de-risking renewable energy projects. This has recently been the case, when massive industrial off-takers with long-term PPAs have repeatedly saved the day for renewable projects. For instance, in case of the Nordlicht wind farm project in Germany, the recent agreement with the chemical giant BASF on a long-term PPA was crucial for the final investment decision to be reached.
Now, this may not work everywhere and at all times. Luckily, we have access to so many investment models that have worked already to support renewables, and we must keep iterating on them to make them even better.
In their recent article titled, Climate change and growth, eminent economists and thinkers Nicholas Stern and Joseph Stiglitz argue that at this juncture, the opportunity costs of taking strong climate actions are especially low whereas the benefits are incredibly high. In other words, it makes macroeconomic sense to invest heavily in climate change mitigation now and that conventional metric of achieving economic growth is in complete alignment with these investment costs.
This is where regulation must step up in its role as a steward of the future generations.
Where corporate boardrooms see a horizon of a few years, at best, for return on capital deployed, regulators and governments must work relentlessly and ruthlessly to force a longer view on both public and private investments.
Once we’ve rid the air of the grandiosity of renewables and acknowledge that they come with their flaws that we must address by public and private investments, how do we adapt current energy markets to transform them to become drivers of the clean energy transition rather than detractors?
This question is explored in the last part of this article series, “Part V: Towards future-ready markets”.
Are electricity markets fit for purpose? Part V: Towards future-ready markets
<hr><p>Are electricity markets fit for purpose? Part IV: Is the commodity wrong? was originally published in Clean Energy for Billions on Medium, where people are continuing the conversation by highlighting and responding to this story.</p>