Incentive Schemes for Renewable Energy

The success of renewable energy in the electricity sector in individual states differs greatly. This is more a result of policy context than natural potential.This raises a few questions. 1. What instruments do governments use? 2. What has proved to be the most efficient and effective way of support? And finally, we look at what governments really do and what that could mean for investors.

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Production-based Incentives

Production-based incentives provide an award that is proporitonal to the actual energy generated.

There are 3 main systems:

  • Minimum Feed-in Tariff: The generator is guaranteed a minimum tariff per kWh for a specified period.
  • Production Tax Credit: Mostly in the U.S. , the generator receives a tax credit. It can therefore only be used by investors with sufficient tax capacity.
  • Quota System: awards the generator with certificates that can be sold into a market. No price guarantee. An alternative to this is an exemption from a charge levied on electricity if generated from renewable sources. E.g. climate change levy in the UK

All of those systems come with a number of parameters, such as

  • Technology Differentiation: Where the tariff pays the same amount for all technologies, some will be benefit from a quasi free-loading effect, whilst others won't pass the hurdle rate. This happened in the UK before the introduction of banding.
  • Inflation Adjustment: Some tariffs (e.g. in the U.S.) are increased annually by inflation.
  • Degression: Some governments have strict mechanisms and measures that govern the reduction in feed-in tariffs. Mostly dependant on the size of new installation during the year.
  • Own use: What tariff do householders get for electrcity used in-house vs fed into the grid.
  • Off-take guarantee: Some countries have imposed annual caps on total installation that can qualify (e.g. Spain).
  • Income Tax Treatment: Do householders have to pay income tax on the revenue from sold electricity?

Investment-based Incentives

Investment-based incentives provide awards for the initial investment, regardless of how much electrcity is generated.

  • Investment Tax Credits: provide individual investors with the opportunity to offset the investment against their own personal income tax.
  • VAT exemption: Allow householders not to have to pay VAT on equipment for small generators.
  • Accelerated Depreciation: In some countries, renewable energy plants can be depreciated for tax purposes in a few years that can be offset against profits elsewhere in the company.
  • Interest-free loans: Some governmental agenices like the Carbon Trust in the UK provide interest-free loans for the purchase of renewable energy equipment.
  • Loan Guarantees: To de-risk the investment in renewable assets in emerging markets, export agencies or the European Investment Bank may provide certain guarantees regarding the exchange rate or the loan up to a limit.

Robust Legal Framework

Although not a direct monetary incentive, a robust legal framework has to be in place to attract investors. This includes

  • Streamlined Planning Process: Has the country implemented a "one-stop-agency" approach or do developers have to submit applications to any number of authorities and interested parties?
  • Spatial Planning Process: Do local authorities prioritise land-use for renewable energy? If so, applications will much more likely be approved, as the land had been pre-vetted. This reduces time for approval and development costs.
  • Building Regulation: What are the requirements and approval processes for renewable energy installations in new / old buildings? Also, do building regulations mandate the use of renewable energy, as is the case in some states in Germany, thus forcing investors rather than just attracting - though the result is the same.

The Art of Setting Incentives

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What is the most effective and efficient way for the market introduction of renewables? It is, without a doubt, a stable, minimum-feed in tariff regime that is sustained over many years.

Fixed Tariff versus Quota System

We compared total wind capacity and growth (relative to the country's overall electricity consumption) in 2009. On average, countries with fixed feed-in tariffs have either grown more or have a much larger base already. In fact, none of the countries with a quota system have achieved a large penetration of wind energy.

Fixed tariffs have not only proved to be more effective, they also appear to be more efficient: Prices paid for wind energy in UK and Italy (without fixed tariffs) are higher than the fixed tariffs. For instance, the UK pays about 1/3 more for its wind energy than Germany. The difference is due to the price uncertainty for the renewable certificates (mostly uncalculable political risk).

What about production tax credits?

Production tax credits in the U.S. are only beneficial to profitable companies, only available for 10 years, and only issued in chunks, i.e. not always available.

Investment Incentives

As with production tax credits, most investment incentives are either tax credits (only available to some) or they do not significantly lower the high capital costs. More importantly, unlike feed-in tariffs, they do not address the uncertainties of the revenue streams.

Legal Framework

Even with the best feed-in tariff on the planet, the introduction of renewables won't be a success without a robust legal framework. The approval and planning processes must be transparent and streamlined. The responsibilities of grid or utility companies must be clearly defined. Despite favourable feed-in tariffs in Greece, there is no significant installed PV capacity - mainly because of bureacracy.

Eco- Taxes & Exemptions

Rather than incentivising investors, governments can (and do) also use the instrument of taxation. There are many examples such as the Eco-Tax or the Climate Change Levy in the UK where the consumption of fuels or electricity is taxed, some of which is promised to be channelled into renewable energy projects, although most of the income is consumed in other departments of the administration. While such taxes may discourage the use of energy, they do not alter the economics of renewable energy plants, and therefore will have only a very narrow effect on investment decisions regarding renewable energy.

However, where levy exemptions for use of renewables are granted (in the UK), the exemption works like a certificate that can be traded for money. See above for effectiveness. Seems bureaucratic and not available to all.

Setting a feed-in tariff


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Assuming a government has decided to introduce a feed-in tariff, what level should it choose?

For photovoltaics, we assumed that countries with less annual solar energy and lower energy prices would pay a higher tariff than sunnier countries. Secondly, we suspected that countries with a relatively high percentage of imported energy may be willing to pay a higher price of renewables.

Wrong! We found no such correlations. Feed-in tariffs(2008) in sunny Spain and not-so-sunny Germany were nearly the same, while Greece paid almost 20 cents more per kWh.

Instead, there seems to be a correlation between the level of feed-in tariff and the gap to reach the EU-imposed renewable energy target for 2020. Countries that are still far away from their target tend to offer higher prices. The newly introduced feed-in tariff for the UK from April 2010 with high rates for photovoltaics seems to reinforce this thesis.

 

Effects of the tariff level


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If countries with a more urgent requirement set higher tariffs, does that have the desired effect?

Unfortunately, no.

We recorded the size of the new installations (of photovoltaics in 2008) against feed-in tariff and the annual solar irradiation in a better-than average loaction in all EU countries with feed-in tariffs. In the diagram, the size of the bubble represents the new installs (relative to the country's electricity consumption).

If the level of the tariff were the sole driver for growth, we would expect larger bubbles top-right and small bubbles bottom-left. Not quite..

The answer seems to depend on whether the tariff is set below or above a technology-specific hurdle rate. In 2008, that hurdle rate for photovoltaics was €0.3 per kWh.

Tariff set below hurdle rate

Below the hurdle rate, the economic case for the technology becomes weak. There is still some investment. However, we suspect that investment decisions may not be influenced by the exact level of the tariff. In fact, Estonia enjoyed more growth than Hungary, Slovakia or Lithuania despite lower tariff, but this is not a statistically significant sample. These countries may as well have achieved the same (low) growth without any tariff.

Tariff set above hurdle rate

If set above the hurdle rate, growth may be unleashed, though the actual growth has little to do with how far away the tariff is from the hurdle rate. In fact, Germany has among the lower insolation and tariff and yet attracted significant growth. Why doesn't new investment follow the tariff? Apart from differences in the legal framework (i.e. bureaucracy), renewable energy plants tend to be target-priced. That is, a solar module in a country with higher production feed-in tariff is priced higher, such that all renewable assets in a technology class attract similar rates of return for the investors. The premium paid for by governments over and above the hurdle rate is captured by equipment manufacturers rather than investors, and therefore not suitable to attract extra growth in the country.

Adjustment for Inflation?

The effect of inflation adjustment depends on how it is calculated. In the U.S. inflation adjustment is a fixed 1% per annum, which is equivalent to a fixed tariff. Where the inflation adjustment is at risk, the additional cost to the government will probably not result in more capacity being built for same reason that quota systems have proved to be less effective.

 

What really drives growth in renewables?

For as long as the economics don't stack up by themselves, renewables can only prosper in countries with determined governments. There has to be evidence of this determination in the law as well as the incentive structure. The system that is in place in Germany may rightly be seen as the gold standard in encouraging growth in both installations and industry. Not surprisingly, many countries have copied this model. Yet, this does not mean that growth cannot be obrtained any other way. Governments that are more concerned with effect than efficiency may subsidise manufacturers or the construction of renewable energy installations directly, although this is may be in breach of anti-trust legislation, for instance in the EU.

 

Conclusion

Governments

Governments want to encourage an increase in share of renewables, and maybe also see a home-grown industry.

The most effective and efficient way to achieve this goal is to introduce a minimum feed-in tariff that is differentiated by technology. The level should be set close to the technology -dependant hurdle rate (as above). An inflation adjustment is not required. The rate of degression should follow an announced timetable and according to a key rather than left to ad hoc decisions. Commitment to this program has proved to be more vulnerable if funded directly out of the national budget rather than being collected from electricity users by utility companies.

Equally important are a streamlined planning and approval process as is a law governing the role and responsibilities of utilities around grid connection and operation. If the framework is too lax, it may attract a gold rush that is unsustainable. If it is too bureaucratic, it will most certainly stifle any investment.

Investors

Investors, be they householders or professional investors, want to invest in projects that provide an acceptable return.

As such, investors should not just concern themselves with a particular feed-in tariff, but take all other factors such as cost, renewable resource, tax implications and financing options into account.

Banks (providing debt) or institutional investors will most likely only put money in, if the tariff is fixed or the market risk hedged.

Generally, investors are detracted by systems that are prone to frequent, ad-hoc, politically motivated changes. They also shy away from projects that involve long approval processes with uncertain outcome.

Sources and References: EU Energy Portal on data of renewable energy in the EU's 27 member states. The above figures are from 2007.
German Department for Environment

 

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