Many of our energy market structures and institutions were established at a time when fuel was plentiful, climate change was not yet seen as a major issue, and power was provided almost entirely by large centralised power stations. But recent trends—most notably the global push for carbon reduction, cost declines of renewables and the corresponding increase in decentralised power generation, and changes in engagement and use of electricity on the demand side—are rendering the current system unfit for purpose.
Existing electricity market arrangements do not provide the right sort of incentives for building clean generation capacity, maintaining flexibility, and spurring innovation. And while clean energy becomes cheaper each year, cost reductions are not happening fast enough to ensure the timely replacement of fossil fuel powered plants. This now threatens security of supply as the capacity margin of the electricity grid reaches historic lows, largely due to inadequate incentives to invest and uncertainty in the direction of future policy.
Both the cost of financing and adequate carbon pricing are important factors to support transition to a low carbon future. A key challenge to delivering this will be in the creation of market, regulatory and institutional arrangements that provide investment confidence by eliminating regulatory and policy uncertainties. Here we draw from two pieces of evidence submitted to the House of Lords Select Committee on the Economics of UK Energy Policy (see links at the end of this article) and outline five key opportunities to address current market failures.
1) Address carbon pricing
Carbon dioxide emissions must be reduced across the entire economy to reduce the risks associated with climate change. For the electricity sector this means installing no further fossil fuel power plants post 2017, unless we are happy to live with stranded assets. Most economists argue that adequate carbon pricing is a necessary step to address this, and its absence is the single largest market failure. Carbon prices need to be higher, to affect a broader range of sectors, ideally to cover cross border issues, and to reflect the social cost of CO2 emissions. This is essential for long-term incentives for renewable generation.
2) Support innovation
While carbon pricing may be the single most effective mechanism for moving towards a low carbon future, other factors such as falling oil prices can also mean the cost of fossil based generation is reduced. This makes research aiming to further reduce costs and accelerate the introduction of low carbon generation, storage, and demand side measures an immediate priority. Research and development incentives such as tax breaks and support schemes can have significant effects on firm spending and innovation outcomes. To help drive down costs, clean energy research and development support needs to be ramped up significantly.
3) Incentivise appropriate investment
Over the coming years a large number of power stations are set to close, and this capacity needs replacement to keep the lights on. Moreover, the addition of both centralised and decentralised renewable energy into the system creates new challenges around real-time balancing of supply and demand. Investment in a combination of demand-side measures, energy storage, interconnection, and flexible backup generation is required, but current market and regulatory structures, designed for a world of fossil generation, deliver inconsistent investment signals to investors and are no longer fit for purpose. A new institutional framework may be required for effective delivery of adequate clean generation capacity and critical grid infrastructure.
4) Strengthen Government decision making
A further challenge to stimulate investment is in ensuring sufficient confidence from the private sector and an affordable cost of capital. The policy-driven nature and long asset life of infrastructure investment implies key continuing roles for government and regulation. Government already acts as a de facto purchaser in UK capacity markets, and this central buyer model reflects technical and market fundamentals of the power sector. However, this central buyer should be at arm's length from the government, with a high degree of sector expertise. Inter alia this can help protect investment decisions from short term political intervention and interest group lobbying.
5) Reconsider consumers
The role that consumers play is changing with growth in micro-generation, smart metering, and storage. New technologies enable new customer offerings that could differentiate between loads that must be satisfied immediately (such as lighting or television) and flexible loads (such as battery charging for electric vehicles or water or storage heating). The shifting role of the consumer, and other changes in infrastructure provision, will lead us to explore new tariff structures.
The work being conducted in the Oxford Martin Programme on Integrating Renewable Energy will be returning to these and other questions, not just for the UK but in a wider international context.
This blog was written with the support of Dr John Rhys and Dr Jacquelyn Pless
Read evidence submitted to the House of Lords Select Committee on the Economics of UK Energy Policy:
- Evidence from Professor Cameron Hepburn, Dr Jacquelyn Pless and Dr Alexander Teytelboym
- Evidence from Dr John Rhys