Inside the global clean energy transition
Technology / Renewables

Why low-cost renewables don’t mean the end of subsidies

Most innovations and technologies we enjoy came about because of government support.

When it comes to renewable energy, the tables are turning. Offshore wind farms that used to require massive government subsidies are, within a few years, set to pay the UK government for every kilowatt they generate.

According to a study by Imperial College, offshore wind farms that just a few years ago were requiring guarantees from the government of £150/MWh were contracted in 2019 to deliver power for £39.65/MWh (in 2012 prices) once they begin operating in 2023. If wholesale power prices are higher, as forecasters expect, they will pay the UK government the difference.

This change is a big deal for the renewable energy industry, which is desperate to show it can stand on its own two feet without handouts from the public purse.

UK offshore wind turbines
Many offshore wind farms that required guarantees from the government of £150/MWh were contracted in 2019 to deliver power for £39.65/MWh (in 2012 prices) once they begin operating in 2023. (Photo by Nuttawut Uttamaharad/Shutterstock)

However, while we have seen dramatic cost reductions in key renewable energy technologies – solar, onshore wind and now offshore wind – and while certain projects in certain jurisdictions can operate without direct subsidy, it is too early to conclude that energy systems will continue to decarbonise without ongoing government support.

What are subsidies?

Part of the challenge of understanding the role of subsidies in energy markets is the different definitions used and the methods to which they are put.

The International Energy Agency (IEA) defines subsidies as “any government action that concerns primarily the energy sector that lowers the cost of energy production and raises the price received by energy producers or lowers the price paid by energy consumers”.

These might include tax breaks, or subsidies either to energy producers or consumers. They might be paid for by the government out of its general revenues or by companies, such as utilities, with the cost passed on to the consumer.

However, even this broad definition only tells part of the story. In addition to direct subsidies, indirect subsidies exist where energy producers or consumers are exempt from external costs that are borne by society as a whole. The cost of storing nuclear waste, the health costs of poor air quality caused by burning coal or the costs resulting from climate change are all external costs.

In a recent report, the International Renewable Energy Agency (IRENA) observed that energy subsidies can be used to pursue a number of specific policy goals, including:

• Making energy more affordable for low-income members of society.

• Correcting the failure of the market to price externalities such as those identified above.

• Driving down the costs of new technologies through accelerating learning curves and economies of scale.

• Enhancing energy security by, for example, reducing dependence on imported energy.

• Creating new economic activity and jobs.

A history of renewable subsidies

Broadly speaking, renewable energy subsidies fall into a handful of categories. Some, such as the US federal Production Tax Credit for wind and the Investment Tax Credit for solar, provide a tax refund for, respectively, every megawatt hour of power produced by a wind farm or a percentage of the initial investment in a solar farm.

Others, such as Germany’s enormously successful feed-in tariffs (FiTs), require utilities to buy power from renewable energy plants at fixed costs, for a fixed duration, often up to 20 years. They are usually combined with regulations requiring utilities to prioritise purchasing generation from renewables projects. Some of these programmes, such as in Spain and Italy, became hugely expensive because of falling technology costs and a failure by regulators to trim the tariff levels in response to massive uptake. This left the government on the hook for substantial liabilities.

Green certificate programmes offer an alternative, market-based approach. Under such programmes, the renewable generator sells its power into the grid at the market price, but is also awarded green certificates for each unit of power it supplies. Utilities (or other companies) are required to buy green certificates equivalent to a rising percentage of the power they sell, creating an additional revenue stream for the renewable energy project owner. The problem here is that a lack of certainty over future green certificate prices can make projects expensive to finance.

In recent years, governments have moved towards auctions, offering commitments to buy a fixed volume of clean power. This allows project developers to compete to offer the lowest-cost projects. This has helped drive prices down, but has also led to concerns that developers have bid too low to buy market share and may subsequently fail to build promised capacity.

Projects can be subsidised in other ways. The Dutch government is paying the cost to connect offshore wind farms to the grid, while Indian developers have been offered leases to government-owned land. Contracts-for-difference, such as those for UK offshore wind farms, are increasingly common. In this case, the project operator receives payments from government if the wholesale power price is below a strike price, but pays the government if it can sell their power above this level. These may be revenue neutral (or indeed revenue positive), but the certainty they provide project operators, using the government balance sheet, has a clear financial value

Great success – up to a point

Clean energy subsidies have helped meet many of the policy objectives they were designed to reach. Most importantly, they have helped to bring down costs. Over the ten years since 2009, onshore wind costs have fallen 70% and utility solar 89%, says investment bank Lazard.

Subsidies have also helped to drive more polluting generating capacity off electricity grids; the growth of utility-scale renewables has (alongside cheap natural gas) helped to shut down 28% of the US coal fleet since 2011.

Along the way, they have also stimulated significant job creation. Globally, the sector employed 11 million people in 2019, estimates IRENA.

Subsidies have a more mixed record in creating vibrant industry sectors. For example, Germany created a world-leading solar industry, pump-primed by its generous FiT regime, only to see its domestic market flooded with cheaper Chinese solar equipment.

Changing nature of grids

Certainly, the declining cost of renewables has allowed the development in a growing number of markets of so-called merchant power plants, which can be financed based on the revenues they expect to earn from selling power in the open market.

However, the success of subsidies in increasing the percentage of power supplied by renewables brings its own problems, which themselves necessitate continuing government support.

The obvious challenge is the intermittency of renewables. While battery storage technology is also getting cheaper and larger-scale, it too will need to be subsidised if it is to provide a large-scale solution. Electric vehicles will also help balance supply and demand on renewables-heavy grids, as could the two-way connection of domestic battery storage systems, creating virtual power plants. By linking large numbers of these batteries together, grid operators could draw upon them at times of high demand, much as when natural gas peaking plants are used today.

The other challenge is known as cannibalisation. Unlike gas or coal plants, wind and solar farms do not need to pay for their fuel. Once they are built, they are therefore (almost) free to operate. As more renewables capacity is added, this serves to depress wholesale power prices, reducing the price that these merchant plants can capture from the market.

The emergence of a hydrogen economy could help address both of these problems, creating demand for surplus renewable power to run hydrogen electrolysers, which can produce green hydrogen from water. Again, the current cost of green hydrogen makes it uncompetitive with alternatives, meaning that government intervention is likely to be necessary to help overcome market barriers.

New technologies mean new subsidies

Much of the discussion around renewables subsidies is focused on more mature technologies, such as onshore wind, solar and offshore wind. There are other potentially promising technologies, however, such as wave and tidal power, ammonia as a transport fuel, or biofuels derived from algae, that remain uneconomic. Here, too, subsidies are likely to be necessary to commercialise them.

Similarly, most subsidies have been directed towards decarbonising the electricity system, which represents the low-hanging fruit of the low-carbon transition. Replacing fossil fuels with sustainable, renewable alternatives in heavy industry, gas heating networks, heavy goods transportation and aviation, for example, will be more challenging and more expensive – and will again require public pump-priming.

‘Twas ever thus

For small government advocates, and those working in the clean energy transition who are impatient for government to get out of the way, this never-ending call on the public purse can be dispiriting. But it is worth remembering that many – perhaps most – of the innovations and technologies that we now take for granted were only made possible with government support in one form or another. The jet engine, nuclear power, the internet – all were developed with government money from one source or another.

And the fossil fuel industry continues to benefit from $180bn in direct subsidies each year, according to the IEA – and that is before the environmental costs and losses to government revenue are taken into account, sending the figure above $5trn. Perhaps that is where the energy subsidy conversation should be focused.