5.3 The Issues Raised by a Focus on Climate Change
A focus on the issue of climate change by the energy regulator has a
number of important implications for the way economic regulation of energy is conducted. While all the issues we go on to discuss are important, some of them could be addressed by agencies outside of the economic regulator. However, my observation is that they are not receiving sufficient focus within economic regulation at the moment due to a lack of mandate or powers in this area. My starting point is as in 3.3: from the perspective of an economic regulator climate change policy is all about ensuring the efficient internalization of the externality created by CO2 emissions. It should not be confused with energy security concerns or industrial policy objectives for domestic technologies. My view is that independent regulatory agencies such as Ofgem can play a key role
in focusing regulatory incentives on the effective internalization of environmental
externalities.
Several new directions for regulation suggest themselves in the light of
this and the areas of work for the energy regulator that suggest themselves. Each of
these areas is currently a small work area within an independent regulatory agency,
such as Ofgem. However each has the potential to become extremely significant.
It is important to be clear that the broadening of the focus of energy
regulation to take account of environmental concerns about climate change raises
clear issues of whether the independent energy regulator established primarily to
promote competition in wholesale and retail markets and incentive regulation of
networks can be adequately adapted to include climate change concerns. In some
countries the regulatory agency may not have the competence and trust to handle
this role and it may be that there will be pressure for the relevant ministry to take
a more active role in energy regulation. This has already happened in The Netherlands
where the energy regulator – the DTe – has been absorbed back into the
Ministry of Economics and behaves more like an inspectorate rather than a ‘rule
making regulator’.
In the UK the Climate Change Committee of the Office of Climate Change
will be a new force in the regulatory landscape, when the Climate Change Act is
passed. This committee will set the carbon budgets for the whole UK economy
every five year period. This will create even more scope for overlap between the
energy regulator and other parts of government. It will also create a new vehicle
for ministerial involvement in decisions which impact the operation of electricity
and gas markets and regulation. Allocating responsibility between this new Office
and Ofgem will need to be carefully done if it is not to result in the objectives and
actions of these two agencies conflicting.
More fundamentally the issue of climate change raises the need to allow
for the possibility of a reintegration of energy supply and energy demand, where
loads take much more responsibility for at least partially satisfying their own supply
needs from local low carbon sources. In many jurisdictions, including the UK,
this poses problems for the deregulated market, as unless supply and demand are
perfectly matched loads need to ‘participate’ in the competitive market. This is
no bad thing as it provides a new source of competition with incumbent utilities.
However the regulatory system will need to adjust in the face of a presumption
that large numbers of small loads will also be trading some production into the
market at some point. It will also need to ensure that the terms that these small
market participants are offered for their sales into the market are fair.
5.3.1 Effective Internalization of Externalities
There is a need for serious independent investigation of whether major
low carbon investments in electricity and heat are worthwhile given that international
schemes (such as the EU ETS) may not provide sufficient incentives to
meet national objectives. In Europe the key issue is the extent to which the EU
ETS will deliver. The EU ETS raises an important discount rate issue, which we
highlight below.
Table 2 shows that the choice of the two low carbon investments varies
according to the discount rate chosen. Both investments take 2 years to make and
pay off equally over 8 years. However Investment 1 involves higher up front construction
costs but lower running costs relative to Investment 2.
At a 10% discount rate Investment 2 has costs with a lower net present
value and should be chosen. However at a 2% discount rate the net present value
of the costs of Investment 1 is substantially less than that of Investment 2. Weitzman
(2007, p.723) and Evans (2008, p.67) argue that a low discount rate may be
justified for climate change investments. Weitzman suggests a figure of 2-4% may
be relevant, whereas Evans suggests a range of 0-2% for investments that pay off
in the long run. However if we actually use a market rate of 10%, the choice of
investment will be changed between these two investments with equal climate
change mitigation effect. The cost of the chosen Investment 2 is 22% higher than
that of the rejected Investment 1 when discounted at the 2% social discount rate.
If we leave it to the EU ETS to provide the incentive for the low carbon
investment, the effect of discount rates is quite striking. In the table the Benefits
streams indicate the annual payoffs required to generate a net present value
equivalent to the discounted costs at the two discount rates. If all private investors
in low carbon investments require a 10% return as opposed to a 2% return, the
price of CO2 in the EU ETS will be 42% higher. Given that this will translate into
higher energy prices this raises important questions about the discount rate to be
used in climate change investments and its implications.
It is highly likely that the government will and should examine a number
of investments in climate change risk reduction which make sense on the basis of
social discount rates but which are very challenging to fit into the existing electricity
market. One can think of nuclear power, the Severn barrage and large scale
domestic heat networks as possibilities. An economic regulator should be in the
business of evaluating these schemes and suggesting how to ensure they are built
at least cost and how any required financial support is best raised from electricity
and heat consumers.
Weitzman (2008) goes further and suggests that discounting may be a bad
way to handle the fundamental uncertainties associated with climate change. In presence
of positive probabilities of catastrophe, discounting is no longer a useful concept
for deciding investments and investments may be justified on the basis of their
insurance value. This does not help with the problem above, however, where the
issue was to decide between two equally beneficial (to the climate) investments.
5.3.2 Demand is as Important as Supply
There is a need to focus on demand management as being as important
as sources of generation (especially in the first instance). This is because relative
to business as usual demand reduction is by far the biggest source of reduction
in CO2 from the energy sector in the longer term. The European Union has ambitious
targets on energy efficiency (a 20% reduction in energy usage by 2020). Low
hanging fruit exists in the area of demand side management. Some of this can be
identified in the UK: low energy light bulbs might cut total demand by 2-3%; LED
street-lighting by 0.7% of total demand (see BERR, 2007c).
Cronin and Garnsey (2007) demonstrate the substantial savings that
would be facilitated simply by moving to GMT+1 in the winter in Great Britain.
They find that winter electricity prices might be 5% lower at the winter peak and
total electricity demand might be 2% lower during the winter. The proportional
savings in carbon emissions might be greater than this. Cronin and Garnsey further
suggest that moving to GMT+2 in the winter might yield even greater energy
and emissions savings.
Many jurisdictions have begun to either trial smart meter programs or
to roll out smart meters to smaller customers. The potential for smart metering to
significantly increase the responsiveness of households to price signals has been
demonstrated in a number of locations (see Brophy, Haney, Jamasb and Pollitt,
2008). There is clearly a lot of scope for further trialing of the schemes that would
be acceptable to the public and would yield social benefits in terms of energy and
emissions reductions. Going forward the smartening of domestic loads via further
Table 2. The Choice Between Two Investments with Identical Energy and
Emissions Reduction Benefits
COS TS Y 1 Y 2 Y 3 Y 4 to Y9 Y 10
Investment 1 500 500 0 0 0
Investment 2 245 245 100 100 100
NPV of investment 1, evaluated at 10%: 867.77
NPV of investment 2, evaluated at 10%: 866.11
NPV of investment 1, evaluated at 2%: 970.78
NPV of investment 2, evaluated at 2%: 1,179.78
BENEFITS Y 1 Y 2 Y 3 Y 4 to Y9 Y 10
Carbon price needed at 10% 0 0 196.44 196.44 196.44
NPV at this carbon price, evaluated at 10%: 866.11
NPV at this carbon price, evaluated at 2%: 1,383.14
Carbon price needed at 2% 0 0 137.88 137.88 137.88
NPV at this carbon price, evaluated at 2%: 970.82
Extra Cost of Investment chosen at 10% discount rate (evaluated at 2%): 209.00 22%
Extra Cost of Carbon Price needed at 10% discount rate (evaluated at 2%): 412.32 42%
use of domestic IT systems to cause energy to respond to movement within individual
rooms and to intelligently control energy consuming equipment is significant
(see Devine-Wright and Devine-Wright, 2006).
Related to stimulating the potential price responsiveness of small consumers,
is the issue of raising electricity prices (in Denmark the tax on domestic
electricity use is 100%) to support demand reduction investments. If the demand
side invests to save CO2 how can it share some of the benefits if they are not fully
reflected in the price of electricity? In the US regulatory agencies often oversee
substantial demand side management programs (e.g. in California) aimed at
overcoming the market failures which exist in this part of the market. These incentivize
electricity companies to achieve demand reductions via allowing them
to finance demand reducing investments in their regulated charges. There is also
considerable scope for market-based initiatives such as tradable white certificates
to improve energy efficiency.
5.3.3 Support New Entrants
New entrants into low carbon production and energy management need
to be encouraged and concerns about the inaction of incumbents in providing
network access or import/export services addressed. We need to recognize the
possibility that existing incumbents may not be best placed to deliver the decarbonization
of the electricity sector. There are a number of reasons for this: they
require legitimacy in spending the large amounts of capital investment that will
be required; more locally based companies may be more effective at engaging
the public in demand reduction or the uptake of micro-generation; new business
models may be more appropriate, such as those focused on energy service management,
rather than ownership of hard assets.
It should also be pointed out that the public sector has traditionally been
important in the rapid roll out of intrusive networks with initially poor returns
(even when run efficiently). While few would advocate a return to public ownership
of energy networks (where these have been privatized), history does suggest
interesting reasons for increased government ownership in the electricity and gas
sectors e.g. to do with cost of private financing and the political sensitivity of
siting assets (see Millward and Ward, 1993, Foreman-Peck, 2003 and Gleaser,
2001). Public operation of the underlying assets is no longer necessary as the financing
advantages of public ownership can be achieved via a public-private partnership.
If the historical reasons for public ownership are mirrored today then it
is quite possible therefore that we will see significant public-private partnerships
emerge in the electricity sector in the coming years. Indeed it is highly unlikely
that any subsidized roll out of a new technology, such as heat networks, would not
have public sector involvement. Such facilities based competition might involve
competition from water companies. Private energy services companies based
around smart control of heating and lighting and joint provision of security or IT
services might also have a role to play in the future. Independent regulators, such
as Ofgem, should have a key role in facilitating the entry of new players into the
market, especially where these have strong political backing.
5.3.4 Engage with Local Initiatives
There is a need to engage with local initiatives as these are start-up projects
that need regulatory assistance and have the potential to be important market
drivers in the future. This relates to the previous point about encouraging new
entrants. The regulatory agency needs to have the capacity to support local initiatives
to get off the ground. These are potentially very significant in terms of climate
change mitigation, but also in terms of supporting the legitimacy of political
support for the whole of climate change policy. Local initiatives have the capacity
to be popular and to engage individuals in environmentally friendly action at low
cost, by for instance being effective ways of targeting subsidy.
In the UK, some small examples of local initiatives currently exist: some
community enterprises in Scotland and local authority heat schemes in places
such as Woking (see London Energy Partnership, 2007). However the capacity exists
for significant take off in this area, with the London Energy Savings Partnership
in place to help deliver London’s ambitious target for reducing CO2 by setting
up local energy service companies. London Energy Partnership (2007) identifies 7
current schemes, with more in planning.
5.3.5 Plan for Large-scale Trials
There needs to be planning for large scale trials of new technologies
in electricity production and demand management. Most current local initiatives
are small, too small to make a real difference to the UK’s overall CO2 targets.
However they are important examples of social entrepreneurship and give rise to
demonstration effects. What is clear is that we will need much larger scale trials to
demonstrate the least cost way of reducing CO2 emissions, given that divergence
of approaches is, at least initially, desirable. These trials will need to take place at
the level of medium sized cities and might involve, for example, setting up a heat
network, smart metering in every home and/or the establishment of a well funded
local energy service company (ESCO). Several requirements to begin moving in
this direction are set out EU Directive (06/32) on Energy End-Use Efficiency and
Energy Services and supported by government responses (e.g. DEFRA, 2007).
Some of these trials, and their associated technologies, would require the
development of regulations for heat networks and ESCOs. These are currently not
subject to specific regulation in the UK. They would also require powers to deal
with the incumbent local monopolies, such that the value of their property rights
is protected, but their ability to impede the successful implementation of trials is
removed.
A focus on the issue of climate change by the energy regulator has a
number of important implications for the way economic regulation of energy is conducted. While all the issues we go on to discuss are important, some of them could be addressed by agencies outside of the economic regulator. However, my observation is that they are not receiving sufficient focus within economic regulation at the moment due to a lack of mandate or powers in this area. My starting point is as in 3.3: from the perspective of an economic regulator climate change policy is all about ensuring the efficient internalization of the externality created by CO2 emissions. It should not be confused with energy security concerns or industrial policy objectives for domestic technologies. My view is that independent regulatory agencies such as Ofgem can play a key rolein focusing regulatory incentives on the effective internalization of environmental
externalities.
Several new directions for regulation suggest themselves in the light of
this and the areas of work for the energy regulator that suggest themselves. Each of
these areas is currently a small work area within an independent regulatory agency,
such as Ofgem. However each has the potential to become extremely significant.
It is important to be clear that the broadening of the focus of energy
regulation to take account of environmental concerns about climate change raises
clear issues of whether the independent energy regulator established primarily to
promote competition in wholesale and retail markets and incentive regulation of
networks can be adequately adapted to include climate change concerns. In some
countries the regulatory agency may not have the competence and trust to handle
this role and it may be that there will be pressure for the relevant ministry to take
a more active role in energy regulation. This has already happened in The Netherlands
where the energy regulator – the DTe – has been absorbed back into the
Ministry of Economics and behaves more like an inspectorate rather than a ‘rule
making regulator’.
In the UK the Climate Change Committee of the Office of Climate Change
will be a new force in the regulatory landscape, when the Climate Change Act is
passed. This committee will set the carbon budgets for the whole UK economy
every five year period. This will create even more scope for overlap between the
energy regulator and other parts of government. It will also create a new vehicle
for ministerial involvement in decisions which impact the operation of electricity
and gas markets and regulation. Allocating responsibility between this new Office
and Ofgem will need to be carefully done if it is not to result in the objectives and
actions of these two agencies conflicting.
More fundamentally the issue of climate change raises the need to allow
for the possibility of a reintegration of energy supply and energy demand, where
loads take much more responsibility for at least partially satisfying their own supply
needs from local low carbon sources. In many jurisdictions, including the UK,
this poses problems for the deregulated market, as unless supply and demand are
perfectly matched loads need to ‘participate’ in the competitive market. This is
no bad thing as it provides a new source of competition with incumbent utilities.
However the regulatory system will need to adjust in the face of a presumption
that large numbers of small loads will also be trading some production into the
market at some point. It will also need to ensure that the terms that these small
market participants are offered for their sales into the market are fair.
5.3.1 Effective Internalization of Externalities
There is a need for serious independent investigation of whether major
low carbon investments in electricity and heat are worthwhile given that international
schemes (such as the EU ETS) may not provide sufficient incentives to
meet national objectives. In Europe the key issue is the extent to which the EU
ETS will deliver. The EU ETS raises an important discount rate issue, which we
highlight below.
Table 2 shows that the choice of the two low carbon investments varies
according to the discount rate chosen. Both investments take 2 years to make and
pay off equally over 8 years. However Investment 1 involves higher up front construction
costs but lower running costs relative to Investment 2.
At a 10% discount rate Investment 2 has costs with a lower net present
value and should be chosen. However at a 2% discount rate the net present value
of the costs of Investment 1 is substantially less than that of Investment 2. Weitzman
(2007, p.723) and Evans (2008, p.67) argue that a low discount rate may be
justified for climate change investments. Weitzman suggests a figure of 2-4% may
be relevant, whereas Evans suggests a range of 0-2% for investments that pay off
in the long run. However if we actually use a market rate of 10%, the choice of
investment will be changed between these two investments with equal climate
change mitigation effect. The cost of the chosen Investment 2 is 22% higher than
that of the rejected Investment 1 when discounted at the 2% social discount rate.
If we leave it to the EU ETS to provide the incentive for the low carbon
investment, the effect of discount rates is quite striking. In the table the Benefits
streams indicate the annual payoffs required to generate a net present value
equivalent to the discounted costs at the two discount rates. If all private investors
in low carbon investments require a 10% return as opposed to a 2% return, the
price of CO2 in the EU ETS will be 42% higher. Given that this will translate into
higher energy prices this raises important questions about the discount rate to be
used in climate change investments and its implications.
It is highly likely that the government will and should examine a number
of investments in climate change risk reduction which make sense on the basis of
social discount rates but which are very challenging to fit into the existing electricity
market. One can think of nuclear power, the Severn barrage and large scale
domestic heat networks as possibilities. An economic regulator should be in the
business of evaluating these schemes and suggesting how to ensure they are built
at least cost and how any required financial support is best raised from electricity
and heat consumers.
Weitzman (2008) goes further and suggests that discounting may be a bad
way to handle the fundamental uncertainties associated with climate change. In presence
of positive probabilities of catastrophe, discounting is no longer a useful concept
for deciding investments and investments may be justified on the basis of their
insurance value. This does not help with the problem above, however, where the
issue was to decide between two equally beneficial (to the climate) investments.
5.3.2 Demand is as Important as Supply
There is a need to focus on demand management as being as important
as sources of generation (especially in the first instance). This is because relative
to business as usual demand reduction is by far the biggest source of reduction
in CO2 from the energy sector in the longer term. The European Union has ambitious
targets on energy efficiency (a 20% reduction in energy usage by 2020). Low
hanging fruit exists in the area of demand side management. Some of this can be
identified in the UK: low energy light bulbs might cut total demand by 2-3%; LED
street-lighting by 0.7% of total demand (see BERR, 2007c).
Cronin and Garnsey (2007) demonstrate the substantial savings that
would be facilitated simply by moving to GMT+1 in the winter in Great Britain.
They find that winter electricity prices might be 5% lower at the winter peak and
total electricity demand might be 2% lower during the winter. The proportional
savings in carbon emissions might be greater than this. Cronin and Garnsey further
suggest that moving to GMT+2 in the winter might yield even greater energy
and emissions savings.
Many jurisdictions have begun to either trial smart meter programs or
to roll out smart meters to smaller customers. The potential for smart metering to
significantly increase the responsiveness of households to price signals has been
demonstrated in a number of locations (see Brophy, Haney, Jamasb and Pollitt,
2008). There is clearly a lot of scope for further trialing of the schemes that would
be acceptable to the public and would yield social benefits in terms of energy and
emissions reductions. Going forward the smartening of domestic loads via further
Table 2. The Choice Between Two Investments with Identical Energy and
Emissions Reduction Benefits
COS TS Y 1 Y 2 Y 3 Y 4 to Y9 Y 10
Investment 1 500 500 0 0 0
Investment 2 245 245 100 100 100
NPV of investment 1, evaluated at 10%: 867.77
NPV of investment 2, evaluated at 10%: 866.11
NPV of investment 1, evaluated at 2%: 970.78
NPV of investment 2, evaluated at 2%: 1,179.78
BENEFITS Y 1 Y 2 Y 3 Y 4 to Y9 Y 10
Carbon price needed at 10% 0 0 196.44 196.44 196.44
NPV at this carbon price, evaluated at 10%: 866.11
NPV at this carbon price, evaluated at 2%: 1,383.14
Carbon price needed at 2% 0 0 137.88 137.88 137.88
NPV at this carbon price, evaluated at 2%: 970.82
Extra Cost of Investment chosen at 10% discount rate (evaluated at 2%): 209.00 22%
Extra Cost of Carbon Price needed at 10% discount rate (evaluated at 2%): 412.32 42%
use of domestic IT systems to cause energy to respond to movement within individual
rooms and to intelligently control energy consuming equipment is significant
(see Devine-Wright and Devine-Wright, 2006).
Related to stimulating the potential price responsiveness of small consumers,
is the issue of raising electricity prices (in Denmark the tax on domestic
electricity use is 100%) to support demand reduction investments. If the demand
side invests to save CO2 how can it share some of the benefits if they are not fully
reflected in the price of electricity? In the US regulatory agencies often oversee
substantial demand side management programs (e.g. in California) aimed at
overcoming the market failures which exist in this part of the market. These incentivize
electricity companies to achieve demand reductions via allowing them
to finance demand reducing investments in their regulated charges. There is also
considerable scope for market-based initiatives such as tradable white certificates
to improve energy efficiency.
5.3.3 Support New Entrants
New entrants into low carbon production and energy management need
to be encouraged and concerns about the inaction of incumbents in providing
network access or import/export services addressed. We need to recognize the
possibility that existing incumbents may not be best placed to deliver the decarbonization
of the electricity sector. There are a number of reasons for this: they
require legitimacy in spending the large amounts of capital investment that will
be required; more locally based companies may be more effective at engaging
the public in demand reduction or the uptake of micro-generation; new business
models may be more appropriate, such as those focused on energy service management,
rather than ownership of hard assets.
It should also be pointed out that the public sector has traditionally been
important in the rapid roll out of intrusive networks with initially poor returns
(even when run efficiently). While few would advocate a return to public ownership
of energy networks (where these have been privatized), history does suggest
interesting reasons for increased government ownership in the electricity and gas
sectors e.g. to do with cost of private financing and the political sensitivity of
siting assets (see Millward and Ward, 1993, Foreman-Peck, 2003 and Gleaser,
2001). Public operation of the underlying assets is no longer necessary as the financing
advantages of public ownership can be achieved via a public-private partnership.
If the historical reasons for public ownership are mirrored today then it
is quite possible therefore that we will see significant public-private partnerships
emerge in the electricity sector in the coming years. Indeed it is highly unlikely
that any subsidized roll out of a new technology, such as heat networks, would not
have public sector involvement. Such facilities based competition might involve
competition from water companies. Private energy services companies based
around smart control of heating and lighting and joint provision of security or IT
services might also have a role to play in the future. Independent regulators, such
as Ofgem, should have a key role in facilitating the entry of new players into the
market, especially where these have strong political backing.
5.3.4 Engage with Local Initiatives
There is a need to engage with local initiatives as these are start-up projects
that need regulatory assistance and have the potential to be important market
drivers in the future. This relates to the previous point about encouraging new
entrants. The regulatory agency needs to have the capacity to support local initiatives
to get off the ground. These are potentially very significant in terms of climate
change mitigation, but also in terms of supporting the legitimacy of political
support for the whole of climate change policy. Local initiatives have the capacity
to be popular and to engage individuals in environmentally friendly action at low
cost, by for instance being effective ways of targeting subsidy.
In the UK, some small examples of local initiatives currently exist: some
community enterprises in Scotland and local authority heat schemes in places
such as Woking (see London Energy Partnership, 2007). However the capacity exists
for significant take off in this area, with the London Energy Savings Partnership
in place to help deliver London’s ambitious target for reducing CO2 by setting
up local energy service companies. London Energy Partnership (2007) identifies 7
current schemes, with more in planning.
5.3.5 Plan for Large-scale Trials
There needs to be planning for large scale trials of new technologies
in electricity production and demand management. Most current local initiatives
are small, too small to make a real difference to the UK’s overall CO2 targets.
However they are important examples of social entrepreneurship and give rise to
demonstration effects. What is clear is that we will need much larger scale trials to
demonstrate the least cost way of reducing CO2 emissions, given that divergence
of approaches is, at least initially, desirable. These trials will need to take place at
the level of medium sized cities and might involve, for example, setting up a heat
network, smart metering in every home and/or the establishment of a well funded
local energy service company (ESCO). Several requirements to begin moving in
this direction are set out EU Directive (06/32) on Energy End-Use Efficiency and
Energy Services and supported by government responses (e.g. DEFRA, 2007).
Some of these trials, and their associated technologies, would require the
development of regulations for heat networks and ESCOs. These are currently not
subject to specific regulation in the UK. They would also require powers to deal
with the incumbent local monopolies, such that the value of their property rights
is protected, but their ability to impede the successful implementation of trials is
removed.
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