PEi: Has the European Union Emissions Trading Scheme (EU ETS) been emasculated to the point where a carbon tax is now preferable?
Professor Dieter Helm CBE, energy economist, Official Fellow of New College, Oxford and government advisor
Helm: If we are going to decarbonize the power sector then there needs to be a carbon price. There are enormously strong reasons of principle and practice that it would be much better if we just had a carbon tax instead of a permits market. However, we have a permits market and the reasons we have one are twofold.
First of all, we have fixed quantity targets for the Kyoto Protocol and presumably the successor to the Kyoto Protocol, and somehow these targets have been translated into a fixed amount of carbon for the European Union.
This is an illusion, as it is not at all clear what is included and what isn’t, CDMs (Clean Development Mechanisms) and CDRs (Carbon Dioxide Reductions) are a moveable feast, and if anyone else joins the scheme between now and 2020, no doubt they would come with a package of hot air.
The second reason that we have a permits system rather than a carbon tax is that we have a very political, industrial economy in the EU. Faced between permits versus a tax, industry assumed from the outset that these would all be grandfathered, so rather than paying the exchequer, they would have the money.
I don’t think it dawned on many people in the power sector that in due course these things would be auctioned. For the industry, an auction is worse than a tax because they pay all the money upfront.
The permit scheme has the additional difficulty that it lends itself to lobbying and to becoming ever more complicated. Any illusion that we were going to have a simple, open, straightforward carbon trading market in which market forces would determine the outcome has given way to a Byzantine complexity of exemptions, concessions and an enormous amount of bureaucracy from determining which are legitimate CDMs through to the policing of handling of permits for particular sectors.
And it is not surprising, as a result, the ETS no longer serves as the main mechanism at the centre of climate change policy. The implementation of renewables, nuclear energy and energy efficiency now turn out to be vastly more important.
PEi: How can the fundamental clash between the profit motive of utilities and the political objectives to mitigate climate change be reconciled in a liberalized market?
Helm: I think we have to be rather clear from the outset that Europe doesn’t have a liberalized energy market. There are elements of competition and elements of trading, but, fundamentally, there must be physical connections for physical energy trade to take place.
What we have in Europe is a virtual market without the physical connection and, as a consequence, you can’t possibly have a true, liberalized, competitive market until those links are in place. In a liberalized, effective market the law of one price applies and there is no evidence whatsoever that one price applies across Europe in energy.
There is nothing wrong with the profit motive in the carbon context, after all we want to find the most efficient ways of reducing carbon emissions.
However, it is also true that the politicians now increasing see the ETS as much as a big pork barrel of money that they can use to deal with their own deficits, and also for lobbyists to earmark bits of it for their own interest. Renewables want a bit, carbon capture and storage (CCS) wants a bit, energy efficiency wants a bit, and large industrial concerns want concessions. This distorts the use of the revenues and, of course, is highly inefficient.
However, the renewables programme will be driven by the renewables target. It’s got nothing to do with the price of carbon. It will be legally required that these mandated targets are hit and there will be fines, or infractional proceedings, if they aren’t. Therefore suppliers will be effectively obliged to buy this stuff to the level required and the costs will pass through.
PEi: What do you think the effect of a falling carbon price may be on power sector investment?
Helm: It is true that the carbon price may fall very sharply, as we have got massive demand destruction, and much of that demand may never return. Therefore it may be much, much easier for the EU to hit their carbon targets as a whole. Not because of the effectiveness of policy, but because the recession and slump may drive down demand for energy so far.
It’s a completely separate argument as to what the effect of a lower carbon price might be on the non-renewables part of the energy market. This is effectively a choice between coal and gas. Since coal is more polluting than gas, the lower the carbon price the greater the relative advantage to coal.
So the economics of coal would move quite strongly into positive territory. Should we build new coal fired power stations without carbon abatement technologies? Well, that goes to the heart of climate change policy. A new coal power station would last 30 to 40 years, indeed some in the EU are over 60 years old. Who knows what the environmental context will be like then?
PEi: Does the world just sit tight and wait for a carbon price to rise to a viable level before the power sector implements CCS?
Helm: CCS has to be government policy. No private sector institution is going to invest in CCS without substantial public support. And in Europe we will have to decide whether we do it, or whether we don’t. I don’t think the CCS issue depends up on the carbon market. That’s a factor, but the issue with CCS is very straightforward: either we have CCS or we have a lot of global warming.
You can doctor the carbon price anyway you like, but this isn’t a situation where one waits to see if the market wants to build a CCS plant. This is a situation where one says that CCS is essential to address climate change what’s the cheapest and most efficient way of achieving it? If there was some offset from the carbon market then that changes the economic situation a bit and makes the support mechanisms a little easier and cheaper than they otherwise would have done.
Governments with a plural ‘s’ have to build them. It’s not at all clear that any particular country should pursue an aggressive CCS policy independently. Why are we building 12 demonstration plants in Europe? Why not four? Why not do it jointly with the US? Or China?
The UK has the advantage of shallow seas off its eastern coast with empty or half-empty gas fields. Clearly, a network of CCS into the North Sea is a practical and straightforward proposition. The EU should say that the North Sea is the area where CCS is to be tested and the UK is to be the demonstration CCS industry for Europe, rather than just take several years to see if it can build a demonstration plant.
We, as a society, have to accept that the technologies required are not economic in the current climate neither are they likely to be for some time and that they have very specific R&D characteristics. There are efficient ways and very inefficient ways of engaging with the private sector to do this, but this is essentially public procurement. We have to ensure, just as we do with public procurement of military hardware, that it is done in a cost-effective way.
It’s more development than research. We’ve known how to separate the gases since the 19th century. We have huge experience of piping gas for at least a century. Sticking it in a hole and putting a plug on top is not rocket science. It’s the co-ordination, the planning, the piping networks, and there are some very important questions that need answering about whether we adopt pre- or post-combustion and how it fits onto existing power stations.
This is a new utility. It will not happen by just looking at a series of disaggregated bilateral relationships. It requires a degree of coherence in policy, a framework, a co-ordination plan, a utility framework for the pipes and so on.
PEi: You have recently published a paper laying out your ideas for a Low Carbon Obligation, which would replace the UK’s Renewables Obligation. Why are you proposing this?
Helm: The Renewables Obligation has been fantastically unsuccessful. About one per cent of the UK’s total energy comes from renewables. Outside Italy, it is probably the most expensive way of achieving renewables in the developed world. If we had a lot of expensive renewables that would be one thing, or we had few, cheaper projects that would be another, but the UK has the worst of both worlds – not many renewables and a huge bill. As a mechanism for making the transition to what is now an enormous renewables target, the Renewables Obligation is extremely badly designed.
I have two reasons for proposing a Low Carbon Obligation. One is that governments shouldn’t be picking between technologies and picking winners. In truth, losers pick governments.
The second reason is that these technologies all have very high, upfront capital costs. These costs are fixed and sunk. The orthodox manner to recoup these costs in a competitive market is for the customers to commit to paying them by way of a long-term contract.
The Renewables Obligation is one such long-term contract. I’m simply saying that it should be extended across to include nuclear, CCS and ‘future’ low carbon technologies.
Energy policies in Europe, particularly in the UK, are heavily based on the idea that we should have a special domain set aside for renewables. That’s because renewables are regarded as ‘special’, but actually they are just a low-carbon technology.
PEi: Would you like to see the UK adopt a feed-in tariff system akin to that of Germany?
Helm: No. My view is that renewables should be treated as a utility, and placed in a regulatory asset base. The cost of capital should be set very close to cost of debt, as these would essentially be guaranteed returns. Therefore, one gets quite close to rate-of-return regulation for these projects.
The regulator has the duty to ensure that the utilities can finance their functions. This means that the investor knows that the bills to the customers will cover the costs of their capital programmes.
That’s essentially a regulated return. In exchange for that, since now you know that you’ve got a very low risk investment as there’s a legal duty that the customers will pay, capital costs will be much lower. This is radically different from the approach we take at the moment,which is to take a market-based way.
The current approach, through the renewables certificates plus the wholesale market plus the carbon market, produces volatile returns, has produced extremely high returns and produced very little wind power.
As we move through the credit crunch into a new world of constrained capital with much higher costs, the crucial issue in delivering the renewables programme, and indeed the nuclear and CCS programmes, is how to minimize the cost of capital. The regulatory asset based utility model is by far the best way of achieving that.
It would reduce the current cost of some renewables by about half. The cost of capital for an equity financed offshore wind farm must be something like 10 per cent.
We know that the internal rates of return of some of these projects are between 15-25 per cent. And we know that the regulated return on the asset-based utilities is between 4-5 per cent. Five per cent on the capital cost dwarfs any operational efficiency loss you could possibly think of!
PEi: Would your Low Carbon Obligation scheme apply retrospectively to existing low carbon generation, like the UK’s nuclear fleet?
Helm: No. The capital on the UK’s existing nuclear plants has long been written off by taxpayers. On the other hand, from a carbon point of view, there is no distinction between nuclear capacity that comes from a brand new plant or from major refurbishments to extend the life of existing plants. The advantage of the plant extensions is that you get the carbon reduction earlier.
So there would have to be some clarity over what the incentives were, but I’m very clear that the risks of building nuclear power stations are enormous, the up-front capital costs are very high and you depend crucially on assumptions of future fossil fuel prices.
Due to the very long timeline involved with a nuclear plant, the carbon price matters a lot too. I’ve always been in favour of a long-term carbon price.
My ideal way would be a long-term carbon tax, or, if we’re not going down that route, a long-term carbon auction now to establish a carbon price post-2020, when new build nuclear would start to come online.
PEi: How can a limited liability company possibly bear the brunt of the legacy issues inherent with nuclear power in a privatized market?
Helm: It is conceivable, however remote, that there could a nuclear accident or series of accidents with Chernobyl-like effects. In such circumstance, society has unlimited liability, companies have limited liability. We know what would happen – the state would step in.
The point is to appreciate that upfront, recognize the need to create incentives for limited liability companies to go beyond what they would do in their profit-seeking objectives in respect to preventing accidents and in respect of the waste.
The waste is going to be there for 100 000 years and no limited liability company has any horizon like that – not even EDF. Ultimately the state has to handle the waste and set up appropriate arrangements for doing so.
The sad thing about nuclear power is that while the private sector has been good at building nuclear plants, the state has been absolutely hopeless at dealing with the waste.
The state’s inability to deal with existing waste is the industry’s Achilles heel. A minimum condition of a new build nuclear station should be that our democracy demonstrates its ability to deal with what we’ve already got, preferably in a scientifically suitable location, not just one that is politically expedient.
PEi: Now that, in effect, the French state runs the UK nuclear power industry, why not store waste across the Channel?
Helm: There’s no reason why nuclear waste should be dumped in any particular country, but it is extraordinarily important to have a link between the democratic mandate and management of nuclear waste. Notwithstanding the fact that different countries could be paid to store waste, the principle that those who create the waste or those who benefit from the creation of the waste should have the obligation to find a solution for it is a clear one.
If we discharge our responsibility by paying someone else to do it for us, we should at least be satisfied that how it is stored meets the same criteria as if we had stored it on our own territory.
But if the nuclear industry was to go down that route, I think they’d lose rightly public support. In practice, I think that means a country should keep its own waste and sort it out.
PEi: The German elections are coming up later this year. What are the implications for the plans for nuclear phase-out?
Helm: My guess is that an outright CDU (Christian Democratci Union) victory i.e. it forms a coalition with the CSU (Christian Social Union) and, say, the Liberals, would see Germany end to the phase out, extend the life of the plants and move on to new nuclear build. A continued Grand Coalition, which is a possibility, might fudge it.
That means they may delay the phase out. I think economic reality will bite. There will also be a difficult moment from the Greens when they’re faced with the choice of either building some more coal plants or keeping the nukes going. The price of going it alone with renewables, given the scale of the existing renewables bills, is very likely to be extremely high.
My guess is that the Green movement itself will have to reassess its overall position in respect to nuclear power. Climate change is now so serious that the luxury of being able to pick ‘nice’ technologies and only the ‘nice’ technologies and expect people who were getting ever richer in booming economies to pay for it is now over.
If you really want to make the transition to a 80 per cent decarbonization by 2050 when you’ve got the Russian stranglehold on natural gas, renewables as expensive and slow as they look like being, and CCS still a long way off, there are few other options.
Professor Helm publishes a series of energy presentations, papers and commentaries on his website.
His recent paper, Time To Invest: Infrastructure, The Credit Crunch and the Recession, can be found at www.dieterhelm.co.uk