Planetary Economics, energy transition & policy experience

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1 Planetary Economics, energy transition & policy experience Seminar to Duke University, 1 st December 2017 Introduction to Planetary Economics : Three Domains and Three Pillars of Policy The Solow Residual and the innovation paradox UK electricity market reform and transformation Innovation pathways and the renewables revolution Energy, Climate Change and the Three Domains of Sustainable Development Porter s Kick? Macroeconomics of transformation World Bank presentation Innovation and adaptive system Modelling RFF

2 Three Domains an Economic Interpretation 1 st Domain 2nd Domain 3rd Domain Resource Use / Energy & Emissions Satisficing behaviour 1. Real-world individual and organisational decision-making Optimising behaviour Transforming behaviour 3. Innovation & evolution of complex systems Economic Output / Consumption PE Fig. 2-3 b Resource trade-offs with the other two domains

Characteristics & theoretical foundations, MsC in EPEE Lecture: Planetary Economics and the Political Economy of Energy & Climate Change Three Domains of decision-making involve different processes

3 Characteristics & theoretical foundations, MsC in EPEE Lecture: Planetary Economics and the Political Economy of Energy & Climate Change Three Domains of decision-making involve different processes with different fields of theory which operate at different scales DOMAIN Characteristics Theoretical foundations T I M E H O R I Z O N Satisficing Optimising Transforming Habits, myopia, inattention to incidental / intangible costs; endemic contractual failures, principal-agent failures, risk aversion to change or investment, varied social constraints Economic optimisation based on relative prices, representative agents with rational expectations, stable preferences and tech trends Structural, technological, institutional and behavioural change, typically from strategising, innovation, infrastructure investment Behavioural & organisational economics & developmnt? Neoclassical and welfare economics Evolutionary and institutional economics S O C I A L S C A L E

4 Ideal policy comprises a package which matches the best instrument to the respective domain of decision-making Domain Standards & Enabling Policy pillars Markets & Prices Strategic Investment H M L Highest relevance Medium relevance Lowest relevance Satisfice H L/M L Smarter individual & corporate choices Optimise M H M Cleaner products & processes Transform L L/M H Innovation & infrastructure

5 Planetary Economics, energy transition & policy experience Seminar to Duke University, 1 st December 2017 Introduction to Planetary Economics : Three Domains and Three Pillars of Policy The Solow Residual and the innovation paradox UK electricity market reform and transformation Innovation pathways and the renewables revolution Energy, Climate Change and the Three Domains of Sustainable Development Porter s Kick? Macroeconomics of transformation World Bank presentation Innovation and adaptive system Modelling RFF

6 First Domain: Behavioural, organisational and social perspectives Focus on capacity ; no inherent optimality Lots of wider evidence around theoretical potential Energy and wider resource efficiency* Concepts and analytic approaches Increasingly sophisticated measures of distance from frontier ** Second Domain: Market perspectives, usually assumption of economy-wide rational discount rate with risk premia Equalise marginal costs, internalise external costs, separability Equilibrium: Optimum defined in in terms of marginal (maths: partial derivatives of components) Third Domain: Long term / Hyperbolic discount rate; finance interplay between 2 nd & 3 rd domain type investments Focus on systems change: no inherent optimality Minimise scenario-based total costs, focus on option values & risks Component (or subcomponent) costs may be inseparable systems perspective Evolution: Decisions at margin need to be based on total (maths: total not partial derivative)

7 First peek at the Macroeconomic context Classical economic growth models since Solow find residual typically half of observed economic growth that cannot be explained by resource and capital accumulation (in PE: the Dark Matter of economic growth) [modern debate on] Economic growth is about Reducing resource misallocation Technological advancement.. Prof Tim Besley, Director of LSE Growth Commission, keynote presentation to UK Government Economic Service annual conference, September 2013 & well covered in intro to World Bank, The Innovation Paradox ie. first and third domain processes are important for macroeconomic growth. Yet these remain largely absent in global (or national) modelling Inadequately charted in policy

8 Resource Use / Energy & Emissions The domains are different, but deeply interconnected for policy Pillar I Smarter choices 1. Private returns >> public returns but not realised => Standards and engagement Pillar II Cleaner products and processes Economic Output / Consumption Pillar III Innovation and infrastructure 3. Public returns (including innovation, security & environment) >> private returns => Strategic investment Innovation paradox Returns to innovation are often positive and high, but below a certain level of development, decrease, with the distance from the frontier and may even become negative Distance breaks the link + Infrastructure not same as innovation! Fig Public and private returns in the 3 domains

3 R&D expenditure by top companies in different sectors as % of sales, 2011 The technology valley of death caused by high up-front

9 Innovation differs by sector : an energy / climate perspective Fig.9.7 Fig.9.3 R&D expenditure by top companies in different sectors as % of sales, 2011 The technology valley of death caused by high up-front innovation costs & long lead times => large risks weak product differentiation and large market risks in innovating especially for policy-dependent value Seeking innovation in some of least innovative sectors (energy, construction and materials..) In principle, the economic gains to accelerating innovation in these could be very high

10 Planetary Economics, energy transition & policy experience Seminar to Duke University, 1 st December 2017 Introduction to Planetary Economics : Three Domains and Three Pillars of Policy The Solow Residual and the innovation paradox UK electricity market reform and transformation Innovation pathways and the renewables revolution Energy, Climate Change and the Three Domains of Sustainable Development Porter s Kick? Macroeconomics of transformation World Bank presentation Innovation and adaptive system Modelling RFF

Figure 1: UK electricity generation by fuel, 1970-2016 Figure 1 The dash for gas the decline of coal,

11 Figure 1: UK electricity generation by fuel, Figure 1 The dash for gas the decline of coal, a competitive market & Elec Market Reform Source (data): Digest of UK Energy Statistics, various years

12 UK electricity journey overview 1990s 2000s 2010s Policy environment First liberalisation - Competition through electricity pool - System marginal price + cap y payment Þ Dash for gas, based on Long term contracts (PPAs) with distrib n companies Þ Some contract support for renewables Þ Collapse of R&D Bilateral trading market (NETA/BETTA) - No pool, pure marginal cost pricing - Vertical integration of generators with supply companies; Þ Limited investment Þ Market certificate trading (ROCs) support for renewables Electricity Market Reform (EMR) + Climate Change Act Regulatory remit Promote competition Concerns about oligopolistic power Protect interests of consumers Growing concerns about lack of investment or new entry, transmission connection & bottlenecks, and short-termism Protect interests of present and future consumers

13 UK Electricity Market Reform - Background Academic struggles between idealised theory and emerging evidence around overall investability Nuclear & renewables seen as key to future Energy transition estimated to involve over 100bn investment during 2010s beyond the pockets of incumbents, terms of finance crucial Political evolution: Ø Rising energy prices Ø Climate Change Committee (2008) concern around low carbon / capital intensive investment, amplified by inadequate C price Ø Ofgem (regulator) concern around security

electricity market Addressing key risks identified became the three aims of EMR: 1 2 3 Reduce

14 Electricity Market Reform (EMR) Controversial step for a pioneer of electricity liberalisation Ofgem s Project Discovery (2009) Regulator s detailed study of the future challenges of the electricity market Addressing key risks identified became the three aims of EMR: Reduce the risks to security of supply Reduce costs to consumers Support progress towards climate change targets

15 UK electricity market reform (EMR) components Low Carbon Support Contracts for Difference (fixed-price 15-yr contracts) Carbon floor price 4 Key Policies Capacity Mechanism (capacity payments on availability) Emissions Performance Standard Security of Supply No new coal EMR brought major changes to the market. Main regulatory input on design of Capacity Mechanism and overall institutional 15

16 1. Contracts for Difference (CfDs) (structure for renewable energy & nuclear) 16

17 Huge cost reductions from auctioned contracts Initial gain from auctions followed by huge offshore wind cost reduction Strike Price ( /MWh) strike price for five offshore wind farms depending on completion date ,89 (Inc. East Anglia 1) (Inc. Neart Na Gaoithe) , administered CfD prices, /MWh* 2015, first auction, offshore wind price: /MWh 2017, second auction, two projects at 57.50/MWh à Competitive CfDs drive down cost hardware, supply chain & finance (Newbery (2015) estimates CfDs reduced WACC by 3 % points saving > 2bn/yr on estimated cost of energy transition). à boost to UK low-carbon supply chain, as part of government s emerging Clean Growth Plan 74,75 (Inc. Triton Knoll) prices halve 40 57,50 (Hornsea II, Moray East) 20 0 Allocation / auction rounds 2013/ / / / /22 Delivery years (to first generation) Round 1 Admin Strike Price (Offshore Wind) Round 1 Contracts - Offshore Wind / ACT Round 2 Contracts - Offshore Wind 4 years difference in delivery years Source: From M.Grubb and D.Newbery (2017), UK Electricity Market Reform and the Energy Transition: Emerging Lessons, MIT working paper (submitted) * 15-yr Contract prices

2. Capacity Mechanism / Market(to reward firm generating capacity) Why Ensure market can deliver security of supply Payment for availability to encourage investment How Market wide auction of

receiving CfDs are not eligible Pilot scheme to help Demand Side Response (DSR) Effect üreduces price volatility üinsurance against blackouts üencourages demand side - somewhat?

18 2. Capacity Mechanism / Market(to reward firm generating capacity) Why Ensure market can deliver security of supply Payment for availability to encourage investment How Market wide auction of capacity obligations, run by National Grid Successful bidders get fixed revenue additional to wholesale market Obligated to deliver capacity when needed or face penalties Technology neutral but those receiving CfDs are not eligible Pilot scheme to help Demand Side Response (DSR) Effect üreduces price volatility üinsurance against blackouts üencourages demand side - somewhat? Expected cost estimate required for new CCGTs, around 50/kw/yr Þ Would give 2.5bn/yr into market, much expected to pass through Þ? Less peaky prices impact on interconnector / other investment Design makes it very difficult for DSR to participate equally 18

19 Capacity: be careful what you ask for Lots of bids, low prices, new options, lots of angst.. First main capacity auction (Dec 2014) Almost 50GW awarded, clearing price 19.40/kW/year* Mix of 1-year, 3-year (refurbishment) and 15 year (2.5GW of new build out of 10GW bid) contracts Mainly existing nuclear, gas and coal generators One new CCGT (1,650MW) wins an agreement but failed to raise final investment Only 174MW of demand side response 2.5GW of capacity reserved for year ahead auction (b) Successful New New Build build capacity in Capacity by fuel and Auctions technology type in the T-4 auctions MW for for for 2020 Battery Reciprocating engine CHP Waste CCGT OCGT CCGT Withdrawn Second main capacity auction (Dec 2015) Clearing price 18.00/kW/year 46.35GW awarded new options replace retiring coal Interconnectors, 1GW of small reciprocating engine Concern about diesel Third main capacity auction (Dec 2016) Clearing price 22.50/kW/year 52.43GW awarded, inc 3.4 GW new capacity over 500MW batteries New diesel largely excluded, but wider concern about embedded benefit exemptions from transmission

Combined with the Emissions Performance Standard, effectively bans new coal and improves economics of gas vis-à-vis existing coal plants Carbon price floor compelling

20 Combined with the Emissions Performance Standard, effectively bans new coal and improves economics of gas vis-à-vis existing coal plants Carbon price floor compelling economics Floor price designed to give market value to the government s Social cost of carbon, through top-up to EU ETS price - Quickly renamed Carbon Price Support (CPS)

21 Mission accomplished..? Likely to overdeliver on the UK renewables target Dramatic (80%) fall since 2012: first hours / days without coal power for over a Century Driven as declining gas price meets rising carbon price, and renewables + (2016) gas Nov 2017: carbon price about right till coal phased out Carbon Price Support GB coal power generation, Q /tco2, added to EU ETS C-Price support doubled to 18/kWh Generation from coal, TWh/yr /tCO2 18/tCO CPS 4.94/tCO2-0

22 Planetary Economics, energy transition & policy experience Seminar to Duke University, 1 st December 2017 Introduction to Planetary Economics : Three Domains and Three Pillars of Policy The Solow Residual and the innovation paradox UK electricity market reform and transformation Innovation pathways and the renewables revolution Energy, Climate Change and the Three Domains of Sustainable Development Porter s Kick? Macroeconomics of transformation World Bank presentation Innovation and adaptive system Modelling RFF

. accompanied by cost reductions, to learning curve expectations

23 Huge market growth + cost reductions in renewables Solar PV strategic deployment.. accompanied by cost reductions, to learning curve expectations growth over 2-3 decades -.. documented across wide range of other supply and demand-side technologies including w.r.t. energy efficiency

Err PV: 2016, installed power prices below wholesale elec prices in many sunny regions Chile = $30/MWh Masdar = $25/MWh Abu

24 and much else in energy systems solar power is by far the most expensive way of reducing carbon emissions. the CO2 price would have to rise to $185 a tonne. - The Economist, Err PV: 2016, installed power prices below wholesale elec prices in many sunny regions Chile = $30/MWh Masdar = $25/MWh Abu Dhabi = $24/MWh Module costs: -29% in 2016 to $0.39/Watt Even offshore wind energy: series of auctions across Europe have seen prices tumble to about half that of 5 years ago Batteries also

25 The perils of the learning model? (Nordhaus, 2013) Critique centred on data uncertainties and correlation is not causation price reductions would also drive growth But: Timing capacity growth has generally led cost reductions, clearly the two reinforce each other * Surge in private patents as markets grew * Common sense: Technology learning-by-doing Private sector revenues resource private R&D Economies of scale in both unit size and production volume Development of supply chains & infrastructure Experience and improved financial confidence in capital-intensive sectors drive big reductions in cost of finance Assuming zero is an unacceptable approximation to something we know to be positive and crucially important * Bettencourt et al (2013) document A sharp increase in rates of patenting [during ], particularly in renewable technologies, despite continued low levels of R&D funding.. reveals a regular relationship between patents, R&D funding, and growing markets across technologies growing markets have formed a vital complement to public R&D in driving innovative activity.

26 A more subtle innovation chain Market Pull User demands and expectations about future demands Growth & Market Pull Supply/ Novel Research technology Invention Developmen t Demonstration Commercial -isation Market accumulatio n Diffusion Mature technology Formation & technology push Technology push Technical knowledge development Basic and applied R&D Policy Environment for a connected innovation chain

27 So the extreme caricatures are unhelpful

28 Innovation & development: not just technology! Effective Innovation involves multiple journeys Source: Grubb, McDowell and Drummond (2017), in Energy Research and Social Science with a high degree of complementarity amongst different factors in the innovation function World Bank, The innovation paradox

A transformation of macroecon & development significance Low innovation, little connection between innovators and markets R&D intensity

Money =========è (at rising scale) Technology push PE Figure 9.7.

Long term R&D in learning industrialised countries much of it spillover learning into IT Initial industrial development led from Japan

. Ultimately funded through markets, by mostly industrialised country consumers particularly Germany in pursuit of strategic national

29 A transformation of macroecon & development significance Low innovation, little connection between innovators and markets R&D intensity < 1% (eg. energy & construction) PV revolution: how did it happen, what future challenges? Money =========è (at rising scale) Technology push PE Figure 9.7. Innovation intensity & the broken chain Technology Valley of Death Market pull ç ======= Markets (credible and strategically growing) Long term R&D in learning industrialised countries much of it spillover learning into IT Initial industrial development led from Japan The big breakthrough invested from German and Chinese state-backed banking systems.. Ultimately funded through markets, by mostly industrialised country consumers particularly Germany in pursuit of strategic national goal Others inc behavioural preferences Integration between public and private, & strategic investment and markets Supporting infrastructure (eg. grid batteries) now following an integrated mix of policies across all pillars leading edge now moving to emerging economies, but far less in the poorer countries

Strategic investment can be costly but the returns can be huge, particularly when integrated with energy/externality pricing North-Sea oil investments in the 1970s cost UK c.

30 Strategic investment can be costly but the returns can be huge, particularly when integrated with energy/externality pricing North-Sea oil investments in the 1970s cost UK c. 10bn/yr; full direct costs >> $100/bbl Same now seems to be playing out for offshore wind Not just big kit : Many vehicles market leaders led in clean, efficient cars Rising carbon price could Help fund innovation Shift capital from clean to dirty Give strategic direction etc + Porter Hypthesis

31 Effective Mission Oriented innovation requires policy integration Standards & Engagement POLICY PILLARS Markets & Prices Values, pull & preferences Strategic Investment Enhanced efficiency Cleaner products, co-benefits Innovation and infrastructure Manage bills, increase responsiveness Attention, products & finance Revenues, revealed costs, strategic value Technology options & competitiveness Need to integrate across all three pillars, harnessed for industrial / development strategy Lower resource costs Consider contribution of energy / carbon pricing (potentially including materials consumption) Aimed to accelerate diffusion-andinnovation for development Education, access & control

32 System level adjustments? Long run constancy of energy expenditure Countries with higher energy prices did not end up spending more on energy - In fact they spend less Eastern Europe had prices lower than any OECD - And ended up spending more on energy Not consistent with classical measures of in-country consumer price elasticities), evidence for: Energy efficiency regulation and related policy responses Innovation throughout energy supply and product chains Challenge is to accelerate such trends for decades without politically untenable policy-driven price shocks

Ignoranti quem portum petat nullus suus ventus est - Lucius Annaeus Seneca No wind is favourable to those who don't know where they are going Global energy costs Clustering of low cost energy futures

system Low-carbon, smart electricity Biomass and electricity in transport High capital costs.

33 Ignoranti quem portum petat nullus suus ventus est - Lucius Annaeus Seneca No wind is favourable to those who don't know where they are going Global energy costs Clustering of low cost energy futures around higher and lower emissions, rather than in the middle, reflects divergent responses to depletion of easy oil We are here Annual global emissions Time Green futures Integrated high-innovation system Low-carbon, smart electricity Biomass and electricity in transport High capital costs. but low operating costs Brown futures Continued dependence on fossil fuels Unconventional and synthetic oil in transport Low capital costs but high operating costs and a host of environmental issues beyond carbon Figure 10-6: Two kinds of energy future the carbon divide Source: Upper panel: Gritsevskyi and Nakićenović (2000); lower panel: authors

34 A final remark: on interdisciplinary economics Fully understanding the Three Domains inevitably must draw also on other disciplines Social and psychological dimensions of risk perceptions and First Domain behaviours Engineering and physical determinants of Third Domain innovations and infrastructure The regulatory, institutional and political-economy dimensions of both

35 Planetary Economics: Energy, Climate Change and the Three Domains of Sustainable Development Pillar 1 1. Introduction: Trapped? 2. The Three Domains Standards and engagement for smarter choice 3: Energy and Emissions Technologies and Systems 4: Why so wasteful? 5: Tried and Tested Four Decades of Energy Efficiency Policy Pillar II Pillar III Markets and pricing for cleaner products and processes 6: Pricing Pollution of Truth and Taxes 7: Cap-and-trade & offsets: from idea to practice 8: Who s hit? Handling the distributional impacts of carbon pricing Investment and incentives for innovation and infrastructure 9: Pushing further, pulling deeper 10: Transforming systems 11: The dark matter of economic growth 12. Conclusions: Changing Course Published Routledge page Highlights paper available for further information #planetaryeconomics

UK Electricity Market Reform: Lessons from a policy and regulatory journey

UK Electricity Market Reform: Lessons from a policy and regulatory journey Michael Grubb Professor of Energy and Climate Change, University College London (UCL) Institute of Sustainable Resources & Energy