Are subsidies good or bad for Renewables and the Zero Carbon Economy?

As global energy demand increases and greenhouse gases (GHGs) continue to pose a threat to the earth via the impact of climate change, it is pertinent that future energy is cheap, secure, and accessible. Low carbon renewable energy still has a huge void to fill in the overall global energy mix, and is generally limited by economics, amongst other issues. A very good example of one of those future energy sources is biogas, where its potential to replace 12% to 42% of the total UK natural gas supply (Fubara, T.C), has not been fully maximized to its technical potential to date (current predicted capacity is 18% of the UK natural gas demand by 2020). To further buttress this, despite various government incentives/subsidies applied in the UK to biogas, combined with the lofty potential of biogas to reduce GHG from UK domestic energy supply by 42% to 85% (Fubara, T.C), its full market utilization is yet to be achieved. So why are subsidies and incentives not forcing a steep shift of the market to renewable energy (Oilprice.com) (The Economist)?

Figure 1: GHG reduction from using biogas to replace natural gas in UK domestic energy supply (Fubara, T.C).

Based on the fact that subsidies and incentives can be broad-based, the key questions to ask are: What really are subsidies? How do they work? Are they effective? What are the alternate solutions?

WHAT ARE ENERGY SUBSIDIES/INCENTIVES?

Energy subsidy can be defined as a tax reduction or financial transfer from a government to a corporation, specific sector, group of individuals, or a group of households, with the aim to achieve beneficial financial and social outcomes. In a perfectly competitive economy, the price of energy would be determined by the equilibrium between supply and demand. In a situation where the government intervenes through policy and instruments to implement a lower price for renewable energy below its equilibrium price, then subsidies can then be assumed to be in place (see Figure 2).

Figure 2: Price gap for subsidies.

TYPES OF ENERGY SUBSIDIES

Several ways exist in which governments can implement subsidies for renewable energy with clear disregard to economic attractiveness, and these include:

1. Direct spending- cash transfers to firms or households,
2. Price controls – imposing price controls on energy products,
3. Tax subsidies – keeping energy product tax rates lower than that for other types of goods,
4. Control of natural resource access – policies on terms of access to domestic resources,
5. Cross-subsidy – reducing costs on renewable energy products by increasing the cost of other energy products,
6. Direct government lending – offering below-market loans or loan guarantees to renewable energy companies,
7. Purchase requirement – the imposition of a minimum purchase of renewable energy products on consumers or particular sectors of the economy,
8. Quasi-fiscal measures – state-owned-enterprises (SOEs) that buy and then sell renewable energy at below-market prices.

COMPONENTS OF ENERGY SUBSIDIES

There are two main components in consumer subsidies, viz:

• Pre-tax subsidy – where the retail price of renewable energy product is lower than its supply cost,
• Post-tax subsidy – where the tax on renewable energy is not at efficient levels i.e., tax on renewable energy is lower than the tax rates on other energy product types or other goods.

SO WHO BENEFITS FROM SUBSIDIES ON RENEWABLE ENERGY?

The beneficiaries of subsidies are either:

1.)   Energy consumers – consumers benefit from lower retail energy price and therefore lower personal expense,

2.)   Energy producers – generally speaking, if the retail price of renewable energy is lower than the supply cost, the renewable energy producer must necessarily be benefiting from subsidies to keep his supply on.

NEGATIVE EFFECTS OF RENEWABLE ENERGY SUBSIDIES ON THE ECONOMY, ENVIRONMENT AND SOCIETY

Following the 22nd session of the Conference of the Parties (COP 22), the 12th session of the Conference of the Parties serving as the meeting of the Parties to the Kyoto Protocol (CMP 12), and the 1st session of the Conference of the Parties serving as the meeting of the Parties to the Paris Agreement (CMA 1), held in Marrakech on November 2016, where it was clearly demonstrated that the Paris Agreement on climate change is well underway, one key question to ask is whether we can achieve the desired reduction in carbon emissions simply by manipulating existing energy subsidies globally? It is therefore worth understanding the negative effects of the financial mechanism of subsidies on the renewable energy market (The Star) (Oilprice.com) (The Economist) (Fubara, T.C).

RENEWABLE ENERGY SUBSIDIES EFFECT ON THE ECONOMY

Renewable energy subsidies have a potential to limit the growth of the sector as it can create an industry that operates with high inefficiencies and high production costs due to lack of competition. Combined with the fact that the artificially low price for renewable energy products in a subsidy regime may not be able to cover the marginal production costs engendering low profits and maybe actual losses, this will therefore hinder investment in the sector.

Also, as renewable energy subsidies affect the price and quantity of renewable energy consumed, it would result in under-pricing and over-consumption, and therefore significantly reduce competitiveness.

In addition, due to the fact that energy is a major input to several other sectors of the economy, creating artificially low prices in renewable energy via subsidies would translate to lower costs in other sectors of the economy. This would therefore lead to inefficient allocation of resources to otherwise uncompetitive capital and energy intensive renewable energy processes.

Subsidies may also depress general growth in the economy as renewable energy subsidies imply that the government would either implicitly loose revenue it was meant to obtain by efficient taxation of renewable energy, or explicitly pay-out money to producers or consumers. This deprives other sectors of the economy of funds, with many countries in the world spending more on post-tax energy subsidies than they do health and education.

Also, the complexity of the financial instruments for subsidies sometimes breeds corruption, financial round-tripping, smuggling and illegal transactions. This is due to the fact that it creates incentives for some to identify schemes to siphon monies from the government illegally (Forbes).

Finally, renewable energy subsidies can distort and exert pressure on the balance of payments in a county. This is amplified in countries that pay huge sums of subsidies to renewable energy industries where the bulk of the allied industries that support that business are all based overseas. This would imply that subsidies are more or less being used to pay overseas companies who manufacture the key equipment, thereby resulting in capital flight.

RENEWABLE ENERGY SUBSIDIES EFFECT ON THE ENVIRONMENT AND SOCIETY

Ill-thought-out renewable energy subsidy frameworks may suffocate investment in cleaner and newer renewable energy technologies, by encouraging and entrenching existing and known renewable energy systems which may contribute more to global warming and air pollution. 

It is worth stating at this juncture that irrespective of what has been said so far, renewable energy subsidies are known to positively benefit people as the lower energy prices would translate to lower prices for other goods and services. However, there is very little intra-generational equity in this benefit. This is due to the fact that those who either consume more energy or more goods and services, would benefit more than those who are poor and consume less.

CASE STUDY OF THE EFFECTS OF SUBSIDIES ON BIOGAS ADOPTION IN THE UK

Techno-economic modelling of a wide range of biogas (anaerobic digestion and gasification) potential feedstocks and plants for supply of domestic energy supply to UK households has shown that where subsidies were applied, the NPV to the companies from investing in biogas infrastructure over a 20 year lifecycle when optimized against various criteria, ranged from a profit of up to ￡7,036 to a loss of -￡7,265 per household, each with GHG savings of ￡206 per to ￡336 per household respectively (Fubara, T.C). This was propped up by government incentives ranging from ￡5,566 – ￡10,441 per household, and biogas sale revenues of ￡693 - ￡1,045 per year per household (Fubara, T.C). The subsidies and incentives, therefore, form a significant part of the income stream to the biogas plant owners. So this means that without incentives/subsidies, the deployment of biogas systems would operate at a loss of -￡910 to -￡16,775 per household (Fubara, T.C).

Figure 3:        Typical effect of subsidies and GHG savings revenue on the NPV for the overall biogas retrofit investment (Fubara, T.C).

To the contrary, where subsidies/incentives are entirely removed, the introduction of biogas becomes a truly profitable business venture with NPVs of ￡1085 to ￡2,274, depending on sensitivities applied to the price of CO2 or the CAPEX spend (Fubara, T.C).

Figure 4:        NPV for the overall biogas retrofit investment where subsidies are not applied (Fubara, T.C).

Also with subsidies, the overall centralized system energy losses amounted to 3,602 kWh as compared to 2310 kWh where no subsidy was applied, implying a 36% reduction in overall centralized system energy losses (Fubara, T.C). This implies that the use of subsidies somehow allows the selection of a less energy efficient path and, therefore, a less sustainable use of primary energy resources.

On the positive side for subsidies, comparing the energy flow scenario for the case with incentives applied and that without any incentives applied showed that applying incentives allows the development of more capacity for biogas plants, especially that of gasification. The total generation capacity of AD biogas generation plants increased by 42% where subsidies were applied as opposed to where they were not (Fubara, T.C). For gasification, there was a 99% increase in capacity with the application of incentives (Fubara, T.C). Also, the natural gas displacement potential of biogas was at 56% with incentives applied as against 13% without subsidies applied (Fubara, T.C). Therefore, subsidy and incentives do help to promote the uptake in the capacity of biogas.

Figure 5:     Energy flow charts [Top = incentives applied] [Bottom = no incentives applied] (Fubara, T.C).

REFORMING THE FINANCIAL MECHANISMS FOR RENEWABLE ENERGY

So, what is the best financial mechanism to support the development of the renewable energy sector as opposed to subsidies? The solution lies in efficient taxation of energy products. Energy products should be efficiently taxed, with corrective taxes applied to cover negative environmental externalities and other externalities, such as health effects, global warming, environmental effects, etc. In this regard, CO2 tax should be sufficiently emphasized in the overall policy and strategy. Therefore, energy tax would necessarily need to be sufficiently above tax on other goods, otherwise an energy subsidy situation is present.

When this is implemented, this increased government revenue should be spent on priority public sectors such as education and health to reduce poverty, as the attendant higher average energy prices might have a short term impact on the low-income earners. It is worth noting that any change from a subsidy-based renewable energy sector to a tax-efficient energy sector should be gradual with relevant declining-mitigation put in place to cater for those without a social safety net, and also to ensure that the particular renewable energy sector doesn't face a sudden shock confining it to an uncompetitive oblivion. Opportune times to introduce this sort of reforms are best when inflation is low and growth is high in the country, as at such times when people have higher disposable incomes, they would be more amenable to transient fluctuations in energy prices. Communication with relevant stakeholders is very important, especially those rather powerful groups and vested interests who might be benefiting from subsidies.

REFERENCE:

Fubara, T.C., Techno-economic Modelling of Sustainable Energy Future Scenarios with Natural Gas as a Transition Fuel to a Low Carbon Economy, October 2016