Energy Transition

Carbon prices play tiny part in cutting renewable energy costs

carbon pricing and energy transition
Cheaper than ever. Source: DPA

Solar costs have fallen 90 percent in the past 10 years. In 2004, German households installing rooftop solar energy systems received a guaranteed price of €0.57 ($0.68) per kilowatt hour (kWh) generated. In Mexico last week, a large-scale energy auction was won at a bid price of $0.0177 per kWh. Improvements in photovoltaic technology make further reductions inevitable: Within five years, we will see prices of $0.01 per kWh in favorable locations.

This stunning achievement has been driven by huge private-sector investment and cutting-edge innovation, but it would never have occurred without strong public policy support. Publicly sponsored research ensured basic scientific breakthroughs, and large initial subsidies in Germany and other countries enabled the industry to achieve critical scale. Solar now costs less than coal in many countries.

All economists who accept the scientific reality of climate change support policy interventions to address “externalities” — costs that polluters impose on others but do not pay. But many free-market economists are inherently suspicious of direct support for specific investments, instead harking after the pure and simple market solution — a carbon price set either by taxation or by competition for permits within an emissions trading scheme. Carbon pricing, it is said, avoids the dangers of picking winners, unleashes a market-driven search for the best technological answer and ensures least-cost emissions reduction.

But explicit carbon prices played almost no role in driving down the cost of solar power or in achieving a similarly dramatic decline in the cost of wind power and batteries. In the real world, direct investment support can sometimes be more effective than theoretically appealing carbon prices.

Low-carbon renewable or nuclear energy entails very high upfront capital investments but near-zero marginal operating costs. As a result, its economics are strongly influenced by the cost of capital (the required rate of return), which reflects assessments of risk. Direct support for initial deployment — with guaranteed prices for electricity delivered — reduces risk and thus lowers required returns.

Carbon pricing alone, by contrast, does not. With carbon prices as the sole policy instrument, risk assessments of renewables investments would reflect highly uncertain forecasts of fossil fuel and marginal electricity prices far into the future. As a result, the cost of capital would be higher, and the pace of deployment and cost reduction far slower.

There is no feasible pathway to low-carbon prosperity without rapid decarbonization of electricity, followed by electrification of as much of the economy as possible.

Fixed-price contracts for certain delivery are a more effective policy to stimulate renewables investment than carbon prices. Auctions for such contracts should remain a key feature of renewables markets, even now that the prices set at auctions often undercut the likely future cost of fossil-fuel-based power generation.

Straightforward regulation is also sometimes more effective than price-based instruments. The plummeting cost of LED light bulbs – down more than 90 percent in the past decade – reflects the effect of public procurement policies and outright bans on inefficient incandescent bulbs.

In economic theory, household light bulb purchases reflect the net present value calculations of lifetime bulb and electricity costs for alternative bulb types, which could be influenced by taxes on incandescent bulbs, or through carbon prices on electricity. But normal human beings, unlike economists, do not make such calculations. In the real world, direct regulation can drive technological investment and reduce costs better than price can.

As for the dangers of failing to pick winners, we need to distinguish between what is uncertain and what is clear. True, we cannot know the precise mix of technologies and investments that will deliver a low-carbon economy at lowest cost. But we do know that there is no feasible pathway to low-carbon prosperity without rapid decarbonization of electricity, followed by electrification of as much of the economy as possible. Policies that directly support low-carbon electricity generation are therefore clearly justified. So, too, is public research expenditure to support further progress in battery technology. That said, carbon prices still have a vital role to play, and their importance will likely increase over time. In power generation, the objective is clear – lower carbon per kilowatt generated – and some mix of a relatively small number of known technologies will solve the problem.

But in steel, cement and plastics production, the routes to decarbonization are less clear, may differ between locations and may involve complex combinations of different techniques. A significant and rising carbon price is therefore essential to unleash a market-driven search for optimal solutions.

The same technological progress that is driving rapid reduction in the cost of renewables is also enabling dramatic declines in fossil-fuel production costs, particularly in the shale industry. In a world where energy prices may decline across the board, a significant carbon price is essential to ensure that the feasible path to a low-cost, low-carbon future is not impeded by falling fossil-fuel prices. Higher prices for carbon-based energy would also usefully strengthen incentives for energy efficiency, reducing the danger of rebound effects, whereby falling energy costs increase energy consumption.

Copyright: Project Syndicate, 2017.

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