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Tuesday, June 28, 2022

Broader system challenges for net-zero energy transition

Evan Ng discusses the various factors affecting the commitment to meet Paris Agreement’s targets of net-zero emissions by 2050

Reaching net zero emissions by 2050 is necessary to meet the Paris Agreement’s targets, so that catastrophic climate disasters can be avoided. This means that the energy system must be decarbonised deeply – fossil fuels which represent 81.2% of the current global energy consumption need to be gradually substituted with cleaner energy vectors as much as possible, while technologies like carbon capture, utilisation and storage will be required to offset emissions associated with the remaining usage of carbon-intensive fuels.

Electrification will be the critical enabler for a net zero energy transition. Technologies like heat pumps and electric vehicles are already available in the market, yet their potential in decarbonizing the building and transport sectors have not been fully realised. Concurrently, continued digitalization of economic activities with robotics and advanced manufacturing methods could reduce industrial processes’ reliance on fossil fuel. Many difficult-to-electrify sectors like aviation, heavy vehicles, and high temperature industrial processes can also transition into using low-carbon processes supported by hydrogen, which can be produced using renewable energy through electrolysis.

To support these demand-side changes for achieving a low carbon future, increasing penetration of renewables in power systems is crucial. However, despite the availability of technologies and abundance of resources, the net zero ambition remains far from realisation – this shows that technical restructuring is likely not the main obstacle hindering energy transitions. Instead, the progression towards a renewables-dominant world is limited by various economic, financial, and market factors across different stages of the energy transition.

Challenge 1: Energy Market Distortions

Despite the falling costs of renewables and energy storage technologies over the past decade, the low-carbon transition is still occurring slower than what is required to mitigate climate change. One key challenge hindering the net zero transition lies in the sustained distortions of energy markets – the economically illogical action of subsidising fossil fuel consumptions in many countries prevents renewables from competing with carbon-intensive incumbents on a level playing field. To put the scale of these subsidies into perspective, post-tax fossil fuel subsidies amounted to US$5.3 trillion in 2015, approximately 17 times the global renewable energy investment in that year.

Not only are persistent fossil fuel subsidies a significant opportunity cost to national budgets, thereby reducing available financial resources to invest in low-carbon energy technologies, but they also manifest substantial economic inefficiencies and encourage excessive energy usage. In fact, an analysis on 50 energy-producing economies found that their fossil fuel consumption almost increases linearly with the amount of subsidy that the government provides. This suggests that legacy fossil fuel subsidies have created social and infrastructural lock-ins in these economies, leading to persisting energy-intensive, inefficient practises. Consequently, this cements inertia in transitioning away from fossil fuels. Reforming fossil fuel subsidies is urgently necessary, as subsidies distort market signals to inform future technology choices, potentially risking additional carbon lock-in which negatively impacts progress towards a net zero energy system.

Besides regulatory distortion, the current energy market also features notable social distortion – the negative environmental and social externalities associated with fossil fuel consumptions are not sufficiently considered. To minimise the inefficiencies from such externalities, emissions must be priced appropriately. Nevertheless, only 16% of global annual emissions are currently covered by carbon pricing arrangements, like carbon taxes or emissions trading schemes. Emissions must be priced appropriately to correct distorted markets, enabling appropriate price signals to guide long-term planning and investment decisions towards achieving the net zero ambitions.

In the power sector where energy generation infrastructures typically have a long lifespans of at least 25 to 30 years, achieving Paris Agreement’s target for net zero by 2050 means that no new fossil fuel power plants should be built from now on. However, without internalising pollution costs to provide clear price signals reflecting Paris’ commitments, an investor who focuses solely on monetary cost will naturally prioritise cheaper fossil fuel incumbents, exacerbating costly stranded asset problems as energy systems progress towards net zero. To put the magnitude of this cost impact into perspective, premature retirement of current fossil fuel power plants to achieve net zero by 2050 will cost Latin America and the Caribbean at least US$37 – 90 billion. Therefore, if the distorted market continues allowing carbon-intensive energy infrastructure to be constructed, greater costs would be required to meet Paris’ targets – exacerbating stakeholders’ resistance towards a net zero transition.

However, both fossil fuel subsidy removal and carbon pricing may burden consumers with rising fossil fuel prices, potentially leading to socioeconomic challenges that affect political stability if mishandled. For instance, a study on the association between fuel subsidies and fuel riots worldwide found that 41 countries had at least one riot related to fuel price increases between 2005 – 2018 . This is because fuel subsidy often entails an invisible social contract upon which a government’s legitimacy is partly dependent on, which may explain why politicians are typically reluctant to remove subsidies despite understanding their inefficiencies. Nevertheless, socioeconomic systems are not stagnant but dynamic. The presence of pro-climate silent majorities in many societies manifest a potential sensitive intervention point. A few “radical” social movements towards energy sustainability can trigger political mobilisation, allowing for accelerated transitions away from existing overreliance on underpriced fossil fuels.

To enable a smooth transition, correcting market distortions via increasing fossil fuel prices can be coupled with artificial price reductions of low-carbon technologies, minimising the risk of social unrest caused by sudden surges in living expenses. As such, carbon tax revenues and savings achieved from fossil fuel subsidy removals can be recycled to subsidise renewable energy deployment, bridging existing financial gaps.

Moreover, earmarking carbon and subsidy reform revenues for specific purposes, like renewable energy investments, exhibits greater transparency and would generally be more socially acceptable than incorporating them into general government budgets. Nevertheless, the effectiveness of this approach is contingent on consumers’ trust towards their governments – in areas with high political distrust, a lump-sum targeted cash transfer to politically important groups, such as fossil fuel industry workers impacted by energy transitions, would likely ensure greater success. Policymakers can then introduce parallel policies to support these targeted consumers in reinvesting revenues towards low-carbon technologies.

Although investing in renewables is often less economical than non-renewable incumbents now, it should be noted that operating a fossil fuel power plant might not be the economically optimal option in the long-run, given that extraction costs of fossil fuels would likely increase as easy-to-extract reserves are exhausted. Conversely, the cost of renewables generally reduces with increasing deployment as they tend to exhibit strong learning-by-doing effects. As such, policymakers can accelerate net zero energy transitions by taking advantage of sensitive intervention points – providing subsidies to support renewables deployment can kick-start a self-reinforcing feedback loop capable of further cost reductions. This subsequently enables renewables to become cost competitive relative to incumbents in the medium-to-long term, even when renewable subsidies are absent.

Challenge 2: Meeting Increasing Energy Demand in The Global South with Renewables 

Striving for the net zero energy target means that increases in demand should predominantly be met by renewable energy expansion, which can often be rapidly deployed to meet the growing demand. This is especially relevant to the Global South where around 789 million people still do not have access to electricity – the region’s energy demand is expected to increase as energy becomes more accessible given improved living standards coupled with growing population. Nevertheless, a research projected that Africa’s share of modern renewables in the energy mix will still likely be below 10% in 2030 despite the anticipated doubling of power generation capacity, due to the abundant planned large-scale fossil fuel infrastructure in the pipeline. To achieve net zero by 2050, most planned and operating fossil-based power plants should be retired before the end of their expected lifespan with rapidly increasing renewable capacity substituting their role in power generation.

The lack of planned renewables deployment can be attributed to different investment profiles of renewables and fossil fuel facilities – although renewables feature a lower recurring cost relative to fossil-based power plants due to lack of fuel requirements, they are also generally more capital-intensive to set up. Currently, most generation plants in Africa are constructed by governments who have limited financial resources to balance multiple priorities for sustainable development. Although the capital required for energy infrastructure can be borrowed from external parties, these loans generally come at high costs, leading to these governments naturally leaning towards investing in fossil-based systems which provide immediate energy needs with minimal capital expenditure.

While public funds like sovereign and multilateral lenders have recently been playing an increasing role to support renewable investment in the Global South, they will still likely be insufficient in meeting the colossal scale of investment required to fully decarbonize the developing world. As such, private investments from the international community would be critical to bridge this financial gap, ensuring developing countries’ long-term energy planning aligns with net zero targets, while taking full advantage of renewable resources in the region that have been historically underutilised.

However, despite featuring a large pool of untapped renewable resources, investing in developing countries can present a severe risk for investors. As private investment decisions are usually based on the perceived risk-return profile, associated investment risks must be lowered to attract sufficient private funding. To that end, research has concluded that providing guarantees is one of the most effective ways to reduce investors’ perceived risk regarding renewable projects. Thus, these countries can collectively adapt international risk guarantee mechanisms, like the Renewable Energy Cost Reduction Facility proposed in the European Union to reduce the risk for private investors, and thus, accelerate much-needed renewable investments.

To this end, relevant developing countries could pool their public financial resources to create a multilateral guarantee mechanism providing private investors with remuneration if a covered risk materialises. In exchange, private investors would be responsible for paying a small fee sustaining the operational cost of this guarantee mechanism. A study on implementing similar multilateral guarantee mechanisms on a global scale found that, not only do these risk-pooling mechanisms reduce the financial risk of any single participating country, but they can also avoid direct conflicts between stakeholders and minimise market frictions. Moreover, since guarantee mechanisms have already been used as part of developing countries’ climate financing, execution of the proposed solution can be relatively easy assuming stakeholders have existing familiarity with these mechanisms. As such, not only does this mitigate the risk currently hindering the flow of private investments required to support renewables deployment imminently necessary to meet increased energy demand, but it can also trigger a positive feedback loop: as financiers become more experienced, capital expenditure in renewables deployment decreases, subsequently attracting more investments to encourage net zero energy transitions in the developing world.

Challenge 3: Inadequacy of Existing Liberalised Electricity Market

While earlier solutions can increase the share of renewables in the energy mix, existing liberalised market architectures in the developed world will need restructuring to avoid the Renewable Energy Policy Paradox, where the wholesale price of electricity fall to an uneconomical level with greater penetration of renewables that has an almost zero short-run marginal cost. Currently, most liberalised electricity spot markets operate under a merit order arrangement where the cheapest marginal generations are prioritised to meet a given demand. The highest cost generators set the clearing price, while more expensive generators are not dispatched.

As such, most of the current energy-only markets function under two assumptions namely, energy generators are dispatchable and span a range of positive short-run marginal costs. Both assumptions are inadequate in high renewable penetration systems considering renewables are intermittent and have negligible short-run marginal cost. As such, energy generated from fossil-based facilities is crucial in providing a floor for electricity prices, without them, renewable facilities will not obtain sufficient returns to finance their operations. This means that it is economically impossible to have a 100% renewable power system under existing market architectures.

Currently, renewables are prioritised for dispatch under existing market designs as they have the lowest short-run marginal costs. Thus, increasing penetration of zero short-run marginal cost renewables can cause electricity prices to become more volatile and depressed – disincentivizing investment on new renewable generations. As such, the dwindling revenues stemming from diminishing wholesale electricity prices will warrant increasing levels of governmental support to facilitate further investments into renewable generation.

These effects can be seen in the Italian electricity market. Between 2005 – 2013, every GWh average hourly increase in solar and wind energy generation decreased the wholesale electricity prices by €2.3/MWh and €4.2/MWh, respectively, leading to increased electricity price volatility. Furthermore, a recent study of the Italian energy market also found that increasing renewable penetration will decrease electricity prices from 50 €/MWh in 2015 to 20 €/MWh in 2040 – making it economically unfeasible to deploy more renewables to achieve the government’s 55% renewable penetration target by 2035. Therefore, existing market architecture needs to be fundamentally redesigned to avoid this challenge.

Since the future cost of a renewable-dominant system will mostly be based on capital expenditure rather than operating cost, it may be more appropriate for the market to operate under kW-basis capacity pricing than current energy-only market pricing – allowing for better guarantee on capital cost recovery. On the other hand, current revenue support, like Feed-in-Tariff for renewable supply, can be replaced with capital support at the time of investment, reducing the barrier to entry in the renewables market and encouraging greater investments. On the demand side, a flat-rate tariff, like the Spanish system where consumers are charged based on their subscription to a maximum capacity access, can be utilised as a complementary solution. Therefore, this proposed solution can generate continuous revenue to sustain the operation of renewable generation and storage facilities, avoiding the Renewable Energy Policy Paradox as the energy system progresses towards net zero.

Interestingly, this solution can also support tackling other common challenges that the existing liberalised electricity market faces as more renewables integrate into the system. Under the current energy-only market, there will be insufficient financial return to incentivize the operation of expensive peaking plants which only run for a minimum timeframe during peak demand. Therefore, capacity pricing would allow these peaking plants to be adequately financed with a fixed return based on their commitment to provide a predetermined capacity during times of high demand, effectively addressing the energy security challenge that a power system with high renewable penetration might face.

In conclusion, economic, financial, and market challenges must be resolved to enable rapid, widespread deployments of net zero energy technologies. Removing fossil fuel subsidies and implementing a carbon tax can correct the distorted market and allow renewables to compete with fossil-based power plants on a level playing field. Sensitive intervention points should be enacted to shift the existing socio economic regime; this could reduce anticipated social resistance to increased fossil fuel prices. The financing challenge of expanding renewable capacity to meet increasing demand in the developing world can be addressed by setting up a multilateral guarantee mechanism to attract private investments, allowing rapid deployment of renewables while minimising risks on any single participating country. Lastly, fundamentally redesigning the market architecture to an alternative based on capacity pricing can be an effective solution to mitigate the current market structure challenges.

Image Credit: Jason Blackeye on Unsplash

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