A balanced mix of policies to achieve decarbonisation

A post by Pippo Ranci (FSR Energy and Università Cattolica of Milan)

The economics of renewable energy sources, as well as of investments in energy efficiency, is influenced by the price of energy from fossil sources. The 2015 Paris agreement came after 7 years of high oil price, between 80 and 120 dollars per barrel, and this circumstance favoured substitution with renewables. Since then, the crude oil price fluctuated around a much lower level of $60/barrel, but in the same period the generation cost of solar electricity halved, providing a powerful support to substitution decisions. In 2020, the Covid-19 shock further depressed the oil price which, after an initial tumble, oscillates around $40/barrel. This has been feeding concern about investment in renewables. While the costs of solar PV and wind generation are still falling, a diffusion of renewables is still in the forecast scenarios for the next decades and the policy targets announced by the European Commission include an impressive increase in capacity of renewable electricity generation.

The option of relying on market prices alone and discontinuing support schemes is not accepted and not acceptable since the goal of keeping world temperature below 1.5 C° has been set. The issue is not whether a positive trend of renewables will survive the oil price decline, but whether substitution will be fast enough. Moreover, since renewable sources are mainly intermittent, as their share increases, costs for adapting the transport and interconnection networks and for providing enough storage capacity increase steeply, offsetting the effect of decreasing generation costs. Support schemes then remain necessary.

Here we come at a crossroads: general – horizontal measures versus targeted instruments.

The most general among general measures belong in the carbon pricing family, including carbon taxes and cap-and-trade systems such as the EU ETS. These largely rely on market mechanisms, sending a message to economic operators all around. They offer the great, although often neglected, advantage of achieving decarbonization at minimum cost, leaving the task and the risk of inventing and selecting ways to market operators.

Subsidies to generation from renewables and renewable portfolio standards lay in the middle, since they target specific energy sources but not specific uses. More specific targeting is when regulations, with or without subsidies, refer to energy uses by one industry, such as building or transport.

Proceeding into the area of industrial policies, we find public programs targeted to industry-specific results.

A clear example is batteries. Here is a small and well-defined product whose impact on the whole energy system may be huge. Once high-capacity batteries are developed and industrialized to become easily available, low-cost tools, the whole energy system may develop along a new trajectory, with benefits in terms of decarbonization and security. Hence, an active role of, and financial support by, government looks justified.

In other cases, like steel from furnaces where energy is supplied by hydrogen or by electricity, the benefit is large in the production process, but the end product does not change. Such innovations should be sufficiently supported by the general discipline, including a carbon price implemented via the ETS accompanied by a border adjustment, without need for direct public involvement.

Betting public money on a specific technology implies assuming significant risk, in front of the social benefits expected: the chosen technology may finally prove inferior to a different technology which unexpectedly springs out of a competing company elsewhere in the world.

This weakness notwithstanding, targeted industrial policies look far more attractive than horizontal measures to the public and to political actors. They evoke something concrete, that can be imagined, while a horizontal tool does not. Moreover, an auctioned emission allowance or a carbon a tax represents a cost to business and it may be seen as a burden on the economy rather than a booster. Any beneficial impact, although real, is indirect and not immediately evident. For a politician, it is awkward to support a carbon tax or the ETS.

We may additionally consider that Member State governments are inclined to set up their own targeted industrial policies, reap the popularity benefits connected, and resist possible criticism by the European Commission based on competition rules. The ETS, on the contrary, is a European creature managed by the Commission, granting no popularity to a compliant Member State government.

Summing up, carbon pricing policies are likely to lack sufficient support. The risk is that, due to insufficient support, they may be too weak to deliver significant results, so that accusations of irrelevance will be confirmed. Such a development must be avoided, through forward-looking attitudes at all levels.

It is good news that, in front of the Covid-19 shock, the ETS system has proved to be solid, thanks to the improvements introduced in the working of the Market Stability Reserve, and the price of allowances has remained stable. It is true that the system aims at reducing emissions and the price of allowances is not an end in itself, yet it is the only signal that everybody can observe every day and it is important that it be kept on a steady upward path from now on if we want the expected large reduction in emissions by 2030 (minus 55%) to be achieved.

Selected policies targeted to specific goals, such as creation of a really European smart grid system, complemented by an adequate energy (electricity and gas) storage apparatus, are crucial. They deserve a strong and coordinated effort. This effort has to be complemented by a specific strategy aimed at building a competitive European batteries industry.

Other targeted industrial policies may be highly desirable, under condition that their prospective likely benefits exceed their costs and be accurately checked for reliability.

Based on these criteria, a well-balanced mix of policies can be adopted in a combined European and national strategy. 

The views and opinions expressed in this post are solely those of the author(s) and do not reflect those of the editors of the blog of the project LIFE DICET.