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Peter Dixon, Equities Economist

Keeping the lights on: the future of renewable energy

  • There has been a revolution in the European commercial power generation sector over the last decade, with renewables accounting for a significant increase in new capacity.
  • At the same time legislative changes requiring the introduction of energy-efficient home appliances have contributed to a sharp slowdown in power consumption, particularly in Germany and the UK.
  • This raises questions about the extent to which Germany’s dash to expand renewable generation capacity or the UK’s desire to build new nuclear stations are supported by demand trends.
  • Difficulties are compounded by the impact of renewables on the price structure of the wholesale electricity market.
  • This reduces the profitability of conventional generation, despite the fact that such sources are still required to ensure that base load demand can be met.

The environmental aspects

We take electricity for granted. It lights our homes; powers our gadgets, and is one of the primary industrial power sources. Many of us are transported to our offices on electric trains and this article was written on a mains-powered computer. The chances are that you are reading this article online on a similar computer, or perhaps on a device which relies on electricity for charging. Indeed, we only really notice how much electricity impacts our lives when its supply is interrupted.

Electricity was traditionally marketed a clean fuel. This is certainly true for the end user: during the course of the 20th century it supplanted coal and gas in many industrial and domestic applications, thus reducing the residue and fumes associated with the burning of carbon-based material. But it is far less true in the generation process. Around 80% of the world’s electricity is generated via the steam turbine, which requires a heat source to produce steam to generate the desired mechanical energy. Historically, this was generated by burning coal: in 1980, around 37% of global electricity derived from this source, with another 18% resulting from the burning of oil (in Europe, the proportion was slightly higher). But the burning of fossil fuels leads to significant pollution emissions (carbon dioxide, nitrous oxides and sulphur dioxide being the most troublesome). It was in response to the sharp rise in pollution, notably the potential effect on the global climate resulting from greenhouse gases, that European governments have taken the lead in reducing such emissions.

In Europe, total electricity output rose by 61% between 1980 and 2014, yet, the amount generated using coal and oil declined by almost 30%. Oil today accounts for a negligible share of the total, whilst coal is used to generate just a quarter of western European electricity (Chart 1). In Asia, by contrast, the situation is rather different with almost 60% of electricity generated using coal and 17% using renewable sources (wind and hydro) compared with more than 30% in Europe. But whereas Asian economies are engaged in a dash for growth, which requires them to generate power any way they can, Europe is at the point where it is much more concerned about the environmental impacts of power generation, and the EU is committed to reducing greenhouse gas emissions to 80% of 1990 levels by 2020, falling to 60% of this level by 2030.

Chart 1: Big changes in the mix of European electricity generation

Whilst this is ambitious, the EU is already on the way to achieving the first of these goals (Chart 2). But key issue for the next two decades will be to ensure that European governments can generate sufficient electricity to keep the lights on, whilst continuing to meet their environmental goals. Indeed, the policy choices made by some governments will act as a hindrance.

Chart 2: EU CO2 emissions are onthe decline

Assessing demand prospects

There is no clear consensus on the trend in European future electricity demand. In 2012, the German government outlined its energy policy on the basis that ‘by 2050, electricity consumption is to drop 25% compared to 2008’. The UK government, by contrast, reckoned that ‘by 2050, electricity demand is set to double, as we shift more transport and heating onto the electricity grid’. In order to look at which of these outcomes is more likely, it is illustrative to look at past trends. The arithmetic suggests that in order to double demand over a 40-year horizon requires an average increase of 1.75% per year. Over the period 1970 to 2005, UK demand did grow at an annual average rate of 1.7% per year, but it has since fallen by 14% relative to 2005 levels, which significantly lowers the long-term average growth rate. Widening the coverage to look across the EU, we see variations by country. Germany, for example, shows a similar pattern as the UK (Chart 3), as indeed does Italy. But we have seen continued strong growth in France, Spain and Poland. All in all, demand across the EU has been relatively flat over the past decade. On the basis of recent trends, we conclude that the UK estimates appear overly optimistic, although, perhaps, the German numbers are overdoing the gloom.

Chart 3: Falling electricity demand in Germany and the UK

Future demand patterns will, of course, depend on the mix of energy demand. Broadly speaking, industry currently accounts for around 40% of European electricity demand with around 30% attributable to domestic use and 26% to commercial and public services. Transport accounts for a very small proportion of the total, although this may well increase significantly, if products such as electric cars become much more widely used. In order to dig deeper into changes in the demand mix, we have looked closely at the UK figures which may allow us to make inferences about general European trends, although we are aware that it is a far from perfect proxy.

What is clear is that domestic electricity intensity has improved significantly, with UK consumption per household having declined by around 25% over the past decade. This in turn is the result of significant improvements in energy efficiency. An examination of UK household electricity usage by type of appliance points to a significant increase in consumption for the purposes of home computing and a small rise from consumer electronics. This has been more than offset by reductions in the amount consumed by lighting, due primarily to the introduction of halogen and light-saving bulbs. However, the switch from standard lighting to energy-saving products is a one-off switch, the positive impacts of which may be close to exhaustion. Extrapolating recent trends suggests that domestic consumption is likely to stabilise in the near future before beginning to trend slowly upwards. Looking across other sectors, the service industries consume a relatively small amount of electricity relative to their share of economic output, whilst the more thirsty industrial sector continues to grow relatively slow. This would appear to confirm our view that expectations of a huge surge in electricity demand in the medium-term may be overdone.

The supply response

The pace at which we expect demand to pick up matters for the generation capacity mix which will have to be put in place in the years ahead. In simple terms, if we only require a modest capacity expansion, it is rather easier to add renewable sources than if we need a bigger boost. Fossil or nuclear stations tend to be more complex and expensive to build although they are correspondingly bigger. For example, the average capacity of each of the six fossil-fuel stations opened in the UK since 2009 is 1.1 GW, whereas the average of the six largest offshore wind farms is 0.4 GW. In principle, therefore, if the thrust of policy is simply to change the mix of generation capacity it is relatively straightforward to swap fossil-fuelled capacity for some form of renewable capacity (wind, hydro or solar being the most obvious choices).

However, European governments have added various levels of complexity to the mix. The UK government, for example, has committed to closing its coal-fired power stations by 2025 in order to meet its carbon emission targets. The German government announced in 2011, following the Fukushima incident in Japan, that all nuclear stations would close by 2022. In Germany’s case, around a quarter of all electricity was generated from nuclear at the time of the announcement, whilst latest figures show that 15.8% of the UK’s electricity was generated from coal in Q1 2016 (down from 31% a year earlier).

Turning first to the problems facing Germany: it immediately closed 8 of its 17 nuclear reactors in 2011, but contrary to fears that it would suffer power blackouts, Germany avoided this fate and worked hard to bring a significant amount of renewable generation capacity online (Chart 4). Solar and wind now account for more than 45% of installed net capacity versus 30% in 2009, with the rise in these two sources massively outstripping the decline in nuclear capacity. In theory, Germany could close its nuclear power stations tomorrow and still have 17% more generation capacity than in 2011.

Chart 4: Huge rise in German renewable generation capacity

Whilst Germany has expanded its generation capacity, the UK’s declined by 11% between 2010 and 2015 with conventional steam turbines (i.e. coal) down by a whopping 40%. Just over a third of the decline in coal capacity was replaced by wind and solar. A look at the power generation statistics indicates that the UK has made up much of the shortfall from coal-fired stations by ramping up output from gas-fired plants: in Q1 2016 the share of gas rose to 38% compared with 25% a year previously (Chart 5). Whilst natural gas emits 50 to 60% less carbon dioxide than coal when burned in power generation, it does generate more methane, which is a problem because it traps more heat than CO2, although it does not linger as long in the atmosphere. Thus the UK’s change of power mix may well help it to meet its carbon emission target, but by burning more of what is still a non-renewable fossil fuel, may not do much to reduce overall greenhouse gas emissions.

Chart 5: The dash for gas may be misplaced

Economic implications of energy policy choices

With electricity demand having declined in both Germany and the UK over recent years, there are no obvious concerns that either of them is about to run into near-term capacity constraints. Even in the UK, where capacity has fallen, the maximum capacity utilisation rate over the last year only hit 72% during the winter. Admittedly, this was a 3.1% increase on the previous year, but it is sufficiently low that it would require an exceptional set of circumstances to induce power shortages. But in the longer term the UK will have to invest simply to replace ageing generation facilities, and unlike Germany, the UK wishes to expand its nuclear programme.

One of the most controversial areas in European energy policy is the UK government’s apparent desire to build a new nuclear station at Hinkley Point. The government lobbied hard to get the French company EDF to build the plant and offered an attractive guaranteed fixed selling price of electricity of GBP 92.50 per MWh (2012 prices) which will be adjusted for inflation over the 35 years of the contract. The difference between this strike price and the market price will be made up by the UK taxpayer. Earlier this year, the National Audit Office calculated that with the price of electricity having fallen to GBP 45/MWh since the deal was agreed in 2013, this would raise the cost to the taxpayer from an original estimate of GBP 6.1 billion to GBP 29.7 billion.

The cost of building the plant was so high that a state-owned Chinese firm was invited to participate in the funding which caused further ructions when new prime minister Theresa May temporarily put the deal on hold, citing security concerns, although it has now been given the go-ahead. However, the real question is not security but its economics. Although it is accepted that aging generation capacity will need to be replaced, the question is whether such a large-scale investment is required. Advocates of green technology argue that four large offshore wind farms could make up for the capacity provided by Hinkley. This may be true, but wind generation suffers from the problem of intermittency and cannot be relied upon to provide a base load. Better storage technology might help resolve this problem, but that lies some way in the future. Alternatively, improvements in demand efficiency may act to contain capacity pressure. Whilst there have been significant improvements at the consumer level, there is scope to improve industrial efficiency by shifting demand to those times when other sectors are using less power, or by turning down heating and cooling equipment. Either way, what this demonstrates is that there are alternatives to simply building more capacity in the expectation of rising demand.

Moreover, big increases in renewable generation cause significant problems for the pricing structure of the electricity supply industry. At times when output from renewables surges (e.g. because weather conditions result in lots of wind-generated energy), other forms of energy supply have to cut back to prevent the grid from overloading, with the strain falling on coal and conventional gas fired stations. The likes of nuclear and lignite-fired output are designed to run close to full capacity so the strain falls on conventional gas-fired stations. The mechanism by which this occurs is for wholesale prices to fall so much that it becomes unprofitable for these stations to continue operating. Indeed, there have been instances where German wholesale prices have turned negative (Chart 6). This is exacerbated by the fact that renewables have grid priority, meaning, that the grid must accept their power before that from conventional sources – a move designed to encourage green energy.

Chart 6: O-peak electricity price volatility has become more pronounced

This is a serious problem for utilities which have to plan capacity in order to meet the base load and threatens the economics of non-renewable power generation. It is thus little wonder that EDF was offered a substantial incentive to engage in the Hinkley Point project. We are now at the point where large segments of the European renewables sector may not need the degree of subsidisation which helped them to get off the ground in the first place. But we are also not yet at the point where renewables will be able to meet all the generation needs of the European market, suggesting that we are very much at an inflexion point.

LAST WORD

For the foreseeable future at least, traditional and renewable sources will continue to coexist. However, looking at the problem in a global context, it is clear that the surge in carbon emissions is being driven by non-European markets and so long as the global subsidy bill for fossil fuels continues to run at more than three times that for renewables, the sector will continue to struggle to make headway. Europe has clearly made great strides to reduce its pollution emissions, but we should not cheer too loudly until the rest of the world follows suit.

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