Policy and financial innovation as important as new technologies in the energy transition

Energy policy is frequently described in terms of the “trilemma”: decarbonisation, security of supply and affordability. Delivering this three-pointed objective requires a three-pointed approach: technological, policy and financial innovation. None of these in isolation can deliver the energy policy objectives.

Technological innovation delivers new possibilities for the energy system

The impact of technological innovation is obvious. Innovation in renewable technology is clear, as costs continue to fall, particularly in solar PV, and other new technologies such as storage and demand-side response are emerging to counter the challenges posed by a more intermittent energy system.

Longer-term, further innovation on both sides of the supply-demand equation is anticipated, with new types of generation (tidal, small-nuclear, synthetic photosynthesis etc) being complemented by further demand-side developments (building-integrated PV, thermal storage, consumer load switching etc).

However there is a risk that this innovation is wasted, if market structures are not adapted to accommodate them. Innovators risk running out of capital if their routes to market are blocked by an inflexible regulatory framework that serves an out-dated market model. Stephen Haw from Baringa was quoted in Utility Week saying:

“We face a risk of ‘redundant innovation’, where the money and time invested in developing new technologies could go to waste as products and services fail to reach the masses”

Policy innovation is essential to support the energy transition

It is also clear that in a subsidy-heavy market characterised by a highly complex web of regulation and overlapping obligations, root-and-branch policy reform is a fundamental requirement. Policymakers should seek to rationalise the entire energy market framework to make it fit for purpose, with a new set of policy objectives including honest consumer engagement and removal of barriers to entry in addition to the traditional trilemma objectives.

The need for improved consumer engagement is vital if the future energy system is to be delivered at the lowest reasonable cost. Consumers are disengaged by highly complex tariff structures, frequent issues with inaccurate billing, unhelpful political rhetoric in relation to “greedy suppliers” which erodes trust, and energy policies which obscure the true costs of a low carbon energy system while pacing increasing financial burdens on consumers.

A reformed energy policy should seek to achieve the following:

• An energy and balancing market where the costs of delivering electricity in each period are fully reflected in prices. This will increase transparency and provide investment signals both for new generation and demand-side services, both directly through appropriate returns, and indirectly by incentivising the use of long-term contracts which provide risk management for users and revenue security for investors.
• Creation of an independent system operator tasked with ensuring electricity can be delivered to all consumers in all delivery periods. The ISO should be separate from the owner of either transmission or distribution networks and deliver its objectives neutrally, accessing all available solutions without bias. The ISO would develop a set of grid management and stabilisation services it would procure form the market in open and transparent tenders.

• Reform and simplification of industry codes to:
  • reflect the new shape of the market, providing clear and specific rules relating to storage and DSR, and with the flexibility to be easily updated as new technologies or services enter the market.
  • remove overlapping or conflicting obligations and to provide a clear governance framework that is accessible to new entrants. This may be facilitated by the creation of an Office for Energy Markets whose job would be to co-ordinate between different regulators and government bodies to deliver a one-stop-shop for market participants where all information on licence requirements and other obligations may be found.
• A streamlined subsidy regime with a clear set of goals, removing as far as possible market distorting actions. Is a post-Brexit world, the government should be more direct in providing subsidies to specific segments if this is necessary to stimulate investment in technologies that deliver decarbonisation and/or defend security of supply. Rules should be carefully crafted to avoid unintended consequences, and designed to directly deliver the desired outcome – for example if the government believes more CCGTs are needed, it should provide a subsidy to CCGTs based on some criteria, rather than changing other market rules in the hope CCGTs will then be built. Subsidies should be recovered through general taxation rather than consumer bills, as the creation of a secure, low carbon energy system has wide social benefits.
  
• Reform of network pricing mechanisms to ensure that the costs of transmitting electricity and maintaining system integrity are fairly met be energy users. This includes fairly pricing the option value of a grid connection recognising that embedded and behind-the-meter generation and storage almost never eliminates the need to use electricity infrastructure, and that pricing only based on usage unfairly imposes additional costs on other users of the system.
  
• A comprehensive programme of consumer engagement to increase understanding of energy policy and its impact on bills, and to educate consumers about the benefits of energy efficiency (including “boring but important” measures such as insulation), demand management, domestic storage and other schemes by which consumers can actively participate in the energy transition. Where government objectives seek to change consumer behaviour, clear incentives should be developed and communicated to consumers to increase take-up.
• Promoting financial innovation and development of sustainable business models in the energy transition. This means ensuring entry costs are minimised (for example reforming collateral requirements), and ensuring revenue models are robust through proper price formation in energy and balancing markets and in the markets for ancillary services. Financial innovation should be used to incentivise investors, through properly structured tax regimes to widen and deepen the investor pool.

This paper from the University  of Leeds discusses the emergence of new, complex, business models in the energy transition and the need for policy reform to accommodate them. It goes on to conclude:

“Attention to complex value business models and their barriers to adoption has the potential to fundamentally reconfigure energy systems and contribute substantively to sustainable energy futures.”

Financial innovation can support policy objectives

While much is said about technological innovation and policy reform, there is relatively less focus on financial innovation. The electricity market is characterised by under-investment, at a time when yields across traditional investment classes are low meaning available capital in the pensions and insurance sector is high. Recent research has shown a growing interest in the energy sector by pension funds.

Financial innovation should seek to close the gaps between the requirements of investors with available liquidity, and projects requiring capital. This gap is generally rooted in mismatched risk profiles where new investments, particularly in markets where long-term, fixed price contracts have become rare leading to high levels of risk that does not match the risk appetite of many investors, as described in this blog post by Timera Energy.

DECC has estimated that £100 billion of energy investments are needed in UK energy infrastructure by 2020. A 2016 report by the House of Commons Energy and Climate Change Committee found that investor confidence had been damaged by a combination of sudden and numerous often contradictory policy announcements, lack of decision-making transparency and lack of a long-term vision. The Committee also found:

“…there is no shortage of money available for projects that have advanced to the late construction or operation phase. Institutional investors in particular favour these kinds of investments. However, the problem occurs earlier in the project pipeline where there is some anecdotal evidence of a pause in investment in the supply chain and development of new projects. If investment in these activities has indeed dried up, it may not become apparent until the end of the decade.”

Various innovative approaches have been developed by the finance industry to narrow this gap, including project bonds, green bonds, securitisation and “yield-co” structures. This process can be supported by the government through de-risking strategies for new energy projects. A number of alternatives are available:

• Favourable tax regimes can be created for classes of projects the government wishes to incentivise;
• Long-term contracts for ancillary services should be more widely available;
• Proper price formation in energy and balancing markets should increase volatility and promote greater use of long-term, fixed-price contracts;
• Targeted and stable subsidy arrangements can support investment in specific areas;
• The Green Investment Bank or similar government backed body could issue bonds backed by portfolios of projects, diversifying the project risk for investors and delivering capital to the projects;
• Supporting the development of liquid wholesale markets for energy trading, where market participants can access hedging and risk management solutions, and ensuring the regulation of these markets does not inhibit legitimate trading activity.

This last point is important, as the direction of travel of financial market regulation in recent years has reduced liquidity in energy markets as banks have largely exited energy trading activities. As part of any review of energy policy, the government should consider how financial as well as physical trading of energy can benefit the energy system, and remove barriers that inhibit this activity.

A three-pronged approach needed to solve the trilemma

The energy transition risks stalling due to the muddle of subsidies and mis-matched incentives. This is aggravated by overly complex market rules and a framework that has not adapted to the advent of entirely new technologies on the system.

To ensure that technological innovation is not wasted, a wholescale review of energy policy is needed, along with creation of appropriate financial incentives to attract the necessary investment. Consumer engagement should be radically improved, in order to the deliver demand reduction and load shifting that will support a secure, affordable, low carbon energy system.