Integrating energy and climate change policy

Australia has found it challenging to integrate energy and climate change policy for the past two decades. This is despite the Climate Change Authority (CCA) stating that the science is clear: Australia’s contribution to global greenhouse gas emission reduction efforts requires a ‘carbon budget’ of no more than 10 Gt of emissions between 2015 and 2050. Such a budget implies emission reductions of around 50 per cent of 2005 levels by 2030, assuming a linear trajectory between now and 2050. 

A range of policies have been introduced and, in some cases, abandoned. These have included carbon taxes, emissions trading schemes and the use of renewable energy production subsidies. All of these policies have explicitly, or implicitly, sought to internalise the externality of emitting greenhouse gases.

Economists largely agree that the optimal climate change policy would involve some form of pricing of greenhouse gas emissions – through a carbon tax or emissions trading scheme that prices the negative production externality of emitting greenhouse gases.

However, experience in Australia suggests that a broad-based emissions trading scheme or carbon tax is politically challenging. In the electricity sector, the preferred approach has tended to be various forms of ‘production subsidies’, such as the Small-Scale Renewable Energy Target (SRES), the Large-Scale Renewable Energy Target (LRET), the Queensland Renewable Energy Target (QRET) and the Victorian Renewable Energy Target (VRET). 

What are the limitations of production subsidies?

Production subsidies are relatively easy to understand. Every unit of energy generated from a new renewable project receives a subsidy. But in electricity markets, using production subsidies for variable renewable energy creates a key problem: subsidies create an incentive to produce electricity all the time, irrespective of whether the electricity system actually needs more energy at the time the electricity is being generated. This is because the subsidy is paid irrespective of the value of the generation to the electricity market. 

In practice, this has led to an accentuated ‘boom-bust’ scenario of electricity prices. As the generator receives a subsidy for producing a unit of energy at any time of the day, they can generate to the point where prices in the wholesale electricity market decline to the negative value of the subsidy. 

Consequently, many other generators have been decommissioned as they have become uneconomic. This has resulted in prices being very low at certain times (i.e. the middle of the day when it is sunny) and very high at other times (i.e. the evening demand peak). This phenomenon is accentuated by the fact that, to date, it has been too expensive for renewable energy generators to store their electricity for sufficiently long time periods.

This phenomenon has two main impacts. Firstly, variable renewable energy technologies suffer from the ‘coincident production problem’. As a result of only producing when fuel is immediately available and not stored (i.e. the sun is shining and the wind is blowing), there is often an ‘oversupply’ of energy from these coincidentally producing technologies. They effectively cannibalise their own revenue streams from the wholesale electricity market. 

And secondly, due to the existence of subsidies, there is limited incentive for these technologies to enter into ‘firm’ financial derivative contracts. The availability of these contracts is critical for allowing participants to manage price risk in the wholesale electricity market. 

Overcoming these production subsidy limitations

But the good news is that there may be a way of overcoming the limitations of production subsidies. Two relatively simple adjustments could be made to renewable energy production subsidies that would correct for the unintended consequences noted above. Firstly, the quantity of the subsidy could be tied to wholesale electricity prices or emissions in the electricity market. Secondly, new generators could be made to demonstrate that they are facilitating the supply of firm financial derivative contracts in order to receive production subsidies – this would be a key element in achieving the Retailer Reliability Obligation (RRO) introduced by the Energy Security Board (ESB).

Let’s take the example of a new wind farm. The quantity of subsidy ‘certificates’ it would receive under this type of approach would be tied to the wholesale price or emissions intensity at the time it generates energy. It would receive more certificates if it generates when prices or emissions are high than if they are low.^[1]However, it would be ineligible to receive any certificates if it could not demonstrate to the regulator that it is facilitating supply of firm derivative contracts that allow participants in the market (i.e. retailers acting on behalf of electricity customers) to manage their wholesale price risk.

Conclusion

While arguments can be made that the optimal greenhouse mitigation policy is a form of carbon pricing, policy makers in Australia are instead focused on renewable energy production subsidies such as the Small-Scale Renewable Energy Target (SRES), the Large-Scale Renewable Energy Target (LRET), the Queensland Renewable Energy Target (QRET) and the Victorian Renewable Energy Target (VRET). As such, it is important to design these schemes to maximise benefits and minimise costs. By making the two adjustments suggested in this article, policy makers would be able to minimise unintended consequences and provide a practical integration of energy and climate change policy. 

*This article is based upon a paper currently under peer review in an academic journal, authored by Tim Nelson, Alan Rai and Ryan Esplin 

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