Discussion Paper

No. 2018-29 | March 23, 2018
Policies for decarbonizing a liberalized power sector

Abstract

Given the agreed urgency of decarbonizing electricity and the need to guide decentralized private decisions, an adequate and credible carbon price appears essential. The paper models and quantifies the useful concept of the break-even carbon price for mature zero-carbon electricity investments. It appears an attractive alternative given the difficulty of measuring the social cost of carbon, but modelling shows it extremely sensitive to projected fuel prices, the rate of interest, and the capital cost of generation options, all of which are very uncertain. This has important implications, and justifies combining a carbon price floor with suitable long-term contracts for electricity investments.

Data Set

JEL Classification:

C65, Q42, Q48, Q51, Q54

Assessment

  • Downloads: 299

Links

Cite As

David Newbery (2018). Policies for decarbonizing a liberalized power sector. Economics Discussion Papers, No 2018-29, Kiel Institute for the World Economy. http://www.economics-ejournal.org/economics/discussionpapers/2018-29


Comments and Questions


Richard John Green, Imperial College Business School, London - Referee report 1
March 29, 2018 - 09:18

see attached file


David Newbery - respones to R Green
May 22, 2018 - 15:29

I am indebted to Richard Green for his thoughtful comments and useful suggestions. Let me take them in order:
“It would have been helpful to have given the carbon price needed to make wind power competitive with gas stations under the central case …”
Figure 2 shows this quite clearly. ...[more]

... This if one takes the central gas price in the short run as £15/MWhth, (the May 2018 NBP price was 56p/therm or £19/MWhth, closer to the high gas price in figure 1) then the breakeven carbon price ranges from £80/tCO2 to £230, depending on the interest rate and the costs of CCGTs and wind.
“The paper states that the value of e/γ (efficiency divided by carbon intensity of the fuel) will fall over time as peaking plant is installed instead of baseload stations (page 11). I agree that the capacity mix should change towards a higher proportion of peaking plant, but don’t think this would lead to a gradual change in e; instead, we’d get one value for new baseload CCGTs and one for new peakers, and their equilibrium running hours should be such as to give them both zero profits.”
This is correct in equilibrium, although a full analysis would need to take account of the technical characteristics (start-up costs, minimum load, ramp rate) and the variety of ancillary services that each technology can offer. New build can be made more flexible with shorter start-up times to offer better ramping and primary reserves, as well as better frequency response, but older plant may remain on the system for a considerable time. The economics of wind will depend on both the carbon price, the fuel prices, and which plant is displaced when the wind is most likely to blow; a calculation that takes us beyond the back-of-the envelope levelised costs adjusted for displacement factors.
“having assured capacity payments ensures low risks and financing dominated by debt (page 20), but not during the construction phase of nuclear plants.”
Exactly how to finance nuclear power plants in the light of the Hinkley Point C financial debacle remains a vexed issue. If we could be sure of the correct design (and there are compelling arguments that the EPWR may not be that), then a cost-sharing procurement contract may be the cheapest way to deliver construction. The offtake risk should be modest.
“The last paragraph of section 3 calls for long-term hedging contracts for renewable generators based on nodal prices, but the natural interpretation (to me) is that these insure the generator against fluctations in that nodal price, and hence against the risk that too many other plants locate in the same area and drive the price down. It would be better to provide hedging against a market-wide or “hub” price, leaving the generator exposed to the basis risk between their location and the hub as a whole. This could in turn by hedged by financial transmission rights, but if too many generators are heading for the same area, their price will be high, discouraging the excess.”
This is a simpler solution to the System Operator having to compute the correct strike price at each node.
“Finally, a consolidated list of notation might be helpful.”
Agreed and provided.


Anonymous - Referee report 2
April 18, 2018 - 08:22

This is an interesting and very nicely written paper on issues facing the pricing of carbon for the purposes of decarbonizing the electricity sector, with a focus on the UK and EU, and a particular interest in showing how to calculate the break-even carbon price and that it is sensitive ...[more]

... to input assumptions to the extent that a carbon price may not be relied upon to deliver the necessary investment in low-carbon power.

I recommend publication subject to tending to the following list of major – in reality reasonably minor – and outright minor comments.

Major comments
• Is this the first paper to compute the break-even carbon price, in the sense of the term you use?
• To my mind the discussion of prices versus quantities need not be so long and extensive, given the emphasis of the paper on policy, rather than ‘high theory’. I would suggest cutting the relevant passage (section 2, before sub-section 2.1) down to one or at most a couple of paragraphs.
• Regarding the difficulty of pinning down the social cost of carbon, arguably the estimation of monetary damages is at least as difficult if not more so than pinning down an appropriate discount rate. The symposium of papers by, respectively, Pindyck, Stern and Weitzman in the Journal of Economic Literature in 2013 is a useful source on this and Pindyck’s paper is a particularly strident statement of the difficulties faced by impact modellers.
• At the end of page 6 the discussion segues from the argument that the price of carbon should be based on the (economy-wide) MAC, rather than the SCC, to the argument that one needs to calculate the break-even price of carbon in the electricity sector specifically. There are a couple of intermediate steps here relating in particular to the role of electricity in decarbonization I think, and it would be good to restate them here.
• I think there is scope to make sub-section 2.3 a little easier to read. In particular, could the analytical results obtained on p11 be summarized in a table, i.e. the partial derivatives and their expected signs?
• I felt that, since the concept of the break-even carbon price is the central contribution of the paper, more analysis of its value and sensitivity to input parameter values is called for. At the moment we only see two among many pair-wise comparisons, so we don’t see the full picture.
• In section 3 the paper argues, correctly in my view, that the carbon price should be predictable and uniform. It also argues, logically, that the break-even carbon price is highly sensitive to uncertain variables. But it does not immediately follow that the carbon price based on the break-even carbon price lacks credibility (p19). To my mind this depends on an implicit view that the government lacks the ability to commit to a carbon price, set using the break-even method, for a sufficiently long period of time thereafter, even if fundamentals like fuel prices change. One of the features of price/tax instruments in this context is that in practice they can be somewhat ‘sticky’. If correct, this assumption of a lack of credible commitment needs to be stated.

Minor comments
• p2, end of first paragraph: “in setting a carbon price”
• p2, 2nd paragraph: wouldn’t it be more appropriate to say that standards are typically criticized for failing to equilibrate marginal abatement costs, rather than marginal damage costs? Doing so would ensure a given emissions objective is met at least cost, irrespective of whether that objective actually equalizes marginal damage and abatement costs, something you later acknowledge is extremely hard to do with any confidence.
• p2, 2nd paragraph: when writing “It is now widely accepted that the EU ETS has failed…” – while I agree wholeheartedly – it would be appropriate to provide some citations/sources for those interested in following up.
• P9, last line: “\theta_t [insert space] measures the ratio…”


David Newbery - response to referee
May 22, 2018 - 17:28

Response to Second reviewer:
“Is this the first paper to compute the break-even carbon price, in the sense of the term you use?”
Apparently not, I will amend the references to the ‘useful concept of a break-even carbon price’ to the ‘break-even carbon price’ and cite as an earlier reference ...[more]

... Fukurozakia et al., (2013). I shall add a discussion of target-consistent carbon pricing as well in the revision.
“Regarding the difficulty of pinning down the social cost of carbon, arguably the estimation of monetary damages is at least as difficult if not more so than pinning down an appropriate discount rate. The symposium of papers by, respectively, Pindyck, Stern and Weitzman in the Journal of Economic Literature in 2013 is a useful source on this and Pindyck’s paper is a particularly strident statement of the difficulties faced by impact modellers.”
Noted, useful references to add in the revision listed below.
• At the end of page 6 the discussion segues from the argument that the price of carbon should be based on the (economy-wide) MAC, rather than the SCC, to the argument that one needs to calculate the break-even price of carbon in the electricity sector specifically. There are a couple of intermediate steps here relating in particular to the role of electricity in decarbonization I think, and it would be good to restate them here.
“I think there is scope to make sub-section 2.3 a little easier to read. In particular, could the analytical results obtained on p11 be summarized in a table, i.e. the partial derivatives and their expected signs?”
Table 4 gives these – it may be worth signalling that after equation (5) in the proposed revision.
“I felt that, since the concept of the break-even carbon price is the central contribution of the paper, more analysis of its value and sensitivity to input parameter values is called for. At the moment we only see two among many pair-wise comparisons, so we don’t see the full picture.”
Fair point, but the main purpose is to set out the methodology, which can be more widely applied (as it has been elsewhere), and concentrate here on salient choices in the electricity sector.
“In section 3 the paper argues, correctly in my view, that the carbon price should be predictable and uniform. It also argues, logically, that the break-even carbon price is highly sensitive to uncertain variables. But it does not immediately follow that the carbon price based on the break-even carbon price lacks credibility (p19). To my mind this depends on an implicit view that the government lacks the ability to commit to a carbon price, set using the break-even method, for a sufficiently long period of time thereafter, even if fundamentals like fuel prices change. One of the features of price/tax instruments in this context is that in practice they can be somewhat ‘sticky’. If correct, this assumption of a lack of credible commitment needs to be stated.”
I agree and will expand on the relevance of a carbon price floor or support, as employed in the UK and proposed elsewhere, referring to Newbery et al., (2018)
Minor comments (to be corrected in the revision unless stated below)
“p2, 2nd paragraph: when writing “It is now widely accepted that the EU ETS has failed…” – while I agree wholeheartedly – it would be appropriate to provide some citations/sources for those interested in following up.”
Perhaps parochially I can add “see e.g. the references in Newbery at al., (2018).
References
Advani, A., S. Bassi, A. Bowen, S. Fankhauser, P. Johnson, A. Leicester, G. Stoye (2013). Energy use policies and carbon pricing in the UK, IFS Report R84 at https://www.ifs.org.uk/comms/r84.pdf
Fukurozakia, S.H., A. B. Netob, J. O. A. Paschoalc, (2013). Marginal Abatement Cost Curve and Break-Even Carbon Price of Fuel Cell Technologies in Brazil, Proceedings Of Ecos 2015 - The 28th International Conference On Efficiency, Cost, Optimization, Simulation And Environmental Impact Of Energy Systems, June 30-July 3, 2015, Pau, France at https://www.researchgate.net/publication/295327310_Marginal_Abatement_Cost_Curve_and_Break-Even_Carbon_Price_of_Fuel_Cell_Technologies_in_Brazil
Stern, N.H. (2013). The Structure of Economic Modeling of the Potential Impacts of Climate Change: Grafting Gross Underestimation of Risk onto Already Narrow Science Models, JEL 51(3) Sep, pp. 838-59
Pindyck, R.S. (2013). Climate Change Policy: What Do the Models Tell Us? JEL 51(3) Sep, pp. 860-72)
Weitzman, M.L. (2013). Tail-Hedge Discounting and the Social Cost of Carbon JEL 51(3) Sep, pp. 873-82
Newbery, D.M., D. M. Reiner, R. A. Ritz, (2018) When is a carbon price floor desirable? EPRG WP forthcoming.


Anonymous - Comment
May 07, 2018 - 11:33

See attached document


Anonymous - response to referee
May 22, 2018 - 17:40

Response to Third referee
Major comments
“Central to the contribution of this paper is the discussion of a break-even carbon price. This is an interesting concept, one that is focused on making specific carbon free technologies economically viable. It is therefore slightly unfortunate that its limitations seem to be emphasized ...[more]

... more than its potential value as a guide for setting the carbon price. Even if it is sensitive to uncertainties in underlying variables, it feels that more weight could be put on the discussion of its policy relevance (i.e. in which context/for which technology is it more likely to be a useful guide, if at all) and how ‘critical’ its sensitivity to the said variables is to making it a workable policy tool.”
I plan to strengthen the policy implications in section 3 and perhaps indicate earlier that while it is important to be aware of the limitations, it is still necessary to give some guidance on particularly investment choices, and by linking the concept to target-consistent carbon pricing make that rather clearer.
“The present paper closely relates to the discussion on target-consistent climate policies (of which carbon pricing is one), i.e. policies in line with politically agreed goals (Hepburn, 2017). Section 2.1, third paragraph, hints at it but I believe this link could be made more explicit, especially as the UK approach to valuing carbon emissions is now based on target-consistent valuation (DECC, 2009) and that the international community has agreed on a specific climate target through the Paris Agreement.”
See above and agree the links to target-consistent carbon pricing (e.g. in the CCC Fifth Carbon Budget) need to be brought out more clearly.
“The paper seems to take for granted the view that the UK (and European?) electricity generation sector is liberalised and will remain so. However, although I agree with the view that it is currently liberalised I am less convinced that it will remain so in the future, especially given that the imperative of tackling climate change has sparked the temptation to revert to more interventionist (and potentially detrimental) practices. It seems therefore appropriate to briefly recall the case for a liberalised electricity sector and how a change towards less liberalised market organisation might affect the policy recommendations.”
I think this takes us too far afield and to papers that I and many others have already written.
Minor comments (to be corrected in next revision, remaining comments below)
“According to some studies, e.g. Pfeiffer et al. (2016), the world has already exceeded its fossil-fuel electricity generation capital stock consistent with a 2C warming target. A short reference to such literature could make the urgency of the problem faced by the power sector clear and provide even more support for the paper.”
Agreed
References
Hepburn, C. (2017). Climate change economics: Make carbon pricing a priority. Nature Climate Change. Available at: http://www.nature.com/articles/nclimate3302?WT.feed_name=subjects_climate-sciences
Alexander Pfeiffer, Richard Millar, Cameron Hepburn, Eric Beinhocker (2016), The ‘2°C capital stock’ for electricity generation: Committed cumulative carbon emissions from the electricity generation sector and the transition to a green economy. Applied Energy. 179 (2016) 1395–1408
UK Department for Energy and Climate Change (2009). Carbon Valuation in UK Policy Appraisal: A Revised Approach.

Fukurozakia, S.H., A. B. Netob, J. O. A. Paschoalc, (2013). Marginal Abatement Cost Curve and Break-Even Carbon Price of Fuel Cell Technologies in Brazil, Proceedings Of Ecos 2015 - The 28th International Conference On Efficiency, Cost, Optimization, Simulation And Environmental Impact Of Energy Systems, June 30-July 3, 2015, Pau, France at https://www.researchgate.net/publication/295327310_Marginal_Abatement_Cost_Curve_and_Break-Even_Carbon_Price_of_Fuel_Cell_Technologies_in_Brazil