Blog post

Carbon pricing and the impact on renewable energy finance

Energy Blog, 20 December 2017

Damiano Ting disusses the impact of carbon pricing on the economics and financing of renewable energy.

It has long been known that the EU has failed in pricing carbon emissions adequately. Last month a provisional agreement to reform the current system, the EU – Emissions Trading System (ETS), was finally reached. The reform of the ETS is supposed to increase the price of carbon emissions and thereby strengthen the EU’s flagship tool for reducing emissions. Many remain sceptical as in the past a few European countries and energy intensive industries have successfully lobbied against any measure that would have an actual impact.

This comes at a time, however, when an increasing number of government bodies and private sector stakeholders push for higher carbon pricing. The French government under guidance of President Macron has argued for a price of 30 euros per tonne of CO2. The Dutch government announced a carbon tax from 2020 onwards. Germany revealed that it will miss its national emission reduction targets for 2020 which has put pressure on its climate policies. Some of the parties forming the new government are now pushing for a minimum price on carbon emissions.

A higher carbon price could have a noticeable impact on power market structures and renewable energy sources. It would force CO2 emitting power plants to internalise the carbon price as a variable cost based on the carbon intensity of the fuel used and the fuel efficiency of the power plant. Power plants with a higher carbon content such as coal and lignite would generate more expensive electricity relative to power plants running on lower carbon fuels such as natural gas. So, in the first instance, the price levels on wholesale electricity markets would be expected to rise as many participants are suddenly made less competitive. Depending on the level of the carbon price, the relative change in competitiveness of different power plants could therefore lead to a so-called fuel switch of the marginal generators which are setting the prices. Consequently, the traditional merit order curve reshuffling could then provide positive investment signals to generators with low emissions which in turn pushes polluting and inefficient power plants out of business.

Renewable energy investments are usually characterised by high upfront costs and very low operating costs, which is the reason why the cost of capital in general (and project finance as an instrument) are so important to this industry. The cost of capital can be translated as the price of risk or uncertainty that owners and lenders assume for providing capital.

One of the key features of regulatory regimes that have allowed renewable energy projects to thrive to date has been long term revenue certainty, effectively shielding these projects from the spot market mechanisms. Investors and lenders have been reluctant to provide funding to projects with merchant revenues (i.e. risk exposure to wholesale electricity prices), and have done so only with heavy discounts on revenue assumptions and/or against more expensive conditions. This in turn has made the internal cost of production of renewables under merchant regimes less competitive (a reminder that “markets” are not neutral – how a market is designed can and will influence the relative competitiveness of technologies).

Putting a price on carbon would send an investment signal for future projects remunerated fully through the wholesale market, without any support regime, and would further increase the relative attractiveness of low carbon technologies. In the short term, there would be no direct impact for existing renewables remunerated under older support schemes such as feed-in tariffs (FiTs) or contracts for difference (CfDs).

Through pricing of carbon (putting a monetary value on its negative impact to society, i.e. externality), it will become easier for renewable energy to be competitive with conventional generation even under marginal “spot” pricing market clearing mechanisms, as overall price levels increase. Price levels will still be determined by fossil fuel power plants as the marginal generators, but the impact of carbon pricing would be to provide a de facto floor to pricing, incremental to the price of fuel.

Under merchant prices, renewable energy projects need to consider minimum electricity market prices rather than average prices in order to be competitive (as revenues need to be sufficient in any period to cover their fixed costs, mainly the repayment of the initial investment) but the presence of such a floor could do the trick. The question is whether the investment signal (i.e. the carbon price) is strong enough to incentivise the development of renewable energy projects when wholesale market price levels are otherwise driven down by renewables themselves as they push more expensive fossil fuel producers out of the merit order.

Recent tenders in various markets showing that renewables can be competitive with revenues from long term power purchase agreements with fixed prices in the 20-50 EUR/MWh range (depending on the technology), it is likely that a carbon price of 20-40 EUR/tonne (which can translate to an increased cost for gas-fired plants of 10-20 EUR/MWh) would provide a favourable environment for renewable energy projects to be competitive.

As we see it, effective carbon pricing would make polluters incorporate the cost of externalities in their business model and, if priced correctly, help decarbonise the electricity sector and other industries.