Sending the right signals?

The European Commission’s energy and climate package has set the stage for massive growth in renewable energy. But, asks Coralie Laurencin, has it done enough to convince investors?

Voters in Ukraine

On 23 January, the European Commission unveiled its proposed renewable energy directive, which aims to deliver a dramatic increase in the proportion of the EU’s primary energy supply derived from renewable sources. But will the directive deliver?

Ultimately, it will be down to the private sector to provide the renewable energy capacity required and, in turn, to the investor community to provide the necessary capital. In recent years, the financial sector has demonstrated its appetite for renewable energy projects and, if policy-makers follow through on the signals they have given, it will continue to support the increase of renewables capacity in Europe. But delivering the EU’s goals depends on member state governments providing the required long-term investment signals to persuade investors and equipment suppliers that support for renewable energy will be long-lasting.

The directive, part of the EU’s package of proposed regulations to tackle climate change, is intended to help member states deliver their target of 20% of energy coming from renewables by 2020.This compares to an expected 9–10% in 2010, falling short of the previous 12% target, largely due to insufficient progress in the renewable heating sector. The key points of the directive are:

National targets for EU member states based on past renewables growth and GDP per capita levels. As a result, western European states typically have more ambitious targets than their Eastern European counterparts. Interim targets for 2011, 2013, 2015 and 2017 have also been defined, and member states are required to report on their progress. A country that has fallen behind on an interim target will have to inform the Commission of the tools it plans to use to make up for its delay.

National action plans must be provided by member states to the Commission by 2010 detailing the targets for each of the renewable sectors: electricity; heating and cooling, and biofuels. The directive sets an EU-wide minimum target for biofuels of 10% of all petrol and diesel consumption by 2020.

Internal EU flexibility is provided in meeting national targets. Renewable energy generators in those member states that comply with their interim targets will be allowed to export Guarantees of Origin (GoOs) to other EU states – effectively transferring that quantity of renewable power to count towards the importing country’s target. Each country will be permitted to limit both imports and exports of GoOs. In the event that a country has opened its borders to GoO exports, the renewable plant exporting its GoOs will receive the support payment of the country to which it is exporting, rather than of its country of origin.

The system is open to imported renewables credits. The directive proposes that production coming from renewable energy plants outside the EU can count towards member state targets provided that the electricity from these plants is exported into the EU.

One of the disappointments of the text for the renewable energy industry is that there are no sanctions for member states failing to meet their 2020 targets; instead, the Commission is relying on careful monitoring of progress (requiring reporting on interim targets) and incentives (member states ahead of their targets may allow exports of GoOs) to encourage compliance.

The debate has shifted in the past year. After the 2007 Spring Council meeting, when heads of state signed up to ambitious EU-wide targets on renewables, greenhouse gas emissions and energy efficiency, member states were concerned with the magnitude of the targets. However, in the run-up to the publication of the directive in January 2008, discussion centred on the flexibility clauses.

Initially, the Commission favoured the creation of a fully fledged trading market, where renewables projects could export their GoOs to the most attractive support systems, creating competition among countries to provide the best renewable energy incentives. While countries could, in theory, prevent foreign projects from benefiting from their support tariffs, in practice they would be forced to open their borders for imports and exports of GoOs if they fell behind their interim targets.

1. 2020 renewables targets

A few countries – led by Spain and Germany – opposed this. So, instead, the Commission chose to create a system where the transfer of certificates was possible for countries on a voluntary basis, as long as they exceeded their interim targets.

The current trading proposal will not lead to massive changes in the existing system. It is unlikely that states on track with their 2011 and 2013 targets will feel comfortable about opening their borders for the export of GoOs, in case they miss later targets. It is likely that the traded market for GoOs will therefore not see large volumes, and renewables support will likely very much remain a national affair.

Undoubtedly, the scale of the 20% target and the gap that needs to be filled are clear signals that significant investment in all renewable sectors is needed out to 2020. However, what is required to deliver this investment are similarly clear signals from governments that they plan to create policies to meet the targets and address the non-financial issues that hinder renewables growth.

According to the EU’s initial calculations, renewables should provide roughly 35% of electricity demand in 2020, up from 19% in 2010. So far, only Germany, Denmark and Spain have managed to increase their renewables capacity significantly; the challenge will be to get all EU states to do the same by 2020. Wind and biomass, whose technologies are expected to remain among the cheapest of renewables, are most likely to fill this gap. In this scenario, biomass capacity could grow to 49GW in 2020 from 6.1GW in 2006, and wind to 165GW from 48GW over the same period. This implies annual capacity growth of 9% for wind – which is less than half the current growth rate – and 16% for biomass, which is much higher than the current rate. The need for investment on an EU-wide level is very clear and now EU countries must step up to the challenge and reinforce national support schemes.

There are signs that such policy reinforcement is under way. While the targets are still regarded as being extremely ambitious, governments have adopted a constructive attitude and are focusing on the options for implementation:

In December 2007, the German government proposed changes to its renewables law (EEG) with a target of 30–35% of electricity coming from renewables by 2020.

The UK is targeting a significant increase in renewable electricity production: up to 40% of electricity in 2020 could come from renewables, from 4.6% in 2006. The government’s proposal to create bands in the existing Renewable Obligation (RO) is a step in this direction: it is aiming to stimulate offshore wind by doubling the number of tradable RO certificates offshore farms earn per megawatt hour, and is similarly incentivising other nascent technologies.

In France, the government is expected to produce in the very near future proposals on how to increase renewable energy penetration after last summer’s government-convened stakeholders’ meeting on climate change.

While policy-makers have a good handle on how to develop financial support for renewables, investors continue to be concerned about the non-financial issues that plague renewables development. These include planning, grid connection and access, and administrative hurdles. Some 3GW of UK projects are held up either in planning enquiries or awaiting grid connection, illustrating just how important these hurdles have become. Similarly, the notoriously lengthy administrative process in France has slowed installed capacity growth. The directive stipulates that national action plans detail how member states plan to address barriers such as grid connection and planning and administrative procedures, and propose advice on these topics. However, it makes no specific requirements on any of these issues.

Voters in Ukraine

Essentially, the current trading proposals provide regulatory certainty. However, there is one large uncertainty looming for investors, as the renewables directive now will be discussed throughout 2008 by EU member states, via the Council of Ministers, and by the European Parliament.

Some stakeholders will take this opportunity to challenge the current flexibility provisions. The current proposal only allows trading of certificates by projects in countries which have exceeded their interim targets. Because the targets are high, this is likely to limit the volume of traded certificates. Those countries that had hoped to import credits to comply will be forced to increase renewable energy capacity at home instead. As a result, several states which feel that their renewable resources are too low to meet their target, or that their resources are very expensive to exploit, may be tempted to lobby for increased flexibility.

They would like to see reversion to previous drafts of the directive: whereby member states would have to open their borders for import and export of certificates at any time, and those states that are behind on their targets would have to open their support systems to imports. A plant producing in Country A would be allowed to sell its GoOs to Country B and reap the support payment of country B, without having to export the associated power. Stakeholders in favour of a full-fledged trading market believe that this will allow for compliance costs to be brought down.

However, reverting to this proposal would be counter-productive and damage, rather than increase, investor certainty. In practice, a trading system layered on top of national support systems will increase the complexity of the regulatory risk for investors. It may also lead member states to take pre-emptive measures; initially, some states may choose to reduce the level of their support schemes to prevent a rush of GoOs coming their way. Conversely, countries with mature renewable support systems and lower payments for renewable energy production could see their production flee to countries which offer more attractive returns. Finally, a trading system placed on top of national measures will not deliver a uniform price for GoOs, preventing the development of financial instruments based on this price.

However, we believe that flexibility, and relatively low-cost compliance, will nonetheless be available under the system as proposed. Because the targets were defined according to GDP per capita, they are relatively easier for Eastern European states, where a large part of the EU’s biomass resource is located. The flexibility could favour Eastern Europe by encouraging strong renewable energy development, and GoO exports from these countries. Exporting renewable energy certificates provides the exporting states with the benefits of the production of clean power – the creation of a renewable energy industry, and emissions reductions that would count under the EU Emissions Trading Scheme (ETS) – without the costs.

Taken together, we believe the climate and energy package offers a coherent set of policies. As well as the renewables directive, it includes the directive on Phase III of the EU ETS, which targets a 20% reduction of the EU’s emissions by 2020 (rising to 30% if an international climate agreement is reached). The EU is also seeking a 20% improvement in energy efficiency by 2020.

These targets mutually reinforce each other. Any underachievement of the renewables or energy efficiency targets is designed to translate into an increase in the carbon price, which in turn reduces the additional cost of investment in renewables and energy efficiency projects, as the electricity price would rise. Estimates indicate that failing to achieve the renewables targets would add an extra 600 million–900 million tonnes of carbon dioxide over the 2012–20 period; this burden would fall on the EU ETS, increasing the carbon price for players in that market.

This interaction is an additional security for investors; if the policies developed by member states do not send the required signals for investment in renewables, the carbon market will provide them.

Coralie Laurencin is associate at Climate Change Capital, a London-based boutique investment bank. E-mail: claurencin@c-c-capital.com

SUBSCRIBE for the full story each month 0 0