How the Subsidy System Works

(To download a word version of the article below with full footnote references to sources, please click here)

Renewables Obligation,

and Climate Change Levy

In this document NOWAP explains the Renewable Obligation Certificate and Climate Change Levy system of indirect subsidy and why it makes onshore windpower stations so profitable. The information is drawn from authoritative and publicly accessible sources, for which references are given as appropriate.

Representatives of the onshore windpower industry often claim that onshore wind stations receive no subsidy. The following remark from Saxon Windpower Ltd. is typical:

Onshore wind power does not receive any subsidies from the Government, unlike offshore wind power: we are self-supporting. We are driven by market forces,” said Saxon Windpower project manager James Townsend.

Such claims are potentially misleading, since they fail to point out while the construction of onshore wind turbine power stations is unsubsidized, the electricity generated by renewable sources is indirectly subsidised through two market mechanisms:

·	The Renewables Obligation, which is an artificial market administered by the government’s Office of the Gas and Electricity Markets (Ofgem).

·	The Climate Change Levy.

The workings of this market are complicated, but not hard to grasp. To simplify the explanation we will treat these two market instruments separately.

One thing must be understood straight away: under the New Electricity Trading Arrangements (soon to be revised and renamed the British Electricity Trading and Transmission Arrangement) there is a market in electricity. Although this market is complicated, for our purposes we will think of it in terms of

1. Generators. who sell their electricity to

2. “Suppliers”, who sell it to

3. Customers.

In fact some “Generators” are also “Suppliers”, and this is a point to which we will return.

The Renewables Obligation: Electricity Suppliers

All “Suppliers” selling electricity to “Customers” must now by law source a certain proportion of their total sales from accredited “renewable” electricity generating sources, such as biomass, wind-power, tidal energy, land-fill gas, or a number of other generation technologies. If they fail to do this, they pay a fine.

In 2002/2003 the law required that 3% of supplied electricity was “renewable”. In 2003/2004 the proportion was 4.3%, and it will gradually rise, until in 2010/2011 it will reach 10.4%. This is the “Renewables Obligation” (RO).

A supplier of electricity proves to Ofgem that they have met this obligation by producing “Renewable Obligation Certificates” at the end of the year, one certificate for every MegaWatt hour (MWh) sold. For example, imagine a supplier which sold 1000,000 MWh of electricity in 2003-2004. This company would have a Renewables Obligation of 43,000 MWh (4.3% of 1,000,000 MWh).

If a supplier fails to meet its obligation it must pay a so-called “buy-out” fine for every MWh it sold that was not “renewable”. In 2003-2004 this fine was Ł30.51.

So, if our imaginary company failed to supply any renewable electricity it would be fined 43,000 x Ł30.51 = Ł1,311,930. In real terms, even missing your RO by a small amount can be very expensive. For example, in 2002/2003 London Electricity plc had a Renewables Obligation of 1,037,179 MWh, and though it succeeded in meeting 90% of its Obligation through ROCs it was left with a 10% shortfall obliging it to pay Ł3,177,090 in a buy-out fine.

These fines are paid to Ofgem, but it doesn’t keep them. At the end of the year the money is distributed to all electricity supply companies possessing ROCs, the amount received being in proportion to the number of ROCs held. In other words, if a supplier meets part or all of its RO, but other companies don’t, the supplier who has ROCs is rewarded with a share of the fines.

In the period 2002/2003 for England and Wales the buy-out fines, plus interest, to be redistributed totalled Ł79,251,930, and the total number of ROCs submitted was 4,973,091, which meant that each supplier who correctly produced ROCs received Ł15.94 back per certificate. In fact, because some companies who had failed their RO became insolvent and also failed to pay their fines, this figure may be unrepresentatively low. TXU UK Ltd and Maverick Energy Ltd, which are companies in receivership, failed to meet their Renewables Obligation for 2002-2003, and failed to pay the required fines. They were thus responsible for a shortfall in the buyout fund:

The shortfall of around Ł23m in the buy-out fund, arising mainly from the failure of TXU to meet its obligations, reduced confidence in the ROC market as well as reducing the potential sum available to suppliers.

In view of this information, it seems that the buyout distribution should have been Ł20.56 per ROC. In the Second Ofgem period a supplier in England and Wales holding ROCs would have received Ł22.92 per ROC held, and in Scotland Ł23.70. The overall buy-out pool comprised Ł157,956,798 for England and Wales and Ł16,436,835 for Scotland.

The Renewables Obligation: Generators

All companies generating power from accredited renewable sources are issued with Renewable Obligation Certificates by Ofgem. One MWh of electricity entitles the generator to one ROC.

When the renewable generator sells electricity to the supplier it is common, though not necessary, to sell the ROC too.

Because the ROC can save the supplier from having to pay a fine it adds to the price of the electricity.

The ROC is also worth something extra because it entitles the supplier to a share of the “buy-out” fines at the end of the year.

Thus, we can see that a renewable energy power station has two sources of income:

1. the price of the electricity they generate,

2. the price charged for the ROCs which they sell on to suppliers.

The following chart, reproduced from the National Audit Office report on the Renewable Obligation represents the system in schematic form.

These may seem to be very high prices, but recall that the fine for not having ROCs is itself high, and that anyone possessing ROCs at the end of the year is entitled to a share of the fines paid by other companies, and you can see why the value goes up. In fact, because electricity and ROCs can, legally, be sold separately, ROCs are freely traded and there is a lively speculative market. For example, a speculator might buy ROCs and electricity early in the year, selling the electricity on separately, but keeping the ROCs in the hope that the overall supply of renewable electricity would be low in that year, and that there would be suppliers desperate to meet their RO and willing to pay high prices for ROCs.

That last statement may seem surprising. Surely, you might think, a supplier has to actually sell renewably generated electricity to meet its RO. The answer, oddly, is that this isn’t necessary. All the power a supplier sells can come from a conventional generator, but provided that the supplier can buy sufficient ROCs on the open market the Renewables Obligation will have been met. This is perfectly legal, and exactly as the designers of the system expected it to be.

A Renewable Energy Station’s Income

We are now in a position to see how much a renewable electricity generator might earn in a normal year. In the following calculations we will use Ł20 per MWh as an approximate wholesale electricity price, and the latest average ROC price of Ł47.18.

Let us imagine a 16 turbine wind farm somewhere in England. Each turbine is of 2 MW. We can calculate the total likely output:

32 MW (total capacity) x 8760 (hours in a year) x 0.241 (Load factor) = 67,557 MWh.

Thus we can calculate the likely income from the RO system:

Electricity income: 67,557 MWh x Ł20 per MWh = Ł1,351,140
Renewable Obligation Income: 67,557 MWh x Ł47.18 per ROC = 3,187,339
Total Income: Ł4,538,479

Thus, we can see that electricity sales constitute 30% of a renewable station’s income. The remaining 70% comes from indirect subsidy.

Clearly, somebody has to pay for the RO system, and the answer is that it is the electricity consumer. The electricity suppliers are businesses trying to stay in the black, and since they have had to pay more for their electricity from the generators, because of the ROC premium, or have had to pay fines to Ofgem, they charge the customer more for their electricity. As the National Audit Office report on the electricity industry states:

Suppliers have passed on to customers new environmental costs arising from the Renewables Obligation and Energy Efficiency Commitment. These have been equivalent to an additional 2 per cent on domestic bills.

The Climate Change Levy

The Climate Change Levy (CCL) is a tax on energy used by businesses. It was announced in the March 1999 budget, and implemented on the 1st of April 2001. In relation to electricity the CLL requires suppliers charge commercial customers (i.e. business not domestic, governmental or charitable customers) an extra 0.43p per kWh (i.e Ł4.30 per MWh), which monies are then remitted to the government, where they are used to fund a national insurance contribution break and energy saving programs.

Electricity produced from designated renewable sources is exempt from CCL, and is issued with exemption certificates which can be bundled with the power when sold to a supplier. Thus, the presence of a certificate acts allows the renewable generator to charge a premium price for renewable power. The reason for this is straightforward. If the electricity is exempt from CCL the supplier can either reduce the price of its power, thus passing the saving on to the customer and increasing its own competitiveness in the electricity market. Or, it can charge the customer full CCL and add the difference to its own operational margin. In either case, the presence of a CCL Exemption Certificate is worth something to the supplier, and the generator can therefore charge more for a MWh from a renewable source. The market seems to expect that this value will be split by the generator and the supplier, though the exact proportion of this cut depends on the deal struck by generator and supplier. C. K. D. Galbraith, one of Scotland’s leading property consultants, in a document advising its clients on the profitability of renewable energy projects, remarks that:

The levy exemption certificate (LEC) this is the climate change levy imposed on commercial sales of electricity. Renewable energy is exempt from this charge and the renewable generators can negotiate a proportion of this value for each unit produced, at approximately Ł2.30 per megawatt hour.

Clearly, however, it could go up to a much larger proportion of the Ł4.30 per MWh. The Energy Saving Trust advice document to those considering Combined Heat and Power schemes says that it may normally be as much as 80% of the levy price. Splitting the difference we might say that a renewable generator might manage to achieve somewhere around 67% of the value of the certificate, or Ł2.88. Thus, we can add this to our calculation for the 32 MW wind power station above, assuming that the premium would be achievable on rougly 66% of the power sold (domestic electricity is roughly 33% of total electricity):

Electricity income: 67,557 MWh x Ł20 per MWh = Ł1,351,140
Renewable Obligation Income: 67,557 MWh x Ł47.18 per ROC = 3,187,339
Climate Change Levy: 67,557 MWh x 0.66 (proportion of electricity assumed to be commercial) x Ł2.88 per MWh (CCL premium) = Ł128,412
Total Income: Ł4,666,891

Thus, when CCL is added to the calculation, we can see that renewables are indirectly subsidized by some 71%.

Vertically Integrated Generator Suppliers

Because of the RO system even stations generating small quantities of randomly intermittent power can be highly profitable money-spinners, and might be attractive to small companies. However, for substantial “vertically integrated” companies that act as both generators and suppliers they are essential as a means of avoiding buy-out fines. In fact large-scale generator/suppliers will pay considerable sums just for uncompleted renewable energy projects so that they can add them to their renewable portfolio. In January 2004, for example Scottish and Southern Energy Ltd bought an uncompleted wind power station of four turbines on Orkney for Ł8.3m. It seems likely that much of the activity we currently see in the wind-power area results from property developers trying to acquire planning permissions in order to sell them.

Are the Subsidies Worth It?

The market for renewable energy is an artificial one created and maintained by government legislation. When the wind-power industry claims that onshore wind generation is not subsidized, and that it is self-supporting, it is indulging in sophistry. It is true that owing to the higher capital cost of Offshore Wind Turbine Power Stations an additional direct subsidy is offered to promote their construction, and that this capital grant is not available to onshore wind. However, the fact that the ROC subsidy is indirect and does not pass through government hands does not make it any less of a subsidy. Without government legislation creating the Renewables Obligation and Climate Change Levy system this source of income would be unavailable to the wind-power industry.

The question is whether this consumer-derived money is well spent. It is becoming increasingly apparent that one very significant problem with the Renewable Obligation system is that does not discriminate between “firm” and “non-firm” renewables, that is between high value and low value renewables. Consequently, many are now concluding that those renewables, such as tidal-based generators which are capable of providing some degree of firm generation, and thus contribute more certainly towards security of supply and emissions reduction, deserve more encouragement than low quality, randomly intermittent generation technologies, such as wind, which have a knock-on effect on the rest of the grid, and are consequently both costly as electricity generators, and both costly and uncertainly effective emissions abatement techniques.

Are the Subsidies Worth It?

Anyone seriously interested in the Renewables Obligation must consult the recent report by the National Audit Office, and the consultants’ reports on which it is in part based. This report not summarises the system in admirably clear terms, but also provides trenchant criticism of the operation of the Obligation. From the present perspective, the most relevant conclusions are that:

1. Onshore wind is very significantly over subsidised. The NAO says that a buyout prince of Ł15 would be sufficient to support most projects, and thus we can conclude that the subsidy stream is in excess of needs by at least 33%.

2. The Renewables Obligation is a very expensive way to save CO2.

3. The RO is faulty in so far as it does not distinguish between technologies of varying merits.

Both observations are correct in NOWAP’s view. We note in particular that the excessive subsidy offered to onshore wind development has drawn developers even to sites such as that at Parham where the wind resource is very weak, and the environmental impact severe. At the time of writing, March 2005, we have good reason to believe that the NAO’s criticisms will be absorbed by the DTI in their review of the Renewables Obligation, and that corrective measures will be taken. We can only hope that these measures will be sufficient to prevent further subsidy-hunting developments in wholly inappropriate locations.

NOWAP Committee
March 2005