Opportunism and competition in the non-fossil fuel obligation

Paolo Agnolucci July 2005

Tyndall Centre for Climate Change Research

Working Paper 78

Opportunism and competition in the non-fossil fuel obligation
Paolo Agnolucci (1) Environment Group, Policy Studies Institute 100 Park Village East, London NW1 3SR p.agnolucci@psi.org.uk

Tyndall Centre Working Paper No. 78

Please note that Tyndall working papers are "work in progress". Whilst they are commented on by Tyndall researchers, they have not been subject to a full peer review. The accuracy of this work and the conclusions reached are the responsibility of the author(s) alone and not the Tyndall Centre.

Summary The Non-Fossil Fuel Order (NFFO), which consisted in competitive tendering for the development of Renewables Energy projects, was the main policy to promote electricity from Renewable Energy Sources for almost one decade in the United Kingdom. This paper focuses on the incentives faced by developers bidding for a contract under the NFFO and shows that the low building rate under this scheme is likely to have been not an unfortunate accident. This paper constitutes the first block of a study analysing the policy implications of the NFFO.

Keywords: Renewably Electricity; Renewable Policy, Non-Fossil Fuel Obligation; Moral Hazard; Post-contractual Opportunism

1 Introduction In the literature the Non-Fossil Fuel Obligation (NFFO) is generally considered a successful policy instrument (AEP, 1997). However, while the instrument has driven down costs, it has not resulted in a scale of deployment comparable to that occurred in other European countries. This failure is puzzling as the NFFO was a very long-term policy, taking into account the importance of the risk-reward ratio mentioned in ICCEPT and E4TECH (2003). In particular, see section 2, the instrument was designed to make the risk born by renewable generators equal to those born by generators using fossil fuels. After describing the NFFO (section2) and the efficiency of this instrument (section 3), this paper analyses the incentives of economic agents bidding for a NFFO contract (section 4) and draws insights on the reasons why this policy has been unable to bring about a considerable deployment of renewable electricity generation capacity (section 5).

2 Introduction and Implementation of the Non-Fossil Fuel Obligation The Non-Fossil Fuel Obligation (NFFO) was introduced in England and Wales by the section 32 and 33 of the 1989 Electricity Act. The Act allowed the Secretary of State to order the Public Electricity Suppliers (PES) to purchase a certain amount of electricity produced from non-fossil fuels and also established a mechanism, the Fossil Fuel Levy (FFL), to compensate the PES for the NFFO. The background of the NFFO is the privatisation of utilities carried out by the Conservative Government in the UK. Through the Electricity Act, the entire sector, previously a vertically integrated monopoly called the Central Electricity Generating Board, was split and auctioned to private companies. Mitchell (2000) points out that when it was found out that the nuclear generators were not commercially competitive, the government removed them from sale and accepted they would remain in public ownership. In 1990, the British government asked the European Commission for permission to charge a Fossil Fuel Levy (FFL) on every electricity consumer in order to subsidise the nuclear generators. Renewable Energy Generators (REG) seized the opportunity and demanded the same price support offered to nuclear power. In order to implement the framework set out in the Electricity Act, two Electricity Orders, one for nuclear, the other for Renewable Energy Sources (RES)1, were issued in 1990. The latter prescribed each PES in England and Wales to make arrangements to secure an amount of nonfossil fuel generating capacity not inferior to those specified in the order. The first NFFO was followed by other four orders2 by the end of 1998. The main difference among the 5 rounds is the time span of the order. While the first two orders were issued for a brief period, the others covered a considerably longer time horizon (until a maximum of 21 years in the 1998 order). This was due to the fact that RES generators when offered a brief price-support policy still had to face considerable uncertainty about the future stream of financial resources.

1 2

These are the Statutory Instrument 1990 no. 263 and 1859, respectively. Statutory Instrument 1991 No. 2490; Statutory Instrument 1994 No. 3259; Statutory Instrument 1997 No. 248; Statutory Instrument 1998 No. 2353.

While the NFFO secured a market for RES, an auction held by the Department of Trade of Industry (DTI) supplied the generating capacity to satisfy the obligation. Private companies winning the auction were given contracts to produce electricity under the NFFO. The whole mechanism was prompted by a consultation on the possibilities of securing investment in RES. After evaluating the responses obtained by interested parties, the DTI published a Renewable Energy Bulletin (REB) and the Non Fossil Purchasing Agency (NFPA) invited expressions of interest to build generating capacity. The initial bids submitted by the generators contained information on the proposed project such as the location, the capacity and the price per kW of capacity. The then Electricity Regulator (OFFER) undertook a “will-secure” test on each of the generators’ bid. This test verified the financial and technical feasibility of the project so as ensure the PES that they could rely on these generators for discharging the NFFO obligation. The DTI decided the final capacity and technological mix of the contracts according to the bids per kWh submitted by REG. For each technology band, the DTI decided the cut-off point, i.e. the highest price per kWh it was prepared to pay. The subsidy per kWh corresponded to the difference between Pool market price and the final bid submitted at the DTI auction. The payments for the NFFO contracts were funded through the FFL, which was recalculated annually to raise the amount required for the previous year’s obligation. 3 Efficiency of the Non-Fossil Fuel Order The rationale behind the DTI auction is shown in Figure 1. The DTI used the price in the pool market, P0 in the figure below to determine the subsidy granted to the RES-E generated at a price per kWh bigger than P0. For example, in Technology Band A the projects that are pricecompetitive with conventional electricity, (q < Q0), would not receive any subsidy, as they will be carried out anyway. The policy instrument aimed to give to each project the subsidy needed to make the generation cost per kWh equal to the pool price. For example, in Figure 1 the project with generation price P1 would receive a subsidy equal to P1 – P0. Eliciting project developers to bid for subsidies allowed the DTI to trace the supply curve of RES-E for each technology band. Fixing the cut-off price for different technology bands (for example P2 for technology A), the DTI determined the amount of electricity generated by each technology.

£
Technology Band A P2 P1 P0

(2)
(1)

Q3

Q0 Q1

Q2

Electricity from RES

Figure 1 Economic rationale of the NFFO. The shaded area (1) is the producer’s surplus arising from the production of the electricity flow Q3 Q0. The shaded area (2) is the subsidy paid by an ideal NFFO in order to generate the electricity flow Q2 - Q0

The NFFO was an efficient instrument in the sense that it contributed to the decrease of the costs of RES-E over time. Although the bids are not fully equivalent because of the different length of the orders, see Section 2, the “average” price paid to each technology decreased between 21-34% between 1994 and 1998. One can wonder if developers passed on savings or if they dangerously undercut profits. 4 Microeconomics of project developing under the Non-Fossil Fuel Order Because of the fairly low share of contracted capacity built after the NFFO rounds, it is worth analysing the incentives of a rational economic agent bidding for a contract. In the following, 4 cases are presented which differ according to the nature of the costs and of the probability of a project not being built. Case 1: Cost and Planning Certainty As shown in Figure 2, after the auction a project developer can either be awarded a contract (state B) or not (state A). The pay-off in A corresponds to the administrative costs of doing the paperwork for the auction (AC). After being awarded a contract, state B, a developer can either build the project (D) or not (C). In D the pay-off corresponds to the revenues (RE) from electricity minus the administrative costs, the costs of obtaining all the needed permissions (i.e. planning costs, PC) and the costs of electricity generation (GC). In C the pay-off corresponds to the administrative costs. Provided that RE > GC + PC, a rational economic agent prefers D to C and therefore B to A. In conditions of cost-certainty and when all projects are awarded a planning permission all the contracted capacity will be installed as developers’ bids should be at least as high as to make RE equal to AC + GC + PC. However, with uncertain costs some developers may find out after the auction that their projects have a negative pay-off; hence they will not build the project (state C).

A (- AC)

B

C (-AC)

D

(RE - AC - GC - PC)

Figure 2. Pay-offs for a generator bidding for a NFFO contract in conditions of cost certainty. The bold lines indicate which branch the developer will choose.

Case 2: Cost Uncertainty Although developers might have not carried out some of the NFFO projects because of uncertain costs, it is implausible that this factor alone is responsible for such high levels of second thinking as those observed in England and Wales. Suppose that the developers have two expectations on

costs: high and low. If a developer bids high, he will not be awarded a NFFO contract while if he bids low he will get one. After being awarded the contract, he has to “find out” if the project he bid for is economically profitable and if the planning permission is granted (i.e. socially acceptable). Suppose that this happen with probability 1-p. When a developer decides his bid, the expected values will be EV (high) = - AC and EV (low) = (1-p) (RE - AC – GC – PC1) + p ( - AC -PC2). Quite reasonably, one can assume that the planning costs for building a project (PC1) are bigger than planning costs born by the developer when projects do not go through (PC2). A rational developer bids a low cost if EV(high) < EV(low) or similarly3 if: (1-p)(RE - GC - PC1)+p(-PC2) > 0 (1).

Under the assumption that bidding high implies not being awarded the any contract, the inequality (1) shows that a has an incentive to bid low when he is optimistic about the probability of the project going through (low p) or about the future level of net revenues (high RE or low GC and PC1). The share of projects not built (state C) will depend on how similar developers’ expectations are to the state of the world observed after the contract is granted. It becomes important to further specify the probability of a project being economically profitable and socially acceptable.

High

Low

A (-AC)

B

p

1-p

C (-AC - PC2)

D (RE - AC - GC - PC1)

Figure 3. Pay-offs for a generator bidding for a NFFO contract with costs uncertainty and strategic behaviour Case 3: Exogenous probability Suppose that this probability p does not depend on any of the variables in (1). In this setting, a developer will set PC2 equal to zero. If planning costs to try to develop a project do not have any influence on its outcome, undertaking them will be pointless. Hence, the (1) reduces to RE - GC - PC1 > 0 (2).

Equation (2) shows that when p is not influenced by the variables of the problem, a developer does not consider the probability of the project being economically not profitable and not socially acceptable. This is influenced only by his expectations on costs and revenues, independently of how implausible these expectations are. If it turns out that his expectations on costs are wrong he

EV(high) > EV(low) is equal to (1-p)(RE-AC-GC-PC1)+p(-AC- PC2) > - AC. After deleting the term AC, only (1-p)(RE-GC-PC1)+p(-PC2)>0 is left.

3

gets a negative pay-off (-AC), which corresponds, to what he would obtain, should he have bid high and lost the auction.

Case 4: Endogenous probability Undoubtedly, it is not very plausible for a developer to consider 1 - p exogenous. In fact p is jointly determined by market forces, local authorities, local communities and by developers themselves. The developer should take into account this interaction, when deciding his bid. He will make a low bid only if EV (low) > EV ( high ) or

(1 − p(•))(RE − GC − PC1 ) + p(•)(− PC 2 ) > 0

(3).

p (•) indicates that the probability is a function of RE, GC, PC1 and PC2 rather than being
exogenously determined. When taking a decision on his bid, a developer will solve the inequation above in conjunction with the equation linking the probability to its determinants. For the purpose of this paper, it is sufficient to point out that in this setting the developer understands that bidding too low increases p. At the same time, he is aware that other developers might be willing to do so. 5 Conclusions In the NFFO the incentives faced by developers and the difficulty in observing their behaviour caused what is called “moral hazard”. Moral hazard is a form of opportunism that may arise when actions influencing the allocation of costs and benefits of economic transactions cannot be freely observed. In these conditions, the person taking these actions may choose to pursue his or her private interests at others’ expense (Milgrom and Robert 1992). By approving the submitted business plans through the “will-secure test”, whose function was to stop not feasible projects, OFFER let the developers know that they would not be responsible for not implementing their plans. In addition, as the effort of developers in trying to build plants was difficult to observe, developers could invest very little time and money on it if they wished so. Under these conditions developers did not bear almost any costs of unrealistic expectations provided that their plans were approved by OFFER. Although the developers holding these expectations and submitting very low bids certainly understood that they decreased their chances of making profit out of a project, the competition in the NFFO auction gave an incentive to developers to underestimate the relation between their bid and the probability of implementing the project. In fact, in section 4, it was shown that when the probability of a project being economically profitable and socially acceptable is exogenous, it is rational for an economic agent to hold unrealistic expectations provided it can set planning costs equal or almost equal to zero. The next steps of this research will analyse the importance of learning in planning renewable generation and the policy implications arising from the NFFO.

Acknowledgements The author would like to thank Paul Ekins, Jim Watson and Tim Foxon for discussing previous drafts of this work and Karin Jonson, Visiting Student at PSI during the preparation of this paper, for invaluable research support. The paper has drawn upon work completed for Tyndall Centre project T2.12 – “ETech+: Technology policy and technical change, a dynamic global and UK approach”. Discussion with colleagues on this project is also gratefully acknowledged.

References Iccept and E4Tech, 2003. The Uk Innovations Systems for New and Renewable Energy technologies, Final Report to the DTI Renewable Energy Development and Deployment Team, downloadable from http://www.dti.gov.uk/energy/renewables/policy/icepttheukinnovation.pdf Mitchell, C. 2000. The England and Wales non-fossil fuel obligation: History and lessons, Annual Review of Energy and Environment, 25, 285-312 Milgrom P. and J. Roberts, 1992. Economics, Organization & Management, Prestice Hall, Englewood Cliffs, New Jersey

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