All Eyes on Renewable Energy: Incentives, Investment and Integration

By Robert W. Anderson and Eric Hsieh

Editor’s Note:

This article is based on a paper presented at POWER-GEN International 2017 in Las Vegas, Nevada.

Renewable energy has followed a process common to disruptive technologies. For a variety of reasons, renewable energy has seen popular support sustain policy incentives that have improved the technology, developed markets, led to economies of scale which facilitate private investment and lead to a broad dispersion of the technology. The rapidly falling cost of renewable energy technology and grid integration along with the spread of renewable energy to developing countries are two clear indicators of the maturation of renewable energy.

To procure the growing fleet of renewables, two prominent approaches are reviewed; renewable energy auctions and wholesale power markets combined with capacity and ancillary services markets. The two procurement strategies are compared in the context of the application in varying global contexts. Finally, techniques to facilitate grid integration and increase the overall flexibility of the generation and demand side resource mix are reviewed as a way forward to continue the process of renewable energy technology and grid integration maturation.

Incentives: Setting the Foundation

Renewable energy is an emerging and rapidly maturing technology. Renewable energy has followed a process common to many disruptive technologies. In the early stages of technological development, the support from incentives to catalyze markets and eventually capture economies of scale are critical. The sustainability of incentives through this early stage development hinges on a foundation of popular support and political will.

In the power sector, this popular support is impacted by several variables. One key correlation is level of income (GDP) per capita in a country. Analyses by the International Energy Agency (International Energy Agency, 2017) has found a 99 percent probability of significant correlation between GDP per capita and RE deployment levels. This study has also found a 97 percent probability of significant correlation for net energy importers and relatively high levels of RE deployment.

However, it is important to remember that no variable is perfectly correlated with support for RE incentives, there are always exceptions to the rule. In summary, high income

countries and countries that are net energy importers tend to favor RE and are likely to sustain incentives leading to increased deployment. Other factors such as the presence of a high RE resource capacity (sun and wind resource), the existing power generation mix and its ability to support increased grid flexibility and the presence of an environmental ethic are examples of factors that can lead to sustained incentives to develop RE technology and markets.

Throughout the process of developing a disruptive technology, it is important to structure incentives to realize maximize public benefit at each stage of development. In the earliest stages, where many competing ideas have small probabilities of significant breakthroughs, government often funds the critical role of basic research and development (R&D). As the technology matures, venture capital, which is often supported by a form of risk mitigation, becomes a more important source of finance. As economies of scale develop and technologies approach market parity, public equity and credit markets take an increasing role leading to the eventual commercialization of the technology and often a diminished role for publicly financed incentives. While continued government R&D support is less often associated with this late stage of market deployment, recent literature suggests that continued innovation, as measured through patent activity, is an important factor in continued cost improvements. (Noah Kittner, 2017).

The process of commercializing renewable energy technology has led to one very clear result —the sharply falling cost of RE technology. From 2009 to 2015 the levelized cost of wind energy declined by 61 percent and the cost of utility scale solar declined by 82 percent. (Lazard, 2015). This remarkable cost decline and increased experience with grid integration methods has led to greater diffusion of RE among developing countries.

In 2015, investment in renewable energy was higher in developing economies than in developed countries for the first time. (United Nations Environment, Bloomberg New Energy Finance, Frankfurt School, 2017). In developing countries, renewable energy investment by 2014 had grown by a factor of 17 over the equivalent figure for 2004. A large part of the renewable investment growth in developing countries can be attributed to rapid growth in China, India and Brazil. However, other developing countries also increased RE investment in 2015 by 30 percent in just 2016 to an all-time high, increasing investment over 20014 by a factor of 12. Meanwhile, renewable energy investment in the developed world has declined consistently since the peak in 2011.

The shifting geography of RE investment and deployment is indicative of a later stage in the process of commercializing a disruptive technology. Higher income countries (especially energy importers) have implemented the research and incentive structure to foster technological improvement, develop markets which can support private investment piloted programs for grid integration and flexibility. All of this has led to sharp declines in RE cost for both technology and grid integration procedures. The lower costs and development of flexibility capacity has allowed developing countries to increase their investment in RE while developing countries investment has slowed with technological and market maturation evidenced by decreased incentives.

Investment: Alternative Methods Tailored to Local Circumstances

Myriad techniques have developed to deploy RE investment. These techniques have emerged to best fit widely varying circumstances among utility structures, national goals and consumer preferences. This article focuses on two investment frameworks that have emerged and grown over time; renewable energy auctions and wholesale power markets structured on bid-based short run marginal costs. As a broad generalization (with many exceptions) auctions have been used for new resource procurement more often in relatively integrated utility systems which also tend to occur in developing countries. Unbundled systems in larger developed countries have moved more toward wholesale power markets for all new resource development.

In the past few years, the use of auctions has grown along with increased renewable energy investment in developing countries. The number of countries that have adopted auctions for renewable energy increased from 6 in 2005 to at least 67 by mid-2016. (International Renewable Energy Agency, 2015). RE auctions have several advantages for more bundled and smaller systems in developing countries. Auctions, managed by central regulator, are by their nature amenable to integrated systems. Renewable auctions that result in Power Purchase Agreement (PPA) from a central regulator mitigate one of the chief risks of generation finance in developing countries, off-taker credit risk. Auctions lead to a formalized agreement between parties that can clearly evaluate PPA terms and counter party risk.

In addition, the resulting legally binding contract can minimize the political risk in the event of institutional change. Finally, developing countries are more likely to use energy policy to for development objectives which can be reflected in auction design.

RE auction design can be summarized by four fundamental elements. First, auction demand specifies the overall volume to be procured, specific technology requirements such as a quota for wind or solar PV and the parameters around project size. Qualification requirements set the criteria for bidders. These can include credit and finance requirements, local employment requirements, regional experience in RE deployment and demonstration of site selection and grid access. Sellers’ liabilities include the commitment to contract signing, and the settlement rules and penalties for underperformance or delays. Finally, the selection component includes the winner’s selection criteria, final contract terms and conditions including contract schedule and the payment profile.

In developed countries the growing prominence of wholesale power markets based on short run marginal cost dispatch has created a different set of issues concerning RE. In a wholesale power market prices are driven by marginal cost and demand. There is no contractual agreement that all costs will be recovered in any given dispatch period. As the dispatch order is driven by variable costs, RE with near zero variable cost tends to be dispatched first, putting additional pressure on fixed cost recovery for all generators. This uncertainty over fixed cost recovery can dampen incentives for investment in new generation — an issue exacerbated by the low variable cost and dispatch priority of renewable energy. This phenomenon, also known as the missing money problem, is illustrated in Figure 1.

Figure 1 shows various generating resource types arranged in order by variable cost. Also shown for each resource is the levelized fixed cost. (U.S. Energy Information Administration, 2017). Two simplified price ranges are shown. These prices are for the Pennsylvania-Jersey-Maryland (PJM) territory and show the highest and lowest (On-Peak, Off-Peak) monthly average prices for 2016. Even at the higher monthly average price, only part of the fixed cost are recovered for most generators. Actual prices vary with much greater frequency and range, but the issue of partial recovery of fixed cost is an issue for wholesale power markets that can be exacerbated by renewables.

In addition to capital recovery issues, renewable energy can add pressure on ancillary services due to increased variability affecting the scheduling and pricing of those services. Design and experimentation of capacity and ancillary services markets to address these issues are well under way. Early capacity markets were instituted in the United States in 2006 and 2007. These markets allow generators to bid their services into supplemental markets in a process that share similarities with RE auctions described earlier. Demand for services, qualification requirements, seller’s liabilities are often specified prior to the selection which often focuses on prices after preliminary necessary conditions are met.

Integration: Shifting the Special Case to Business as Usual

During the initial stages of RE deployment, system operators can manage variability issues through conventional methods, such as dispatch of fossil-based load-following generators. As the RE share increases, these conventional methods can become costlier, negating some of the benefits from the new clean resources. Alternatively, the system operator can begin implementing more fundamental reforms towards flexibility.

The California Independent System Operator (CAISO) illustrates this transition from conventional to flexible practices. In 2007, when RE accounted for about 11% of generation, CAISO undertook a significant study to examine the feasibility of a 20% renewable portfolio standard. This report concluded that the 20% level would require “several additions to the operational practice” in order to avoid “significant effects on the market clearing prices and unit commitment costs.” (California Independent System Operator, 2007) Ten years later, following multiple market and operational reforms, CAISO now integrates nearly 30% RE, with goals of 50 percent by 2025 and a further target of 100 percent by 2050 under consideration. In this high-RE future, the CAISO envisions that “Renewables supply an increasing share of Essential Reliability Services, including Primary Frequency Response, regulation, voltage support, and spinning reserves, all of which had previously been supplied by fossil, nuclear, and hydroelectric power.” (California Independent System Operator Corporation, 2017)

These market and operational reforms seek to increase network ‘flexibility’ to better accommodate RE into existing grids. Flexibility is the capability to maintain generation and load balance under uncertainty and is key to integrating RE. Network flexibility is composed of three related dimensions; power range (MW), ramp rate (MW/min) and duration (MWh). These three dimensions are summarized below in Figure 2.

Often some of the most cost-effective procedures involve relatively simple operational adjustments. For example, most North American power markets integrate wind power into their economic dispatch process, allowing the dispatch of wind plants along with conventional power plants. Using wind forecasting can reduce reserve costs. Most regions now achieve wind forecast accuracy in the 90-95 percent range. As another example, U.S. organized markets must now pay resources based on 5 minute intervals, rather than an hourly basis which was an earlier norm. Shorter intervals will create price signals for generators to move up or down based on system needs, encouraging and rewarding flexibility.

“Using wind forecasting can reduce reserve costs. Most regions now achieve wind forecast accuracy in the 90-95 percent range.”

Beyond operational adjustments, changes to certain market structures have also provided a financial signal to motivate supply and demand resources to operate in a manner that facilitates RE integration. As an example, FERC Order No. 755 required system operators to incorporate a resource’s speed and accuracy into a performance-based payment. Prior to FERC Order 755, even though some resources can provide higher performance for frequency regulation they were not compensated for this capability. These new performance-based payments not only created a business case for storage, but created a more efficient means to procure frequency regulation service. Over time, batteries have displaced other resources in providing frequency regulation, and now provide almost half this service in PJM. As a result of these performance-based payments, independent developers built 200 MW of storage in PJM between 2013 and 2015. PJM may have been too successful as the region may now have more storage than necessary for its current frequency regulation requirements.

In the longer-term, updates to network management can have significant impacts on RE integration. A key to improved operation is to facilitate larger balancing areas. This can be accomplished through pooling and other forms on cooperation and integration. Larger balancing areas can help reduce flexibility requirements. The random variations in both loads and variable generation resources smooths out from aggregation and become a proportionally smaller share of the total system demand as the geographic area grows. For example, the Western Energy Imbalance Market (EIM) integrates CAISO dispatch with other western balancing authorities. Since 2014, the EIM has grown from California to include Balancing Areas from 6 other states. After integration, the EIM has realized savings from reduced reserve, dispatch, and curtailment costs, totaling $173 million.

Taken together, these operational improvements help facilitate RE procurement, whether by auction or market. Aggregation of variability across large geographies and reduction of forecast error both help reduce reserve costs, whether allocated to the RE producer or consumer. Steps that reduce RE curtailment improve project economics, which further improves the competitiveness of these new resources. System operators that shift from conventional to innovative practices can maximize the benefits of RE.

Conclusion

Renewable energy has followed a path common to disruptive technologies. This development can be summarized in three phases; incentives which act to spur technological improvement, investment growth in which the bulk of investment shifts increasingly from the public to the private sector and finally more widespread integration through increased grid flexibility. The tangible result of this phased development can be seen in the sharp decline of capital costs, the spread of renewable technology to developing countries and the phasing out of some incentives in developed countries. The combination of incentives, investment and integration acting together over time to lower cost and increase the competitiveness of RE is summarized in Figure 3.

Authors

Robert Anderson is the Director of Energy at Millennium Challenge Corporation. Eric Hsieh is Director of Energy Finance and Incentives Analysis in the Energy Policy and Systems Analysis Office at the U.S. Department of Energy.