Select Committee on Environmental Audit Appendices to the Minutes of Evidence


APPENDIX 24

Memorandum from Friends of the Earth

OVERALL COMMENTS

  1.  We welcome the opportunity to provide input to this inquiry, particularly given the important role that the Environmental Audit Committee has played to date in helping and encouraging the Government to make progress on integrating considerations of environmental protection and sustainable development into its policies.

  2.  Friends of the Earth is keen to see open and an effective appraisal of the Government's policy on energy beginning with the part played by the Performance and Innovation Unit and the recent publication of the Energy Review.

  3.  The destabilising impact anthropogenic emissions of green house gases are having on the climate is now widely accepted. To achieve emission reductions in the energy sector it is essential that we increase resource efficiency and move quickly to replace existing fossil based fuels with clean sources of power from renewable sources.

  4.  Numerous studies including the Royal Commission on Environmental Pollution report "Energy the Changing Climate" have shown that large cuts in emissions are theoretically possible over relatively short timescales. What is required is political will to sort out the regulatory and tax and spend frameworks that set the parameters of the market place in which commercial energy companies now trade. Liberalisation and increased competition are welcome, however, if social and environmental objectives are to be met Government must continue to play an active role in determining, delivering and monitoring clear and unequivocal sustainable energy policies.

The impact of recent developments in energy policy such as the New Electricity Trading Arrangements and the Renewables Obligation

  5.  Electricity generation in the UK accounts for 32 per cent of our annual CO2 emissions (still the single biggest category) other emissions also contribute to acid rain and reduced air quality. Future predictions for transport indicate that we will become increasingly reliant on electricity either as a direct source of power or as a means of producing hydrogen for fuel cells. Successfully arriving at cheap and clean ways of producing electricity is therefore of primary importance in energy policy.

  6.  The electricity industry is being affected by two major policy developments: market liberalisation, including the introduction of new electricity trading arrangements (NETA); and market intervention through the introduction of a Climate Change Levy and the introduction of a Renewable Energy Obligation (REO) on suppliers. If it is to meet its targets for green house gas emission reductions Government must ensure that the combined effects of these policies is to drive industry towards clean renewables and away from fossil fuels.

  7.  The delay in the introduction of the REO means we cannot yet assess whether this will prove to be the case. What is known is that since the introduction of NETA in March 2001, a premium has been placed on flexible plant which combined with high gas prices has led to an increased proportion of electricity being generated from coal reversing the downward trend in emissions from the electricity sector. The Government should be considering now what corrective actions it will take if this increase in emissions continues.

Impact of NETA

  8.  The way in which the NETA operates discriminates in favour of large flexible generators because they are better able to avoid and absorb the costs of the penalty system designed to punish inaccurate supply forecasts. Being in the main both small in scale and intermittent in nature, renewables and CHP are being adversely affected. OFGEM in their recent report on the impact of NETA on small generators acknowledge that there is a problem but conclude that there is nothing fundamentally wrong with the NETA mechanism and that it is a matter for Government to develop measures to support renewable and small scale operators. Friends of the Earth agrees that NETA has successfully met many of its objectives two important problems both apply to renewables but believes there are both changes within NETA and within the wider market place that will help to correct the distortions currently being experienced.

  9.  NETA's balancing mechanism is a way of quantifying the risk of system failure due to over or under supply of electricity. Suppliers failing to meet their contracted volume of output must pay the System Buy Price to make up the difference. Those overproducing must accept the lower System Sell Price for their surplus.

  The system is designed to incentivise the accurate forecasting of supply. However because many other factors including transmission constraints, differing quality of electricity and unpredictable demand, affect the National Grid's (NGC) ability to balance the grid, the balancing mechanism unnecessarily singles out and penalises less predictable sources of power.

  10.  Indisputably, balancing the system incurs costs. The question is how should those costs be distributed. Currently two mechanisms are used: the Balancing Service Use of System Charge which applies to all parties equally and the Balancing Mechanism, described above, which penalises all those who inaccurately forecast their volume of output. The later applies even if the error is wrong in the right direction eg if the supplier overproduces when there is a shortage of power or the supplier underproduces when there is a surplus. NGC are required to balance the net physical imbalance and do not correct each contractual inaccuracy. Therefore many errors which can be netted off against each other are penalised unnecessarily as costs are not always incurred.

  11.  Friends of the Earth believes that smaller generators are being disproportionately disadvantaged. Neither electricity demand nor supply are entirely predictable and yet NETA penalises unrealised supply contracts even where the "error" may be as insignificant as a very slight surge in demand. Pre NETA small differences in predicted output would have been lost in the "noise" of the system.

  12.  Finally, NETA is having a perverse effect on the market making electricity generation less efficient — the system buy price is usually considerably higher than the system sell price and so to minimise their exposure to risk suppliers are over contracting (and offering lower wholesale prices to compensate). This means that more electricity is being generated than is actually needed, making the whole system less efficient.

  13.  Numerous suggestions have been put forward as to how NETA might be improved to make it more cost reflective for all generators and less penal for smaller scale intermittent generators. In the longer term after an appropriate period during which the impact of NETA can be fully assessed it may be necessary to consider fundamental changes to NETA, however, in the meantime there are a number of immediate adjustments that can be made to increase the degree of certainty in the market place.

Suggested NETA reforms

  14.  These measures would help to further reduce the uncertainty inherent in the balancing mechanism providing benefits for all generators:

    —  Reducing gate closure period from three and a half hours to one hour

      This would enable more accurate forecasting of output and help to reduce uncertainty particularly for intermittent generators;

    —  Reducing the balancing reserve from 150 MW to 0

      Removing the balancing reserve would not affect the way in which NGC operates but would alter the way in which system buy and sell prices are derived, reducing the difference between the two prices and blunting the risk. It would not remove the incentive to accurately forecast as penalties would still be levied but would reduce the range of the prices and distribute costs more evenly between system balancing payments which are universally applied and predictable and variable energy balancing payments which apply individually and can be volatile.

    —  Encouraging within day trading;

      Although trading in futures has taken off there is currently little within day trading. This has the effect of extending the gate closure period making it harder for suppliers to fine tune the balance between supply and demand in advance of gate closure.

Barriers to market entry and market failure

  15.  It is very difficult for smaller players to gain entry to the electricity supply market—the cost of the necessary software systems alone is beyond the reach of all but the largest companies. This was predicted from the outset and the Government has always held that "consolidation" was the answer eg the creation of an aggregated generational portfolio by a third party. There are signs that as experience of NETA grows third party consolidators are emerging, and actions by the Government to hasten this would be welcome. However, there will remain the question of whether independent and small generators should be required to absorb the cost of deadening the risk in this way if the risk is fundamentally unfairly apportioned.

  16.  In addition third party consolidation is currently being held back by issues surrounding access to embedded benefits. At the moment the embedded benefits of a particular generator can only be collected by the regional supplier in which that generator is located. So consolidators wishing to create a portfolio of output from embedded generators have to negotiate with the regional suppliers to receive the associated financial benefits.

  17.  A separate aspect that further complicates the issue is the question of how independent generators are able to negotiate with suppliers. The barriers to market entry mean that there are still only a relatively small number of suppliers, many of which are highly vertically integrated. The imbalance of power between large supplier and independent generator is considerable and there is a real threat that insufficient competition and lack of objective market information is leading to renewable generators being offered, and accepting, reduced wholesale prices when they need not. The lack of any information about the prices being paid to independent generators means that the extent of this problem is hard to assess. Guidance for generators to help strengthen their negotiating position is almost certainly needed particularly to explain how the workings of the REO and CCL should affect the wholesale price they are offered—in addition information about how to trade into Europe would increase competition and drive wholesale prices for green power up.

  18.  If problems persist it could be worth considering calling for the Office of Fair Trading/OFGEM to investigate with a view to justifying a statutory code of guidance for suppliers (as has happened recently with supermarkets).

The Renewable Energy Obligation

  19.  The impact of the Renewable Energy Obligation (REO) on demand for renewables in this country will largely depend on how suppliers react to its introduction on 1 April 2002. All suppliers face a choice of buying the requisite three per cent of green electricity, buying Renewable Obligation Certificates (ROCs) or paying the buy-out price of three p per KWh. Suppliers choosing to meet their target by purchasing green electricity will in effect buy more than simply the electricity itself—they also purchase the saleable ROCs and for business supply they can add the value of a climate levy exemption certificate (LEC) priced at 0.43 p/KWh. In addition the money raised from the buy-out price is recycled or "smeared back" to suppliers in proportion to the amount of ROCs they present.

  20.  So in effect although the buy out price is set at 3 p/KWh, generators of renewable energy should be able to secure contracted prices at a higher rate than this. This combined with the fact that the REO is set to increase the percentage of green power to 10 per cent by 2010 should help to stimulate high levels of investment in the renewables industry.

  21.  The most competitive sources of renewable power will come from on-shore wind and biomass. An attractive option for owners of plant might be the co-firing of biomass in existing coal fired power stations which is allowable under the obligation rules until 2006 when the eligible proportion of fossil fuel drops to 25 per cent—and 2011 when co-firing will be exempt from the scheme altogether. If this option is pursued it could help to stimulate the supply market for biomass fuel in this country and act as an effective stepping stone towards 100 per cent biomass generation. However, there is nothing to guarantee that the biomass is sourced from sustainable sources or to prevent importing from overseas, for example from Canada and Scandinavia, where existing supply chains and lower land values make commodities such as wood chip far more economical. Another issue that would need careful assessment is whether co-firing would lead to older plant not currently fitted with Flue Gas Desulphurisation equipment being brought back on stream leading to an increase in harmful emissions.

  22.  Because the value of the LEC makes it more profitable to sell green electricity to business customers there is a possibility that domestic tariffs will, as a result, contain a higher proportion of "brown power" than is currently the case. There is little in the way of market intervention to prevent this from happening and without a domestic tax on energy there is nothing to encourage demand reduction within the domestic sector. Friends of the Earth therefore believe it is appropriate to begin consultation on the introduction of a domestic energy tax to mirror the effect of the climate change levy by encouraging energy efficiency measures and stimulating demand for green tariffs. The tax could be designed in such a way as to avoid harming the fuel poor (by for example introducing a free tranche where consumption up to a certain level is tax free) and funds from the tax could be recycled to speed the implementation of the Government's Fuel Poverty Strategy.

  23.  Domestic customers may be unaware of the "content" of their electricity tariff and will almost certainly not appreciate that following the introduction of the CCL, it has in effect become more "brown". Full disclosure on customer bills of the fuel sources used to generate the electricity and the resulting environmental consequences is therefore necessary and we call on Government to take action to implement the recommendations contained in the EU Renewables Directive on this issue.

Current policies to support renewables (including R&D and capital grants) and the likelihood of meeting Government targets in this area

  24.  R&D spending on renewable energy needs to be increased. Friends of the Earth's analysis, of International Energy Agency data, shows that in 2000, Britain spent less in total on renewable R&D than Switzerland, Denmark or Spain and that renewable R&D spend per head is three times greater in Germany and the USA and over 10 times greater in Denmark and Switzerland than it is in Britain.

  25.  Our analysis shows that, over the last 25 years, more than three-quarters of our energy R&D have gone to researching nuclear power. Even in 2000, almost 60 per cent of Government energy R&D was spent researching nuclear power.


  26.  The UK R&D budget for renewables for 2001-04 is £18.5 million per year. Additional funding of between £5-10 million is also available from Research Councils. However, the total sum is still dwarfed by comparison with nuclear spend which over the last 25 years has averaged over £230 million per year.


  27.  In addition to increasing R&D spend on renewables Friends of the Earth is calling for the following fiscal instruments to be introduced in support of renewable technologies.

Commit to introducing a tax incentive to encourage investment in off-shore wind energy, photovoltaics, off-shore tidal and wave power.

  28.  These technologies will be vital to maintaining security of supply whilst meeting the UK's climate change commitments and the Government's targets for increasing the uptake of renewable energy. The present incentives for renewable energy, such as the obligation on electricity companies to supply a percentage of power generated from renewable energy sources, will benefit most those technologies that produce electricity most cheaply. It is important the Government provide an incentive to the next generation of renewable energy technologies that are currently higher up the cost curve. Providing an additional tax break for these technologies can be persuasively justified on the following grounds.

  29.  This is a tax expenditure made to avoid the external costs of climate change. Expanding renewable energy generation is recognised by the Government as central to tackling climate change. But restricting that expansion to technologies which have lower costs at present would be short-sighted and inefficient. It will be necessary to exploit the full range of available renewable technologies, each of which have particular characteristics, in order to deliver the levels of output required. Thus, for example, off-shore wind can exploit the substantial resource provided by constant high winds and shallow seas in many areas around the UK; and, photovoltaic technologies can by-pass conventional electricity infrastructure and be installed directly at the customers' point of use, their buildings.

  30.  This measure would reduce the price of renewable technologies. Early investment in these technologies is undertaken the faster the costs will fall for future investments. In other words, investments now have a positive external effect on investment costs in the future.

  31.  Third, this policy improves the cost-efficiency of the overall package of policies aimed at increasing renewable energy output by reducing the costs of investment.

  32.  Investing in these renewable energy technologies would become less risky. A declining cost base does not mean that investing in renewable energy is free of commercial risk, as the rate of decline, for example, cannot be predicted with certainty. Tax breaks can help reduce those risks and stimulate further output of renewable energy. Investment decisions are very sensitive to expectations about the future, and to the costs of the initial capital investment rather than to the costs of operation. Tax breaks on investment in these technologies reduce initial investment costs and increase confidence.

  33.  Action is needed to increase the pace of innovation. The urgency with which these investments need to be made cannot rely on the market eventually bringing investment costs down and addressing climate change now has a clear timetable for action. Tax incentives of this type speed up investment rates, increase technological innovation and reduce the costs of future investments.

  34.  These technologies offer clear and specific opportunities for UK companies in terms of job creation and competitiveness. The UK has an established marine engineering industry that can combine with UK firms that have begun to compete successfully in the market for wind turbine components to exploit increased demand for off-shore wind generation. Two major UK companies are significant players in the photovoltaics market and would be well placed to exploit increased demand for this technology. The UK has a technological lead in the development of wave and tidal power that should be built upon immediately and not allowed to be lost.

  35.  What form the tax incentive takes should be the subject of a consultation announced at this Budget to be completed in time for the measure to be installed at Budget 2003. Other countries that have a lead in renewable energy technologies, and those which aspire to have, use a variety of tax incentives alongside subsidies. In Denmark individuals, co-operatives and companies investing in wind energy could claim exemptions from income tax and company taxes. More recently individuals and companies no longer have an exemption as the market has become established but can claim deductions on annual depreciation of the investment and on operation and maintenance expenditure. In the United States the Energy Policy Act of 1992 included a 10 per cent investment tax credit available to any company investing in or purchasing solar energy property.

  36.  The effectiveness of these incentives is dependent upon them being part of a package of measures including subsidies for capital investment and funding for R&D. The Chancellor should make clear that developing this tax incentive would complement spending commitments that will be announced in Spending Round 2002.

Commit to a tax break for farmers and households investing in renewable energy

  37.  The UK's renewable energy obligation is an important policy for increasing large scale renewable energy projects. But the old energy supply structure of a small number of large power stations feeding a grid needs to change rapidly. Embedded generation which supplies energy more locally and net-metering which allows farms, businesses and households to be both consumer and small-scale producers will weaken the dominance of the large-scale power plants. At present those who can play a role in this reform, such as farmers, small businesses and home-owners, are concerned about the risks of investing in this exciting future despite being squeezed by energy costs. The evidence from countries that have expanded renewable energy capacity faster than the UK is that tax incentives can help to overcome this market failure.

  38.  In Denmark farmers have been central to the wind-power revolution. As well as receiving subsidies for capital investment private co-operatives of farmers have enjoyed a tax exemption on 40 per cent of the income from electricity sold. This is highly attractive given the 50 per cent tax rate. The Home and Farm Wind Energy Systems Act in the United States proposes a 30 per cent investment tax credit for investments in wind power.

  39.  Existing Government support for renewable energy is heavily focussed on larger units. Smaller units installed in farms and households have the potential to make a significant contribution to meeting both the renewable energy and CO2 emissions target set by the Government. Wind, solar and biomass all offer opportunities. The "Community Renewables" initiative, developed by the Countryside Agency and DTI, suggests that small-scale generators could deliver up to 10 per cent of the UK's renewable energy. Investments by farmers in renewable energy will also cut their climate change levy bill.

  40.  Encouraging a far greater level of investment by farmers and households in renewable energy will help the Government to both meet its renewable energy target and demonstrate its commitment to help farmers and rural economies diversify in a sustainable manner. At this Budget the Chancellor should commit to installing this incentive in Budget 2003 and should indicate that new money to support small-scale renewable energy will be forthcoming in Spending Review 2002.

Include renewable energy technologies within the Green Technology Challenge.

  41.  In the Pre-Budget Report the Government excluded renewable energy technologies from the Green Technology Challenge, which will grant enhanced capital allowances to listed technologies. Instead the scheme will be restricted to two types of technology that already receive or are set to receive tax breaks (energy saving technologies and cleaner fuels and vehicles) and only one, water use and treatment technologies, that does not.

  42.  Friends of the Earth believes it is short-sighted of the Government not to include renewable energy technologies. The justification appears to be that the consultation exercise did not identify a strong enough demand. Companies are only just waking up to the opportunities of investing in their own efficient small-scale renewable energy plant presented by the exemption from the climate change levy. In light of this the decision to exclude renewable energy from the scheme seems to have been taken from an extremely static viewpoint. This is not appropriate for a measure that is aimed at increasing investment and innovation. The Chancellor should take a more forward-thinking position at this Budget and announce that renewable energy technologies will be included in the Green Technology Challenge. Announcing that the cost and risk of investing in these technologies can be reduced by claiming an enhanced capital allowance would speed-up the knowledge and expansion of this market.

The extent to which current developments reflect "joined-up" working between the parties involved (Government departments, Ofgem etc)

  43.  As might be expected in any situation involving a wholesale shift in priorities there will be competition between existing objectives and the instruments in place to meet them and new objectives and their instruments. This is no more evident that in the policies of the DTI which retain commitments to fully exploit indigenous fossil fuel reserves and whose energy policy seeks to achieve low energy costs to secure our competitiveness. DTI's sustainability strategy sets out clear objectives for achieving CO2 reductions and increasing resource efficiency, however, it is not yet clear how the various components of the department working on energy will contribute to these targets.

  44.  The PIU report comments on the revised hierarchy of objectives for energy policy and recommends that, where there are conflicts, environmental interests should tend to take precedence. This is a somewhat timid expression of the fact that increasing climate instability will have a profound effect on our society, economy and environment urgent action is necessary to decrease anthropogenic emissions of green house gases. It is important that this new hierarchy is adopted and that the appropriate instruments are introduced to enforce it. Key amongst these will be the restatement of revised energy policy objectives and the redrawing of the terms of reference for the independent regulators, OFGEM. Additional work will be needed to assess the implications of a properly enacted policy shift and to develop transitional policies including for example re-training programmes for affected work-forces and regeneration budgets for regions affected by declining fossil fuel industries.

  45.  Greater collaboration between DEFRA and DTI is needed with regard to the role renewables can play in helping achieve multiple objectives. For example, farmers could benefit from reduced outgoings and a secondary income through diversifying into renewable electricity generation. Unfortunately support is often concentrated on larger scale projects that will not be appropriate for the vast majority of farmers. For example, soon to be announced support for biomass is expected only to apply to plant over 30 MW in capacity. Similarly the "WindWorks" Initiative focuses on large scale wind turbines, seemingly ignoring the fact that lower capacity turbines exist and are capable of wider deployment, particularly in off-grid situations. Either DTI or DEFRA or a cross departmental agency should conduct an assessment of the potential contribution from widespread deployment of small scale technologies. In addition the contribution energy from farm waste technologies can make towards meeting the demands of the Nitrates Directive should be explored in more detail.

  46.  It is also essential that Treasury and DTI collaborate effectively particularly with regard to the Spending review 2002. All Government tax and spend decisions should be accompanied by an assessment of the CO2 impacts that will result. The Treasury does not have a Public Service Agreement committing it to sustainable development — this would formalise the need to put the environment at the heart of tax and spend decision making.

The outcome of the PIU energy review and the development of a sustainable energy strategy

  47.  The Energy Review was commissioned to consider how Britain will meet its future energy needs, and how the Government will meet its commitment to tackle climate change and reduce emissions of greenhouse gases. The PIU's 200 page report and various supporting working papers talk, rightly in our view, about setting energy policy within a sustainable development framework and make sensible recommendations about the need to prioritise environmental concerns and to shift to a low carbon economy.

  48.  But Friends of the Earth believes the report does not deliver on crucial issues: its target for renewables in inadequate; it brushes aside the possibility of strong domestic policies on transport and it proposes keeping the nuclear option open. Moreover, it has failed to deliver a long term vision and is short on detailed policy proposals for supporting renewables or for energy conservation and demand reduction.

  49.  A supplementary briefing outlining our thoughts on the review in more detail is enclosed, (see Annex A).

March 2002



 
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