Will subsidy for offshore wind pay off in the long-run?
The Offshore Renewable Energy Catapult (OREC) produced a report last week (originally at ore.catapult.org.uk/download/24232/, but no longer available), which acknowledged that support for offshore wind is (so far) costing the UK economy more than it is contributing (according to a Times report which is still available), because 100% of the funding comes from British taxpayers, but only 30% of the spending goes to British recipients. But (it argued) this would reverse in future, because the levels of support would fall, and a higher proportion of the benefit would go to British recipients. "At a [CfD strike] price of £90/MWh, with 50 per cent UK content, each gigawatt of offshore wind capacity would deliver a 'net benefit' to the UK of £1.7 billion, the report finds."
Contracts for Differences
CfDs are Contracts for Differences; the UK government's latest way of subsidising renewable electricity. They insulate investors against the risk of varying electricity values, including the risk that the investment that they encourage may suppress the value of the electricity produced by those investments (because highly-correlated output from intermittent renewables that are not correlated with demand result in low prices during the periods of high output by those generators).
The strike price is the price that the generator receives under a CfD, including the wholesale value of the electricity, regardless of the value of the electricity. The subsidy contained within the CfD is the strike price minus the wholesale value of the electricity.
OREC do not say what assumptions their study makes about the wholesale value of the electricity.
Gross Value Added
Their calculations seem to rely on simplistic analysis. "The net financial benefit of this investment to the UK economy can be evaluated as the net present value (NPV) of the lifetime GVA of projects minus the NPV of 15-year CfD support" (discounted at the Treasury's standard 3.5%). The GVA (Gross Value Added) is calculated as the income to the UK part of the supply chain, multiplied by a "multiplier" to allow for the indirect supply-chain activity (i.e. the money paid from the project's immediate suppliers to their suppliers, and so on).
There are a few problems with this:
1. Discount-rate Catch-22
If 3.5% is the correct discount rate, then we shouldn't spend much on mitigating the risks of climate change. The arguments for substantial spending in the present to avoid unknown but potentially-huge costs in the distant future hinge on arguments such as those deployed by Lord Stern, that typical discount rates are ethically inappropriate for inter-generational comparisons. They argue for ultra-low discount rates (a fraction of 1%) on the basis that future lives are as valuable as current lives.
If discount rates are exceptionally low, then it is worth significant expenditure now to avoid substantial costs in the distant future. If discount rates are more typical, like OREC/Treasury's 3.5%, then it is indefensible to spend much money now to avoid risks in the distant future.
OREC rely on this higher discount rate to reduce the NPV of the cost of 15 years of support, compared to the NPV of the upfront spending. But their reliance on this discount rate undermines the raison d'etre for the spending that they are seeking to justify.
2. Multiplying the benefits but not the opportunity costs
They owe the concept of a "multiplier" to Keynes. The theory is that government can counteract a temporary inadequacy of demand in the economy (because of depressed animal spirits) by raising its own spending. Because the people receiving the additional government expenditure would spend that money, and the recipients of that money would spend it, and so on, the economic benefit is not simply equal to the government expenditure, but a multiple of it: the multiplier.
There are many reasons to question whether this is a sensible guide to good government policy, not least that it was invalidated by history (e.g. the 1970s), until enough time had passed for people to forget the lessons of history and reheat old, convenient fallacies (e.g. post-2008).
Even if one accepts the basic idea, there is plenty of room for debate about the scale of the multiplier. It may well be less than one in most cases (i.e. you get less out than you put in).
But putting these objections aside for now, OREC's use of the multiplier concept fails even in Keynes's terms. Keynes would not have proposed that the funds to pay for the additional government expenditure should be raised from present taxes or levies, as CfDs are funded. That would negate the point of the exercise.
If multipliers are a useful concept, it is reasonable to assume that they apply equally to money taken out of the economy as to money put in to the economy. In other words, if we take money from people in order to fund spending, not only the value of the levies is lost to those on whom it would otherwise have been spent, but also the spending by those recipients on further recipients, and so on. If we tax and spend, we lose as much as we gain, including the multipliers on both sides of the balance. In fact, we are bound to lose more than we gain, because government is not frictionless, and, by forcing money to be spent in ways that people would rather not spend it themselves, we are producing outcomes that are lower down people's preference scales (i.e. that are less valuable).
(Looking only at the benefit of the spending and not at the negative impact of the fund-raising to pay for that spending is a classic example of the broken window fallacy.)
The Keynesian model of promoting growth through government spending relies on deficit spending, i.e. funding the spending through government borrowing, not through taxes and levies. It effectively brings forward spending, deferring the costs to later years when the debt has to be repaid. It may have no benefit in the long run, but "in the long run, we are all dead". In the short run, it may stimulate the economy at times when the economy needs stimulating, leaving the drag on the economy from repayment of the debt to later years, when hopefully the stimulation has had its effect and the economy is robust enough to support the repayment.
But the mechanisms that support offshore wind are funded by levies on the current cost of energy. The money comes out of consumers' pockets now. We have to set against the GVA of the offshore wind projects the negative impact on the economy of this drain on consumers' disposable income, and their expectations that this burden will continue for 15 years after the last CfDs are contracted (or 35 years in the case of nuclear).
To some extent, subsidy for offshore wind brings forward spending in the classic Keynesian way, because the technology has a high capital cost and low running cost, so a revenue-support model encourages a large proportion of the spending in the early years and spreads the cost over subsequent years.
But Keynesian deficit spending is only ever intended to be a temporary measure to get past a collapse in confidence. It should be repaid in the ensuing economic upturn. If it goes on for years, it ceases to be a stimulus to make up for a temporary lack of demand in the economy, and becomes a boondoggle and a drag on the economy. A growing repayment burden and the expectation of never-ending increases in indebtedness start to have a depressing rather than stimulating effect on the economy.
It could be argued that the public hostility to the ever-increasing unit costs of retail energy are a case in point, and evidence that the short-run boost has been overcome by the negative, long-run impact on expectations of a perpetuation of this approach.
3. Costs are treated as benefits
The GVA is calculated as the sum of the expenditure on the British parts of the systems, multiplied by a multiplier. This is seen as the positive side of the equation, with the discounted support on the negative side of the ledger.
By this logic, the more expensive the technology, the greater the benefit. The support would have to increase concomitantly if the cost increased, but discounting is used to ensure that the NPV of the cost exceeds the NPV of the support, so the net benefit should increase in proportion to the cost.
The secret to prosperity is clear. Find the most expensive ways of doing things, and all the money that is spent on inefficient solutions will cascade through the economy to everyone's benefit.
What is wrong with the idea that spending benefits the economy? It is back to Bastiat and broken windows. Ce qu'on voit et ce qu'on ne voit pas. We see the spending on the windfarms. We do not see the spending that could otherwise have occurred on other goods, if the money had not been spent on the windfarms.
This scenario differs from Bastiat's example in at least one way. Bastiat makes no comment about the cost-effectiveness of the glazier that repairs the window. It is assumed that the glazier does a reasonable job. There is a straightforward comparison between spending 6 francs on a replacement window or on a pair of shoes or a book. We may conclude that welfare has not been increased, because the shop-owner could perfectly well have chosen to replace the window without it being broken, if that was how he preferred to spend his money. If he chose not to until he was forced, there were presumably other things on which he would rather have spent his 6 francs. But the difference may have been marginal, and the cost to society small.
Now imagine if the shop-owner chose a particularly inept glazier, and was charged 12 francs for a window that was only worth 6 francs. Everyone is a loser. The shop-owner has swapped 12 francs for something that is only worth 6 francs. The glazier charged 12 francs because he was low-skilled and it took 12 francs of his labour and parts to supply something that a more skilled glazier could supply for 6 francs. The sellers of shoes and books do not make the sales that they might otherwise have expected if the shop-owner had not had to replace his window and chosen an expensive way to do it.
This is clearly a loss to the economy, compared to either not breaking the window or replacing the window as cost-effectively as possible. The loss to the economy is roughly equal to the difference between the expensive option and the cheapest way of providing the same product (plus something for the loss of utility from being forced to spend the money on something he wouldn't otherwise have chosen).
Where we spend money obtaining a good less efficiently than we could, that is a cost, not a gain for society.
What is the good that we are obtaining when we subsidise offshore wind?
It is not energy. We can have energy a lot cheaper than from offshore wind, and no subsidy is required in order for energy to be obtained cost-effectively. The energy is rewarded by the wholesale price for energy embedded within the CfD price. The balance of the CfD price is the subsidy and is paying for something other than the energy.
It is not energy security. By using an intermittent form of energy whose output is variably intermittent, highly correlated with other installations of the same technology, and poorly correlated with demand, we are not enhancing our security of supply. It is not obvious that the market is incapable of valuing security of supply for however much customers value it (as opposed to how much our intellectuals think we should value it) without intervention.
It is unlikely to be industrial policy, given the figures provided by OREC for the share of imports in the supply chain. We are net importers, not exporters, of this technology. In any case, history suggests that we should not assume that government winner-picking provides a benefit to the economy. There is a circular-reasoning issue here, because there is no prospect that this "winner" will succeed in export markets if it does not provide a positive benefit to those who invest in it, and that appears questionable unless we believe that a substantial value should be attributed to the industrial-policy benefit.
The only justification for some form of intervention is to put a value on the technology's contribution to avoiding anthropogenic global warming. But it makes no difference to the climate how greenhouse gas emissions are reduced. The displacement of carbon emissions by one form of low-carbon energy has exactly the same effect on the climate as displacement by other forms of low-carbon energy.
The subsidy within the CfD is paying for something (carbon reduction) that could be delivered by many alternative means. If some combination of those alternatives could reduce emissions sufficiently at lower cost, then any subsidy above that cost represents a cost not a benefit to society.
(In fact, if the cost of even the cheapest options exceeds the NPV of the anticipated damage from global warming, or the NPV of adapting to rather than mitigating the effects of climate change, then any spending on avoiding carbon emissions that costs more than that represents a cost to society. But that is an issue for another day. There are technical challenges to the valuation of those options.)
The subsidy within offshore wind CfDs may be heading down to around £70/MWh, if (a) the claims of forthcoming cost-reductions are delivered in practice, but (b) the increase in capacity has a predictable effect on the value of the electricity. That equates to around £175 per tonne of carbon dioxide (or equivalent, aka tCO2e). And that equates to around £44/MWh of heat. If we could cut our emissions with support of less than £70/MWh (electrical) or £44/MWh (thermal) or the equivalent for transport energy, then support at the levels proposed for offshore wind would still represent a loss to society, not a gain.
There are several technologies that are deliverable for less than those costs. Whether they can deliver all of the carbon reductions that we need should be tested in the market. Ensuring that support equates to the same value of carbon across all uses, scales and technologies is the key way to ensure that we can discover in the market which are the most cost-effective options.
We should do as much of the cheaper options as we can, before filling the gap with more expensive options. UK policy has been to do the reverse (i.e. prioritise the expensive options). The OREC study tries to pretend that there is a benefit to society from continuing to make this mistake.
The small number of large companies who can develop capital-intensive projects like offshore wind farms have grown fat on the British government's unwise generosity to this technology. It should be no surprise that a sock puppet for the industry should try to justify fisting even more taxpayer funds down their throat, despite the prohibition of this sort of lobbying. Their arguments are an offence to reason, but that is inevitable when your job is to argue that black is white (i.e. subsidy is a benefit, not a cost). The Establishment buys this nonsense, for reasons that are unclear.
Public expenditure should be balanced between the cost of tasks that it is necessary for government to carry out, and the ability of taxpayers to fund those activities without a detrimental impact on the economy. But with the offshore fatboy at one end of the see-saw, pivoting on Establishment gullibility to self-interested, ethically-questionable, logically-indefensible lobbying, taxpayers at the other end of the see-saw know what is likely to happen to them again.