Risks, revenues and investment in electricity generation: Why policy needs to look beyond costs

Energy policy goals frequently depend upon investment in particular technologies, or categories of technology. Whilst the British government has often espoused the virtues of technological neutrality, UK policies now seek to promote nuclear power, coal with CO₂capture and storage, and renewable energy.

Policy decisions are often informed by estimates of cost per unit of output (for example, /MWh), also known as levelised costs. Estimates of these costs for different technologies are often used to provide a ballpark guide to the levels of financial support needed (if any) to encourage uptake, or direct investment away from the technologies the market might otherwise have chosen. Levelised cost estimates can also help to indicate the cost of meeting public policy objectives, and whether there is a rationale for intervention (for example, based onnet welfare gains).

In the UK electricity sector, investment is undertaken by private companies, not governments. Investment is driven by expected returns, in the light of a range of risks related to both costs and revenues. Revenue risks are not captured in estimates of cost or cost-related risks. An important category of revenue risk is associated with electricity price fluctuations. Exposure to price risks differs by technology. Low electricity prices represent a revenue risk to technologies that cannot influence electricity prices. By contrast, price makers that set marginal prices are, to an extent, able to pass fuel price increases through to consumers. They have an inherent hedge against fuel and electricity price fluctuations.

Based on recent research by the UK Energy Research Centre, this paper considers the implications of such price risks for policy design. The authors contrast the range of levelised costs estimated for different generating options with the spread of returns each is exposed to when electricity price fluctuations are factored in. Drawing on recent policy experiences in the renewable energy arena, in the UK and elsewhere, the authors provide an assessment of investment risk in policy effectiveness and consider how policy design can increase or ameliorate price risk. They discuss the circumstances under which policy goals might be best served by socialising price risk, through fixed price policies. The importance of increased and explicit attention to revenue risk in policymaking is discussed, along with the means by which this might be achieved.