State support mechanisms: learning from the past to accelerate the future

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Published Date
Mar 7, 2024
Government backing is critical to tilt markets in favour of green energy. But to incentivise the innovation required, we have to reflect on past failures.

In his 2021 book How to Avoid a Climate Disaster, Bill Gates coined the term “green premium” to explain the economics of decarbonization. Gates used the concept to articulate why green energy is more expensive than grey – because most new low-carbon innovations have not yet benefited from the same economies of scale built up by carbon-intensive supply chains over decades, and because the price of high-carbon power usually doesn’t factor in the environmental cost of generating it.

Gates goes on to highlight that government support measures are critical to reduce and progressively negate the green premium. Market forces will eventually incentivize green over grey, but without state intervention the transition to Net Zero will be too slow to avoid the worst effects of climate change, and too disorderly to manage the impact on economies.

As much as the transition is about economics, it is also to a large extent a legal issue. In addition to risk allocation and legal design, there is a pressing need for stakeholders (primarily, investors) to have clear visibility of the regulatory landscape over long periods of time.

The last two decades have brought good news and important lessons. The growth of renewables (for instance, offshore wind in northern Europe) shows how effective state support can be. The accumulated experience also shows how the tools need to evolve over time, and the pitfalls governments need to avoid.

A brief history of support measures

Early mechanisms included feed-in tariffs schemes (which are still in use in some jurisdictions and for certain technologies), whereby a project owner sells renewable energy to the state for an agreed price, ensuring the bankability required to build the necessary infrastructure or assets. Under these tools, market price risks are largely borne by the public sector and some cases has resulted in significant costs to the public finances.

Over the past decade, as technologies and supply chains have matured and the price of renewables has fallen, new risk-sharing mechanisms have emerged. Contracts for difference (CFDs) were designed in the UK and have turned the country into an offshore wind superpower. CFDs also involve the project owner and government agreeing a price for electricity, but rather than the state buying the power directly, it’s sold on the market with the government subsidizing any shortfall between the contracted price (the “strike” price) and what the market will pay.

This increased exposure to market risk has led project owners to enter into power purchase agreements (PPAs), typically with “aggregators” (entities in charge of bundling capacities and selling to wholesale buyers such as suppliers and traders) but also increasingly with large corporations looking to decarbonize their businesses (e.g., data centers operators). The rise of corporate PPAs (CPPAs) is a sign of maturity, although they require tailored risk allocations.

Overall, there is debate over whether the public money channeled in subsidies to renewables has always been well spent. There is little doubt however that public investment has been instrumental in driving down costs, enabling rapid development across the globe – most impressively in China and some parts of Europe.

Past policy failures reveal important lessons

Understanding the dynamics of state support schemes – what has worked and what hasn’t – is essential to accelerate the transition to Net Zero. Decarbonizing the global economy will require a vast array of new technologies beyond “classic” renewables (i.e. wind and solar), from sustainable aviation fuels to green hydrogen and its derivatives (e.g., green methanol). These will need to be delivered at scale with a decreasing “green premium” over time. To do this quickly, stakeholders must learn from the past.

On the European side, Spain provides an example of what happens when incentives are poorly designed. In 2007 the Spanish government introduced generous feed-in tariffs to increase the country’s solar generation capacity, setting a fixed price for electricity from solar farms connected to the grid within a certain timeframe that was several times higher than the market rate.

Spain was immediately flooded with supply, resulting in the government’s 2010 target for additional capacity being met within months. However, there was no provision in the legislation to reduce the tariffs in line with market developments, and when the 2008 financial crisis hit there was public outcry over the spiraling cost of the policy. The government eventually lowered the incentives by 30%, and then introduced legislation in 2013 which applied further retroactive cuts. The U-turn has sparked a rash of arbitration claims as investors scramble to recover their losses; at the end of 2022, Spain was still facing at least 51 claims worth more than EUR8 billion.

In the U.S., feed-in tariffs for solar energy were also introduced in the late 1990s and early 2000s, and are only one example of pricing schemes that have failed to adjust to changing market conditions over time.

California, for example, implemented net metering rules for residential solar energy use in 1995, allowing homeowners to install solar panels and sell excess electricity back to the utility company at the retail rate.

At the end of 2022, however, a unanimous vote by the California Public Utilities Commission resulted in an overhaul of the regulations that reduced payments to homeowners by 75%. The changes sparked intense debate, with government officials maintaining that price cuts were necessary to reflect evolving consumer habits; heavy residential power use has shifted to evenings yet solar energy is abundant during the day. The new rules accordingly include state funding for paired solar-battery storage systems, as well as incentive payments for low-income households.

Policy failures can also stem from setting the bar for state support too low. Recently the UK government found this out to its cost when its 2023 offshore wind auction failed to elicit a single bid. The auction would have paid producers GBP44 per megawatt hour for their electricity – slightly higher than the previous auction in 2022 (when contracts were selling for GBP37.50 per MWh) but well below 2015, when producers were guaranteed GBP155 per MWh. Ministers had been told that the impact of inflation and significantly higher borrowing costs made GBP44 unrealistic, but failed to heed the warning.

Governments must stand strong in the face of opposition

Not only must governments set the right sort of policies to achieve Net Zero, they must also stand by them in the face of opposition and react quickly in case of destabilization.

In 2012, a well-known French pressure group Vent de Colère (wind of wrath) sued the government over its feed-in tariffs for wind producers, arguing that they should be barred under EU state aid laws. For four years the case progressed all the way to the European Court of Justice, with the policy eventually annulled and replaced (for new projects) with a new CFD scheme. During this period the government was equivocal in its backing for the industry and provided little visibility on what would happen if the challenge had a negative impact on tariffs. This had a chilling effect on investment and significantly slowed down the rollout of renewables in France.

Had the state sent a stronger signal that wind power had its support despite the challenge, this could have been largely averted. Navigating the complex state aid rules in Europe remains a challenge for all member states and businesses alike, but is essential to setting a stable, efficient support scheme.

Businesses are taking the lead to navigate regulatory fragmentation

Of course governments do not always lead business. Companies are also working ahead of policy by collaborating to build new technologies and accelerate the development of supply chains so they can achieve economies of scale. They are also joining forces to create the certainty they need to pursue more ambitious Net Zero investments and navigate complex and sometimes contradictory regulatory regimes.

One example of this in action is in the U.S. auto sector. The U.S. regulatory framework for electric vehicles is fragmented, with the market influenced by everything from the Inflation Reduction Act to the Environmental Protection Agency, federal grant schemes and state and municipal rules.

Amid a partisan political environment in which climate policy is a battleground issue, car manufacturers are taking the initiative in a bid to reduce political risk. Several leading automakers (including BMW, Ford, Honda and Volkswagen) have agreed bilateral framework deals with the Californian government that incentivize faster emissions reductions than current laws require. The reason this is important is because California’s EV laws are adopted in a further 13 states, meaning these support measures now extend across more than a third of the U.S.

Another example is the burgeoning clean hydrogen production sector. Businesses were quick to identify the need to establish clear rules to certify that the hydrogen produced complies with low-carbon standards and regulations. For instance, CertifHy, a public-private partnership, started working as early as 2020 to develop certification processes open to all players active in Europe. They are now being integrated as a certified voluntary scheme into the recently stabilized set of rules on so-called “renewable fuels of non-biological origin” (RFNBO). This approach is a clear accelerator for the development of the sector and could be used for other types of transition assets, including sustainable aviation fuels.

Finally, companies are also adapting their purpose to accelerate their transformation strategies.

In the U.S., for years corporate law has been cited as a barrier to decarbonization because of the widely held view that fiduciaries must give primacy to shareholder returns over broader societal objectives. However, there is now a growing body of case law in which values-first decision-making has been protected under states’ business judgement rules.

For example, Leo Strine, former Chief Justice and Chancellor of the State of Delaware – as well as many other experts – have argued that the majority of states’ flexible corporate chartering statutes give companies a generally free rein to pursue any new line of business as long as it’s legitimate and above board. This broad freedom is possible because the principle is underpinned by statutory requirements for lawfulness in states’ corporate codes, and these codes explicitly allow directors to consider interests other than those of stockholders when making corporate decisions.

Similarly, in August 2019 the Business Roundtable, a nonprofit organization whose members are CEOs of some of the biggest U.S. companies, updated its statement on the purpose of a corporation to include “commitment[s] to all of our stakeholders”: customers, employees, suppliers, communities and shareholders.

A similar trend can be seen in Europe. For instance, in France, the government paved the way for companies to insert in their statutes a fundamental purpose (raison d’être) which goes beyond financial success, through the 2019 “PACTE” law. Many businesses have answered that call, contributing to an acceleration of their transition to sustainability with increased appetite and investment towards low-carbon assets and energy.

Proposed EU market reforms reflect past policy failures

Looking ahead, there are signs that lessons have been learnt from two decades of low carbon policy development.

First, we are seeing more tailored, stable support schemes. Following Spain’s ill-fated solar tariffs, Europe’s proposed electricity market reforms are based on two-way CFDs that provide the flexibility to handle energy price shocks. Under these bilateral structures, producers still receive a guaranteed strike price, but where they sell their electricity for more on the market (as has been the case at points during the war in Ukraine), the excess flows back to the state without limitations. Setting clear rules, with stability and visibility over time, will be crucial for guaranteeing the credibility of this system which is likely be tested in the coming years as energy systems transition to low carbon, high renewables and high storage capacities.

As some technologies continue to mature, public support schemes must evolve in parallel. The more rapid development of corporate PPAs is now an official goal of the ongoing electricity market design reform being debated in Brussels. But it is recognized that market players (developers and customers) may not yet bear all the risks. That is why the use of public guarantees for these schemes is being considered if a project fails to hit certain financial goals over a period of time.

Second, the support required goes beyond financial considerations. Effective permitting is just as crucial. The rollout of renewables has been plagued in many jurisdictions by slow, uncertain permitting regimes, with some countries taking many years to grant the necessary approvals. The EU has been moving since 2022 to require member states to deliver permits within a set deadline (typically, one year) – although it remains to be seen whether in practice this will be possible, given the lack of resources some authorities face to process applications.

Another key concern is legal challenges against projects and their permits. Investors typically refuse to fund projects where challenges are on-going or still possible. Some countries have moved to limit the right for third parties to challenge projects, for instance by setting a limited duration for proceedings or referring challenges directly to appeal or even supreme courts. Here again, finding the right balance will be critical.

Looking ahead

Finally, as well as building flexibility into regulations, policymakers must also reflect on the importance of engagement with industry to create effective regimes and consider the optimal duration of support mechanisms to provide businesses with certainty. The U.S. Inflation Reduction Act has won praise in this regard, with many of its credits extending for more than a decade.

This is where case law developments such as those in the U.S. offer further hope. An increasing slate of decisions in favor of values-based decision-making should create momentum for more ambitious decarbonization strategies among purpose-driven boards. Ultimately, it will require a combination of government and private sector action to provide the coordination and clarity needed to advance the Net Zero transition.