FIT Policy Revisited: On Quandaries and Rebound Effects

I like a good paradox, but, being also somewhat pedantic, I reluctantly have to class aspects of the UK’s FIT (feed-in tariff) scheme as the result of trying to resolve a quandary, and not, strictly speaking, paradoxical.

Of course, there’s a quandary involved in all renewable energy incentive schemes. In fact, they are subject to a special case of quandary, which, due to the physics precedent (the boffins keep telling us that you can’t simultaneously measure a particle’s position and momentum), should perhaps be known as a quantum quandary.

The renewable energy policy quantum quandary is this: should the incentive for renewable energy generation be in terms of quota or price? If a quota system is chosen, such as the UK’s Renewables Obligation scheme, then the cost of acquiring the renewable energy is indeterminate; if the price is set, as for FITs, then it becomes very difficult to manage the quantity generated, as discussed yesterday.

By imposing a budget on the UK’s FIT scheme, a price-based system has in effect been turned into a quota system. This is perhaps the worst of all possible worlds, since, if a rational entity only wanted to buy a fixed value (or quantity) of renewable energy, she, he or it would probably devise some method of discovering the true market price, for example (in the absence of a mature, liquid market), auctions. This, I understand, is what the UK now intends to do in the proper, grown-up energy market, as opposed to the play market for small-scale and domestic renewable generation covered by the current FIT scheme.

More about the new rules for the UK’s electricity market another time. The quandary other than the quantum quandary which I want to explain relates to the detailed operation of the UK’s FITs for domestic electricity generation.

Now, you’d expect that the feed-in tariffs involve the operator (in this case the homeowner) being paid a set tariff for supplying electricity to the grid. If so, you’d be wrong, as least for the UK’s scheme [I’d be interested in the detail of how FITs operate in other jurisdictions, if anyone cares to add a comment].

If you stick a solar panel on your roof in the UK and jump through some bureaucratic hurdles, you qualify for two types of payments:

  • a generation tariff, of 41.3p at 2010-11 prices (adjusted by inflation so already around 44p) per kWh.
  • an export tariff of 3p/kWh.

The key point is that the price of electricity you use yourself (but don’t generate) is around 12p/kWh. So there is an incentive built into the scheme to use rather than export the electricity you generate. This is a deliberate feature.

But how might you use this elecrtricity?

Let’s consider a few possibilities:

1. You would have used the electricity anyway – great, the FIT is actually worth 53.3p/kWh to you (41.3p generation tariff + the 12p it would have cost you to buy the electricity). As far as the rest of us are concerned, we’ve paid 41.3p to avoid having to generate a kWh of electricity by other means. Everybody’s happy. Ish – this is already extortionately expensive electricity.

2. You can change your behaviour to use electricity you’ve generated rather than other electricity. For example, you may use storage (for heating) or immersion (for hot water) heaters to shift your electricity consumption from the evening or night to the day when, clouds permitting, you are generating electricity. It seems to me it would even be feasible to use batteries to store the electricity – remember, it’s only worth 3p/kWh if you export it, it’s worth 12p/kWh if you manage to displace electricity you would otherwise have had to buy. Everybody’s happy (ish), although the rest of us are probably not quite as happyish as in case 1, as inefficiencies are likely to be involved. That is, you’ll likely have used more electricity by shifting your consumption in time – the storage and immersion heaters will have lost some of their heat by the time you actually want it. So there’s a small rebound effect already – you’re using more electricity in total than before, so, for every 41.3p the rest of us are paying, we’re avoiding having to generate not 1kWh, but less than 1kWh, of electricity.

3. You could change your behaviour to use electricity you’ve generated rather than another form of energy. For example, you could charge an electric or hybrid car. Or you could switch from gas to electricity, for cooking or heating. Again, there are inefficiencies involved. Now, you’re using more energy (not just electricity) than before, and, for every 41.3p the rest of are paying, we avoiding having to find, not 1kWh, but less than 1kWh, of energy.

It’s this last point, case 3, that is crucial to the quandary. The export tariff was originally planned to be 5p/kWh, not 3p. This change is significant, because gas also costs around 3p/kWh. Reducing the opportunity cost (i.e. the income foregone by using rather than exporting your electricity) to a mere 3p makes it irrational for domestic generators to switch from gas to electricity. It would be sensibe to charge car batteries, rather than use petrol or diesel, but it wouldn’t be sensible to use electricity rather than gas for cooking or heating (unless you prefer to use electricity for one or other of these activities, as some people do).

But, in rewarding actual export of the electricity so poorly, policy-makers must – or should – have been wrestling with a quandary. Because there’s one other thing you might do with this 3p electricity:

4. You could afford to use the electricity for things you couldn’t afford before (or didn’t want to pay for). For example, you might install air-conditioning.

The quandary policy-makers must have been wrestling with was that the higher they make the incentive for using home-generated electricity to displace other forms of energy consumption, the higher they also make the incentive for simply increasing electricity consumption. If they’d made the export tariff much higher, of course, then they would have introduced an incentive for increasing the consumption of gas, for example, by ceasing to use electric immersion water heating and using a gas boiler instead (or even by installing a gas-based domestic CHP system, which itself qualifies for FITs! – I can’t get my head around the full implications of this).

But this leads to a problem with the UK’s scheme. It might simply result in a rebound effect, whereby FIT suppliers simply use much of the subsidised electricity themselves.

Unfortunately, it gets even worse, because householders benefiting from generous FITs will increase their income significantly (beyond what they could have otherwise earnt with the funds that paid the upfront installation cost), so:

5. Because of the FIT income, you could afford forms of energy consumption you couldn’t afford before. For example, you might fly away for an extra weekend break every year, happy in the knowledge that while you’re away your solar panels are steadily earning money for you! Or you might buy more goods, which required energy to produce. This is another rebound effect. The subsidy may result in less extra energy available for other consumers than is generated. In fact, it’s possible that the benefit could be negative, that is, domestic FIT suppliers’ energy consumption might increase by more than they actually generate!

In the worst case, then, the money spent on domestic FITs might make no contribution whatsoever to reducing the consumption of other forms of energy in the UK economy. The FIT subsidy might simply involve a transfer of wealth to FIT suppliers of around £400m a year by 2015 (increasing every year as the number of installations increases).

In less worse cases, we can work out the cost to electricity consumers per kWh of FIT electricity generated net of increased consumption. Remember, electricity consumption by households with solar panels may increase by a proportion – beyond displacing other forms of energy use – reducing the net increase in the nation’s electricity supply achieved the ludicrously high FIT cost. If the rebound effect is, say, 50%, that is, if FIT providers increase their overall electricity (or strictly speaking energy) consumption by half of what they generate, then the cost to electricity consumers of the extra electricity made available by domestic FITs would be not the already extortionate 41.3p, but 82.6p/kWh.

As I said, I’d be interested to learn how other jurisdictions have structured their FIT schemes. It seems to me that it’s very difficult to avoid incentive problems of one sort or another. Perhaps the whole business is misconceived.