Simon-Erik Ollus
Posted by: Simon-Erik Ollus

What is an ideal energy and climate policy framework?” can be considered a naïve question, but still worth spending some thoughts on.  Policy frameworks are important for several industries, but in particular for the energy industry as it is an essential player in decarbonisation and one of the most capital intensive industries.

Meanwhile, the energy sector landscape – which has traditionally been stable – has changed and become increasingly complex in the recent years. At the same time, the society calls for sustainability, carbon mitigation, competitive energy prices, more renewables and national security of supply, just to mention a few. Naturally we – as the energy industry – need to adapt and deliver what the society requires.  And we have a responsibility to answer these calls efficiently, keeping the total cost as low as possible.

In Europe, much of the discussion lately has been about whether we should have market-based mechanisms or re-regulate. I think this discussion is missing a crucial point: what is the actual credibility of any policy framework if the framework is constantly changing. Especially in an industry where the investment horizon is decades.

From Eurozone crisis to energy industry

The basic principle of capital markets is that if the risk for failure increases, the risk premium for return on the required capital also increases. A good example is the Eurozone debt crisis, where the investors could not trust the borrowers’ ability to keep their commitment and interest rates to several indebted nations skyrocketed. The comparison between the capital markets and the energy sector might sound strange at first hand. However, this is exactly what has happened in the energy sector: the demand for risk premiums has increased. Projects, which in the past were considered as nearly risk free, have become high risk projects.

Today, about 90 % of all new investments in generation are based on subsidies and no new market-based investment decisions are taken in Europe. More worrying is that the required feed-in-tariffs in various member states for new investments notably exceed the levelised costs of the actual projects – again, due to the increased risk premium for capital.

Cost of decarbonisation dependent on stability of policy framework

Back of the envelope, I have calculated that the capital costs, alone, for a decarbonised energy system in Europe are at least  5-7 trillion euros by 2050 in today’s monetary terms, assuming that the market should meet the European Union’s desire to reduce emissions by 80 % by 2050 from the 1990 level. This transition is fully feasible, but the full cost of it depends much on the chosen market design, policy framework and stability of the actual framework. The cost can be manifold if we do not conduct consistent energy and climate policy in Europe. And please note that today, the actual political desire to transform the sector by 2050 is still only indicative.

The recent EU 2030 climate and energy framework proposed by the European Commission is very much welcome. Firstly, it is very good that we already now make concrete commitments to year 2030 supporting the overall 2050 target setting, as any investment decisions made today will be operational for several decades. Secondly, the adoption of only one leading policy target, namely the 40 % CO2 reduction target, is very welcome instead of several overlapping targets as in the past. Thirdly, the proposal calls for the internal energy market to work with less state interventions. And finally, the proposal clearly interlinks the climate and energy policy to one, as we cannot run them efficiently separately.

It is too early to cheer, as the proposal still needs to be adopted by the member states – but it is definitely a very brave and good one. It is great that the European Commission seems to understand, that decarbonisation needs to be conducted cost efficiently. Let’s hope the member states will accept that too.

Simon-Erik Ollus, Chief Economist, Fortum

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