Sometimes you can be wading through a report and hit something that abruptly tells you it isn’t really worth reading on: the report is mad and you are wasting your time. And so it happened when reading through the SDC report Tidal Power in the UK, and coming across Table 33 on page 119 – see left.
This shows the cost of the Cardiff-Weston Severn barrage for different discount rates (the horizontal lines), compared to other low carbon technologies (the bars). The report declares:
…at an 8% discount rate, [the barrage options] lie at the higher end in comparison to other low carbon technologies; at 15%, they are well above the costs of all other technologies except wave power; but using low discount rates of 2 or 3.5% a barrage becomes highly cost-competitive.
Oh dear…! If you were also to assume a very low cost of capital (discount rate) for the other technologies, they get much cheaper too! So the costs given for offshore wind or nuclear, both highly capital intensive, would be much lower if they had 2-3% discount rates and the bars would shrink below the lines. The chart is distorting and meaningless, but it does rather betray the tendency to appraisal bias that pervades the report. About this there is more to say….
The economics in the SDC report is too much about ‘how?’ and not enough about ‘why?’. The first job of economics is to help with deciding where and where not to invest resources. When things come out hugely more expensive than the alternatives, that should be cause for a searching examination of why we would want to do it. In the SDC report, it instead sets off a concerted effort to justify exceptional treatment. A 16 Km dam with over 200 turbines producing only the output of two Sizewell B power stations for £15 billion (and counting) should set off alarm bells for anyone with the slightest feel for power project costs. It’s just a very very expensive way to reduce carbon – about £200/tCO2 on the same sort of assumptions used elsewhere in the energy / carbon market, which is more than 10 times the going rate. Why should society want to tie up its resources in this unproductive way? Could not £15 billion be put to better use?
Severn barrage in context – the alternatives are cheaper and better
The Severn barrage should in the first instance be considered along side other options for reducing carbon emissions. In fact, consideration of available options is a requirement of the Habitats directive, Art 6.4. A common way to do this is to set out the available carbon abatement options from in order of cost and showing potential as the width of the bar, in what is known as a marginal abatement cost (MAC) curve. The chart to the left is an attempt at the MAC curve for the UK from the recent Energy White Paper (see fig 10.2 p286). I’ve added an estimate for the Severn barrage (£767/tC and 2mtC/year – note the chart uses carbon not CO2), based on SDC figures and the 10% discount rate, which would be typical in this industry (see my last posting: Case for the Severn Barrage – does it hold water). You can see that the barrage is way off to the wrong side of the chart. Note this chart is specific to 2020, so some of the technical potential estimates for other technologies will be constrained by how much can be delivered by 2020 – and it is far from clear a Severn Barrage would be producing anything by 2020, it is far from clear that the positions wouldn’t be even worse than this. The main point is that on a like for like basis with other technologies, this is a very expensive way to cut carbon – amongst the most expensive, and not particularly huge potential compared to say wind power.
The case for exceptional treatment… not made
The report tries to escape from this conclusion by making a case for doing something different. In a world in which private sector companies deliver power and, through policy-created markets, deliver carbon reductions, the SDC calls for a some form of taxpayer-funded public sector enterprise which, it argues, would expect or tolerate a very low rate of return on its investment. A scheme that provides low cost of capital is the only way the numbers can be made remotely respectable – so that is what has been attempted. The report moves quickly from ‘if’ to ‘how?’ with the only slightest pause for ‘why?’ in about one and a half pages (p.120-1). The following three sections are subheadings from section 4.8.3:
“Long term public benefits”. Irrelevant. If a barrage produces power for 120 years and a nuclear power station for 60 years but with lower average (‘levelised’) cost, you just have two nuclear power stations in sequence. Same applies for other shorter lived and modular technologies like offshore wind etc. In fact, shorter project lives have some advantages: technology moves on, you know more about the problem, society may be richer and better at taking decisions. We are instinctively wary of placing high values on promised benefits far into the future because we feel they may not actually materialise.
“Mismatch between risk and reward”. This seems to be based on the misconception that government always ultimately bears a range of project risks. In fact, the right people to bear risks are those best able to manage them – meaning construction risks should be borne by constructors, operating risks (ie. low output) by the operators etc. Government has got better at not standing behind big projects – with the Channel Tunnel it was 200 banks that took a bath. Offering low cost capital to a high risk project is just another type of subsidy – only less explicit and transparent than paying for valuable outputs (like carbon reductions) that are beset by market failures.
“Ensuring the public interest”. The report argues for public sector involvement to secure public benefits – but why wouldn’t the government just specify what it wants and pay a private sector body to deliver those benefits, if they were valuable? That’s the standard practice and something like the barrage would probably need its own legislation. The public interest is strangely defined in the report – apparently with no regard for how much of the public’s money is spent badly, and how much risk the taxpayer is asked to take on. I think it is also quite naive – and certainly poorly baked with evidence – to believe that public ownership is somehow in the benign public interest. Political and spending pressures to cut corners and make false economies are legion – witness the gross under-investment in water infrastructure by publicly-owned water companies prior to privatisation. Public ownership and direct involvement too easily sets up ‘principal-agent’ problems, making the Leninist mistake of conflating the interests of the state with the public interest.
Is there an innovation case?
One argument for paying over the odds and subsidising technologies that are way off market is that they will improve in cost-effectiveness and may be replicable and scalable. No such argument plays here. As the SDC puts it:
it would be difficult for the Government to justify treating a tidal barrage as a new renewable technology that requires innovation support (the justification behind the establishment of the RO), as the technology itself is certainly ‘mature’, and there is only limited potential for learning and further replication.
However, there are technologies that do justify innovation support as they are key climate technologies – eg. carbon capture and storage, which might have the all-important result of containing Chinese and Indian coal-related carbon emissions.
I don’t see a compelling case for exceptional treatment on any of these grounds at all… but let us just go with the flow and imagine that it was going to be done by the government. Even here, the position is not as the report suggests…
Public procurement – about managing risk and appropriate returns
The crux of the Severn barrage case is that its carbon economics are awful if a commercial rate of return is required for the project. The SDC point to lower rates of return implicit in ‘social discount rates’ and attempts to justify a ‘public sector project’. But if the government wants to buy a construction project, there is guidance on how that should be done. And it isn’t by setting up a government building company with cheap capital.
The SDC acknowledges that it it would have to upend current energy policy to make the barrage work, but it would also require rewriting other principles too. One reason is that higher costs of capital or discount rates capture ‘risk’. The government’s policy is to transfer risk, and it does this through contracting and procurement.
The Treasury Green Book discusses transfer of risk as follows Treasury Green Book Annex 4:
When faced with significant risks, a public body should consider transferring part or all of it to the private sector. The governing principle is that risk should be allocated to whichever party from the public or private sector is best placed to manage it.
Appropriate transfer of risk generates incentives for the private sector to supply timely cost effective and more innovative solutions. As a general rule, PFI schemes should transfer risks to the private sector when the supplier is better able to influence the outcome than the procuring authority.
OGC guidance on procurement require private sector contracting
The Office of Government Commerce publishes guidance through the Achieving excellence guides for government construction procurement, and guide 06 deals with Procurement and contract strategies. This says:
“Since April 2000, government policy has been that projects should be procured by one of the three recommended procurement routes (PFI, Prime Contracting or Design & Build)”. (click left to expand definitions)
This means that if the government wanted to buy a Severn barrage it would use a form of procurement that transfers risk to the developer and operator, who would expect a rate of return commensurate with the risk.
What about a central government project?
But what if some sort of Ministry of Works project was authorised? Would it command a low cost of capital simply because it is government. No, actually it wouldn’t.
But before we get in further, let’s examine another ‘stop reading‘ moment in the report. One of the more extraordinary comments is this:
“the Government can obtain debt finance at very low interest rates, and there would be no need to justify a high rate of return from the project due to the absence of any incentive to maximise short-term profits. For example, HM Treasury recently released index linked bonds at a nominal interest rate of 1.75%.”
Er… ever noticed how your bank gives you a lower interest rate on your savings than it charges on your overdraft? The Bank of England’s ‘base rate’ is currently 5.75% and this is the cheapest money available. The 1.75% is paid on ‘gilt-edged’ bonds that the government issues to finance the public debt – its is government borrowing not lending. The government has the highest credit rating and negligible default risk for the purchaser of the bond. None of these things applies to government lending for a risky capital project in an otherwise private market place.
Apply a social discount rate? One might wish to point to the discount rate used in government policy appraisal as set out in ‘Green Book‘ guidance on policy appraisal… 3.5% and declining over time [here]. But where the output is sold in a competitive market (for example in markets for electricity, renewables certificates, carbon) the government’s priority is to avoid excessive distortion. The Treasury Green Book is clear that where the government acts in otherwise private market. The Green Book and related guidance is set out in sequence of quotes below below.
1. Treasury Green Book.
5.54. Some central government bodies sell goods or services commercially, including to the government itself. These activities may be controlled by requiring prices to be set to provide a required rate of return (RRR) on the capital employed by the activity as a whole. Government policy is generally to set charges for goods and services sold commercially at market prices, and normally to recover full costs for monopoly services, (including the cost of capital as defined in the Treasury Fees and Charges Guide [see below].
That means the government should use an appropriate cost of capital, not just the social discount rate.
2. PES (2003) 16 Fees and charges policy
5 (second bullet) for commercial services where there is or may be private sector competition, and a profit may
be appropriate, to replace the required rate of return of at least 8 per cent with an illustrative range starting with 5.5 per cent – we want departments to make their own assessment of the appropriate rate of return for commercial services, but we would expect the rate to fall in a range 5.5 per cent to 15 per cent depending on factors such as the level of risk.
14.b) For commercial services where there is or may be private sector competition departments should make their own assessment of the appropriate rate of return, taking account of the illustrative range in paragraph five above, and the further advice in Annex 3 [see below]. For some this may mean a significant change in the rate of return and level of prices. For some it may be that that the level of charges is already be consistent with the revised guidance and will need no change.
That means that rates of return (discount rate) should be between 5.5% and 15%.
3. PES (2003) 16 annex 3
The assessment of the rate of return may also be assisted by an overview of the weighted average cost of capital (WACC) of competitors in the relevant market. Existing overviews of WACC in the relevant market (or a comparable market – see paragraph 9 above) may be available from relevant organisations such as a competition regulator, or other reputable organisations (but would need to be of reasonably recent date). Alternatively, the public sector body could consider whether there would be value in seeking a new assessment of this type of information.
That means the rate of return (discount rate) should be set with reference to the costs of capital of participants in the related market. In my previous post, I suggested 10% would be a sensible comparator (see table). The SDC suggested 9% in its report on nuclear.
Is this mindlessly following guidance…? What if the guidance is wrong?
Though I’ve set out what the government says about appraising and funding projects like this in general (not just in the energy sector), there is the possibility that the guidance is inappropriate and an exception justified for the Severn Barrage. If there is a case for an exception, the SDC hasn’t made it, and although it draws on ‘social discount rates’ it doesn’t mention the guidance above. The guidance isn’t arbitrary and it is designed to implement some sound economic ideas – about distortion of markets, about risk, and about the opportunity cost and scarcity of capital – and a reluctance to transfer resources to the public sector from the private sector so that it can be used in ways that have a lower rate of return. I don’t see why these ideas wouldn’t apply to carbon policy.
Is there any justification?
The only case I can think of rests on meeting the extreme EU renewables target of meeting 20% of primary energy from renewables by 2020. In this case, a new instrument like the Renewables Obligation, only better designed would be the way to go. If the justification for the barrage flows from this, it simply reflects the poor design and over prescriptive nature of the ‘reckless EU renewable target‘, as I called it in an earlier posting. It’s precisely because the target would drive really expensive carbon-reducing projects that I think it is a bad policy.
What should be done?
Long-term low-carbon framework. The SDC do suggest some good ideas for addressing the true market failure – the weakness of the long term price signals for carbon and framework for developing low-carbon technologies (p.123) and I discussed these in my earlier Severn barrage posting. However, there is no case for tying these to the Barrage. I think it would be very good for the government to recognise the immaturity of the carbon market, the fact that it is laden with ‘policy risk’ (ie. no-one can guess what the policy framework will be in 2025), and the fact that long-term investments are necessary but are inhibited in the current framework. That says to me that a more credible less risky long term carbon framework is needed – perhaps with the government underwriting a long term future carbon price.
Innovation strategy – carbon capture and storage. There is a good case for investing at over the market rate in technologies that will play a role in the future or that would allow for some diversity in the response. Things like the wave hub and London array looking promising. I’m particularly keen on seeing a kick-start for carbon capture and storage. We have 8GW of new coal plant awaiting licensing in the UK (far more output and carbon than the barrage). Devoting resources (£15 billion!) to CCS would be a far better approach – a lower cost of carbon, and a scalable critical technology.
Long-term abatement cost curve / surface – the ‘why now?’ question. We should be paying much more attention to the ‘marginal abatement cost curve’ as this should guide the focus of policy – telling us where the most cost-effective carbon savings are. However, this 2D curve (as shown above) should really be visualised as a 3D surface, with an axis for time… costs and technical potential will change over time for each technology, and so will the depth of cuts required in emissions and the ‘strike price’ for carbon (ie the cost of the marginal tonne saved). It is possible that a barrage will become a cost-effective at some point in the future as better options are exhausted. Equally possible is that new options will appear or costs and potentials of existing options will continue to improve. Another question not addressed (or asked) in the SDC report is ‘why now?’. We have an option on the barrage and it might be that the right to do it will be in 60 years time in a more carbon constrained world.
I could go on, but let me draw this together.
- The Severn barrage costs too much for too little. On a like for like basis with other low carbon technologies, it creates extremely expensive carbon savings – more than 10 times the going rate.
- The case for some sort of exceptional treatment is very weak – with a poorly defined case for the public interest, market failure or innovation
- Even if it was built as an exceptional public sector project, the procurement would need to transfer risk to the private sector and use something like a PFI, which would reintroduce financing costs commensurate with risk
- Even if an exception was made to this and the government somehow builds the project itself, guidance on policy appraisal requires a commercial rate of return to be used where the government is intervening in a market where there are private sector actors delivering the same things (energy, carbon savings)
- The Habitats Directive (92/43/EEC Article 6.4) has three levels of test before a designated area can be disrupted:
1. consideration of alternatives…
2. assessment of ‘over-riding public interest’…
3. specification of acceptable compensating measures…
- The barrage fails the first two of these, and so the third should not arise. There are clear alternative low carbon technologies that are cheaper and more widely applicable. There is no over-riding public interest in upending energy policy in order to develop an extremely expensive renewables project. These tests are supposed to be sequential, so discussion of compensating measures should not arise.
- A better strategy would be to establish a long-term framework for rewarding carbon savings, promote innovation in technologies that will matter for the future and keep the option of the barrage open until we have exhausted better approaches – if that ever happens.