An energetic exchange on the costs of decarbonizing Europe

We very much enjoy responding to our colleague Amory Lovin’s comments on our earlier article describing Sweden’s energy mix for electricity generation.

Lovins is quite correct in describing our picture of the Swedish electricity market as a snapshot—as it indeed is. And it is quite correct that to assess how electricity markets will evolve, one needs to take into account the highly dynamic technical evolution of energy generation, especially as it regards renewables such as wind and solar power. But we fear that he may have misjudged our intentions: We were not arguing that the Swedish conditions are a model for how energy markets (such as the ones in the United States) should be structured. Our goal was far more modest, namely to demonstrate by explicit example that it is possible to construct a mix of energy generation technologies that successfully completely decarbonize the production of electricity, and to do so for the long haul (i.e., Sweden has had a decarbonized electricity sector for decades) and at reasonable retail electricity costs, i.e., rates that are not out of line with rates experienced by retail consumers in markets that are dominated by fossil-fueled electricity generation. In other words, our intention was (and remains) to provide an “existence proof” that a national electricity sector can be completely decarbonized while maintaining highly reliable service and without causing traumatic economic stresses.

As for specifics, Lovins offers some speculations about how Sweden’s energy mix might evolve, focusing virtually exclusively on the sharply lowered costs of energy generation by wind and solar technologies. While we fully agree with him about the remarkable decrease in generation costs by wind and solar, we fear that Lovins appears to be a bit reluctant to discuss the details of exactly what transitioning to a largely renewable power-dominated electricity will really cost.  That is, while it is surely correct that the steep drop in generating costs by solar and wind technologies will influence (and benefit) that evolution, there are constraints other than just generating costs that influence how utilities evolve their energy generation mix, including the demands imposed by efficient and effective dispatching, the requirements imposed by assuring continuous operations and electricity supply, and finally the social acceptance and behavioral changes that moving to a truly carbon-free energy system entails. And once one takes into account these complexities of the ongoing decarbonization transition, it turns out that electricity retail customers do see increased retail electricity costs.

All these issues are discussed in great detail in a 2021 study carried out by Nordic Energy Research for the Nordic countries (Finland, Norway and Sweden), with a time horizon of 2050. This careful, quantitative study makes the case that, for a variety of scenarios—ranging from one that minimizes the transition costs to one that positions the Nordic countries as significant electricity exporters to the rest of Europe—the Nordic group’s generation capacity would be dominated by a mix of hydro, wind, nuclear, solar and biofuels. They predict that the largest changes on electricity demand and in generation in the period leading up to 2050 would be the total decarbonization (and consequent electrification) of transport and a huge increase in wind power (generated both on land and off-shore), respectively; this would make hydro and wind by far the largest contributors to electricity generation in the Nordic countries, with wind actually substantially dominating hydro in the most ambitious scenario (in which these three countries become significant exporters of electricity).

What is particularly striking in these scenarios is that their dispatching modeling shows that the inevitable fluctuations in generation due to renewables can be effectively dealt with without resort to grid-scale energy storage, namely via the combination of the existing fully dispatchable generation sources—mostly hydro, nuclear and biofuels—which allow for some degree of ramping; this is especially true for biofuels, which are thus seen by these authors as an essential tool dealing with fluctuations in renewable energy generation. Finally, they demonstrate explicitly that the required evolution in generation technologies can occur without drastic changes in retail energy costs: costs will increase slightly, but not as dramatically as has already occurred in other venues.

Which gets us to Lovin’s critique that we unfairly compared energy prices in Sweden and Denmark, asserting that we ignored the distorting effects of the relatively high tax rates in Denmark. Actually, we were particularly interested in the electricity costs presented to retail consumers, including taxes and fees. The reason it is useful to examine the details of the retail electricity costs experienced by consumers is that they contain, in addition to the costs of electricity generation (i.e., what the utilities pays for the generated electricity—costs that do reflect the wholesale price of electricity that Lovins refers to) and the costs of electricity transmission and distribution, a wide variety of fees and taxes. And it is these fees and taxes, which can actually more than double the retail electricity costs, that can in part reflect the costs of implementing decarbonization, which the wholesale electricity prices do not reflect. This is where the Swedish electricity market differs from those elsewhere: As we discussed in our article, Sweden eliminated the explicit tax on nuclear-generated power (this was one of the “policy instruments” we discussed in some detail). In other European countries, the situation is more complex.

Germany is a useful example. In our previous article, we noted that country has extraordinary retail energy costs (32.16 Euro cents per kilowatt hour) and vastly increased renewable energy generation. Germany also imposes electricity taxes that explicitly relate to the energy transition. Three fees are included in this tax: a “renewable energy surcharge” (6.5 Euro cents per kilowatt hour, or 20 percent of the total retail cost), an “offshore liability levy,” which operators pass on to consumers (0.4 Euro cents per kilowatt hour, or 0.03 percent), and a “surcharge for combined heat and power plants”—all fossil fuel-based (0.25 Euro cents per kilowatt hour, or 0.08 percent).

The transition to renewables is forcing a significant restructuring of Germany’s electricity grid, principally because its current grid was not designed to carry large amounts of power from the north (where much of Germany’s wind power is generated) to the south (where much of its energy consumption takes place). While the existing grid has been fully amortized (so that electricity transport charges have largely been based on operating and maintaining the already-existing grid infrastructure), paying off the capital construction costs from grid restructuring leads to additional costs for retail customers. As a result, at least one third of the retail electricity costs in Germany are basically a combination of subsidies to renewables, added fees on fossil fuel-based generation, and added transmission costs due to grid restructuring. In other words, they are part of the costs of transitioning to renewable power.

As for the politics: The new German coalition government elected in 2021 came into office with plans that explicitly addressed the high electricity costs; in particular, the coalition plan will seek to “reliev[e] electricity consumers by no longer having the billion-euro renewable energy surcharge financed on electricity bills.” If higher electricity bills would not be used to pay for the required costs of transiting to renewables, those funds will need to be found elsewhere in the government’s annual budget. That does not mean that these additional costs don’t exist, just that it will be much more difficult to explicitly tie specific sources of government income (taxes and fees) to the expenditures funding the energy transition.

Which brings us to the Danish case. The first point to make is that Lovin’s comment about Denmark’s taxes on electricity is quite on the mark: For example, the total electricity price in the second quarter of 2021 was 256.41 øre per kilowatt hour (about 37 US cents), of which 21 US cents per kilowatt hour (56.9 percent) is attributable to taxes and fees. This tax burden can be further broken down into an “electricity tax” (13 US cents per kilowatt hour), transmission and system tariffs (about 2 US cents per kilowatt hour), an explicit subsidy fee/tax for renewables (a modest 1.1 US cents per kilowatt hour), and finally the value added tax.

It is particularly interesting that Denmark is explicit about not using electricity taxes or fees as a primary tool to encourage decarbonization. Instead, the policy instruments used to drive decarbonization are largely subsidies. In other words, the explicit tax supporting a renewable subsidy mentions above is actually not the primary fiscal tool used by Denmark to steer electricity decarbonization. Similar to the proposal by the new German government, the dominant costs of the decarbonization transition (including the subsidies) are funded through national tax revenues, and so cannot be directly linked to the current electricity retail prices paid by individual consumers. We leave it to the reader to deduce what the political motivation might be to disassociate the costs of the decarbonization energy transition from retail electricity costs.

Finally, some comments about nuclear power. It is certainly true that Sweden is currently benefiting from the fact that their current nuclear generation capacity is largely already amortized, e.g., Swedish consumers are no longer paying much (if at all) for the capital construction costs of these power plants. They are also benefiting from the high capacity factor of these plants, a factor that does matter in the economics of electricity generation, and which Lovins does not take into account when comparing wind and solar generation costs with current nuclear power generation costs in Sweden. That is, he is correct that the capacity factor for various generating technologies is taken into account when computing (for example) the levelized cost of electricity; but those costs don’t account for the system-level costs imposed by the low capacity factors for renewables, and these are the costs we were referring to in our article.

New construction—especially for gigawatt-scale plants—is currently quite expensive, as Finland has discovered recently. Whether the Nordic countries continue to use nuclear power after the existing plants reach their nominal service life will depend on the future construction costs of nuclear power plants, and exactly what these will be is unknown. This is indeed the conclusion of the aforementioned Nordic Energy Research study of the Nordic nations’ energy future.

All this leads us to ask what conclusions may be drawn? First, it is a very smart idea to start “greening” one’s electricity generation early. That is a clear message that the Swedish example is sending us. The Swedes have been doing this for decades—and they did not need to resort to additional tax revenues (explicit or hidden) to fund this transition. Second, if a country is set on decarbonizing electricity generation now, with (reasonable) targets for complete decarbonization by, say, 2050, the sharply lowered costs of solar and wind power generation seen over the past decade will ameliorate, but not eliminate, the fact that total electricity costs will rise substantially as the network is decarbonized. The reason is an obvious one: The shorter the amortization period for paying the inevitable transition costs, the higher the retail electricity costs will be. So, given that decarbonization of the electricity sector is widely agreed to be inevitable, delaying that transition is a recipe for increasing retail electricity costs, and the longer one waits, the more expensive it will be. The only remaining question is then how transparent this process of paying for the energy transition will be.