In its new State Aid guidelines, the European Commission presents auctioning as the standard procedure for allocating support for renewable energy. Member States may deviate from this rule, but only for very good reasons. Although auctioning can in theory be a useful instrument, experience all over the world shows mixed results. It is crucial that auctions are adapted to the specific market context. If not, they will deliver sub-optimal results or may even destroy renewable energy markets. In this article Corinna Klessman and Rolf de Vos of international energy consultancy Ecofys identify some of the dos and don’ts of renewable energy auctioning.
In April the European Commission adopted new rules on public support for projects in the field of environmental protection and energy, including renewable energy. These new State Aid guidelines are intended to address the market distortions that may result from national subsidies granted to renewable energy sources. To this end, the Commission’s guidelines promote a gradual move to market-based support for renewable energy, specifically by requiring auctioning or other “competitive bidding processes” in allocating support for renewable energy.
The possible benefits of auctioning
In a standard renewable energy auction the government puts out a tender and chooses the cheapest bid. In theory, then, auctions allow for an efficient use of public budgets. They will deliver the largest volumes of production against the lowest cost. For this reason, auctions are increasingly applied internationally. For instance, the Netherlands introduced feed-in premiums combined with auction rounds in 2011. Germany—famous for its successful and now often criticised feed-in tariffs—recently announced that it plans to move from administratively defined feed-in tariffs to auctioned support payments no later than 2017.
In addition, auctions allow for an easy alignment between development of renewable energy and infrastructure planning. In general, auctioning meets the principles of a liberalised market and free competition, assuming that cartels are avoided. In the EU, The Directorate-General of Competition increasingly calls for market-based instruments in sustainable energy support.
Challenges of auctioning renewable energy support
However, it is important to keep in mind that auctioning also has its challenges, including the following:
- Not all projects that are selected will actually be carried out: the rate of implementation almost always falls short of 100%.
- The risks for applicants are higher than in open feed-in schemes, because a proposed project may not be selected and bidders may incur costs or face penalties when they are unable to implement a project that has been selected.
- A sufficient number of bidders are required to participate, otherwise the auction will not produce a competitive result.
- Auctions may invoke strategic behaviour of market players which can drive up costs. Market players will also try to exercise market power. Large market actors may have a favoured position over their smaller competitors.
Not all projects that are initially rewarded are necessarily realised in the end. This is an important point, because implementation rates matter for the achievement of political targets, especially for the legally binding targets of European member states.
There are different reasons for a low implementation rate. First, there are normal project risks: problems with receiving permits and grid access, changes in component prices and project costs, etcetera. These risks also exist under other support schemes (e.g. FIT) but they are more acute with auctions, because the support is rewarded before the project becomes operational. The lower the development status of bidding projects, the higher the risk that they are not implemented.
Also, there is the so-called ‘winner’s curse’, when a bidder with too little knowledge or information underbids below cost, pushing the more realistic bids out of the competition.
Possible solutions are:
- High prequalification requirements or penalties will increase the implementation rate, although they also increase the risks and costs (see also the next paragraphs) and reduce the number of bidders.
- Governments could also auction higher volumes than needed for target achievement. However, this approach may be difficult to ‘sell’ politically and controlling the volume is a challenge.
- Another option is to make support allowances transferrable to other projects and/or market actors. This will create flexibility for market actors but may also create speculation. It will only work in combination with high penalties and it tends to increase the required implementation periods.
The challenge therefore is to find an optimised balance between these design elements. As a prerequisite for the design of the auction, the policymaker has to explore how the national targets relate to envisaged annual deployment rates, auction volumes and renewable energy market size.
While competition is an incentive for project developers to offer lower tariffs, auctions also expose bidders to risks that can increase risk premiums, project costs and tariffs:
- Developers whose projects are not selected face sunk costs for project development which cannot be recovered. The amount of sunk costs depends on the prequalification requirements (e.g. how far must the project be developed to fulfil the requirements and which permits does it need).
- Developers whose projects are selected still face a risk of having to paying a penalty, if the project is delayed or cannot be realised. This risk depends on the penalty defined (how high, which time frame) and on how complex or risky the project is. For instance, in wind energy, the risk of failure is higher than in PV.
Sufficient number of bidders
Auctions will only work properly if demand for support exceeds supply. Scarcity is a crucial criterion for making auctions work efficiently. Note in this context that high prequalification requirements, leading to high upfront costs, will automatically reduce the number of bidders. This usually benefits larger market players with more financial capabilities. The same is true for high penalties, unless support allowances are made transferrable. Ceiling prices can serve as insurance in case a lack of bidders drives up prices.
With auctions there is a risk that bidders communicate with each other and agree on prices beforehand..
Bidders with market power may also underbid to push others out of the market. They will be able to compensate for the initial losses by asking higher prices when only few market actors are left.
A high number and variety of bidders reduces the risks of strategic bidding.
International experiences with renewable energy auctioning show a very mixed picture. Auctioning is not always effective in supporting renewables.
Sometimes, very few projects are actually realised. For instance, experiences in the past in the UK, Ireland and China have shown low implementation rates. In most of these cases, penalties were not in place or not applied systematically.
Also, experience has shown outcomes both with low and high prices. The range of results is quite broad. For example, very low tariffs were achieved in highly competitive wind energy auctions in Brazil. From a policymaker’s perspective this is a positive outcome, but some analysts believe that bidders offered wind energy below generation costs in order to secure future market shares. This could reduce competition in the future.
On the other hand, the first renewable energy auction in South Africa in 2011 was characterised by limited price competition due to high overall auction volume. The resulting prices were close to the ceiling level, because bidders anticipated that their bids would still have a high chance of being successful. This problem was avoided in later auction rounds by better matching the volume caps to the technology markets.
An auction for large PV rooftop systems in France in 2013 was cancelled because price results were higher than expected.
Assessments show that many external factors (other policies, market development, other conditions) affect the result of the auction. In many cases, the context matters much more than a sophisticated auction design itself. One more example illustrating this was the fourth offshore wind auction in Denmark in 2009/10. In this tender for the Anholt offshore wind park, prices dramatically increased compared to earlier tenders due to changes in external market conditions, i.e. the financial crisis. Furthermore, the Danish auction was held in parallel to a large UK offshore auction, which caused bottlenecks in the supply of offshore wind turbines. The competition with UK prices drove the price upward.
For a better understanding, it is also important to differentiate between European and non-European markets. Outside the EU, auctioning is often applied by monopolistic utilities that commission a certain number of renewable power plants to independent power producers. These auctions draw in foreign expertise, while the local power company stays in control of the budgets spent and of the volume generated.
By contrast, the EU market is already more or less liberalised and in many countries, renewable energy has matured. Therefore, implementing auctions in the EU is a different story. Many support policy instruments and actors are involved and targets are already in place. Introducing auctions will be a matter of a careful match with the existing instruments, markets and market structure (e.g. type and number of actors). For instance, in Germany the yearly growth targets for onshore wind are already in the same order as the actual wind market development. What could an auction add to that?
To sum up, an inadequate design of auctions may result in low effectiveness in renewables deployment and in not achieving the targets. There are some options to prevent this from happening, but policymakers have to realise that all options have trade-offs, for instance higher costs or a lower number of eligible bidders. The design and choice of instrument should be decided above all by the specific context in which the auction takes place.
Auctioning should be seen as one possible option among different support scheme designs, and not as the silver bullet that the State Aid guidelines seem to view it. Policymakers should always ask whether an auction is the right instrument under the given circumstances. They should ask above all whether a competitive market exists with a sufficient number of potential bidders and a level playing field among those bidders.
If such precautions are not taken, auctions may even destroy existing market structures. For instance, badly designed penalties or prequalification requirements may reduce the number of market actors and push small and medium-sized actors out of the market. Of course to some extent this lesson applies to all types of support and allocation mechanisms. For instance, a feed-in tariff that does not provide an adequate support level or that is cancelled or strongly capped for reason of budget control will also destroy or prevent sustainable market development.
In any case, experiences so far cautions against the strict preference for auctioning that the European Commission is displaying. More experience is needed to improve design, to make outcomes more predictable, to upscale the size and to evaluate under which conditions they are a suitable instrument to meet ambitious renewable energy targets.
The authors are researchers at the international energy consultancy Ecofys (@Ecofys). Fabiand Wigand and Malte Gephart of Ecofys also contributed to the article.