A renewable future?

Last week the regulator, Ofgem, warned that the UK energy market is in desperate need of reform. We look at the challenges ahead.

Ever since the Brussels summit in March 2007 the European energy industry has been on borrowed time. When Europe's political leaders, including Tony Blair, pledged to reduce the EU's greenhouse gas emissions by 20 per cent whilst increasing the share of energy produced by renewable sources by 20 per cent - and to do both by 2020 - it seemed like a sensible idea. Europe appeared to be leading the way on global climate change. It was hoped that the US, China and the major developing countries would follow. In 2006, when Russia cut gas supplies to the Ukraine following a long running commercial dispute, much of Europe experienced shortages and price spikes. The new strategy seemed to promise increased security as well as a chance of saving the planet. However, when they were calculating how much it would cost, the architects of this plan did not count on there being a global financial crisis.

The level of financial investment required to meet these targets is daunting. The bill for Europe is estimated at €1,000 billion (£870 billion). The UK is committed to increasing its share of energy produced from renewable sources to 15 per cent by 2020. This will cost in the region of £200 billion. This money is supposed to come from private investors (hedge funds, pension funds, private equity groups and so on). Last week a report by the industry regulator Ofgem concluded that this isn't going to happen without significant market reforms. "It's not that the lights will go out all over Britain, but we could be in quite an uncomfortable situation," said Ofgem's chief executive, Alistair Buchanan.

It's the combination of targets which makes them so expensive. The cheapest way to reduce CO2 emissions would be to build more gas fired power stations. However, you can't do this and increase the share of renewable energy at the same time. When you consider that most of Europe's largest economies (the UK, Germany, France, Italy and Spain) were already facing the expense of replacing the old, post-war infrastructure the costs become crippling.

The UK's predicament is particularly acute. The Conservatives, under Margaret Thatcher, liberalised the energy markets, relying on North Sea oil. Ofgem supported this process because it had the effect of pushing prices down for consumers. All the other major European states retained some control over the energy industry. But North Sea Oil reserves are dwindling and Britain now gets most of its oil and half its gas from abroad. Ofgem now believes that the free market model will not provide enough incentives for investment in renewable energy projects. This is because investors are put off by the knowledge that their money would go straight into building new infrastructure (more windfarms etc). Any profits generated will need to be reinvested, which means they are unlikely to see any returns for the next decade or so. That's assuming that there are any profits. In the current market, renewable energy projects will struggle to break even, given the huge costs involved in development.

Existing supports are not sufficient. Most European countries already operate "feed-in" tariffs, where the price of energy from renewable sources is fixed. These will have to be raised at a time when many people are still feeling the pinch, which will not prove popular and could have political ramifications. The chief executive of the state-controlled EDF in France, Pierre Gadonneix, lost his job when he angered President Nicolas Sarkozy by suggesting bills might have to rise.

The European Union's Emission Trading System (ETS) was supposed to help renewable energy companies make money (and so attract investment) by allowing them to sell carbon credits to other businesses with higher emission levels. The amount it costs to buy permission to emit one ton of CO2 is called the carbon price. This is subject to the normal market forces of supply and demand. During a recession businesses use less energy and, as a result, many now have more carbon credits than they need. Consequently, the carbon price has dropped to €15 (£15). This is a ridiculously low level. The environmental audit committee of the House of Commons has called on the government to introduce a new tax to push the carbon price back up to nearer €100.

Last week, the chief executives of several banks and energy companies warned the Prime Minister at a meeting in Downing Street that the current incentives to invest in renewable energy were insufficient. But there is no industry consensus as to how to reform the market. They cannot even agree over whether or not it would be desirable to introduce a minimum carbon price. However, the representatives from Centrica, BP and Royal Dutch Shell were united in calling on the government to do more to educate and inform the public that higher prices are inevitable. Ofgem have warned that energy bills may have to rise by as much as 25 per cent (or approximately £2,000) by 2020.

The government will set out new proposals next month, on the same day as the budget. The Energy and Climate Change Secretary Ed Milliband has already accepted that the country needed "a more interventionist energy policy". The Conservative's energy spokesman, Greg Clark has also said that his party will introduce market reforms if they win the next election.

The uncertainty surrounding the future of the energy market will do nothing to reassure investors that they can make money from renewable energy. Last month, licences to develop offshore wind farms were issued to 14 groups of energy providers. The government hopes wind will be able to generate 32,000 megawatts of energy by 2020, accounting for a quarter of the UK's capacity. To put these figures in context, the worldwide capacity of offshore wind is currently about 2,000 megawatts. Gordon Brown has said he hopes the investment in offshore wind will create 70,000 new jobs by 2020. But the offshore wind farms are expected to cost £75-100 billion. They won't be built unless the government can find away to convince investors that wind can turn a profit, as well as turbines.

With the right incentives, renewable energy should be attractive to investors looking for stable, long-term returns. There is a built-in level of consumer demand: we may stop buying shoes but we cannot stop buying energy. And there are inherent limits to competition levels (no one will knock-up a windfarm on the cheap and start competing with you). But to secure the necessary investment, European governments must promise that consumers will start paying more for renewable energy. And yet economic growth in Europe is currently an anaemic 0.1 per cent. Dark clouds of the Greek debt are gathering over the continent. Given that neither the US nor China seem willing to pull their weight when it comes to cutting emissions, the people of Europe may start to question the wisdom of paying more to get their energy from renewable sources.