As I continue my PhD research, I keep coming back to two major questions: what are the fundamental risks inherent in building solar and wind generation capacity, and how should society best manage these.
This post attempts to outline my current thoughts on these questions. It is aimed at people already thinking about the subject — for me to understand how my views compare with theirs. It is therefore work in progress, and shouldn’t be taken as a fully-considered argument for or against additional generation capacity or changes to government policy.
I am looking at the questions from the perspective of an individual generator — although I’d like to think the insights raised by this level of analysis will also be relevant to whole-systems analysis. And I’m primarily thinking about Europe, US and Australia (the markets I know best) — but some of these thoughts apply to other markets.
When you build a solar or wind farm, you are first exposed to uncertainty as to how much sun or wind there will be. You are next exposed to uncertainty as to how much electricity you will produce given that sun or wind. Thirdly, you are exposed to uncertainty as to how much you will get paid for the electricity you generate. You can think of the first of these as meteorological in nature, the second engineering, and the third market related, but it is important to recognise that they interrelate.
Having uncertainty as to how much you will produce and how much you will get paid isn’t unique to solar and wind farms. However, the unique lack of control solar and wind generators have over when they generate increases the chance that they will be harmed by the uncertainty. In particular, there is a very real risk that if enough solar or wind generation capacity is built, prices at windy or sunny times of the year will fall to unexpectedly low levels.
This is not to say that solar and wind developers have no control over the uncertainties: there are choices that can be made. For example, by choosing a different location for a wind farm, or adjusting the angle of the solar panels, there is scope to increase the expected revenue, even perhaps while reducing the expected quantity produced.
Solar and wind farm owners have options available to manage these uncertainties, with customers, insurance, financial markets and government. I will discuss these options in sections 3 and 4, however it is important to note that many of these methods create other uncertainties, for example exposure to credit risk or policy risk.
2 Modelling the uncertainty
There are a number of models out there that attempt to quantify the uncertainty, and the expected outcomes, in terms of how much solar and wind production there will be, and what price it will achieve. I am still working through these to understand how they work, and the assumptions they make.
In the meantime, I offer an indication of how I am currently thinking about modelling the uncertainty.
- In given hours, there will be a particular wind and solar outturn
- Conditional on wind and solar outturn, and time of day / week / year, there will be expected demand
- Conditional on wind and solar outturn, and the available generation capacity (taking into account marginal costs) and interconnectors, there will be a generation supply curve (ie what generation will be available at different prices). This will give us expected raw price.
- Given expected raw prices in different hours, available storage and demand side response will adjust the demand, leading to adjusted prices.
Under this kind of a model, I would be able to determine expected power prices, expected wind generation and revenue, and expected solar generation and revenue. I would also be able to understand how changes to the wind and solar generation capacities affected these results, as well as how increasing storage and demand side response would improve the profitability of wind and solar farms.
3 Current ways of managing the uncertainty
At present, the simplest way in which wind and solar generators reduce uncertainty is via a feed-in tariff, in which generators receive a fixed rate for any electricity generated, for a period of 20 years or even longer. While having obvious benefits, such feed-in tariffs have several weaknesses. They do not protect the generator from reductions in revenue from reduced generation, whether due to meteorological or operational issues. They encourage developers to maximise generation rather than revenue. And given the long term and significant potential cost to the government, there is a risk (at least in some markets) that governments will withdraw these schemes retrospectively (indeed, many governments are reducing feed-in tariffs for solar and wind generators).
The next main way solar and wind farms manage their uncertainty is by forward-selling electricity under Power Purchase Agreements, either to electricity retailers or to large electricity consumers. Unfortunately, these also suffer from downsides. First, not many purchasers have the credit rating, let alone the desire, to lock in prices for more than 5 years of a generator’s 25 year plus life. Some contracts have tackled this by allowing the price to adjust based on market prices, but that reduces the extent to which the generator’s risk is managed. Second, customers are generally forced to take the electricity when it is generated, leaving them exposed to the cost of covering shortfalls (and potentially selling excess). Some intermediaries will take this risk, either converting the uncertain generation profile to a specified profile (often base load) or to the customer’s actual demand profile. But here the intermediary is taking a risk, and consequently few will agree to fix a price for this service for more than a few years.
Next, while I am less familiar with the insurance products on offer to solar and wind generators, I assume these exist, at least to cover wind and solar farms for operational outages.
As a result, I believe that much of the uncertainty for solar and wind generators, at least those that do not receive feed-in tariffs, currently sits with the owners and financiers of these projects. I fear that as solar and wind capacity increases, and some of these uncertainties begin to hurt, these owners and financiers will become reluctant to finance additional much-needed wind and solar capacity.
4 Alternate ways of managing the uncertainty
When I think about how best to manage risks, I first ask who would benefit if each risk took place. In the case of solar and wind, one of the major risks is that despite significant solar and/or wind generation, it will attract low prices. This may occur because power prices are generally low, or because of negative correlation: prices are high when generation is low, and low when generation is high.
I don’t believe it is that likely that power prices will be generally low over a long period of time. If this occurred, I would expect governments to increase environmental levies which would raise prices, and I would expect fewer generators in the market. But, if this risk did occur, end customers would benefit: both those that buy electricity, and those that buy goods and services that will be cheaper as a result of the cheap electricity. I therefore believe that the public (and the government) is well-placed to take this risk.
Far more likely in my opinion is the risk that power prices will be high when wind/solar generation is low, and low when generation is high. The beneficiaries of this scenario are battery owners, and consumers that can take advantage of demand flexibility.
Finally, there is the risk of wind and solar capacity achieving low generation, either for operational or meteorological reasons. To the extent that it is operational reasons, other generators will benefit a bit, and I would expect insurance to play a part. But I could also see much of this risk remaining with developers and investors — with the developers with a good track record being given funding to develop additional projects. When it comes to meteorological reasons for low generation, other generators may benefit from higher prices; either non-renewable generators, or wind generators benefitting from low solar or solar generators benefitting from low wind. There may also be other parties that benefit from the meteorological conditions that would lead to low wind or solar generation.
This consideration of the different uncertainties of wind and solar generators, and who might benefit from each, may imply that we can create a number of separate risk management products, each with a different natural counterparty, and which combine to fully eliminate the generator’s uncertainties. Unfortunately, it is not that simple, as the uncertainties interact in ways that inevitably leave residual uncertainties.
I therefore believe there is a role for an organisation to take on many of the risks of wind and solar generators, selling components of the risk where this makes sense. For example, such an organisation could offer wind farms a fixed revenue stream, in return for the money it received for its actual generation (adjusted for operational deficiencies deemed insurable). It could strike deals with consumers (individuals or companies) to pay them money if power prices rose. It could strike deals with battery operators, receiving money if price volatility rose but paying them money if it fell. The organisation would still hold the residual risk, but it would be able to monitor that responsibly. This organisation could be government owned or guaranteed, allowing it to enter 25 or 30 year contracts without exposing the developers to excessive credit risk.
But having such an organisation certainly isn’t the only answer, and in its absence there should be opportunities for the market to offer some of the products to manage these uncertainties. I look forward to learning more about what is possible and what is being tried, as I believe that having a better understanding of how to assess and manage these uncertainties is crucial if we want to scale up wind and solar generation in a sustainable way.
If you have views on this, or can recommend good articles, please do get in touch, either in a comment this post or directly to me.