A green solution for the Arab world

A green solution for the Arab world

B. Fattouh, R. Poudineh and A. Sen (OIES)
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The growing demand for energy, and shrinking reserves, are encouraging many Middle Eastern countries to opt for renewable energy, despite the uncertain regulatory framework and, in many cases, the lack of effective incentives, slowing down the transition process

There are many reasons why major oil and gas producing economies of the Middle East and North Africa (MENA) need to keep pace with the rest of the world and invest in renewable energy. Among these are rapidly growing domestic energy demand, growing uncertainty over long-term demand for hydrocarbon resources, the ensuing need for economic diversification, the importance of maintaining fiscal stability and tightening constraints from global environmental policies. Rising electricity demand driven by economic growth, high rates of urbanisation, expanding populations, and low electricity prices have meant that increasing amounts of liquid fuels (crude oil, fuel oil and even diesel) and natural gas (imported in a number of countries) are diverted to the power sector, often at prices below international levels. In the last two decades, state-owned utilities in the region have responded to soaring electricity demand by building the cheapest and quickest options for new generation, usually open cycle gas turbines or oil-fired boiler plants. These technologies’ low energy conversion efficiencies are compensated by cheap, almost unlimited fuel reserves. Shortfalls in revenue collection have contributed to insufficient cost recovery by utilities, impeding capacity investments. The funding for investments frequently falls back on national budgets, pushing up government expenditure, which is in turn reliant on resource revenues. Thus, resource-rich MENA countries face a triad of challenges: rising electricity demand, thinning reserve margins and generation investments increasingly subject to the budget constraint from lower oil prices.

A potential yet to be explored

Simultaneously, resource-rich MENA economies have great potential for renewable energies, owing to high levels of irradiation throughout, and wind potential in some. Many countries in the region also have fewer limitations on the use of land for construction of wind and solar farms. Furthermore, their locations are often close to the regions’ main energy markets. Collectively, these conditions create a unique opportunity for MENA countries to exploit their renewable resources to their full potential to serve rising domestic demand, whilst also harmonizing with the changing global energy landscape in which renewables are fast becoming mainstream. By increasing the share of renewables in electricity, MENA countries can free crude oil and natural gas for export markets. Renewables can help reduce their climate footprint as per capita emissions are amongst the world’s highest. They can contribute to economic diversification by establishing new industries and developing the local value chain. There is also a strong belief that renewables can create high-quality jobs that would be desired by the local population. Despite the start of large-scale projects and the huge potential for renewables, to date the share of renewable energy only accounts for 1% of total primary energy and 3.5% of electricity generation across the entire MENA region (this differs across the resource-rich and resource-poor countries of the region). Moreover, more than 90% of this is hydroelectricity, whilst the share of non-hydro resources barely exceeds 1% of the region’s total electricity generation. This raises two fundamental questions: What have been the barriers to the deployment of renewable sources in most resource-rich MENA countries? What are the policy solutions for incentivising investment in renewable energy in these countries?

Making every investment in renewables simple and profitable

Although governments of MENA resource-rich economies may have different objectives to achieve by deploying renewables, the solution always involves creating incentives and eliminating or lowering the barriers to investment. The government needs to design appropriate policies to tackle deployment barriers in the areas of grid connection and management, institutional challenges and risk and uncertainties. At the same time, governments must design policies that create incentive for investment. There are two extreme policy solutions to incentivise renewable investment in resource-rich countries. In one approach, the government introduces a full renewable subsidy programme (in addition to current fossil fuel subsidies) and steers investment towards specific renewables. This requires long-term government support and commitment in order to create investor confidence. In the other case, the government eliminates barriers and lets economics determine market outcomes with respect to the quantity and type of renewable technologies installed. This requires the complete removal of fossil fuel subsidies (and internalising the cost of externalities) so that those forms of renewable technologies that are already competitive can kick in. A long-term fully subsidised renewable energy programme, in addition to current fossil fuel subsidies, is fiscally difficult across all resource-rich MENA economies. Similarly, the implementation of full energy price reform to enable the market, in a short period of time, would be nothing short of a revolution in these countries. Therefore, the application of polar solutions in their pure forms would be extremely challenging, if not impossible.

A "combination" approach

In a recent paper, we argue that resource-rich MENA countries should adopt a combinatorial approach, which can be part of a dynamic process in which the countries start from the most feasible point on the proposed policy instrument spectrum, given their current context, and gradually move towards phasing out fossil fuel subsidies over the medium to the long term. This not only reduces the fiscal pressure on government budgets (compared to a fully subsidised model), but also averts political risks by allowing businesses and households to slowly adapt to the new environment where energy carriers are priced at their full economic costs. The position on the policy instrument spectrum is a function of the countries’ institutional setting, the state of energy price reform, fiscal situation of the government and public acceptance, among others. An important feature of the combinatorial approach for incentivising renewables is that it takes not only the economic factors into account but also the political issues related to subsidies. That way, the pace of price reform can be adjusted for each individual resource-rich country based on its own context. As opposed to a fully subsidised programme which transfers the whole cost of renewable deployment to the government budget, the combinatorial approach partially relies on government and partially on the market. And contrary to a fully market based model which transfers the political risks to government but economic risk to market agents, the combinatorial approach distributes the risk between market players, government, and consumers in a more efficient way. In this sense, the combinatorial approach provides a practical way forward for the hydrocarbon economies to increase the share of renewables in their power generation mix.

Obstacles to the installation of renewables

Although the provision of investment incentives is necessary for renewable deployment, such incentives are not sufficient on their own, as barriers to deployment also need to be removed. Resource-rich countries need to ensure that the necessary institutional capacity exists in the country to deliver renewables, generators have access to a reliable and flexible grid and also appropriate risk mitigation instruments are available to deal with inherent risks and uncertainties. These barriers can cause underinvestment in renewables as well as the conventional generation essential to backup renewables. Of these barriers, policy risks and uncertainties are key. In resource-rich MENA countries, renewable investors face uncertainty in the pre-implementation and the post-implementation phases. The pre-implementation uncertainties include not knowing if, when, or what type of policy will be implemented to incentivise renewables. Post-implementation uncertainties relate to the stability, transparency, trust and insurance for long-term support.

Reforming the energy sector

Furthermore, the structure of the power sector directly affects renewable deployment as it is the platform upon which incentive mechanisms for renewables should be designed. In countries with non-liberalised power sectors, electricity services are provided through a vertically integrated monopoly (VIM) which owns and operates generation, transmission, distribution and retail supply. Although most MENA countries had vertically-integrated electricity sectors until the late 1990s/early 2000s, electricity reform legislation has led to the beginnings of a transition away from this model, but progress has been slow. The reform laws of Iran (1999), Saudi Arabia (2005) and Algeria (2002) envision wholesale markets; the UAE’s (Abu Dhabi) reform law (1998) envisages disaggregated single buyers with bilateral trading and third party access, whereas the reform laws of Kuwait (2008; 2010) and Qatar are limited to Independent Power Producers (IPPs) in generation, and unbundling (for Qatar).

Monopoly models and private investments

The challenge of a bundled single buyer is that the coexistence of a huge integrated monopoly (single buyer or public utility) along with several private generators may hamper renewable advancement. Firstly, from an investment perspective, penetration of renewables disrupts the business model of the incumbent monopoly. This is because the promotion of private renewable plants and on-site generation transfers assets away from the utility company to its consumers and private investors. Since utilities generate a return on the equity or assets they own, this is a direct threat to their earnings. Thus, provision of incentives to private investors and end-users for the installation of renewables tends to not be supported by vertically integrated single buyers. Secondly, from an operational standpoint, the vertically integrated single buyer may prioritise its own generation assets for dispatching when demand is weak. The inefficiency generated from this behaviour benefits the monopoly at the cost of smaller private generators and consumers. While they have moved away from vertically integrated structures, most MENA economies retain variants of the single-buyer model which in some cases is accompanied by the unbundling of generation and network segments. In order to avoid the perverse incentives seen in integrated monopolies and reduce the credit and default risk posed by having just a single power off taker, an appropriate market structure needs to be developed. The fact that resource-rich MENA countries have not emulated the experiences of other OECD and non-OECD countries implies that they have a last-mover advantage, in the sense that they can tap into years of international experience to avoid design mistakes and create a sustainable solution compatible with their own context.