Misguided Incentives

Today's Wall St. Journal includes an interesting article on the emerging controversy concerning Germany's subsidies for solar power and their unintended consequences for that country's solar industry. It seems that solar incentives there have been so generous that they have discouraged German solar manufacturers from focusing on becoming competitive, rather than merely bigger. As a result, a growing share of the incentives is going to foreign firms that can sell these products cheaper. The hue and cry about this suggests that perhaps the original motivation behind the subsidy program, which not long ago was paying as much as a dollar per kilowatt-hour for power generated from solar panels, had at least as much to do with industrial policy as protecting the environment. In fact, Germany may have harmed the environment by wasting money on an impractical solution for such a cloudy place, when the same funds could have bought much greater emissions reductions in other areas of the economy. This should serve as a cautionary tale for those who are promoting similar incentives here, and for columnists--even those with a Nobel Prize in Economics--who argue that going green will be cheap. It won't be if we encourage the wrong technologies with bloated incentives.

At the heart of the solar debate in Germany is something called a "feed-in tariff" or FIT. It requires utilities to buy the output of qualifying solar power installations at a guaranteed fixed price well above the prevailing price in the power market. What's unique about the FIT compared to incentives such as the US federal renewable Production Tax Credit of 2.1 cents per kWh is that the funds to pay this green premium don't come from the government but from each utility's ratepayers. In other words, it is a mechanism for redistributing wealth from utility customers to the owners of solar installations, whether the affected ratepayers receive any solar power or not. The paradox of the FIT is that it makes the most sense when a technology is at its very earliest stages, producing so little energy that the cost to average utility customers is just pennies a month. The more solar power is produced and bought at inflated prices, the higher utility bills go and the less competitive the entire economy becomes.

So far, this just sounds like a political matter. Germany decided to nurture a large industry to build and install solar products and chose to pay for it by sending the bill to utility customers every month. That might even make a certain amount of practical sense, if not for two facts. First, the subsidy remains extravagantly generous, even after having been significantly reduced in recent years. It currently stands at a range of 34-43 €cent/kWh, depending on the kind of installation involved. At current exchange rates, that equates to $0.50-0.635/kWh. A recent study comparing levelized power costs for a variety of power technologies puts the cost of unsubsidized solar power between $0.26-.32 for the crystalline silicon photovoltaic cells that most German solar firms produce, based on an average capacity factor above 20%. After adjusting for Germany's much poorer solar intensity, the cost of solar power might rise to as much as $0.40/kWh, still well below the level of the FIT. This makes un-sunny Germany a remarkably attractive place to sell solar panels, and German companies haven't been the only ones to notice this. Suddenly the FIT looks like a means for Germans to subsidize Chinese solar firms, and that is not going down quite so well. More importantly for the success of Germany's solar industrial policy, the Journal indicates that the head of one of the country's largest solar module manufacturers is now arguing that German suppliers will not become efficient enough to compete in the global market for solar panels unless they are weaned off such generous support.

The high effective cost of the emissions reductions these subsidies are buying ought to be of equal concern to German policy makers. Even if you assume that each kWh of power generated by FIT-subsidized solar panels backs out a kWh generated from coal, the extra premium over the cost of other low-emission power sources such as wind is enormous. The difference in the average solar FIT vs. Germany's FIT for offshore wind of 13 €cent/kWh ($0.19/kWh) yields an effective cost of CO2 reduction from solar of about $400 per ton. That compares to a current price for emissions credits on the European Climate Exchange of around $19/ton CO2. The more you pay for reducing emissions, the less of them you can afford to reduce, even in a prosperous country like Germany.

At the end of the day, German politicians appear to have spent billions of Euros of German consumers' and businesses' money to build a solar industry that has thrived on the installation of high-costs solar panels in one of the least suitable countries for solar power imaginable, and that may not be able to compete internationally without drastic restructuring. This initiative has also failed dismally as climate policy, purchasing less than 5% of the emissions reductions that could have been bought had this money been spent on other, more cost-effective power technologies or on energy efficiency. The further irony is that much of the German investment in solar technology to date would have to be written off should it turn out that the current generation of technology can't be made cheaply enough under any circumstances, and crystalline silicon cells ultimately give way to cells relying on non-silicon thin-film techniques or novel nanotech-based designs. These are the perils of industrial policy masquerading as environmental policy, and it is hardly a winning case for the application of a similar FIT in the US.