The economics of coal phaseouts: auctions as a novel policy instrument for the energy transition

Abstract:

Background: The combustion of coal, the world’s most polluting form of energy, must be significantly curtailed to limit the global average temperature increase to well below 2°C. Since carbon pricing is politically constrained, alternative policies, such as compensating coal plant owners, for early closure are being considered. Methods: Germany is the only country to date to have implemented a reverse auction to give compensation payments for early coal retirement. We analyse the merits and demerits of Germany’s policy, drawing comparisons with other countries that have phased out coal through other means. Results: While bilateral negotiations can lead to excessive compensation due to asymmetric information, a competitive auction can discover the true cost of closure and help allocate funds more efficiently and transparently. Germany’s experience illustrates the practical necessity of adjusting auction design to ensure additionality, reduce the risk of gaming and manage the security of supply. Conclusion: While auctions have attractive properties in theory, in practice, their design must address these concerns to unlock the full benefits. Retirement auctions that deliver compensation payments can be a pragmatic policy option, particularly in countries where an incumbent coal lobby makes punitive measures such as carbon taxation hard to implement. However, where there is a concentration in coal plant ownership, auctions will not work and alternative policies, such as enhanced incentives for scrappage and repurposing of coal assets, could be used instead.

Key policy Insights:

• In many coal-burning areas, the decline of coal is slowed down by long-term contracts that insulate coal-fired generation from competition.
• Compensation for early closure is a ‘pay-to-break’ mechanism which may be a politically feasible alternative to ‘polluter-pays’ policies such as carbon pricing.
• Competitive auctions can deliver efficient and transparent compensation payments for early coal closures relative to negotiations which suffer from asymmetric information.
• Ensuring that there is sufficient competition in a coal closure auction through design adjustments can ensure discovery of true closure costs.
• Shutting down coal-fired power plants can lead to fiscal savings in countries where coal-fired generation is supported by capacity payments.