(Today’s post is co-authored with Veronica Irastorza, who is a graduate of UC Berkeley’s Goldman School of Public Policy and former Undersecretary of Energy in Mexico. Veronica is Associate Director at NERA Economic Consulting.)
The winning bids in the latest Mexican renewables auctions were below two cents per kilowatt hour.
The latest good news on renewable electricity generation comes from Mexico, where results were just announced for the country’s third renewables auction for large-scale projects. After average winning bids in April and September of last year of 4.8 cents and 3.3 cents, the average winning bids in 2017 were 2.1 cents per kilowatt hour. The list of winners includes both solar and wind projects, and represents a total expected investment of $2.4 billion.
These are shockingly low prices – 50% lower than last year and among the lowest prices ever observed anywhere in the world. These prices are especially remarkable because there are no subsidies here, either explicit or implicit. By all accounts, the cost of renewables has fallen dramatically. But 2 cents!?! Are renewables really this cheap?
Note: Wind farm on the Tehuantepec Isthmus in Oaxaca, one of areas with best wind resources in Mexico. Image licensed under creative commons.
Can Winners Renegotiate?
Are companies bidding aggressively, in part, because they believe they can renegotiate later? Renewables procurement auctions have now been held in 48 countries, and this issue has come up repeatedly. In India, for example, energy procurement auctions have often ended up in the courts, with developers sometimes being allowed to raise prices retrospectively.
This appears not to be the case for Mexico, however. Previous energy procurement contracts have not ended up in the courts, nor has any renegotiation been possible. In fact, under the terms of the latest auction, if a developer fails to deliver they must pay a “guarantee” equal to about nine months of revenues. And after a developer has invested sunk capital, why would Mexico agree to revisit the contract? This is a tricky area, but in Mexico renegotiation seems quite unlikely.
Note: Close up of solar panels. Image licensed under Creative Commons.
Are Companies Betting on the Future?
But even if renegotiation is unlikely, this still could be a bet on the future. Are companies bidding below cost today because they believe it will give them a competitive advantage in the future? Mexico is planning large future investments in renewables, so with good reason there are many companies jostling to be in position to claim a part of this market.
Betting on the future only makes sense if there are large learning spillovers. There needs to be something about doing a project today that makes subsequent projects cheaper. This could be improving working relationships with other companies, or learning about a country’s legal and regulatory systems. Ideally, this learning would spillover not only on future projects in a given country, but also to other projects elsewhere.
But key here is this learning must be company-specific. If you do a project which makes it easier for other companies to do subsequent projects, you’ve gained nothing in being the first-mover. Your company needs to somehow have intellectual property over this learning, which is not necessarily the case.
The hyper-aggressive bidding in this latest round in Mexico suggests that this “betting on the future” does seem to be part of the explanation. Our view is that this is a very risky strategy. Lose too much in the short-run, and you won’t even be around to participate in the long-run.
So yes, there may be a bit of irrational exuberance here, but we think the main reason that prices are so low is that Mexico is a great place for solar and wind. The country has some of the best solar and wind resources anywhere in the world.
Note: Imaged licensed under Creative Commons SolarGIS © 2014 GeoModel Solar.
The map above shows that most of Mexico receives solar irradiation in excess of 2000 kilowatt hours per square meter annually. In contrast, early solar adopter Germany receives only about half as much sun. Lots of sun and wind means more electricity produced for a given capital investment, and thus a lower cost per kilowatt hour.
In addition, land and labor costs are low. Solar power, in particular, is just beginning to emerge, so all the best locations are still available, and labor costs matter both for construction and operation. Low costs, and high quality sun and wind can’t explain the large decrease in prices between 2016 and 2017, but they can help explain the overall low level of prices.
Another factor is that the Mexican contracts are structured so that developers face zero risk from energy prices, macroeconomic fluctuations or currency devaluations. These are 15- and 20-year guaranteed price contracts in dollars, so even if Mexican wholesale prices collapse, this won’t affect revenues. Moreover, under the contract the buyer receives the power at the generation node, so the developer bears no transmission or congestion risk.
Interestingly, some of the developers are planning to build adjacent projects and sell the energy on the spot market. Mexican spot prices have been around 65 USD/MWh this year, so these “merchant” developments could end up being more profitable than those under long-term contracts. The risk profile is entirely different, however. If demand for electricity falls, for example, that would hurt the merchant project but have no impact on the contracted project.
The results from the Mexican auction also highlight a broader global trend. Large firms are entering the renewables development business. Early renewables projects in Chile, for example, were developed by smaller companies that sometimes struggled to obtain financing.
Not true today. Now, the market is becoming dominated by large, well-financed multinationals. Indeed, two of the biggest winners in the latest Mexican auction were ENEL and ENGIE, both with the size and track record to command a very low cost-of-capital.
These are large capital-intensive projects, paid for over long time periods. So the cost-of-capital is crucial when it comes to determining total project cost. The entry of large, patient companies, during a time of low global interest rates means that these projects can be done at very low cost.
Note: Parques Eólicos Ventika wind farm in Nuevo León, Mexico. Image licensed under Creative Commons.
Consumers and the Environment
Whatever the exact mix of explanations, these results are very good news for electricity consumers. Mexican electricity demand is growing at 3%+ per year as a generation of households buy air conditioners and other electricity-intensive durable goods. Cheap renewables will help Mexico meet this demand without increasing rates. And, of course, cheap renewables are good news for the environment. Mexico has a goal of getting 35 percent of its energy from clean sources by 2024, and this is looking more and more possible.
Lucas Davis is the Jeffrey A. Jacobs Distinguished Professor in Business and Technology at the Haas School of Business at the University of California, Berkeley. He is Faculty Director of the Energy Institute at Haas, a coeditor at the American Economic Journal: Economic Policy, and a Faculty Research Fellow at the National Bureau of Economic Research. He received a BA from Amherst College and a PhD in Economics from the University of Wisconsin. Prior to joining Haas in 2009, he was an assistant professor of Economics at the University of Michigan. His research focuses on energy and environmental markets, and in particular, on electricity and natural gas regulation, pricing in competitive and non-competitive markets, and the economic and business impacts of environmental policy.