Economics Bulletin, 2014, Vol. 34 No. 3 pp Introduction

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Russell Owen
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2 1. Itroductio Aroud the world, electricity geeratio is a major source of carbo emissios. May atios have begu employig policy istrumets capable of stimulatig ad supportig deploymet of reewable ( gree ) eergy sources (RES) with a primary objective of lowerig greehouse gas (GHG) emissios (Tsao et al., 011; Nielse ad Jeppese, 003; Currier, 014). I additio to coferrig evirometal beefits, such measures are believed to cotribute to eergy security by permittig reewable producers to compete with covetioal eergy techologies (fossil fuel, or black, techologies) (Held et al., 006). As a example of such a iitiative, the Europea Uio Climate ad Eergy Package of 007 calls for a 0% reductio i GHG emissios, icreasig the share of eergy obtaied from RES to 0%, ad a 0% improvemet i eergy efficiecy by the year 00 (the pla ). Feed-I Tariffs (FITs) are kow to be a effective method of stimulatig the developmet ad deploymet of RES (Couture ad Gago, 010). A system of FITs operates by offerig subsidies (or guarateed prices) for fixed periods of time for electricity geerated via RES. Uder such a scheme, etwork operators are required to coect electricity geerated from RES. FITs are offered to gree producers for every kwh of electricity produced, thereby compesatig for the higher costs of the reewable geeratio. FITs are widely applied aroud the world, icludig 19 coutries i the Europea Uio (del Río ad Cerdá, 014). While the structural details of FIT schemes vary widely across applicatios, FIT desig elemets broadly cosist of possible likages to other policy targets (e.g., reewable portfolio stadards (RPS)), techology eligibility requiremets, tariff rate settig ad differetiatio, tariff duratio ad degressio, ad fudig/cost recovery methods. There is a geeral cosesus amog policy aalysts that FIT subsidies should i geeral be (i) differetiated across istallatios (i.e., be project specific) so as to esure a ormal retur to a wide array of RE project sizes, locatios ad techology types ad (ii) be ratepayer fuded (as opposed to taxpayer/ govermet fuded) so as to esure cost recovery ad reduce the risk that fudig be withdraw etc 1. Policy cosideratios typically ivolve ivestor cofidece (i.e., risk reductio), eergy access (particularly i developig coutries), grid stability, policy costs, eergy price stability, eergy portfolio diversificatio, admiistrative complexity, ad potetial ecoomic developmet. (For details, see Couture et al. 010; del Río, 01; ad UNEP, 01.) The choice of desig elemets will i geeral have implicatios for the attaimet of policy goals. There are several otable recet cotributios to the literature o the implicatios of istrumet ad FIT desig elemet choice for the attaimet of evirometal/eergy goals. del Río (01) studies the maer i which various FIT desig elemets affect dyamic efficiecy (i.e., achievemet of techological diversity, stimulatig learig, iovatio, ad private R&D ivestme etc.) of FIT regimes. I additio, del Río (010) examies the impact of policy istrumet ad desig elemet choice o the iteractio betwee eergy efficiecy ad reewable eergy (RE) promotio via FITs. Most recetly, del Río ad Cerdá (014) study cost effectiveess (miimizatio of cosumer costs versus miimizatio of geeratio costs) ad policy istrumet choice i the developmet of RES. Other cotributios iclude Medoça et al. (010) ad Ragwitz et al. (007). 1 Couture et al. (010) ote that i Spai ad Germay more tha 50 distict FIT subsidy levels are employed. 174

3 As oted by del Río (01), reduced ivestor risk ca be expected to have positive (dyamic) impacts o the promotio of techological diversity; the developmet of immature RE techologies; learig effects; ad research, developme demostratio, ad deploymet. Thus, a importat policy objective should be to reduce the risk associated with RE ivestmets by esurig efficiet reewable producers reveue sufficiet to recover project costs ad to allow for a reasoable rate of retur o the ivestmet. I this paper, we cosider a differetiated FIT scheme that is liked with a madated gree quota / RPS ad fuded by a ed-user tax o electricity., 3 We first characterize the FIT equilibrium ad aalyze its formal mathematical structure so as to determie the umber of policy istrumets that are available to the policy maker. We show i particular that the FIT subsidies ad the level of the RE target caot be simultaeously employed as exogeously specified policy istrumets without perverse cosequeces. We ext establish several simple propositios regardig the properties of a FIT equilibrium. Fially, we provide a simple umerical example ad examie some comparative statics properties of (i) usig the ed-user tax ad the gree quota as the exogeously specified policy istrumets, ad (ii) usig the FIT subsidies as the exogeously specified policy istrumets. While the merits of ay policy ca oly be assessed i terms of its distributio of beefits ad costs to all iterest groups, our results suggest that employig the FIT subsidies as exogeously specified policy istrumets to achieve a RE target will likely lead to more predictable ad stable profits for gree producers ad hece less ucertaity ad risk for ivestors. Our results thus imply a FIT implemetatio method that ca i priciple avoid perverse cosequeces ad improve prospects for rapid deploymet of efficietly operated RE istallatios ad attaimet of a ultimate RE target.. The Model We cosider a closed competitive electricity market cosistig of a sigle black (fossil fuel) producer ad gree (reewable) producers. We assume that black electricity y is produced uder costat returs to scale at costat margial ad average cost cy. 4 Gree firm i produces output xi with cost fuctio c i (x i) satisfyig ci ( xi ) 0 ad c i ( xi ) 0, i = 1,,. Emissios e are proportioal to black productio: e = θy. Damages from emissios are D(e) with D > 0 ad D 0. There are o emissios from gree productio. Total electricity is q y x i. Cosumers are price takers, ad demad is formed by the maximizatio of cosumer surplus V = U(q) pq where U deotes total utility ad p deotes the ed-user price of electricity. We assume U > 0 ad U < 0. Iverse demad p = D(q) ad therefore satisfies D (q) < 0. Medoça et al. (010) argue that rate payer (ed-user) fiaced FITs lead to lower ivestor risk tha govermet fiaced FITs. 3 FITs have bee used to achieve RPS objectives i the U.S., Germay, Idia, ad the Philippies, amog others (UNEP, 01). 4 I our model, output levels should be iterpreted as geeratig capacity (Tamas et al. 010). For evidece that black electricity geeratio is subject to costat returs to scale, see Christese ad Gree (1976) ad Josko ad Schmalesee (1983). 175

4 The gree quota i the electricity market requires the share α of total productio to be provided by gree productio: xi q, 0 1. We assume throughout that as a desig eleme this costrait is madated to hold as a exact equality. The gree quota is implemeted via a system of differetiated FITs fiaced by a ed-user tax t o electricity. The vector of FITs is (s 1,, s ). Black firm profits are π y = (p t c y)y, ad gree firm profits are p t si xi ci xi i, i = 1,,. All firms are price-takig profit maximizers. Usig to deote equilibrium values, equilibrium uder the FIT system satisfies: p p y xi p. (1) p t = c y, () t si ci xi, i 1,...,, (3) xi y si xi t y x, (4) i. (5) i x Equatios () ad (3) are the profit maximizatio coditios. It should be oted that the cost efficiecy (equimargial) coditio c 1 (x 1 ) = = c (x ) ca oly be achieved with a uiform (i.e., techology eutral) subsidy. However, with o-idetical gree producers, a uiform subsidy sufficiet to permit the highest cost firm to ear a ormal retur could lead to uacceptably high rets for lower cost producers. 5 Equatios (4) ad (5) are the gree quota ad budget costrait uder the FIT system. Figure 1 provides a illustratio of the equilibrium for the case of =, where cosumer surplus is idicated by area A ad budget balace (5) esures that area B equals the sum of areas C, D, E, ad F. 3. Choice of Policy Istrumets For ease of otatio, we shall heceforth omit the from the equilibrium values. Now defie:,, 1, y, x1,..., x..., s, p t c y, 3 y x1,..., x..., s, p t s1 c1 y x1,..., x..., s p y xi p, x1, y, x1,..., x..., s p t s c x,, 5 The fact that FIT subsidies are widely differetiated i applicatios aroud the world is prima face evidece that policy makers are ot primarily cocered with satisfactio of the equimargial coditio. As oted by Couture et al. (010), subsidy differetiatio ca sometimes be i coflict with cost efficiecy. 176

5 Observe that with 1,..., 4 y x1,..., x..., s xi y xi,, y, x1,..., x..., s si xi t y xi. 3, 4, 4 4, we have a mappig : R R. The set of FIT equilibria is ϕ -1 (0), which we assume is o-empty. It is straightforward to show that ϕ -1 (0) has dimesio ( + 4) ( + 4) =, which is thus the umber of policy istrumets that the policy maker may select exogeously. Equivaletly, the system of equatios above is either uderdetermied or overdetermied whe the umber of edogeously determied variables equals the umber of equatios + 4. Sice + ( + 4) = + 4, the policy maker has degrees of freedom, i.e., policy variable values may be exogeously specified, with the remaider edogeously determied. $ $ $ $ MC MC 1 t A B Demad p t c y 1 s C D p t s E F q q y y x 1 x 1 x x Figure 1. FIT Equilibrium We have the the followig propositio. Propositio 1: The policy maker ca always use the FITs (, s) as the exogeously specified policy istrumets, lettig the tax rate ad the gree quota be determied edogeously. The followig two corollaries are immediate. Corollary 1: The policy maker may ot employ the FITs ad the gree quota as exogeously specified policy istrumets simultaeously without violatig (4) ad/or (5). 6 6 Forecastig errors could result i uderfudig the FIT program. I phase 3 of the Germa FIT pla, there is icreased emphasis o esurig that reveue received from rate payers is sufficiet to fud the FIT program (Couture et al., (010)). 177

6 The result is of obvious importace i situatios where a FIT regime is liked with a gree quota. Corollary : If the gree quota is a exogeously specified policy istrume the at least oe gree firm s FIT subsidy must be edogeously determied. I the followig sectios, we explore some implicatios of Propositio 1 ad its corollaries. I view of the precedig results, we shall heceforth cosider the case of two gree producers ( = ) ad thereby cosider situatios where (i) s1 ad s are exogeously specified policy istrumets, with t ad α determied edogeously; ad (ii) t ad α are exogeously specified policy istrumets with s1 ad s determied edogeously. 4. Properties of FIT Equilibria I this ad the followig sectio, we examie some properties (icludig umerical comparative static properties) of FIT equilibria uder cases (i) ad (ii). The followig simple results are cetral to our aalysis. i Propositio : 0, i = 1,. x i Proof: Gree profits are i p t si xi ci xi. Usig (3), we have i ci xi xi ci xi d dx i implyig that ci xi xici xi ci xi xici xi i,. The result follows sice c i 0, i = 1,. Propositio states that gree firms equilibrium profits icrease if ad oly if output is expaded. Case (i): s1ad s are exogeously specified policy istrumets with α ad t edogeously determied. Propositio 3: A ceteris paribus icrease i si will icrease gree firm i s profit πi, i = 1,. Proof: Uder this sceario, p ad t will be edogeously determied with p t = c y. Thus (3) dxi implies c y si ci xi, i = 1,. Implicit differetiatio yields 1 ci, implyig dx i / ds i > 0. dsi Thus, a icrease i si raises firm i s productio. The result the follows from Propositio. Propositio 3 states that promotio of reewable productio i the sese of icreasig ay gree firm s subsidy must ehace profitability of that firm. Case (ii): α ad t are exogeously specified policy istrumets with s1 ad s edogeously determied. 178

7 Propositio 4: A ceteris paribus icrease i either α or t must reduce the profits of some gree producer. Proof: Cosiderig first the case of a icrease i gree quota α, assume that a icrease i α reduces black output y. Sice py x1, x t c y = costat ad y falls, some xi (without loss of geerality, say x1) must icrease, which ca happe oly if s1 icreases. Sice s1x1 s x ty x1 x = costat ad s1x1 icreased, sx must decrease, which implies x decreases. By Propositio, π must decrease. For the case of a icrease i observe that a icrease i t must icrease the ed-user price p, which meas total productio y + x 1 + x must fall. Sice x1 x y x1 x, total gree productio must fall, implyig some xi (without loss of geerality, say x1) must fall. By Propositio, π1 must fall. Propositio 4 states that promotio of reewable productio, i the sese of icreasig the gree quota or the ed-use tax that fiaces i must reduce the profits of some gree producer. It is importat to ote that the otio of a ceteris paribus icrease i α or t is oly meaigful i the case of differetiated subsidies. Ideed, uder a uiform subsidy s, the policy maker has oe degree of freedom ad t α = s. Therefore, if (for example) α is icreased, edogeous adjustmets i t ad s must occur. With a uiform subsidy, a icrease i α will icrease the profits of all gree producers. It is also importat to observe the possibility of multiple equilibria i case (ii) due to the fact that subsidies are differetiated. This ca be see by cosiderig the case of symmetric gree producer variable costs c 1 (x 1 ) = c (x ) i which case, due to the budget balace equatio (5) there exist two pairs of equilibrium subsidies of the form (s 1, s ) = (μ, ν) ad (s 1, s ) = (ν, μ ). Multiplicity of equilibria holds (geerically) for the osymmetric cost case by a cotiuity argumet. 5. A Example I this sectio, we preset a umerical example that yields additioal isights. Assume q cosumer utility U ( q) Aq, A > 0, where q = y + x 1 + x. Black output is produced uder costat margial ad average cost cy > 0. Furthermore, gree output is produced with cost fuctios c x c ad c x c, c1, c > 0. Let the parameter values be A = 100, cy = 15, 1 1 1x1 3. c1 = ½, ad c = 5 x Suppose that the iitial FIT equilibrium is s1 = 10.33, s = 17.69, y =.53, x1 = 5.33, x = 7.4, p = 4.90, t = 9.90, ad α =.70. Note that (1) (5) are satisfied. 7 Assume ow that the policy maker wishes to icrease the gree quota to α =.7. Employig α ad t as the exogeously specified policy istrumets with α =.7 ad t = 10.35, the ew FIT 7 Nothig is assumed here about the historical forces/policy istrumet choice that brought this equilibrium about other tha at ay poit i time oly two of the policy variables could have bee exogeously specified. 179

8 equilibrium is s1 = 15.51, s = 1.89, y = 0.90, x1 = 30.51, x = 3.4, y = 0.90 ad p = Observe that by Propositio 3, π1 must icrease ad π must decrease relative to their values at the iitial equilibrium. 8 Alteratively, agai suppose that the policy maker wishes to icrease α to.7 but employs the FIT subsidies s1 ad s as the exogeously specified policy istrumets. Icreasig the subsidies to s1 = ad s = 18.5, the ew FIT equilibrium is y = 0.83, x1 = 5.88, x = 7.71, p = 5.58, t = 10.58, ad α =.7. Sice both subsidies are higher tha their iitial values, Propositio 3 implies that both π1 ad π must exceed their iitial values. I the followig sectio, we discuss some prelimiary policy implicatios of the results cotaied i Sectios 3 through Policy Implicatios ad Discussio It is well kow that electricity geeratio is a major source of carbo emissios aroud the world. Substitutio of reewable geeratig capacity (geothermal, biomass, wid-powered turbies, etc.) for fossil-fuel geeratig capacity ca substatially reduce these emissios. It is clear that the desig ad implemetatio of reewable support policies such as FITs represets a importat ad formidable policy challege. Oe importat policy desig elemet ivolves the possibility of likig a system of differetiated FITs to other reewable support mechaisms such as a gree quota/rps. Moreover, while a umber of welfare/policy objectives ca be ad are pursued i eergy markets aroud the world, ivestor cofidece ad security are fudametal prerequisites for successful RE deploymet. Couture et al. (010) argue that combiig a system of FITs with a gree quota (icludig formal compliace requiremets ad pealties) ca ehace ivestor cofidece by providig additioal evidece of govermetal commitmet to RE developme etc. We have show that whe a system of differetiated FITs (fiaced by a ed-user tax) is combied with a bidig gree quota, a additioal desig elemet emerges with respect to the choice of exogeously specified policy istrumets sice the gree quota ad the -FIT subsidies caot be employed simultaeously as exogeously specified policy istrumets. While a variety of combiatios may be cosidered i geeral, we have cosidered two possibilities: (i) employig the ed-user tax ad the gree quota as the exogeously specified policy istrumets while allowig the FIT subsidies to be edogeously determied; ad (ii) employig the FIT subsidies as the exogeously specified policy istrumets while allowig the ed-user tax ad gree quota to be edogeously determied. 9 With the gree quota ad the ed-user tax as policy istrumets, we have show that relative to the status quo, ceteris paribus icreases i either the tax or the gree quota will create wiers ad losers i the sese of icreasig the profits of at 8 Whe α =.7 ad t = 9.90, there also exists a secod FIT equilibrium: s 1 = 17.0, s =9.66, y =.53, x 1 = 3.0, x = 0.55, ad p = 4.9. If α ad t are the exogeously specified policy istrumets ad are icreased to α =.7 ad t = 10.35, the the equilibrium values of s 1 ad x 1 fall ad the equilibrium values of s ad x icrease, implyig that π 1 falls ad π icreases. Total gree productio is costat across equilibria (x 1 + x = 5.57) ad the equilibria differ oly i the maer i which gree profits are distributed across producers. 9 Aother possibility is that of employig the gree quota ad 1 of the FIT subsidies as exogeously specified policy variables, lettig the ed-user tax ad the th subsidy be edogeously determied. Alteratively, a combiatio policy that operates by likig the ed-user tax, FIT subsidies, ad gree quota could be ivestigated. 1730

9 least oe gree producer ad decreasig the profits of at least oe other. Moreover, as our example illustrates, the same result ca occur whe the tax rate ad the gree quota are icreased simultaeously. I additio, the problem is further complicated by the fact that withi the cotext of our example, it is easy to specify(α, t) pairs for which o equilibria exist. Alteratively, we have show that whe the FIT subsidies are the exogeously specified policy istrumets (ad the ed-user tax ad gree quota adjust edogeously), each gree producer s profit is icreased if ad oly if that producer s FIT subsidy is icreased. Therefore, stimulatig RE deploymet via subsidy icreases will have a kow ad certai effect o gree producers profits, thus ehacig ivestor cofidece. Our results suggest that rather tha iitially madatig a bidig gree quota, the policy maker should systematically icrease the idividual subsidies from the status quo (allowig the tax ad the gree quota to be determied edogeously) util the desired gree quota is ultimately satisfied, as i our example. 10 Fudametally, our aalysis demostrates that (i) i order to avoid perverse cosequeces, the policy maker must exercise cautio with respect to the umber of exogeously specified policy istrumets employed; ad (ii) the choice of these policy istrumets may have implicatios with respect to the attaimet of policy objectives. While we emphasized ivestor security/gree producer viability, it is importat to poit out that this is but oe of may (potetially coflictig) policy objectives ad it is for this reaso that our results must be regarded as prelimiary. 11 Subsequet research should examie the impacts of exogeously specified policy istrumet choice o other policy objectives. More geerally, the formulatio of a welfare fuctio embodyig the relevat cosideratios ad weights is itself a formidable challege. The stadard uweighted sum of cosumer ad producer surplus et of evirometal damages is W V ( q) D( e) where πy deotes black firm profits ad y i q y x i Whe (1) (5) are satisfied, this may be alteratively expressed as W U y xi cy y ci xi D( e). With the FIT subsidies as the exogeously specified policy istrumets, the solutio to (1) (5) may be expressed as y = y(s), xi = xi (s), i = 1,,, e = θy(s) where s = (, s), i which case W = W(s). If W subsumes all policy objectives, the policy maker could i priciple attempt to determie the welfare maximizig FIT subsidy vector s. If oe or more gree producers ear deficits i this situatio (due to fixed costs), the subsidies could be systematically adjusted upward (thereby icreasig profits) util acceptable levels of profit are achieved as a secod-best solutio.. 10 As the FIT subsidies are icreased, gree productio displaces black productio. If there exist subsidies sufficietly high such that all black productio is displaced by gree productio, implyig that α = 1, by cotiuity, there must exist FIT subsidies for which the equilibrium value of the gree quota is equal to ay value of α As a illustratio, i our example whe the subsidies are icreased so as to achieve the reewables target of α =.7, the ed-user price of electricity icreases from 4.90 to del Río (01) otes the importace of balacig the desire for high ivestor cofidece with low cosumer prices. 1731

10 Refereces Christese, L.R. ad W. Gree (1976) Ecoomies of scale i U.S. electric power geeratio Joural of Political Ecoomy, Couture, T. ad Y. Gago (010) A aalysis of feed-i tariff remueratio models: Implicatios for reewable eergy ivestmet Eergy Policy 38, Couture, T., K. Cory, C. Kreycik, ad E. Williams (010) A Policymaker s Guide to Feed-I Tariff Policy Desig. Techical Repor Natioal Reewable Eergy Laboratory, NREL/TP- 6A Currier, K. (014) Some implicatios of ivestmet cost reductio policies i eergy markets employig gree certificate systems Evirometal ad Resource Ecoomics forthcomig. Held, A., R. Haas, ad M. Ragwitz (006) O the success of policy strategies for the promotio of electricity from reewable eergy sources i the EU Eergy & Eviromet 17(6), Joskow, P.L. ad R. Schmalesee (1983) Markets for Power: A Aalysis of Electric Utility Deregulatio, MIT Press: Cambridge MA. Medoça, M., D. Jacobs, ad B. Sovacool (010) Powerig the Gree Ecoomy The Feed-I Tariff Hadbook, Earthsca: Lodo. Nielse, L. ad T. Jeppese (003) Tradable gree certificates i selected Europea coutries: Overview ad assessmet Eergy Policy 31, Ragwitz, M., A. Held, G. Resch, R. Haas, T. Faber, C. Huber, P.E. Morthors S. Jese, R. Coeraads, M. Voog G. Reece, I. Kostatiaviciute, ad B. Heyder (007) Assessmet ad Optimizatio of Reewable Eergy Support Schemes i the Europea Electricity Market. Fial Report of the Project OPTRES. Supported by the Europea Commissio, Brussels Belgium. del Río, P. (010) Aalyzig the iteractios betwee reewable eergy promotio ad eergy efficiecy support schemes: The impact of differet istrumets ad desig elemets Eergy Policy 38(9), del Río, P. (01) The dyamic efficiecy of feed-i tariffs, the impact of differet desig elemets Eergy Policy 41, del Río, P. ad E. Cerdá (014) The policy implicatios of the differet iterpretatios of the cost-effectiveess of reewable electricity support Eergy Policy 64, Tamas, M.M., S.O.B. Shrestha, ad H. Zhou (010) Feed i tariff ad tradable gree certificates i oligopoly Eergy Policy 38, Tsao, C.C., J.E. Campbell, ad Y. Che (011) Whe reewable portfolio stadards meet capad-trade regulatios i the electricity sector: Market iteractios, profits implicatios, ad policy redudacy Eergy Policy 39, UNEP (01) Feed-i tariffs as a policy istrumet for promotig reewable eergies ad gree ecoomics i developig coutries. Available at FIT_Report_01F.pdf. 173

EU ETS Hearing, European Parliament Xavier Labandeira, FSR Climate (EUI)

EU ETS Hearing, European Parliament Xavier Labandeira, FSR Climate (EUI) EU ETS Hearig, Europea Parliamet Xavier Labadeira, FSR Climate (EUI) 0. Thaks Chairma, MEPs. Thak you very much for ivitig me here today. I am hoored to participate i the work of a Committee whose previous