Should Cap-and-Trade Systems be Supplemented with Renewable Portfolio Standards?

Cap-and-trade systems have become a central pillar in existing and proposed U.S. and European policies to control carbon dioxide (CO2) emissions. But that’s not the only regulatory scheme being pursued both here and abroad: many policymakers are pushing for ambitious increases in the production of renewable energy. Are there any synergies between the two? Maybe, maybe not.

Federal production tax credits for renewable power have recently been expanded in the United States, and more than half of the states have established renewable portfolio standards (RPS). These require a certain share of power generation to come from renewable sources, providing a potential basis for a future federal RPS. The EU is even more ambitious, promising to increase its share of renewables in overall energy use to 20 percent by 2020, together with a 20 percent reduction in greenhouse gas emissions. Individual member states typically rely on either RPS or feed-in tariffs (which provide temporary subsidies to encourage market penetration of new technologies), or both, to stimulate renewable power production (in Europe, RPS is usually termed tradable green certificates).

Renewable Policies and the Costs of Cap-and-Trade

If the only objective was to reduce CO2 emissions, and there were no other market imperfections, then an appropriately scaled cap-and-trade system alone would be sufficient. The price on emissions would promote cost-effectiveness by equalizing the marginal costs of abatement through different options for reducing emissions, such as switching from coal to renewables and other low-carbon energy sources, adopting carbon capture and storage technologies at coal plants, reducing overall electricity use, reducing transportation fuels, and so on.

Under these conditions, supplementing a cap-and-trade system with an RPS would be counterproductive. If the emissions cap was binding, the RPS would have no effect on emissions (unless they become so stringent that the renewable policy stand-alone caused emissions to fall below the emissions target). At best, the RPS would be redundant if the renewable constraint is already met by the cap-and-trade system. But the more likely result would be to raise the overall costs of the emissions cap by inducing excessive abatement from expansion of renewables and too little abatement from other mitigation opportunities.

In a recent paper, we examined the implications of implementing RPS in addition to a cap-and-trade system in the context of the German electricity market. Using a numerical model of this market, we considered a cap-and-trade system that imposes a 25 percent emissions reduction below the business-as-usual level. An RPS that progressively forces up the share of renewables in the generation mix by 10 percentage points above the share with no RPS roughly doubles the overall costs of the emissions cap.

Christoph Böhringer is a professor of economic policy at the University of Oldenburg, Germany. Between 1999 and 2007 he was head of the Environmental and Resource Economics and Environmental Management department at the Center for European Economic Reserach at Mannheim. His research focuses on impact analysis of environmental, energy, and trade policies.

Knut Einar Rosendahl is a senior research fellow at the Research Department of Statistics Norway. He is currently a visiting scholar at Resources for the Future and at the School of Advanced International Studies at Johns Hopkins University. His research focuses on climate policies and energy market analysis.

Under a binding emissions cap, an RPS benefits not just renewable producers but also the most CO2-intensive power producers, while other low and zero carbon sources (like nuclear and coal with carbon capture and storage) lose out. The explanation for this presumably unintended effect of renewable policies is that the price of CO2 allowances falls, which is especially beneficial for the most emissions-intensive power plants. According to our results, when emissions in the German power sector are reduced by 25 percent through a cap-and-trade system alone, lignite power production (the most CO2-intensive power plants in Germany) falls by around 40 percent. Then, when the share of renewables is raised by 10 percentage points, production of lignite power increases by 17 percent (that is, to a level around only 30 percent instead of 40 percent below the business-as-usual level).

Rationales for Renewables Policies

So is there a definitive case against portfolio standards and other renewables policies? The answer is not entirely clear, as there are other possible “market failure” arguments that might justify the use of these policies as a complement to a CO2 cap-and-trade program.

One possibility is that the market penetration of renewable fuels, even under a cap-and-trade system, may otherwise be too limited, due to technology spillovers. In particular, an early adopter of a new technology may find ways to lower the costs of using that technology through “learning-by-doing.” Later adopters benefit from the knowledge created through earlier learning-by-doing at other firms, but they do not have to pay for it. Correspondingly, early investment in a technology may therefore be too low, because early adopters do not take into account the knowledge spillovers to other firms. In principle, this market imperfection may justify the use of a technology-forcing policy like an RPS.

However, at present there is little evidence available on the magnitude of these knowledge spillovers for relatively new technologies like wind and solar, so it is difficult to judge to what extent, if any, an RPS is justified as a complementary measure. A similar example would be the tax credit for hybrid cars in the United States; the question of whether that credit made enough of a difference early on to persuade consumers has never been thoroughly studied either.

Another possible rationale for using RPS is energy security interpreted as reduced import dependence for oil and gas. Increased production of renewable power will typically suppress gas power production, and therefore reduce the demand for imported gas. This is presumably a more important issue in Europe than in the United States. With a cap-and-trade system in place, this effect might be strengthened because, as noticed above, introducing RPS will expand both renewable and coal power production, partly at the expense of gas power. The effect of RPS on oil imports is more modest and indirect, because oil is only marginally used in the power sector. Again, it is difficult to translate energy security in terms of reduced import dependence on fossil fuels into monetary economic benefits that may offset the additional cost of RPS.

Design Issues

The economists’ case for cap-and-trade has largely been made but the jury is still out when it comes to renewables policies. Given that these policies are becoming increasingly prevalent for many other reasons, it behooves us to recommend design features to contain the costs of these policies.

With a cap-and-trade system in place, designing renewable policies should focus on other issues than CO2 emissions, such as the potential market failures referred to above. If these are supposed to be equally important across renewable technologies, a market-based RPS, where firms are allowed to trade credits derived from renewable production, may be a proper instrument. It stimulates the cheapest renewable options, and so the renewable target is reached in a cost-effective way. As long as RPS are implemented at the state and not the federal level, overall costs can be further contained by also allowing trade in credits across states. Banking and borrowing can reduce costs even further, and also help smooth the price of credits, and consequently the price of electricity. Broadening the coverage of RPS to include large-scale hydro power (which is often excluded), nuclear, and coal power with carbon capture can also bring down costs. However, the choice of technologies covered by the RPS as well as the specific design should be driven by the market failure(s) it is supposed to confront.

In the case of import dependence, for example, it is reasonable to consider the market failure to be of equal importance for all renewables. The answer is less clear when it comes to technology spillovers. If these are believed to be largest for the most immature renewable technologies, which are often the least competitive ones, other instruments than RPS may be more appropriate. This could, for instance, be technology-specific subsidies that are reduced over time as the technology matures.