A variety of policies have been adopted in many countries to reduce greenhouse gas emissions for the power sector and promote clean fuel technologies. To what extent is there a case for preferring one policy instrument over another, and are combinations of policies more efficient than one policy alone?
To help reduce greenhouse gas (GHG) emissions, many nations have proposed ambitious targets for renewable energy production. Proposals in the United States, for example, aim to increase the share of renewables in power generation to 15 percent by 2020. Given that hydroelectric power, which currently accounts for about 8 percent of power generation, will not expand due to environmental concerns about damming large rivers, meeting this target will require ramping up the share of other renewables in generation from 3 to about 12 percent. Whether such a goal is feasible depends largely on technological innovation to improve the competitiveness of wind, biomass, geothermal, solar, and other renewables, relative to fossil fuel generation.
A wide range of market-based policy instruments to reduce GHGs and stimulate clean technology innovation have been implemented, or are under consideration, in OECD countries. Among those affecting the power sector include:
A carbon dioxide (CO2) emissions price—via either an emissions tax or a tradable emissions permit system—provides incentives to reduce CO2 intensity (that is, CO2 emissions per unit of economic output) and makes fossil fuel sources more expensive than renewables. Several Scandinavian countries, as well as British Columbia, have introduced carbon taxes, while CO2 cap-and-trade programs are in effect in the European Union and under the Regional Greenhouse Gas Initiative of northeastern United States.
A tax on fossil-fueled energy favors renewables over coal and natural gas generation. The United Kingdom, Germany, Sweden, and Holland tax fossil fuel sources, typically by exempting renewable sources from an energy tax.
A tradable emissions performance standard mandates that the average emissions intensity per unit of output (averaged across all generation fuels) not exceed a certain level. Above average emitters like coal-fired power plants would have to buy credits from below-average emitters like renewables and possibly even natural gas generators (depending on the stringency of the intensity standard), which receive a net subsidy.
Renewable energy portfolio standards (RPS) require a certain percentage of electricity production to come from renewable sources. A number of European countries and U.S. states have adopted such policies, and the U.S. federal government is also considering a standard. Nonrenewable sources face an added cost of purchasing green credits to accompany their generation, and those credits serve to subsidize renewable generation.
A production subsidy for renewables improves the competitiveness of these sources vis-à-vis fossil fuels. For example, the United States has a renewable production tax credit of 2.1 cents per kilowatt hour and about half of the states have their own individual programs.
Subsidies for R&D investment in renewable energy encourage near-term and long-term innovations through targeted research incentives. Major programs of tax incentives and other subsidies exist in the United States, United Kingdom, Denmark, Ireland, Germany, Japan, and Holland.
If the goal is to reduce greenhouse emissions in the near and medium terms, which of these policies is the most cost-effective?
Evaluating the Alternatives
In theory, a direct price for CO2 (whether a tax or tradable emissions permit system) would create the most efficient incentives for developing and using cleaner technologies. In practice, the answer is complicated not only by political acceptability and distributional questions, but also by other economic efficiency considerations. For example, spillovers in R&D markets reduce incentives for firms to innovate, because some of the returns on their investments will be captured by others. Similarly, issues may arise when innovation occurs through learning by doing.
Carolyn Fischer is a Senior Fellow at Resources for the Future
Together with a colleague (see Further Reading), I developed a modeling framework for the electricity sector that incorporates both a knowledge accumulation stage (when R&D and learning occur) and a knowledge application stage (when the cost-reducing benefits are realized). We then evaluated all the policy options based on their emissions reduction, renewable energy production, R&D, and overall economic efficiency or cost-effectiveness.
Setting a modest emissions price of $7 per ton of CO2 (or about $25 per ton of carbon) and using the resulting emissions reduction as a target for the other policy scenarios allowed for an apples-to-apples comparison. We set the tradable standards (the RPS and the emissions performance standard) such that the market price of credits would be constant across our two time stages while meeting the implied emissions target. The resulting RPS rises from 6 percent in the first stage of the model to about 10 percent in the second.
Our results indicate that the emissions price is indeed the most efficient single policy for achieving a given emissions target. However, the tradable emissions performance standard (which retains a carbon price signal for reducing the intensity of nonrenewable generation) and the output tax on fossil-fuel generation (which retains a price signal to electricity users to conserve) are only moderately more costly for this modest reduction target.
The renewable portfolio standard is the next most costly—about twice as expensive as the emissions price policies—and the renewables production subsidy is a little more costly still (and borne fully by taxpayers rather than ratepayers). The renewables research subsidy is by far the most costly single policy for reducing emissions: relying on the R&D subsidy alone is an order of magnitude (12 times in our framework) more costly than putting a price on emissions.
Overall, policies that create incentives for fossil-fueled energy generators to reduce emissions intensity and for consumers to conserve energy perform better than those that rely solely on incentives for renewable energy producers. For the modest emissions targets we examined, a renewable energy R&D subsidy turns out to be a particularly inefficient means of emissions reduction. By forgoing cost-effective abatement opportunities in the near term, the R&D subsidy must achieve all emissions reductions in the out years by making renewables less expensive than fossil fuels without any emissions reduction or conservation incentives.
An emissions price is the most efficient single policy because it delivers three simultaneous incentives: for fossil energy producers to reduce emissions intensity, for consumers to conserve, and for renewable energy producers to expand production and invest in knowledge to reduce their costs.
Nonetheless, no single policy can simultaneously correct more than one market failure—in this case the failures associated with the emissions externality and the knowledge spillovers from learning and R&D. Each policy posts different trade-offs.
The optimal policy combines an emissions price with policies to capture spillovers in the market for knowledge—namely, a proportional R&D subsidy and a small subsidy for renewable production associated with learning-by-doing. These corrective policies provide positive benefits and allow the emissions price to fall by one-third to meet the same target. Together, they can achieve emissions reductions at significantly lower cost than any single policy alone.
If even a modest emissions price is not politically feasible, an R&D subsidy by itself is still not the next-best policy. The costs of that political constraint are likely to be quite large and increasing with restrictions on the remaining policy options and the level of ambition for reducing emissions. In the long run, however, the prospect of developing breakthrough technologies that might achieve deep reductions gives R&D policies greater salience than in the near- to mid-term, in which improvements are more incremental. Still, that should not diminish the central role of emissions pricing to improve the competitiveness of all green alternatives in the market.
Although climate change is a long-term problem, our results emphasize the important role of policies that encourage abatement across all forms of energy generation and time frames, as well as the limitations of narrowly targeted policies.
Carolyn Fischer is a Senior Fellow at Resources for the Future
Fischer, Carolyn, and Richard G. Newell. 2008. Environmental and Technology Policies for Climate Mitigation. Journal of Environmental Economics and Management 55: 142–162.
Fischer, Carolyn, and Richard G. Newell. 2008. What's the Best Way to Promote Green Power? Don't Forget the Emissions Price. Resources 169 (Summer).
The Economist. 2009. The efficacy of climate-change policies. Dec 3.