An Option Analysis of the European Union Renewable Energy Support Mechanisms

Abstract

We examine the economic efficiency of incentive mechanisms used to promote Renewable Energy (RE) across the European Union (EU) by looking at returns to investors along with any negative externalities or social costs. Using electricity price data from 2009 to 2013, we evaluate the RE support mechanisms adopted by some of the largest EU economies. We explain the limitations of various metrics used to inform incentives for RE and propose an alternative metric reflecting investor requirements. Our results show that while the EU schemes were effective in delivering RE capacity, the incentives provided were overly generous and economically inefficient. To assess the indirect costs of RE in liberalized electricity markets we employ real option theory to quantify the costs of hedging and pricing the exposure faced by conventional fossil fuel generators required to accept RE under dispatch priority. We find that the cost of hedging against random RE output under dispatch priority is expensive while increasing RE in liberalized markets, by depressing prices and increasing price volatility, may place greater burden on conventional, dispatchable generators. As support for RE is presented as a public good, we argue that economically efficient RE support mechanisms require recognizing both their direct and indirect costs.