Cost reduction incentives in electricity markets with overlapping regulations

Abstract

Recent research has documented some potential unintended consequences of so called “overlapping regulations” in electricity markets. A primary example of these overlapping regulations are the emissions trading scheme and the various renewable energy (RE) support mechanisms currently employed in the EU to enforce a “green quota”. One common RE support mechanism is a system of premium feed-in tariffs. Under such a system, RE producers receive subsidies that are typically “generation cost based” but there is an expectation that as technological improvements in the RE production chain reduce costs, the subsidies will be eliminated as RE installations become competitive with fossil fuel producers. Therefore, one important component of the study of overlapping regulations is the analysis of the cost reduction incentives facing RE producers. To this end, we employ an example based on a stylized partial equilibrium model of a closed, competitive electricity market operated under both an emissions trading scheme and a green quota implemented via a system of premium feed-in tariffs. We demonstrate that there will always be one RE producer that has an incentive to both pad its own costs and attempt to disadvantage its rivals by increasing their costs. Moreover, we show that the total RE resource cost of meeting the emissions target and green quota are unaffected by cost reductions by RE producers. However, cost reduction incentives can be restored if the subsidies remain fixed for a “reasonable” period of time and the green quota is eliminated.