Effects of Electricity Sector Climate Policies in a Second-best World of Missing Risk Markets

Abstract

Analyses of climate policies often assume the economy is in a first-best equilibrium with well-functioning markets. This paper studies policy effects in power systems characterized by a market failure known as the missing market problem, whereby the incompleteness of long-term markets leaves investors exposed to uninsured risk. We find that renewable tax credits and CO 2 taxes may partly correct this market failure, thus providing an economic benefit additional to climate change mitigation. Consequently, illustrative experiments show the costs of these policies to be lower, and in some cases even negative, in power systems with missing risk markets.