First-Best Policy and Decentralized Mechanisms

Abstract

Externalities stemming from greenhouse gas (GHG) emissions may drive a wedge between social and private incentives concerning investment and operations in the power sector. While a central planner who internalizes GHG emissions via a Pigouvian tax to curb consumption may yield a first-best policy, decentralized mechanisms are typically deployed in OECD countries’ power sectors in order to align the incentives of private power companies with those of society. Using a bi-level modeling approach, we develop a framework in which a welfare-maximizing policymaker at the upper level sets the renewable portfolio standard (RPS) target for industry, which takes it as a regulatory parameter at the lower level when making its profit-maximizing capacity-expansion and generation-operation decisions. We demonstrate that even in the case of perfect competition, RPS cannot fully align social and private incentives in mitigation of GHG emissions since consumption is not curbed to the same extent as under the first-best policy. Consequently, “too much” renewable energy (RE) investment takes place. This distortion is less pronounced when power companies behave a la Cournot because the exercise of market power already diminishes consumption, thereby reducing the need for RE investment. We illustrate these principles using case studies based on a stylized network and provide techniques for resolving the bi-level problems. Extensions to these cases are explored in the end-of-chapter exercises with implementation of the problem instances in GAMS.