More Birds Than Stones – A Framework for Second-Best Energy and Climate Policy Adjustments

Abstract

Tinbergen's seminal work showed that we need as many policy instruments as there are market failures to address. In practice, however, regulatory power is often constrained, making it difficult or impossible to implement the first-best policy portfolio. We analyze analytically and numerically how available policy instruments should be adjusted vis-a-vis the first-best to account for under-internalized secondary market failures. As a concrete example, consider the power sector: alongside the external costs of emissions, evidence suggests that consumers undervalue energy efficiency investments, and knowledge spillovers hamper R&D and learning-by-doing in low-carbon technologies. By exploring the potential and limits of policy instrument substitution, we provide guidance for policymakers on how to adjust first-best policies in second-best situations. We calibrate the theoretical model to the European electricity sector and find that, compared with the first-best policy portfolio, relying on CO2 pricing alone increases the policy cost of the EU CO2 emissions target by about 30%. Uninternalized R&D spillovers contribute the most to this increase, and are the most difficult to address indirectly, even with learning subsidies. By contrast, almost 40% of the additional cost created by the absence of optimal energy efficiency subsidies can be recuperated by a second-best electricity tax.