INTEGRATED TRADABLE GREEN CERTIFICATE MARKETS: FUNCTIONING AND COMPATIBILITY WORKING PAPERS IN ECONOMICS. Department of Economics

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1 WORKING PPERS IN ECONOMICS No. 03/05 EIRIK S. MUNDSEN ND GJERMUND NESE INTEGRTED TRDLE GREEN CERTIFICTE MRKETS: FUNCTIONING ND COMPTIILITY Department of Economcs U N I V E R S I T Y OF E R G E N

2 Integrated Tradable Green Certfcate Markets: Functonng and Compatblty by Erk S. mundsen 1, og Gjermund Nese bstract: Many countres plan to ncrease the proporton of ther electrcty supply obtaned from renewable sources relatve to nonrenewable sources. Recently, the EU has mplemented a system of tradable emsson permts and many countres have ntroduced systems of tradable green certfcates (TGCs). In ths paper, we analyze how ntegrated TGC markets functon and how they are affected by harsher CO emsson constrants. key result of our analytcal model s that TGCs may be an mprecse nstrument for regulatng the generaton of green electrcty. Furthermore, our analyss shows that the combnaton of TGCs wth a system of tradable emsson permts may yeld outcomes contrary to the ntended purpose. The results are vald under both autarky and nternatonal trade. JEL classfcatons: C7; Q8; Q4; Q48 Key words: Renewable energy, electrcty, green certfcates, emssons tradng 1 Correspondng author. Department of economcs, Unversty of ergen, Herman Fossgate 6, 5007 ergen, tel.: , fax.: , e-mal erk.amundsen@econ.ub.no Insttute for Research n economcs and usness dmnstraton (SNF), revksveen 40, 5045 ergen, tel.: , fax.: , e-mal.: gjermund.nese@snf.no 1

3 1. Introducton 3 Many countres pursue polces to ncrease the share of renewable energy n ther total energy consumpton. For example, the EU has an explct target to ncrease ts share of "green" electrcty, generated from renewable energy sources, from ts current level of 14% to % by 010 (EU/COM, 000). Smlar targets exst for the US (e.g., see EP, 003). Untl recently, the generaton of green electrcty had been stmulated by varous subsdy schemes, ncludng subsdzed nvestments, tax relef, and drect subsdes per unt of green electrcty generated. However, wth the lberalzaton of electrcty markets, nterest has shfted towards other subsdy measures. One proposton that has become popular s to ntroduce systems of tradable green certfcates (TGCs). Such systems tend to have dfferent desgns n dfferent countres, but a common feature s that they seek to replace drect publc subsdes for renewable energy wth ncentve systems that use the market mechansm. More precsely, the objectve s to create a market where varous knds of green electrcty compete on equal terms to releve the government of the burden of drect nvolvement n the electrcty sector's nvestment decsons. Snce 1998, the Netherlands has appled a system of "green labelng", whch s a voluntary system of green certfcates. The UK and Sweden have compulsory systems that use the market mechansm more drectly for TGC tradng. These systems dffer sgnfcantly from the more establshed feed-n tarff subsdy schemes that exst n countres such as Germany (see utler and Neuhoff, 004). Many European countres partcpate n the Renewable Energy Certfcate System (RECS) that, although not a support scheme tself, facltates many support schemes for green energy. 4 In addton, several countres outsde the EU have shown an nterest n ntroducng TGC systems, ncludng ustrala, US, Chna, and Inda (see Govnetto, 003). In 00, the UK ntroduced a TCG system called the UK Renewables Oblgaton Certfcate (ROC) Market. Sweden ntroduced ts system n 003. The Norwegan Parlament has decded that Norway wll ntroduce a TGC system on January 1, 006. The plan s that Norway and Sweden wll start tradng TGCs from ths date onwards, creatng the frst ntegrated TGC 3 Fnancal support from SNF's Energy Research Program (fnanced by Gassco, Statkraft, Statnett and Statol), the Norwegan Research Councl (SMSTEMT), and the Nordc Energy Research Program (NEMIEC) s gratefully acknowledged. 4 RECS s not restrcted by natonal boundares. It provdes a mechansm for representng producton of a MWh of renewable energy by a unque certfcate, whch can be transferred from owner to owner before beng used as proof of generaton, or exchanged for fnancal support (

4 market nvolvng several countres. 5 s well as analyzng the general functonng of a TGC market of the Nordc type, 6 ths paper dscusses how a TGC market s expected to perform 7 when t expands to nclude several countres. long wth the development of the TGC markets n Europe, a more general and comprehensve system of CO emsson permts tradng (ETS) 8 s about to emerge n the EU. The smple dea underlyng the ETS s that the emsson permt prce wll add to the cost of usng a CO -emttng resource, the cost ncrement beng n proporton to the emssons per unt of the resource used. s a result, nput substtuton s expected to take place n electrcty generaton, away from coal and gas power towards hydro, wnd, and nuclear power. Hence, even though ths system s not drectly targeted at ncreasng the share of renewables n electrcty provson, clearly the system wll have an nfluence on the relatve cost of provdng green electrcty. n essental ssue dealt wth n ths paper s the compatblty of the TGC and ETS systems, wth partcular emphass on how harsher CO emsson constrants affect the generaton of green electrcty wthn the settng of a TGC market. s n any other market, the markets for TGCs consst of supplers and buyers. Supplers are the producers of green electrcty who receve an amount of TGCs correspondng to the amount of green electrcty they generate. The supplers may sell these TGCs on the TGC market. In ths way, the producers receve both the wholesale prce and the TGC prce per MWh of green electrcty generated. uyers of TGCs are the retalers or consumers, who are oblged by the government to keep a certan amount of TGCs n relaton to the total amount of electrcty they consume (.e., both green and "black" electrcty). Ths requrement s referred to as the "percentage requrement". Thus, the demand for TGCs s derved smply as a 5 In 004, Nord Pool began tradng TGCs on the Swedsh market. TGC prces are posted on the Nord Pool web page at 6 One partcular characterstc of the Nordc system s that only small new hydro power plants qualfy for TGCs, whereas exstng large hydro power plants do not. Hence, even though electrcty generaton n a country lke Norway s based on almost 100% waterpower, only electrcty generated by bomass, wnd, and new small hydro power plants' bomass wll count as green electrcty n the TGC system. For ths reason, t s lkely that the percentage requrement wll be set at a rather low level (.e., 5%). 7 One basc dfference between the UK system and the Nordc system s that the former allows recyclng of revenues from the buy-out payments requred of electrcty companes that do not obtan suffcent ROCs. These buy-out payments are recycled to supplers that have presented ROCs. y contrast, the Norwegan system does not nvolve any recyclng of the correspondng penalty payments. 8 The EU Emssons Tradng Scheme (ETS) s based on the EU Drectve of Emssons Tradng, whch was adopted n July 003 (European Commsson, 003) and wll be put nto effect n 005. t frst, t wll comprse only CO emssons, but other greenhouse gases wll be ncluded later. The system covers emssons from several sectors, ncludng electrcty and dstrct heatng. 3

5 percentage of the total end use demand for electrcty. ased on supply and demand, a sngle TGC prce s establshed between admnstratvely set upper and lower prce bounds. The TGC markets are based on two polcy measures that the government uses to nfluence the role of green electrcty n the power market; these are the percentage requrement and the upper and lower prce bounds for the TGC prce. The percentage requrement s partcularly mportant, but the prce bounds may also play a sgnfcant role. 9 oth Sweden and the UK have specfc plans to ncrease ther percentage requrements. Thus, the percentage requrement s vewed as a means of attanng specfc targets for green electrcty. mundsen and Mortensen (001) nvestgated aspects of these polcy measures for domestc TGC and electrcty markets. TGC prce volatlty and bankng were dealt wth by mundsen et al. (004), whereas market power ssues were addressed n mundsen and Nese (00). Furthermore, numercal models of TGC and electrcty markets for specfc regons and settngs have been formulated and analyzed (e.g., ergman and Radetzk, 003; ye 003; Hndsberger et al., 003; Nese, 003). s mentoned above, the man problems nvestgated n ths paper relate to the ntegraton of TGC markets and how these markets are affected by actng n concert wth a CO permts market, such as the emergng European ETS system. To some extent, problems of compatblty have been addressed earler; e.g., n Fnon and Menanteau (003), Jensen and Skytte (003), and Unger and hlgren (003). However, unlke these papers, our focus s on the ntegraton of domestc TGC markets nto a jont TGC market and the effects of the major polcy measure, the percentage requrement. Seemngly paradoxcal results are derved from the analyss, such as the fndng that an ncrease of the percentage requrement n one country may lead to less green electrcty generaton n ths country, but more green electrcty generaton n another country. nother example s the result that a harsher emsson constrant n the CO emsson permts market may actually lead to less green electrcty generaton when TGC markets are nvolved. Such results wll be derved and explaned lthough the questons we pose are smple, t s not so easy to derve both general and precse answers. Consequently, a formal approach s requred, and we formulate an analytcal model 9 On the sgnfcance of prce bounds, see, for example, mundsen and Nese (00). We wll not deal wth the mportance of prce bounds n ths paper. 4

6 wth general assumptons; e.g., for demand and cost functons. From ths model, we derve and prove specfc results. The paper proceeds as follows. Frst, we consder the jont functonng of a TGC market and an electrcty market under autarky, focusng on questons such as how the generaton of green electrcty s affected by an ncrease of the percentage requrement n one of the partcpatng countres, or by harsher CO emsson constrants. Then, we analyze the case where two countres trade n electrcty, but not n TGCs. Ths stuaton may be consdered an nterm case before a complete set of markets s n place. However, even n such a case, changes n the TGC market of one country may nfluence the TGC market of another country, as well as the common electrcty market. Therefore, we proceed to analyze cases nvolvng both a common TGC market and a common electrcty market. Fnally, we dscuss the results obtaned and conclude the paper.. The model under autarky In order to analyze the nterplay between the electrcty market and the TGC market n a longrun settng under autarky, we apply the followng symbols and functonal relatonshps. p End-user prce of electrcty s Prce of TGCs q Wholesale prce of electrcty x Total consumpton of electrcty y Producton of "black" electrcty z Producton of "green" electrcty α Green electrcty requred as a proporton of total electrcty consumpton ("percentage requrement") β Emsson constrant on CO d g s g Demand for TGCs Supply of TGCs p (x) : Inverse demand functon of electrcty, where ( p ( x) / x) p' < 0 5

7 c c( y; β ) : Industry cost functon 10 for black electrcty wth emsson constrants. 11 We c c c assume > 0, 0, and > 0. The case where β 0 sgnfes that there are y y yβ no emsson constrants. h h h(z) : Industry cost functon for green electrcty, where > 0 z Π Π(.) : Proft functon h and > 0 z.1. Frst-order condtons and the equlbrum The electrcty producers supply a common wholesale market wthn whch a sngle wholesale electrcty prce s establshed. Retalers purchase electrcty on the wholesale market and TGCs on the TGC market. The electrcty s dstrbuted to end users and a sngle end-user prce s establshed. It s assumed that perfect competton prevals n all markets, wth many producers of black and green electrcty, many retalers, and many end users of electrcty. Hence, all agents treat the varous prces as gven by the market. The producers act as f they jontly maxmze: [ q + s] z c( y; ) h( ) Π( y) qy + β z. The frst-order condton for black electrcty generaton s: c( y, β) q y. 10 The ndustry cost functon s derved by "horzontal addton" of the ndvdual cost functons;.e., the cost of aggregate market supply s mnmzed. Usng the ndustry cost functon avods usng messy notaton to descrbe ndvdual decsons and our prme nterest s n the equlbrum market soluton, not ndvdual decsons. However, lttle detal s lost by ths approach as ndvdual frst-order condtons for electrcty producers correspond drectly to those derved n the analyss; e.g., condtons 3) and 4). 11 The cost functon for black electrcty condtonal on CO emsson constrants may be derved from a standard cost mnmzaton problem, wth the addton of a CO emsson constrant. Ths functon explctly takes nto account the fact that supplers may contnue to generate a gven quantty of electrcty even f the emsson constrant s made harsher. Ths s possble f supplers use cleaner fuels and cleaner generaton technologes. However, such a substtuton mples ncreased generaton costs, whch shft the cost curve upwards compared wth ts poston before the ntroducton of frmer emsson constrants. 6

8 The frst-order condton for green electrcty generaton s: h( z) q + s. z For each unt of electrcty (.e., each MWh) purchased n the wholesale market and sold on to end users, retalers have to pay the wholesale prce plus a share α of the TGC prce. For smplcty, electrcty dstrbuton s assumed to be costless. Wth a large number of retalers, the equlbrum establshed n the market (.e., the compettve equlbrum) must be characterzed by: p q + αs. We assume that the amount of TGCs s measured n the same unts as the amount of green electrcty. Thus, the demand for TGCs s gven by by g s z. g d αx and the supply of TGCs s gven Denotng equlbrum prces and quanttes by starred symbols, the equlbrum of the two markets s characterzed by: 1) ) 3) p( x s ) q + α ; z x y + z ; α c( y, β ) q ; y 4) q + s h( z). z Insertng ), 3), and 4) nto 1), we fnd that the end-user prce n equlbrum may be wrtten as a lnear combnaton of the margnal costs of black and green electrcty: 7

9 5) c( y, β ) h( z) p( x ) (1 α ) + α. y z From ), we see that and z αx y ( 1 α) x... The effects of the percentage requrement as a means for promotng green electrcty generaton In the TGC systems, the percentage requrement s perceved as a polcy nstrument to determne the amount of green electrcty n end-use consumpton. However, because the requrement s set as a percentage and not as a specfc quantty, t s not necessarly true that an ncrease of the percentage requrement leads to an ncrease of green electrcty generaton. The share of green electrcty generaton n total electrcty consumpton may well ncrease even f green electrcty generaton declnes, f there s a suffcent reducton of electrcty consumpton and of black electrcty generaton. However, an ncrease n the percentage requrement wll defntely lead to a reducton of black electrcty generaton and, therefore, a reducton n the wholesale prce of electrcty (see condton 3). s the effect on the generaton of green electrcty s ndetermnate, the effects on total electrcty generaton and consumpton, as well as the end-user prce, are also ndetermnate. In the followng secton, we study these effects n more detal. 1 To examne the effect of an dz ncrease n the percentage requrement (.e., ) on the generaton of green electrcty, we z α ( 1 ) z substtute x and y nto (5) and take the mplct dervates. Hence, α α omttng the starred symbols for the sake of smplcty, we obtan: p c αs + x ( 1 α) dz x y, D where 1 The results n ths paragraph represent a generalzaton of those obtaned by mundsen and Mortensen (001, 00). 8

10 D p c h (1 α ) α. x y z n nspecton of the sgns shows that the denomnator s negatve, whereas the numerator s ndetermnate. Hence, the effect on green electrcty generaton s ndetermnate. In the same way, we obtan an equaton representng the effect of an ncrease n the percentage requrement on black electrcty generaton: h p ( 1 α) s + xα dy z x D < 0. n nspecton of the sgns shows that the numerator s postve, whereas the denomnator s negatve. The generaton of black electrcty s reduced as the percentage requrement ncreases. Wth respect to the total electrcty consumpton, we fnd: dx h c s + xα ( 1 α) z y. D n nspecton of the sgns shows that ths expresson s generally ndetermnate. However, f c dx the margnal cost of black electrcty s constant (.e., 0 ), we fnd that < 0. Thus, y an ncrease of the percentage requrement wll lead to a reducton of total electrcty consumpton. However, the mpact on green electrcty generaton remans ndetermnate. In addton, the effects depend on the level of the percentage requrement, α. 13 For example, f dz α 0, then > 0, whereas dx s ndetermnate. 13 y smplfyng the functonal forms of the model, for example by assumng lnear or constant elastc demand and lnear margnal cost functons, t s possble to study n more detal how the electrcty consumpton changes as the percentage requrement ncreases from 0 to 100%; see ye (003) and Jensen and Skytte (00). 9

11 Hence, n concluson, the ntroducton of a TGC system of the Nordc type does not necessarly lead to greater green electrcty generaton, but t s true that t wll lead to a reducton of black electrcty. Furthermore, t s not obvous how total electrcty generaton s affected..3. The effects of harsher CO emsson constrants In order to nvestgate the equlbrum effect of harsher CO emsson constrants on green electrcty, we take the mplct dervate of expresson 5) wth respect to β. Hence, we obtan: c α(1 α) dz yβ < 0 D. Wth the assumed cross effects of the margnal cost functon of black electrcty t follows that the numerator s postve whle the denomnator s negatve. Therefore, the total effect s negatve. Hence, harsher CO emsson constrants wll not lead to an ncrease n the generaton of green electrcty. On the contrary, generaton of green electrcty wll declne. 14 Owng to the fact that z αx α( 1 α) y, both the generaton of black electrcty and the total consumpton wll be reduced as the CO emsson constrant becomes harsher. Furthermore, we see from expresson 4) that a reducton n the generaton of green electrcty mples that the sum of the wholesale prce and the TGC prce must fall. However, t s not necessarly true that both the wholesale prce and the TGC prce fall. It may seem paradoxcal that harsher CO emsson constrants can actually lead to a reducton n the generaton of green electrcty. Harsher emsson constrants mply an ncrease n the prce of emsson permts, whch s supposed to advantage the producers of green electrcty. However, owng to the nterplay of the emsson constrants wth the TGC market, ths wll not be the case despte the fact that, vewed n solaton, both systems work towards the same end, a reducton of CO emssons. The reason for ths les n the specfc constructon of the TGC system. Harsher CO constrants mply an ncrease n the prce of 14 In general, any postve shft of the margnal cost functon for black electrcty (such as may result from an ncrease of nput prces n the generaton of black electrcty) wll nduce a reducton n the generaton of green electrcty. 10

12 emsson permts and an ncrease n the wholesale prce of electrcty. Wthn the TGC system, ths mples that the TGC prce s reduced by more than the ncrease n the wholesale prce (dependng on the sze of the percentage requrement), so that the sum of the TGC prce and the wholesale prce s reduced. The extra remuneraton for green electrcty generaton n the TGC system s composed of the margn between the wholesale prce and the end-user prce. s the wholesale prce ncreases n response to the harsher emsson constrants, ths margn, equal to the TGC prce multpled by the percentage requrement, wll be reduced. To recognze ths, assume, as an example, that ths margn s reduced by one cent and that the percentage requrement s 0%. In such a case, the TGC prce wll be reduced by 1/0. 5 cents. Therefore, the total remuneraton to producers of green electrcty (.e., the sum of the wholesale prce and the TGC prce) s reduced. Consequently, the equlbrum effects of harsher CO emsson constrants are reductons n both black and green electrcty generaton. 3. Trade n electrcty In ths secton, we nvestgate how a TGC system functons n an open economy. Thus, we expand the model to nclude smultaneously functonng markets for electrcty and TGCs n two countres, country and country. The varables nvolved are the same as those under autarky, but there s one set of varables for each country. In addton, we ntroduce the "trade varables", m and n, representng mports of electrcty and TGCs, respectvely. In the exposton to follow, we apply the subscrpt, where,. Demand may dffer between the two countres, and t s assumed that the nverse demand functons are gven by: p ( x ), where p x ( x ) < 0. Furthermore, we assume that the technologes appled n generatng black and green electrcty may dffer between the two countres. Ths mples that comparatve advantages and dsadvantages may exst n the generaton of black and green electrcty n each of the countres. 11

13 The cost functon of black electrcty n country s gven by: 15 c c c c c ( y, β ), where > 0, 0, and > 0. y y y β The cost functon of green electrcty n country s gven by: h h h ( z ), where > 0 z h and > 0. z 3.1. Frst-order condtons and the equlbrum Frst, we assume that cross-border trade takes place only for electrcty, not for TGCs. Furthermore, for smplcty, we assume that there are no transacton costs nvolved and that there are no transmsson constrants between the countres. For these reasons, we can consder the electrcty markets of countres and to be a sngle market wth a common wholesale prce;.e., q q q. s there are only two countres nvolved, one country's M mports must equal the other country's exports. Therefore, n equlbrum, t must be the case that m. m It s easly recognzed that the optmzaton problems and the frst-order condtons for the agents n each of the countres must be smlar to those under autarky, except that mports and exports must be accounted for explctly. Therefore, the equlbrum condtons for each of the markets n each of the countres can be expressed as follows: p 6) ( ) α x q + s ; M 7) x z y + z + m ; α 8) q M + s h ( z ) ; z 15 The cross-effects may dffer between the countres because the share of black electrcty n each country may be dfferent. If the prce of emsson permts ncreases, the country wth the hghest share of black electrcty wll experence the largest shft of ts margnal cost curve. 1

14 13 9) M y y c q ) (, β. Insertng 8) and 9) nto 6), we fnd that the equlbrum end-user prce can be wrtten as a lnear combnaton of the margnal costs of black and green electrcty: 10) ( ) ( ) z z h y y c x p + ) ( ), ( 1 α β α. 3.. The effects of the percentage requrement as a means for promotng green electrcty generaton In ths secton, we assume that the percentage requrement may be dfferent between the two countres and focus on the effects of an ncrease n the percentage requrement n one of the countres. More precsely, we seek to determne the effects of an ncrease n country 's percentage requrement on green and black electrcty generaton and electrcty consumpton n both countres. Takng the mplct dervate of expresson 10) wth respect to α, we fnd that the only sgns that can be determned wth certanty are those belongng to the effects on total combned black electrcty generaton for countres and, and the effects on country 's green electrcty generaton and electrcty consumpton. These effects follow from the expresson below: ( ) E D E D E x p z h x s d dy α α α, where y y Y +, ( ) 0 1 < z h y c x p D α α for, and y c x p z h E α.

15 n nspecton of the sgns shows that the numerator s postve, whereas the denomnator s negatve. Therefore, the effect on the combned generaton of black electrcty n the two countres s negatve. Furthermore, t can be shown that: 16 dy sgn dy sgn. dm sgn sgn dx sgn dz Y y s < 0, t follows that < 0 α α y and < 0. Furthermore, t must be the case that α dx > 0 dz and > 0. In other words, somewhat surprsngly, the ncrease of the percentage requrement n country leads to an ncrease n both electrcty consumpton and green electrcty generaton n country. The other effects are ndetermnate. 17 From ths analyss, we note n partcular that the effect of an ncrease n country 's percentage requrement on green electrcty generaton n that country s ndetermnate. However, the effect on country s determnate. The generaton of green electrcty n country wll ncrease. Furthermore, electrcty consumpton n country wll ncrease, whereas the generaton of black electrcty wll fall n both countres. s explaned earler, an ncrease n the percentage requrement wll necessarly lead to a reducton n the wholesale prce of electrcty. For country, the effects on electrcty generaton and consumpton are the same as those under autarky. However, n ths two-country model wth a common electrcty market, the reducton of the wholesale prce wll nfluence the demand for electrcty n country. The reduced wholesale prce mples that electrcty becomes cheaper n country, leadng to an ncrease n electrcty consumpton n ths country. In order to satsfy the percentage requrement, the demand for TGCs wll have to ncrease n country. s there s no trade n TGCs between the countres, the ncrease n demand for TGCs can only be satsfed by a correspondng ncrease of the TGC supply n country. Hence, the generaton of green electrcty wll have to ncrease n country. Therefore, we arrve at the 16 Proofs may be obtaned from the authors upon request. 17 From a numercal model satsfyng the assumptons of ths paper, t can be shown that equlbra exst where the green electrcty generaton and electrcty consumpton n country may ether ncrease or decrease followng an ncrease n the percentage requrement n country. The detals of ths proof are not ncluded n the paper, but may be obtaned from the authors upon request. 14

16 somewhat counterntutve result that an ncrease of the percentage requrement n country may lead to a reducton of green electrcty generaton n country, but wll defntely lead to an ncrease of green electrcty n country The effects of harsher CO emsson constrants Harsher CO emsson constrants mply a reducton of green electrcty generaton n both countres. To see ths, we rearrange 10) to obtan: p ( x ) ( 1 ) h ( z ) α qm + α. z Dfferentatng ths expresson, we arrve at: p dx h dz dqm 11) α (1 α ),,. x z From 7), we have that z α x. Therefore, we may wrte: 1) 1 1 α p x 1 α h α z dz dq M 1 1 α p x 1 α h α z dz. dz To obtan a contradcton, assume 0. Inspectng the sgns of expresson 1), we see that ths mples that dz dx 0, dx dq 0, dq 0, and M 0. From 9), we see that M 0 mples that dy < 0 dy and < 0. Upon applyng 7) and elmnatng m, we fnd that: dx dx dy dy ) ( α ) + ( 1 α ) n nspecton of the sgns of expresson 13) reveals that the left-hand sde s nonnegatve, whereas the rght-hand sde s negatve. Hence, there s a contradcton. Therefore, t follows 15

17 that the generaton of green electrcty and the consumpton of electrcty must fall n both countres. Furthermore, from expresson 13), t s apparent that the total generaton of black electrcty must be reduced, whereas expresson 1) makes t clear that the wholesale prce of electrcty wll have to go up. The ntuton behnd the reducton of green electrcty as a result of harsher emsson constrants s the same as the ntuton for the autarky case, dscussed n secton.. 4. Trade n electrcty and TGCs The focus of ths secton s on the case where both electrcty and TGCs can be traded between two countres. Ths mples that both the wholesale prce of electrcty and the prce of TGCs are common between the countres. Hence, s and s are replaced by s M n the objectve functons and frst-order condtons below. Otherwse, the model specfcaton s as n the prevous case Frst-order condtons and equlbrum TGCs wll be mported f the domestc demand for certfcates exceeds the domestc supply. In equlbrum, the mports of one country wll be equvalent to the exports of the other country;.e., n. The trade n certfcates mples that the relatve share of green n electrcty generated n one country may be dfferent from the percentage requrement (see expresson 15). The equlbrum can be expressed as follows: p 14) ( ) x q + α s ; M M 15) x z + y + z + m α n ; 16) q M + s M h ( z ) ; z 17) q c ( y, β M. y ) Insertng 14) and 15) nto 1), we fnd agan that the equlbrum end-user prce may be wrtten as a lnear combnaton of the margnal costs of black and green electrcty: 16

18 18) p ( x ) ( 1 ) c ( y, β ) h ( z ) α + α. y z 4.. The effects of the percentage requrement as a means for promotng green electrcty generaton Once agan, we focus on the effect of changng the percentage requrement. The analyss shows that t s possble to determne only the effect on black electrcty generaton n ths case. gan, an ncrease n the percentage requrements leads to a reducton of green dy electrcty generaton;.e., we have < 0. To realze ths, assume the opposte result, namely, that an ncrease of α, the percentage requrement n country, ether ncreases, or has no effect on, the total generaton of black electrcty. Ths mples an ncrease n green electrcty generaton n order to fulfll the percentage requrement n both countres. Hence, n equlbrum, the consumpton of green electrcty must ncrease n both countres, as we now have a common market for both electrcty and TGCs. Constant or ncreased generaton of black electrcty mples that the wholesale prce, q M, s constant or ncreases, respectvely. Furthermore, for the generaton of green electrcty to ncrease, the prce of green electrcty, q M + s M, must also ncrease. From equaton 14), we notce that ths mples an ncrease n the end-user prce of electrcty n both countres. Ths s not compatble wth an ncrease n the consumpton of electrcty. Thus, we have a contradcton, whch leads to the result that dy < 0. dy dy s n the case of trade n electrcty only, t can be shown that sgn sgn. Ths mples that the generaton of black electrcty s reduced n both countres;.e., we have dy < 0 dy and < 0. Consderng the total generaton of green electrcty, the effect of ncreasng the percentage requrement n country wll be ndetermnate agan. s we now have a common market for TGCs n countres and, t can be shown that: dz sgn dz sgn. Thus, n contrast to the case of trade n electrcty only, an addtonal opportunty for tradng certfcates mples that we no longer obtan the unambguous result 17

19 that an ncrease of α leads to an ncrease n green electrcty generaton n country. The change n green electrcty generaton must now occur n the same drecton n both countres. 18 The effect on the other varables s ndetermnate. Fnally, the results show that the effect on electrcty consumpton s ndetermnate n both countres The effects of harsher CO emsson constrants In ths case, harsher CO emsson constrants mply a reducton of green electrcty generaton n both countres. To see ths, frst observe from expresson 15) that: 19) α dx dx dz dz + α and + 0) dx dx dy dy ( 1 α ) + (1 α ) +. To obtan a contradcton, assume that the generaton of green electrcty n country s not dz reduced;.e., 0. From expresson 16), we fnd that f one country does not reduce green electrcty generaton, ths mples that the other country wll not reduce ts green electrcty generaton ether. Ths must be the case as both countres are subject to the same change n q + s. From expresson 19), we observe that ths means that the consumpton of M M electrcty n at least one of the countres must be ether ncrease or reman constant. ssume dx that country does not reduce ts consumpton of electrcty;.e., 0 (a parallel proof exsts for the case where country does not reduce ts consumpton of electrcty). Dfferentatng expresson 18) n the same way that we found expresson 1), we fnd: 1) 1 1 α p x dx h α z dz dqm 1 1 α p x dx α z h dz. 18 Proofs may be obtaned from the authors upon request. 18

20 s dz dx 0 and dq 0, we observe from expresson 1) that M 0, whch mples dy dy < 0 and < 0. Therefore, the rght-hand sde of expresson 0) s negatve, whereas the rght-hand sde of expresson 19) s nonnegatve. For ths to happen, we must have dx < 0 and n addton α > α. s we have assumed that green electrcty generaton does not declne and we have that dq ds M 0, we must have M 0. From expresson 1), we see that for green electrcty generaton to decrease n country, we must haveα < α. Ths contradcts the above result ofα > α. Once agan, the concluson s that green electrcty generaton wll be reduced n both countres as a consequence of harsher emsson constrants. The mechansms underlyng the result n ths case, where trade takes place n electrcty and TGCs, are the same as for the cases of autarky and trade n electrcty only. Moreover, both total black electrcty generaton and total consumpton of electrcty wll be reduced. The wholesale prce of electrcty wll ncrease. 5. Dscusson One of the man conclusons of ths paper s that the percentage requrement s not a very precse polcy measure for stmulatng nvestments n green electrcty generaton capacty. Thus, n general t s not true that an ncrease n the percentage requrement leads to more nvestments n such capacty. Ths result s apples not only to a domestc TGC market under autarky, but also to the case where two countres trade n TGCs and electrcty. However, t should be noted that a larger percentage requrement may be compatble wth more green electrcty generaton over tme f there s a general ncrease n demand. However, the mmedate effect of a hgher percentage requrement on green electrcty generaton cannot be guaranteed. Ths weakness s unque to ths system. For nstance, a fxed per unt subsdy system would not nvolve such ambguty because an ncrease of a fxed per unt subsdy defntely leads to more green generaton capacty. 19 Hence, f the objectve s to acheve a 19 Moreover, the percentage requrement for a sngle country s not a very potent measure f the country n queston s part of a large nternatonally ntegrated system of compettve markets for electrcty and TGCs. Such a crcumstance would mply that the prces of electrcty and TGCs are gven, and that the electrcty 19

21 gven target of new green generaton capacty, a TGC system s not the best system to use. Other systems, such as a tenderng or aucton system, or a system of plan subsdes, may work better n ths respect. However, the TGC system provdes a strong role for market forces and takes account of consumers' wllngness to pay for electrcty va the effects on demand and the end-user prce. In addton, the TGC system allows for voluntary purchases of TGCs by consumers who wsh to support green electrcty generaton. 0 Untl recently, only a few economes had experenced runnng TGC markets. In the UK, TGCs were traded at around 45 GP/MWh n 004 (Platts, 004). Ths system seems to have generated nterest among nvestors n the constructon of new green electrcty generaton capacty (see e.g., utler and Neuhoff, 004). In Sweden, trade statstcs show that the TGC prce has been establshed at a rather hgh level, partly because of Sweden's hgh percentage requrement, whch was set at 9.5% n 005, and ts ambtous plans to ncrease the percentage requrement to 15.3% by 010. In addton, the TGC prce has been set close to the penalty prce, the upper prce bound. Partly for ths reason, many retalers have chosen not to purchase TGCs, but nstead to pay the penalty prce drectly, thereby avodng some transacton costs. Indeed, n 003, one out of four companes chose to pay the penalty rather than to purchase or use ther TGCs. From 005 onwards, a new system for determnng the penalty s beng ntroduced. Essentally, t nvolves settng the penalty prce at 150% of the annual average of the TGC prce. It s lkely that the expectaton of even hgher TGC prces under ths new system has led many companes to hoard ther TGCs for future sale/use. In 003, only 77% of ssued TGCs were used. Records of the Swedsh experence of TGCs are scarce and uncertanty remans as to the sgnfcance of the TGC market for generatng new green electrcty generaton capacty. n mportant result of the paper s that makng CO emsson constrants harsher and ncreasng emsson permt prces leads to less capacty for green electrcty generaton when CO trade s combned wth a TGC system, as explaned n secton.3. Thus, the tradable emssons permt system (TEP) and the TGC system may be vewed as alternatves. In addton, ths rases the queston of why two polcy measures are requred to acheve one goal, producers and the retalng companes n the economy wll adapt to these prces. However, ths n turn mples that nether the percentage requrement nor the TGC prce bounds for a gven country can be used to nfluence the green electrcty generaton or the composton of green and black electrcty n that country. 0 The opton of buyng green electrcty at a surcharge has been offered n many countres, for nstance Vattenfall n Sweden. However, demand has been low. 0

22 as n the case of the European ETS and TGC systems, whch both seem to am at achevng clean energy generaton. Presumably, the answer s that the ams of the two systems are somewhat dfferent. The TEP system s targeted at reducng the global emssons of CO, whereas the TGC system s targeted at achevng an electrcty supply from renewable sources. Clearly, the TGC system may acheve a reducton of CO emssons, but t also reduces the use of nonrenewable sources, notably crude ol and natural gas, that are n scarce supply and used at the expense of future generatons. further ssue s how to combne the systems n an optmal way. One opton for Europe s to retan ts wdespread ETS system as a base and put the TGC system "on top" of ths. 1 s yet, the mpact of the ETS system on the generaton of green electrcty s unknown. On ts own, the ETS system f t behaves accordng to prncples wll lead to an equalzaton of the end-user prce of electrcty wth the margnal cost of black electrcty generaton and wth the margnal cost of green electrcty generaton plus the mputed subsdy from the ETS system. If the green electrcty generaton stmulated by the ETS system s not suffcent, the TGC system may act as further stmulaton of green electrcty generaton. In that case, the equalzaton of the varous margnal costs, ncludng the subsdes, wll be dstorted, as explaned n the prevous sectons (.e., t wll result n lnear combnatons of margnal costs). However, as explaned earler, more drect ways of stmulatng green electrcty generaton nclude allowng per unt subsdes of green electrcty generaton capacty, or usng an aucton or a tenderng system. ddtonal problems assocated wth the TGC systems need to be resolved. One problem relates to TGC prce volatlty. If the green generaton technologes n a country largely consst of wnd or water power, szable and erratc varatons of green electrcty generaton may occur, owng to natural annual varatons of wnd or precptaton, whch may amount to as much as ± 0% for each for the Nordc countres. Therefore, there wll be smlar varatons n the numbers of TGCs for sale. Ths n turn wll gve rse to a hgh prce volatlty of TGCs, nvolvng serous prce spkes. The reason for the hgh volatlty s that TGC demand s hghly nelastc because, under the percentage rule, t s only a fracton of the demand elastcty for electrcty. Hence, potental nvestors n green electrcty capacty face a hghly uncertan rate of return on ther nvestments and therefore requre hgh expected rates 1 On ths problem, see Hndsberger et al. (003) and Jensen and Skytte (003). 1

23 of return to be wllng to nvest. To some extent, the problem of prce volatlty may be resolved by the ntroducton of bankng;.e., allowng agents to keep TGCs for future use/sale. Ths knd of arrangement s known to have a prce-dampenng effect, even though occasonal prce spkes may stll occur. In addton, bankng s known to mprove the functonng of the market n terms of an ncreased socal surplus. nother problem related to the TGC market s the potentally hgh market power that a producer of green electrcty may possess. The reason for ths s that the percentage requrement mples that one TGC counts for a multple of MWh n consumpton. For nstance, f the percentage requrement s 10%, the acton of not sellng a TGC wll reduce consumpton by 10 MWh, wth a correspondng ncrease n the end-user prce. Hence, by wthholdng TGCs, a producer of green electrcty may sgnfcantly ncrease the end-user prce, even though the producer's own power generaton s not that large. mundsen and Nese (00) have shown that a TGC market wth market power may even collapse nto an ordnary subsdy system where the prce lmts (.e., the upper-end penalty prce or the lower-end resale prce) consttute the per unt subsdy. 6. Summary and concludng remarks The focus of ths paper has been on the role of polcy measures n TGC markets, the ntegraton of country-specfc TGC markets, and compatblty ssues between TGC markets and an ntegrated TEP system. The analyss was based on a statc long-run analytcal model, whch was used to deduce results for three dfferent scenaros: frst, a TGC system n an autarky; then, a TGC system mplemented n a country that trades electrcty wth another country; and fnally a case where TGC systems are mplemented n two countres that trade both electrcty and TGCs. For all scenaros, the effects of harsher CO emssons constrants were nvestgated. Our man results can be summarzed as follows: The effect of changng the percentage requrement on the generaton of green electrcty s ndetermnate. Thus, an ncrease of the percentage requrement wll not necessarly lead to an ncrease of green electrcty generaton n the long run. It guarantees only an ncrease n green electrcty's share of total consumpton. These

24 results are shown to be vald for all the cases nvestgated;.e., under autarky and when electrcty, or both electrcty and TGCs, are traded between two countres. The effect of an ncrease n the percentage requrement on black electrcty generaton wll always be negatve. Under autarky, an ncrease of the percentage requrement wll have an ndetermnate effect on the total consumpton of electrcty. In the case where one country mplements a TGC system and trades electrcty wth another country, the effect of an ncrease of the percentage requrement on total consumpton wll be ndetermnate n the country mplementng the TGC system. However, the other country wll experence an ncrease n both the total electrcty consumpton and green electrcty generaton. However, allowng the trade of TGCs between the countres leads to an ndetermnate effect on both these varables n the country that does not mplement the TGC system. In the case of TGCs workng n combnaton wth a system of traded CO emsson permts, a harsher CO emsson constrant wll push the prce of TGCs downwards, lowerng the profts of the green electrcty producers. Therefore, such a polcy wll nduce a reducton n the generaton of green electrcty. Ths result was shown to be vald n all our specfed cases. long wth the other potental problems dscussed above, the problems revealed n ths paper clearly call for cauton n the desgn and mplementaton of TGC systems, not least when they are put nto place on top of emsson tradng systems. 3

25 References mundsen, E.S. and J.. Mortensen (001): "The Dansh green certfcate system: Some smple analytcal results", Energy Economcs, 3, mundsen, E.S. and G. Nese (00): "Provson of renewable energy usng green certfcates: Market power and prce lmts", Workng paper No. 5/0, Department of Economcs, The Unversty of ergen. mundsen, E.S., F. M. aldursson, and J.. Mortensen (003): "Prce Volatlty and ankng n Green Certfcate Markets", Workng paper No. 0/03, Department of Economcs, The Unversty of ergen. ergman, L. and M. Radetzk (003): "Global klmatpoltk (Global clmate polcy)", SNS Förlag, Stockholm. utler, L. and K. Neuhoff (004): "Comparson of Feed n Tarff, Quota and ucton Mechansms to Support Wnd Power Development", Workng paper, Department of ppled Economcs, Unversty of Cambrdge, Cambrdge, UK. ye, T.. (003): "On the prce and volume effects from green certfcates n the energy market", Dscusson paper 351/003, Research Department, Statstcs Norway. European Commsson (003): "Greenhouse gas emssons tradng: Commssoner Wallstrøm hals fnal agreement on clmate change breakthrough", Press Release IP/03/931. EP, (003). EP Strategc plan: Drecton for the future. U.S. Envronmental Protecton gency. EU/Commsson, (000). Drectve of the European Parlament and of the councl on the promoton of electrcty from renewable energy sources n the nternal electrcty market. Com(000) 79 fnal, russels. Fnon, D. and P. Menanteau (003) "The Statc and Dynamc Effcency of Instruments of Promoton of Renewables", Energy Studes Revew, 1(1): Govnetto, nna, (003). On the track of green certfcates. Envronmental Fnance, September 003. Magnus Hndsberger, Malene Hen Nybroe, Hans F. Ravn and Rune Schmdt Hndsberger, M., Nybroe M.H., Ravn H.F. and Schmdt R. (003): Co-exstence of electrcty, TEP, and TGC markets n the altc Sea Regon", Energy Polcy, 31, pp Jensen, Stne G., Skytte, Klaus, (00). Interactons between the power and green certfcate markets. Energy Polcy 30, Jensen, S.G. and K. Skytte (003): "Smultaneous ttanment of Energy Goals by Means of Green Certfcates and Emsson Permts", Energy Polcy, 31(1),

26 Nese, G. (003): "Essays n Lberalzed Energy Markets", Doctoral dssertaton, Department of Economcs, The Unversty of ergen. Platts (004): "UK Renewables Certfcates Market", McGraw-Hll, London Unger, T. and E.O. hlgren (003): "Impacts of a common green certfcate market on electrcty and CO emsson markets n the Nordc countres", n T. Unger "Common energy and clmate strateges for the Nordc countres model analyss", Doctoral dssertaton, Chalmers Unversty of Technology, Gothenburg, Sweden. 5

27 Department of Economcs Unversty of ergen Fosswnckels gate 6 N-5007 ergen, Norway Phone: Telefax: