DISCUSSION PAPER. Environmental and Technology Policy Options in the Electricity Sector. Interactions and Outcomes

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1 DISCUSSION PAPER December 03 RFF DP 3-0 Envronmenal and Technology Polcy Opons n he Elecrcy Secor Ineracons and Oucomes Carolyn Fscher, Rchard G. Newell, and ous Preonas 66 P S. NW Washngon, DC

2 Envronmenal and Technology Polcy Opons n he Elecrcy Secor: Ineracons and Oucomes Carolyn Fscher, Rchard G. Newell, and ous Preonas Absrac Myrad polcy measures am o reduce greenhouse gas emssons from he elecrcy secor, promoe generaon from renewable sources, and encourage energy conservaon. To wha exen do nnovaon and energy effcency (EE) marke falures jusfy addonal nervenons when a carbon prce s n place? We exend he model of Fscher and Newell (008) wh advanced and convenonal renewable energy echnologes and shor and long-run EE nvesmens. We ncorporae boh knowledge spllovers and mperfecons n he demand for energy effcency. We conclude ha some echnology polces, parcularly correcng R&D marke falures, can be useful complemens o emssons prcng, bu ambous renewable arges or subsdes seem unlkely o enhance welfare when placed alongsde suffcen emssons prcng. The desrably of srngen EE polces s hghly sensve o he degree of undervaluaon of EE by consumers, whch also has mplcaons for polces ha end o lower elecrcy prces Even wh mulple marke falures, emssons prcng remans he sngle mos cos-effecve opon for reducng emssons. Key Words: clmae change, cap-and-rade, renewable energy, porfolo sandards, subsdes, spllovers, energy effcency, elecrcy JE Classfcaon Numbers: Q4, Q5, Q55, Q58 03 Resources for he Fuure. All rghs reserved. No poron of hs paper may be reproduced whou permsson of he auhors. Dscusson papers are research maerals crculaed by her auhors for purposes of nformaon and dscusson. They have no necessarly undergone formal peer revew.

3 Conens Inroducon... Model... 4 Nonrenewable Secors... 5 Renewable Energy Secor... 6 Consumer Demand and Energy Effcency Invesmens... 9 Economc Surplus... Polces... Opmal polces... 4 Numercal Applcaon... 6 Funconal Forms... 6 Elecrcy Generaon and Knowledge...6 Energy Effcency...7 Parameerzaon... 7 Resuls... Baselne... Emssons Prce and Opmal Polcy Combnaons... Sensvy of Opmal Polces o Assumpons... 4 Sngle Polces... 3 Subopmal Polcy Combnaons Dsrbuonal Consequences Concluson References Appendx... 4 Dervaon of Welfare Impacs of Polcy Porfolo Change Dervaon of Energy Demand Parameers... 44

4 Resources for he Fuure Envronmenal and Technology Polcy Opons n he Elecrcy Secor: Ineracons and Oucomes Carolyn Fscher, Rchard G. Newell, and ous Preonas Inroducon Over he las decade, concerns abou global warmng, local ar qualy, and energy secury have led o a plehora of acual and proposed naves a he federal and sae levels, parcularly n he power secor. These measures am o reduce emssons, promoe elecrcy generaon from renewable sources, and encourage energy conservaon. Examples of polces nclude: Porfolo sandards and marke share mandaes, such as hose requrng producon shares for renewable or clean energy sources. Subsdes and ax relef for renewable sources lke wnd power, solar, geohermal, and bomass generaon. Polces o prce greenhouse gas (GHG) emssons hrough cap and rade or a carbon ax, and relaed proposals o shf more of he ax burden ono energy or polluon. Performance sandards, such as maxmum emsson raes per KWh of elecrcy and energy effcency sandards for household applances. However, lle aenon has been pad o wheher hese myrad polcy effors work ogeher or a cross purposes. Research on polcy nsrumen choce n he conex of mulple neracng polces and marke falures has been denfed as an mporan area of furher nvesgaon (Goulder and Parry 008). In oher words, s mporan o recognze ha he whole of our energy polcy mx s gong o be que dsnc from he sum of s pars and possbly less han ha sum (Fscher and Preonas 00). Fscher s a Senor Fellow a Resources for he Fuure (RFF), Washngon DC, a Vsng Professor a Gohenburg Unversy and a Fellow of he CESfo Research Nework; Newell s he Gendell Professor of Energy and Envronmenal Economcs and Drecor of he Duke Unversy Energy Inave a Duke Unversy, and Research Assocae a he Naonal Bureau of Economc Research; Preonas s an adjunc research asssan a RFF and a graduae suden a he Unversy of Calforna a Berkeley. We acknowledge fnancal suppor from he US Envronmenal Proecon Agency and he Swedsh Foundaon for Sraegc Envronmenal Research (MISTRA) INDIGO program.

5 Resources for he Fuure For many of hese polces, he prmary movaon s addressng an emssons exernaly, such as he damages from ar polluon or he rsks of clmae change. If ha were he only marke neffcency, hen only one polcy nsrumen would be needed: an approprae emssons prce or oher mechansm o nernalze he envronmenal exernaly. Indeed, f a bndng emssons cap s n place, supplemenal polces for renewable energy and energy effcency (EE) lead o no ncremenal emssons reducons, bu raher drve down he emssons prce, whch ends o benef he dres energy sources (Boehrnger and Rosendahl 00a). By dsorng he marke allocaon of abaemen, he supplemenal polces acually ncrease overall complance coss unless here are oher marke falures. Perhaps he kchen snk approach we observe of combnng many modes polces represens an aemp o compensae for a polcy falure polcal consrans agans mposng a suffcenly robus emssons prce. However, wo addonal knds of marke falures are ofen ced as raonales for echnology-relaed ncenves. One s mperfecons n he marke demand for energy effcency. These mperfecons may arse due o he lack of credble nformaon, landlord-enan arrangemens, or myopc behavor, bu hey generally presen hemselves as an undervaluaon of energy effcency n he purchase of energy usng applances or homes (Gllngham e al. 009). A second s spllovers from knowledge accumulaed hrough research and developmen (R&D) or learnng-by-dong (BD). Because frms are unable o approprae he full benefs arsng from her nnovaons, hey do no have suffcen ncenve o develop and deploy new echnologes (Jaffe e al. 005). The presence of such polcy and/or marke falures wll affec he relave desrably of dfferen polcy combnaons. Fscher and Newell (008, henceforh FN) assessed dfferen polces for reducng carbon doxde emssons and promong nnovaon and dffuson of renewable energy, wh an applcaon o he U.S. elecrcy secor. The sylzed model represens wo sages, one n whch nvesmens n R&D and BD are made, and a second sage n whch he resulng nnovaons are appled. The arcle revealed ha, due o knowledge spllovers, opmal polcy nvolves a porfolo of dfferen nsrumens argeng no only emssons, bu also learnng and R&D. Despe hose spllovers, however, he mos cos-effecve sngle polcy for reducng emssons s an emssons prce, followed by (n descendng order of cos-effecveness) an emssons performance sandard, fossl power ax, renewables share requremen, renewables subsdy, and lasly an R&D subsdy. In hs paper, we exend and updae he FN analyss n several mporan ways. Frs, we dsngush beween convenonal renewable energy sources (lke wnd or bomass) and advanced echnologes (lke solar), whch have dfferen coss and learnng or nnovaon poenal. In hs

6 Resources for he Fuure way we can beer assess he performance of overlappng polces n erms of he knds of echnologcal change hey nduce. Second, by allowng for poenal long-run growh n nuclear energy, we can also evaluae nuclear power as a zero-carbon alernave alongsde renewable generaon. Thrd, we ncorporae a rcher represenaon of elecrcy demand over me, ncludng shor and long-run nvesmens n energy effcency mprovemens. As a resul, we can ncorporae demand-sde polces for mprovng energy or fuel effcency. We also allow for mperfecons n he demand for energy effcency, as well as n he marke for nnovaon. We analyze how hese dfferen mperfecons affec opmal polcy combnaons and also he relave cos-effecveness of sngle or oherwse subopmal polces. Fnally, we updae he enre parameerzaon based on more recen daa, parcularly for renewable energy supples. The elecrcy secor s an approprae subjec for hs analyss, beng he mos affeced secor by proposed polces for clmae mgaon. Elecrcy generaon accouned for roughly 40 percen of CO emssons n he Uned Saes n 00 (EPA 0). Moreover, he poenal emssons reducons from hs secor are much larger han s share of oal emssons. One analyss of an economy-wde polcy for clmae mgaon concluded ha well over 80 percen of cos-effecve emssons abaemen would sem from he elecrc power secor (EIA 0a). In our framework, a carbon prce s a powerful and necessary ool, bu on s own s no fully effcen. To brng he ncenves of he ndvdual acors n lne wh ha of socey, he opmal polcy porfolo requres addonal ools, ncludng: subsdes for early-sage BD o correc for learnng spllovers for each echnology; an R&D subsdy equal o he R&D spllover rae for each echnology; and subsdes o EE nvesmens o offse he unvalued share of EE benefs, boh n he shor and long erm. Whle concepually vald, he emprcal magnude of such addonal ncenves s an mporan focus of hs paper. An mporan pon o noe s ha we allow he marke falures o vary by echnology: convenonal versus advanced supply echnologes, and shor versus long-erm EE nvesmens. When hese marke falures vary by echnology, a echnology neural polcy wll no n prncple be opmal. Thus, we can represen some of he ensons beween wanng o avod pckng wnners and wanng o arge specfc echnologes. We hen compare a varey of plausble combnaons of polcy nsrumens o evaluae how hey nerac, wha hese neracons mply for boh emssons reducons and overall welfare coss, and how hese effecs depend on marke falures oher han envronmenal 3

7 Resources for he Fuure exernales. We apply he model numercally o ge an emprcal sense of he relave magnude of dfferen polcy levels and effecs. We fnd ha whle some echnology polces can be useful complemens o emssons prcng, ambous renewable porfolo sandards or producon subsdes seem unlkely o enhance welfare when mposed alongsde a suffcenly srngen carbon prce. Correcng R&D marke falures has a larger poenal for reducng he coss of achevng sgnfcan emssons reducons. The desrably of srngen energy effcency polces s hghly sensve o he assumed degree of undervaluaon, whch also has mplcaons for he cos-effecveness of polces (lke renewable energy subsdes) ha end o lower elecrcy prces. Even wh mulple marke falures, emssons prcng remans he sngle mos cos-effecve opon for meeng emssons reducon goals. Model The model s sylzed o be as smple as possble whle sll beng able o address he key feaures of mulple neracng marke falures. (Parameer defnons are summarzed n he Appendx.) The supply sde of he model s based on FN. I ncludes wo energy supply subsecors, one characerzed by maure echnologes usng nonrenewable fuel sources and he oher characerzed by nnovang echnologes usng renewable energy sources. Boh subsecors are assumed o be perfecly compeve and supplyng an dencal produc, kwh of elecrcy. Nonrenewable producon ncludes sources wh dfferen emssons nenses: a CO -nensve echnology relan on coal, lower-emng echnologes usng naural gas, and nonemng nuclear energy ha serves prmarly as baseload. To he exen ha renewable energy s made more compeve, dsplaces he margnal mx of nonrenewable generaon. The model has wo sages: a frs sage made up of n years, represenng he me akes for nnovaon and longer-erm energy effcency (EE) mprovemens o occur, and a second sage of n years, roughly represenng he lfeme of he new echnologes and nvesmens. Elecrcy generaon, consumpon, shor-erm EE mprovemens, and emssons occur n boh sages, whle nvesmen n long-erm energy effcency and n knowledge akes place durng he frs sage. Through echnologcal change, knowledge nvesmens made durng Alhough large porons of he elecrcy secor reman regulaed, polcy-nduced changes o margnal producon coss are lkely o be passed along o consumers, and n a longer horzon, a ranson o more deregulaed markes s also lkely o make markes relavely compeve n he fuure. 4

8 Resources for he Fuure he frs perod lower he cos of renewables generaon n he second perod, whle long-erm EE nvesmens lower energy consumpon raes. An mporan assumpon s ha boh consumers and frms ake no only curren prces as gven, bu also ake prces n he second sage as gven, havng perfec foresgh abou hose prces. For smplcy, we assume ha no dscounng occurs whn he frs sage; hs assures ha behavor whn ha sage remans dencal. However, le represen he dscoun facor beween sages. I s possble o allow for dscounng whn he second, longer sage by alerng n o reflec such dscounng; n ha case n can be hough of as effecve years. Nonrenewable Secors We dsngush he nonrenewable secors as maure sources of power generaon ha are assumed wll no experence sgnfcan echnologcal change relave o renewable sources. These sources nclude coal (x), naural gas urbnes (ng), and nuclear (nu). Of course s no srcly rue ha nonrenewable echnologes wll experence no furher echnologcal advance, and we do allow for some modes auonomous cos changes over me along he lnes commonly forecas. Srcly speakng, he assumpon s herefore he absence of an endogenous echnology response among hese sources. 3 Mos opporunes for CO abaemen n elecrcy generaon arse from fuel swchng; generaon effcency mprovemens end o explan lle of he predced reducons n clmae polcy models (see, e.g., [0]). Hence, we assume ha hese emssons facors are fxed, where x ng nu 0. Carbon capure and sequesraon (CCS) echnologes are also excluded; her use would only be rggered by a suffcenly large carbon prce, whch s ousde he range of polces we consder n hs paper. e q be oupu from source. Consequenly, x x ng ng oal emssons n year equal E q q. We are gnorng ol generaon here; alhough he quanes are relavely small, ol generaon s ncluded explcly n he numercal model below. 3 Incorporaon of an endogenous echnology response n nonrenewables would complcae he analyss whou addng subsanal addonal nsghs. An excepon s room for advancemen n lowerng coss of cleaner generaon echnologes for fossl fuels, lke carbon capure and sorage. Our qualave resuls should carry over o polces argeng oher low-carbon echnologes, alhough he quanave resuls would depend on he cos, echnology, and emsson parameers parcular o hose oher echnologes. 5

9 Resources for he Fuure Each echnology has an upward-slopng supply curve. In oher words, margnal producon coss for source, ( C q ), are assumed o be ncreasng n oupu ( C ( q ) 0). In our numercal model, we wll assume hese supply curves are lnear n he neghborhood of he prce changes consdered. e P be he consumer prce of elecrcy. e be he prce of emssons a me, as mgh be mplemened wh an emssons ax or hrough a cap-and-rade sysem. e represen he ne ax on generaon from source, whch may be explc or mplc, as wh he porfolo sandard. Profs for he represenave frm of nonrenewable source are revenues ne of producon coss and axes pad: ( ) ( ) ( ) ( ) n P q C q q n P q C q q. The frm maxmzes profs wh respec o oupu from each fuel source, yeldng he followng frs-order condons: 0: P C ( q). q Thus, each source of generaon s used unl s margnal coss nclusve of her respecve emssons coss are equalzed wh each oher and he prce receved. Toally dfferenang, we see ha dp d d dq. () C Ths equaon reveals ha renewable energy polces crowd ou each nonrenewable source n drec proporon o he changes n he ne prce receved and n nverse proporon o he slopes of her compeng supply curves. Noe ha an emssons prce s he only polcy o dfferenae among emng sources, so hgher emssons prces lead o a larger reducon n more emssons-nensve sources, lke coal, han polces ha rea he nonrenewable sources alke. Renewable Energy Secor We characerze he renewable energy secor as no only beng clean (nonemng), bu also as beng a less maure ndusry ha s sll experencng sgnfcan echnologcal change. Whn hs secor, we make a dsncon beween wo knds of renewable energy echnologes: a convenonal echnology (w), such as wnd or bomass, and an advanced echnology (s), lke solar. We do nclude hydropower (h0) n he baselne, bu assume provdes baseload capacy 6

10 Resources for he Fuure ha does no change over me, n quany or n cos. The focus here s on he newer renewable sources. To represen echnologcal change, he coss of generaon for renewable sources depend on a sock of knowledge ha can be ncreased hrough R&D or BD. We assume ha for j j j={w,s}, hese generaon coss, G( K, q ), are ncreasng and convex n oupu, and declnng and convex s own knowledge sock, K, so ha G 0, G 0, G 0, and G 0, where j leered subscrps denoe dervaves wh respec o he subscrped varable. Furhermore, snce margnal coss are declnng n knowledge and he cross-parals are symmerc, G G 0. j j j The knowledge sock K ( H, Q ) s a funcon of cumulave knowledge from R&D, H, and of cumulave experence hrough BD, Q, where KH 0 and KQ 0, and KQH KHQ. Cumulave R&D-based knowledge ncreases n proporon o annual R&D knowledge generaed n each sage, h, so H H nh. Cumulave experence ncreases wh oal oupu durng j j he frs sage, so Q Q nq. Research expendures, R ( h ), are ncreasng and convex n he amoun of new R&D knowledge generaed n any one year, wh Rh ( h) 0 for h > 0, Rh (0) 0, and Rhh 0. The srcly posve margnal coss mply ha real resources specalzed scarce npus, employees, and equpmen mus be expended o gan any new knowledge. 4 A suble ssue s wheher research and experence are subsues, n whch case K HQ 0, or complemens, makng K HQ 0. Two prce-based polces are drecly argeed a renewable energy: a renewable energy producon subsdy (s), and a renewables echnology R&D subsdy n whch he governmen offses a share (σ) of research expendures. q In our wo-sage model, profs for he represenave nonemng frm are j j j j j j j j j j j j n ( P s ) q G ( K, q ) ( ) R h n ( P s ) q G ( K, q ) () j j j j where K K ( H, Q). qq K KK qk Kq 4 As a paral equlbrum model, we do no explcly explore ssues of crowdng ou n he general economy, bu hose opporuny coss may be refleced n he R&D cos funcon. 7

11 Resources for he Fuure e be a facor reflecng he degree of approprably of reurns from knowledge nvesmens. 5 For example, would reflec an exreme wh perfec approprably and no knowledge spllovers, whle 0 reflecs he oppose exreme of no prvae approprably of knowledge nvesmens. Smlarly, reflecs he degree of knowledge spllovers. 6 The resulng frs-order condons are (droppng he superscrps for now): Rh( h) ngk( K, q) KH( H, Q) ; (3) ( ) G ( K, q ) P s n G ( K, q ) K ( H, Q ); (4) q K Q G ( q K, q ) P s. (5) An mporan dfference beween he renewable and nonrenewable secors s he response across me o polces. The nonrenewable secor behavor depends only on curren perod prces and polces, whle renewable secor responses are lnked over me hrough nnovaon ncenves. In he frs sage, he frm nvess n research unl he dscouned appropraed reurns from addonal R&D lower producon coss n he second sage equal nvesmen coss on he margn (equaon (3)). By nfluencng fuure coss, polces n he second sage hus nfluence curren prvae nnovaon decsons. Smlarly, n equaon (4), each renewable energy source produces unl he margnal cos of producon equals he value receves from addonal oupu, ncludng he marke prce, any producon subsdy, and he approprable conrbuon of such oupu o fuure cos reducon hrough learnng-by-dong (noe ha he las erm n equaon (4) s posve overall). Second-sage oupu does no generae a learnng benef, so here s no relaed erm n equaon (5); a ha pon, gven he coss nhered from he knowledge nvesmens n he frs perod, renewable energy provders smply equae he margnal coss wh 5 We model general knowledge as beng approprable, wh no dsncon accordng o he source of ha knowledge, R&D or learnng. Whle an emprcal bass s lackng for such a dsncon, one mgh expec ha some forms of learnng are less easly appropraed by oher frms. We dscuss he mplcaon of relaxng hs assumpon n he conex of he numercal smulaons. 6 Ths represenaon of aggregae appropraon as a share of he oal benefs of nnovaon was formally derved n FN. We assume ha all knowledge s ulmaely adoped, eher by maon or by lcensng. Therefore, he spllover facor does no ener drecly no he aggregae prof funcon, whch reflecs operang profs. censng revenues also do no appear because hey represen ransfers among frms. However, he spllover facor does ener no he frs-order condons for R&D and learnng, snce deermnes he share of fuure prof changes ha can be appropraed by he represenave nnovaor. These ssues are furher elaboraed n he Appendx of FN. 8

12 Resources for he Fuure he ne prce receved. Thus, for he same prce effecs, he renewable energy producon decsons respond dfferenly n he wo perods. Noe ha f appropraon raes are mperfec ( ), from a soceal perspecve, frms have nsuffcen ncenve o engage n exra producon for he purpose of learnng by dong. Smlarly, f he R&D subsdy does no fully reflec he spllover values ( ), frms have nsuffcen ncenve o nves n R&D. Thus, a knowledge exernaly accompanes he emssons exernaly, and boh can be affeced by polces ha arge one or he oher. Consumer Demand and Energy Effcency Invesmens Demand for elecrcy s derved from consumers own opmzaon problem. Consumers experence uly u( v ) from energy servces v, and hey are ndfferen o he generaon source, be renewable or fossl-fueled energy. 7 The quany of energy consumed s v, where s he energy consumpon rae per un of energy servces. The cos of energy servces hus depends on boh he consumer elecrcy prce and he energy consumpon rae. The energy consumpon rae (or energy nensy) s a funcon of reducons ha can be made n boh he shor- and long-run by nvesmens n EE mprovemens. Ths formulaon allows us o separaely consder rebound effecs, facors affecng EE decsonmakng, and behavoral responses o prce changes. Specfcally, we assume ha n he frs sage, S 0 ( ) e 0 S, where s he baselne consumpon rae, and and are he percenage reducons n energy nensy from shor and long-run nvesmens, respecvely. In he second S 0 ( ) sage, we assume ha e 0, where reflecs he second perod consumpon rae n S he baselne, and resuls from addonal nvesmens n shor-run EE mprovemens n he second sage. We allow baselne EE o dffer, o allow for auonomous changes n EE (e.g., 0 0, where represens any exogenous nnovaon n EE). e Coss of shor-run reducons ( S Z ) S, occur n boh perods, whle coss of long-run reducon Z ( ) are ncurred n he frs perod. One mgh hnk of shor-lved elecroncs, lgh bulbs, and smlar equpmen n he frs caegory, whle changes o buldngs, nfrasrucure, durable equpmen, and oher long-lved deermnans of energy demand fall n he 7 Noe ha u s money-merc uly o smplfy he opmzaon problem. 9

13 Resources for he Fuure laer. However, gven he longer duraon of he second sage, hose shor-run mprovemens may reflec a blend of boh shorer and longer-run opporunes over hs horzon. We also allow for marke mperfecons n he demand for EE reducons. The represenave agen may face ncomplee nformaon, may be myopc, or may oherwse perceve ha would no fully benef from EE nvesmens. e be he perceved shor-run EE valuaon rae whn perod, he valuaon rae for EE benefs of long-run EE nvesmens n he s perod and he valuaon rae for hose benefs ha accrue n he nd perod. Undervaluaon, or, ndcaes a marke falure; for whaever reason, he consumer does no expec o receve he full benefs. Snce nformaon and oher polces mgh nfluence hese valuaon raes n dfferen sages, we rean a me perod dsncon beween he wo sages. As wh he valuaon rae for renewable energy nnovaon, hese EE valuaon raes reveal hemselves n he frs-order condons bu do no appear drecly n he aggregae ne uly funcon. e b S be he percenage subsdy for nvesmens n shor-run EE mprovemens made n perod ; le b be he subsdy for nvesmens n long-run EE mprovemens, whch are by assumpon made only n perod. Aggregae ne consumer uly n he frs sage of our wosage model s hen S 0 ( ) S U nu( v) Pv e ( bs ) ZS,( ) ( b) Z( ) (6) S 0 ( ) S n u( v ) Pv e ( b ) Z ( ) S S, The represenave consumer maxmzes ne uly by choosng a level of energy servces S S and raes of EE mprovemens n each sage (.e., v, v,,, ). In perod, gven any energy consumpon rae per un of servce (whch s deermned smulaneously), he represenave consumer maxmzes uly wh respec o v, resulng n he frs-order condon S u( v ) P (7) e D( P, ) be he derved consumer demand for elecrcy, a funcon of he prce and an energy consumpon rae. Because D v, we can rewre he energy demand funcon as D u P. We assume funconal forms for uly ha lead o a consan-elascy demand funcon (derved n he Appendx): D N P (8) 0

14 Resources for he Fuure where represens a very-shor-run elascy of demand, and N s an exogenous demand growh facor. Wh hs funconal form, we fnd ha energy expendures, gven effcency levels, are P D N P, and { PD}/ P( ) D 0 ;.e., prce ncreases rase oal expendures. Dfferenang consumer uly wh respec o shor-run EE mprovemens, and smplfyng he expresson for energy paymens, we oban he followng frs-order condons n each sage: S S ( bs ) Z S, ( ) PD (9) ( b ) Z ( ) PD (0) S S S S, In oher words, consumers balance he margnal ne cos of mprovng EE wh he perceved energy coss of ha perod. The choce of long-run EE mprovemens depends on boh curren and fuure energy spendng, as well as he respecve EE benef valuaon raes: n ( b) Z ( ) PD PD () n Thus, polces ha rase energy prces and hereby energy expendures lead o ncreased nvesmen n energy effcency. In equlbrum, oal consumpon mus equal oal elecrcy producon, he sum of nonrenewable and renewable energy generaon: D q. () Change n consumer surplus s calculaed as he change n ne uly. Economc Surplus Polces also have mplcaons for governmen revenues, whch we denoe as V. We assume ha any changes n governmen revenues are compensaed by (or reurned n) lump-sum ransfers. The amoun of hese ransfers equals he ax revenues ne of he cos of he subsdes: w w s s S V nq q s q sq R( h) bs ZS,( ) bz( ) (3) w w s s S n q q sq sq bs ZS,( )

15 Resources for he Fuure Envronmenal damages are a funcon of he annual emssons and he lengh of each sage; however, we wll hold cumulave emssons consan across he polcy scenaros, so a change n damages wll no be a facor n he welfare comparsons. The change n economc surplus (excludng envronmenal benefs) due o a polcy s hen he sum of he changes n consumer and producer surplus and revenue ransfers from he subsdy or ax: W U V, (4) where. Snce consumer paymens o frms and ax and subsdy paymens are ransfers, we can smplfy he represenaon of economc surplus o be W n u(v ) Z S, ( S ) Z ( ) C (q ) G j (K j,q j j ) Rh x,ng,nu jw,s n u(v ) Z S, ( S ) C (q ) G j (K j,q j ) x,ng,nu jw,s Of course, economc surplus s unlkely o be he only merc for evaluang polcy. Oher ndcaors may be consumer surplus, renewable energy marke share, and so on. General equlbrum facors lke neracons wh ax dsorons, leakage, or oher marke falures can also be mporan for deermnng welfare mpacs. 8 Polcal economy consrans may also be mporan for deermnng polcy goals. To he exen ha hese unmodeled ssues are presen, hs paral equlbrum presenaon of economc surplus whn he secor wll no reflec he full socal mpacs; sll, represens a useful baselne merc. (5) Polces Polcy nervenons cause he enre sysem o re-equlbrae. In all cases, he consumer prce of elecrcy s an endogenous varable ha sgnals he value o producers (and consumers), and polces can creae a wedge beween he consumer prce and he prce receved by a 8 Allowng for dsoronary axes n he model s lkely o wden he effcency gap beween revenue-rasng polces (e.g., emssons axes) and revenue-usng polces (e.g., renewable subsdes). For a comprehensve survey of he ax neracon leraure, see Goulder [6].

16 Resources for he Fuure parcular knd of producer. As seen n he precedng equaons, he slope of he supply curve deermnes he sensvy of he quany produced wh a gven echnology o changes n he ne prce. Imporanly, he effec of ndvdual polces and combnaons hereof on he consumer prce no only n magnude bu n some cases n drecon can depend on he slopes of hese curves n relaon o one anoher. For example, usng a sac model, Fscher (009) explans how renewable porfolo sandards may decrease or ncrease consumer elecrcy prces, dependng on hese facors. ecuyer (03) shows ha when he elecrcy secor s already regulaed wh a cap-and-rade sysem, feed-n-arffs necessarly lower consumer prces. The curren model adds more complexy hrough he dynamc effecs of nduced echnologcal change. FN dsngushes beween fxed-prce polces and endogenous prce polces. Fxed-prce polces se a parcular ax or subsdy rae, such as an emssons ax, a nonrenewable energy ax, or subsdes for renewable sources. Endogenous prce polces are marke mechansms ha rely on radable allowances such as emssons cap and rade, renewable porfolo sandards, or low carbon fuel sandards and allow he marke o se he prce ha reflecs he cos of complyng wh he regulaon. Imposng new polces on secors ha are already regulaed under hese laer schemes wll only affec he marke prce of allowances he new polces wll no affec he regulaory oucome (.e., emssons or renewable energy level), whch s already se by he cap or sandard. In oher words, wh a bndng emssons radng scheme, zero ncremenal emssons reducon wll be realzed from a supplemenary renewables quoa sysem; raher, he addonal shf oward renewables wll cause he emsson allowance prce o fall. Böhrnger and Rosendahl (00a) pon ou ha he lower perm prces can favor he dres fossl fuel echnologes; whle overall fossl fuel producon falls as a resul of he combned regulaons (whch lower he prces receved by hese producers), he dres producers may acually ncrease oupu o keep oal CO emssons a he bndng emssons cap. Fscher and Preonas (00) exend hs analyss wh a unfed model of polcy neracons. They furher show ha polces ha mpose marke share mandaes, by defnon lnk renewable generaon o fossl energy generaon. Addonal polces ha rase he cos of fossl energy herefore no only lower generaon from fossl sources, hey also reduce renewable generaon by relaxng he porfolo consran. (See also Amundsen and Morensen 00). Moreover, under a porfolo sandard, addonal polces ha suppor renewable energy (lke producon subsdes) also may nduce fossl sources o expand alongsde hem o manan he mandaed marke shares, resulng n hgher emssons. These are a few examples of he unnended consequences of combnng polces wh radable quoa mechansms. 3

17 Resources for he Fuure If he emssons prcng sysem s oherwse effcen ha s, n he absence of oher marke falures hen supplemenary polces for renewable energy are unnecessary and acually rase oal complance coss, even hough emssons prces are lower. Fscher and Preonas (00) revew several arcles makng hs argumen. If an emssons cap (or suffcen carbon ax) s polcally nfeasble, hen clean energy polces may be deemed a second-bes alernave for reducng emssons. However, under an aggregae emssons consran, hey lose hs effec, so he raonale for supplemenal suppor for clean echnologes mus be o address oher marke falures. In hs paper, we address wo mporan marke falures frequenly rased regardng clean echnologes: knowledge spllovers, and undervaluaon of he benefs of EE nvesmens. Opmal polces In he presence of mulple marke falures, a carbon prce s a powerful and necessary ool, bu on s own full effcency s no acheved. Addonal ools are necessary o brng he frs-order condons of he ndvdual acors n lne wh ha of he socal opmum. The opmal polcy porfolo would nclude mulple nsrumens:. A carbon prce o address he envronmenal exernaly, rsng accordng o he dscoun facor ( ).. Subsdes for early-sage BD n he frs sage o correc for learnng spllovers for each echnology j j j j j j j ( s ( ) n G ( K, q ) K ( H, Q ) ). K Q 3. An R&D subsdy equal o he R&D spllover rae ( ). 4. Subsdes o EE nvesmens o offse he unvalued share of EE benefs, boh n he S shor and long erm: b, b. S An mporan pon o noe s ha we allow he marke falures o vary by echnology: maure versus advanced supply echnologes, and shor versus long-erm EE nvesmens. If hese marke falures do vary, a echnology neural polcy wll no be effcen. Formally, he welfare mplcaons of addonal polcy-nduced changes can be derved by oally dfferenang he socal welfare funcon and usng he decenralzed frs-order condons ha mus hold n equlbrum, as well as he fac ha oal changes n consumpon equal oal producon changes. We derve hese expressons n he Appendx. Takng a carbon prce alone as a sarng pon (wh ), we consder he effecs of a polcy varaon ha ncludes an addonal nervenon, X, where X { s, b,, } s some combnaon of he ax j j 4

18 Resources for he Fuure and subsdy opons. We look a devaons n whch oal emssons are held consan wh he polcy varaon (.e., by he carbon prce adjusng n response o oher polcy changes). As a resul, we can express he poenal benefs and coss of addonal nervenon: dw dx ( S S n P D ) b S d ( b S ) dx ( ) b d ( b ) dx ( n P D ) b d ( b ) dx ( Value of EE changes S S ) b S d ( b S ) dx n n G j (K j j,q j j dq K )( )K Q s Value of BD changes (6) jw,s dx n n G j (K j,q j ( ) K )K H ( ) dh j Value of R&D changes jw,s dx n dq x,ng,nu dx n dq x,ng,nu dx n s dq j j Oher cos changes jw,s dx The frs four lnes represen he margnal benefs versus he polcy expendures for a j j change n energy effcency, producon, and knowledge ( d, dq, dh ). For a posve change n he varable, he ne margnal benefs are posve o he exen ha he correspondng marke falures are nsuffcenly nernalzed. For example, an nervenon ha ncreases EE nvesmen rases welfare on he margn o he exen ha he EE subsdy s smaller han he undervaluaon rae. Smlarly, an nervenon ha ncreases frs-sage renewable energy producon rases welfare f he subsdy s less han he spllover benefs. The las lne represens he coss: addonal fossl axes ha reduce fossl generaon lower surplus (snce he clmae exernaly s nernalzed by he emssons prce), as do addonal renewable subsdes ha ncrease renewable generaon n he second perod (when here s no learnng exernaly). Noe ha f we subsue n he opmal polces lsed above, we have dw = 0, and economc surplus canno be ncreased wh addonal polcy devaons. However, f he addonal marke falures are no fully correced by he relevan subsdes, ncreases n energy effcency, BD, or R&D ha resul from nervenon X have addonal value on he margn. On he oher hand, f a subsdy overcorrecs for an exernaly, a furher ncrease n ha varable 5

19 Resources for he Fuure generaes a welfare loss. These componens of Equaon (6) form he essence of he nuon underpnnng our numercal resuls. Numercal Applcaon Funconal Forms Elecrcy Generaon and Knowledge The funconal forms for generaon and knowledge follow hose of FN unless oherwse noed. All producon cos funcons are quadrac n oupu, yeldng lnear elecrcy supply curves for each fuel source. For nonrenewable sources of elecrcy generaon, he coss all ake he form C ( q ) c0 c ( q q0 ) c ( q q0 ) /, where q 0 s he baselne (no polcy) oupu n sage for source. Furhermore, from he frs-order condons for he baselne, he margnal cos of generaon s c P, base. Toal baselne cos, c 0, does no affec nonrenewable energy decsons; we assume n effec zero profs n he baselne ( c 0 P, baseq, ), o focus only base on he changes n profs nduced by polcy. For renewables generaon (j={w,s}), he cos funcon s nversely relaed o he j j j j j j j j j, ( ) ( ) j j G K q g g q q g q q / K / K, so knowledge sock: j 0, base, base, base ha echnologcal change lowers boh he nercep and slope of he renewables supply curve. Snce oal baselne coss ndcae he poenal scope for cos reducons, we err on he hgh sde j (an opmsc assumpon for opmal renewable generaon subsdes) and normalze g0, so ha baselne profs for renewable generaon are zero. Ths parameer wll be vared laer n sensvy analyss. The knowledge sock assumes a commonly used funconal form expressng a consan elascy relaonshp wh respec o boh he sock of experence and he sock of R&D: k k Q H KQ, H, mplyng ha K. Frs perod R&D knowledge sock s Q H normalzed o H. From he frs-order condons, wh hese funconal forms, he baselne j j j margnal cos s g, P, kng0, / Q,. base base Rh 0h R&D nvesmen s also modeled as a consan elascy funcon: ncreasng margnal coss assumng., wh 6

20 Resources for he Fuure Energy Effcency Deals of our energy effcency parameerzaon are n he Appendx. We assume a uly funcon ha leads o consan elascy of demand: D N P, where 0. The elascy can be nerpreed as a very shor run elascy, as mgh be refleced n he rebound effec (.e., he rebound effec reflecs he change n energy servces, such as lumens, wh respec o he change n he cos of hose servces). The full shor-run elascy of demand for elecrcy wll also nclude shor-run responses n he energy nensy of hose servces. We assume lnear margnal cos of EE mprovemens around he baselne, so for each j j j j j ype of mprovemen j, coss are a quadrac funcon Zj( ) z z ( ) /, wh j j j j margnal coss Z j ( ) z z ( ) and slope Z ( j ) j j z. S In he baselne 0, so from he frs-order condon, we ge n z S P D and S 0 0 n z P q P q. In oher words, he nerceps of he margnal cos funcons are deermned n par by our assumpons regardng he perceved valuaon facor for each ype of EE mprovemen. To calbrae he slopes of he margnal coss of EE mprovemens, we derve he mplc shor, medum and long-run elasces of elecrcy demand. To do so, we solve for energy effcency nvesmens from he frs-order condons, evaluaed wh no addonal polcy measures (.e., n he absence of subsdes). Nex, we oally dfferenae he demand funcon (snce changes n energy effcency depend on quanes as well as prces n each perod), evaluaed a he baselne. Solvng for he equlbrum quany changes due o a prce change, hs gves us a sysem of four equaons (own and cross-prce elasces for each perod). Seng S S hese expressons equal o our arge elasces, we solve for our calbraed values of z, z, z and he relaonshp ha mus hold beween and. See he Appendx for more deal. Parameerzaon We have closely followed FN n parameerzng hs model. Ceran parameers have been updaed and dsaggregaed, especally hose based on EIA NEMS model projecons or relang o generaon from naural gas, renewables, and nuclear. Addons o he demand sde of he model have nroduced several new parameers relang o he demand elascy and energy effcency nvesmens. 7

21 Resources for he Fuure The slope parameers for each generaon source ( c, g ) are calbraed o he EIA Annual Energy Oulook (AEO) 03. By comparng ne prces and generaon levels n he AEO sde cases No GHG Concern and GHG Polcy Economy-wde, we derved hese mplc 0 supply parameers for each source n each me perod. Baselne generaon levels ( q ) and emssons nenses ( ) are lkewse calbraed o NEMS model projecons, namely he AEO 03 Reference case. As n he above model, we classfy non-hydro renewables no wo caegores: solar (s) and wnd/oher more maure renewables (w) (ncludes wnd, bomass, muncpal sold wase, and geohermal) (IEA 00a, 34). We also se our baselne elecrcy prce a 9.3 cen/kwh based on AEO 03, wh all moneary values adjused o 0 dollars. The remanng renewables cos parameers ( g ) are solved for n he baselne scenaro. Nuclear generaon n he frs sage s fxed a baselne levels, reflecng he long lead me n brngng new nuclear facles onlne. For smplcy, we also fx ol and hydro generaon n boh perods. To parameerze separae knowledge funcons for wnd/oher and solar, we consder boh her respecve knowledge socks and he relave mpacs of research or learnng-by-dong o reduce coss gong forward. I s very dffcul o esmae cumulave publc and prvae R&D expendures. However, cumulave hsorc U.S. federal research spendng on solar echnologes appears close o combned spendng on oher renewable echnologes (Schllng and Esmundo 009). Hence, we normalze he frs-perod R&D knowledge sock for boh wnd/oher and w s solar, so ha H H. We se Q w =. x 0 and Q s = 9.5 x 0 0 so ha annual wnd and solar generaon represen, respecvely, abou percen and 33 percen conrbuons o her sock of experence. These esmaes are conssen wh he curren conrbuon of wnd/oher and solar o cumulave U.S. generaon of each echnology (EIA 00). 9 j j Dsngushng k and k by renewable echnology allows us o consder her relave responses o learnng-by-dong and R&D knowledge. Several sudes 0 have compared learnng raes for esablshed renewables (wnd) and developng echnologes (solar), bu hey ypcally do 9 Usng EIA(00) and EIA (03a), we calculae ha cumulave hsorc/projeced generaon (hru 04) of he maure renewable echnologes n our wnd caegory (.e., wnd, bomass, geohermal, and muncpal sold wase) s approxmaely 9 mes greaer han AEO s projeced 05 generaon for hose echnologes. kewse, cumulave solar generaon (.e., phoovolacs and solar hermal) s approxmaely 3 mes greaer han 05 projeced solar generaon. 0 See ndman and Söderholm (0) for a mea-analyss, and also Jamasb (007). 8

22 Resources for he Fuure no separae knowledge no learnng and research componens. We use echnologcal learnng assumpons from boh EIA (03b) and IEA (009; 00b) o esmae k w = 0.0 and k s = In oher words, a doublng of cumulave producon leads o a 7 percen cos reducon j for wnd/oher and a 9 percen cos reducon for solar. Usng hese values, we calbraed k such ha oal baselne renewables cos reducon was n lne wh EIA NEMS projeced oal echnologcal mprovemen, gvng us k w = 0.5 and k s = 0.0 (EIA 03, 04). As n FN, we w s specfy he R&D nvesmen funcons by seng.. 3 We assume ha annual baselne R&D expendures represen abou.5 percen of wnd/oher and 3.0 percen of solar revenues, 4 j and solve for each 0 n he baselne scenaro. We also rean FN s assumed knowledge approprably rae for boh wnd/oher and solar of 0.5 n he cenral scenaros. 5 An exensve emprcal leraure has esmaed he prce elascy of elecrcy demand. We assume a very shor-run demand elascy of 0.0, based on several sudes of he rebound effec n household elecrcy consumpon. 6 Oher demand elasces for elecrcy are based on hs esmae, wh =0., =0.4, and =0.05, represenng roughly shor erm, long erm, and cross perod demand elasces. For a permanen 0 percen change n he elecrcy prce (.e., across boh perods), he mplc elascy of demand n he s sage s We se exogenous demand growh a 3 percen, based on AEO 0 projeced elecrcy generaon, annualzed across each sage; hese demand scalars nclude exogenous rends n energy effcency. We assume a frs sage lengh of n = 5 years, sarng n 05, and a second One excepon s Kobos e al. (006), whch emprcally derves wo-facor learnng curves for wnd and solar. However, her resuls across several scenaros are nconclusve on wheher R&D or learnng-by-dong has a sronger effec on eher echnology. For wnd, EIA (03b, 04) assumes k w = 0.0, whle IEA (009, 7) assumes k w = 0.0. For solar, EIA (03b, 04) assumes 0.5< k s <0.3, whle IEA (00b, 8) assumes k s = For example, Jaffe (986) fnds an elascy of paens wh respec o R&D of over 0.8 n hs preferred specfcaon; Boazz and Per (003) ce a relaonshp of smlar magnude. Our model uses he nverse of hs elascy for he comparable knowledge producon o R&D elascy (/0.8=.). 4 The average R&D nensy of U.S. ndusry les n hs range (NSF 006). med nformaon s avalable on curren prvae U.S. renewables R&D spendng. 5 Ths esmae comes from economy-wde sudes such as Grlches (99) and Jones and Wllams (998); emergng work from Dechelprere e al. (03) ndcaes ha spllovers may be hgher for clean echnologes. 6 See Kamerschen and Porer (004), U.S. EPA (005), and Sorrel e al. (009). 9

23 Resources for he Fuure sage lengh of years, machng AEO projecons ou o 040. Because we dscoun he second sage back o he presen a a rae of 7 percen, hs mples a dscoun facor 0.7 and a second sage wh he effecve lengh of n =.6. Table shows he parameers assocaed wh elecrcy generaon cos funcons and energy effcency nvesmen funcons (derved usng he equaons n he Appendx). Table lss he oher parameers ha do no vary over me, ncludng CO emssons nensy, R&D nvesmen, knowledge appropraon raes, and arge demand elasces. As he model does no perm an analycal soluon, we numercally solve he nonlnear sysem of equaons usng Newon s mehod. Table. Supply and Demand Parameers by Sage 7 Sage Sage Slope of coal elecrcy supply (c x, ) ($/kwh ) Slope of naural gas elecrcy supply (c ng, ) ($/kwh ) Slope of nuclear elecrcy supply, sage (c nu ) ($/kwh ). 0 3 Slope of wnd/oher elecrcy supply (g w ) ($/kwh ) Slope of solar elecrcy supply (g s ) ($/kwh ) Inercep of shor-run energy effcency nvesmen cos supply (z S ) ($) Slope of shor-run energy effcency nvesmen cos supply (z S ) ($/%) Inercep of long-run energy effcency nvesmen cos supply (z ) ($). 0 Slope of long-run energy effcency nvesmen cos supply (z ) ($/%) Exogenous demand growh 3% 7 The sx parameers relaed o energy effcency are derved gven an assumpon abou he appropraon rae; hese assume a base case where bea =

24 Resources for he Fuure Table. Oher Baselne Parameers Base value CO nensy of coal elecrcy (μ x ) (ons CO /kwh) CO nensy of ol elecrcy (μ ol ) (ons CO /kwh) CO nensy of naural gas elecrcy (μ ng ) (ons CO /kwh) earnng parameer for wnd/oher (k w ) 0.0 R&D parameer for wnd/oher (k w ) 0.5 earnng parameer for solar (k s ) 0.30 R&D parameer for solar (k s ) 0.0 Wnd/oher R&D cos parameer (γ w 0 ) Wnd/oher R&D cos parameer (γ w ). Solar R&D cos parameer (γ s 0 ) Solar R&D cos parameer (γ s ). Degree of knowledge approprably (ρ) 0.5 Very shor-run demand elascy (ε) 0.0 Shor-run demand elascy (η ) 0.0 ong-run demand elascy (η ) 0.40 Cross-perod demand elascy (η ) 0.05 Resuls Baselne The baselne resuls are repored n Table 3 and represen he no-polcy scenaro. Of noe s he relavely small share of non-hydro renewable energy n he baselne (7 percen n he frs sage and 9 percen n he second), nearly all n he form of maure non-hydro renewables, such as wnd, bomass, and geohermal. Solar remans a fracon of a percen of generaon. Sgnfcan renewable energy cos reducons occur n he baselne, wh wnd/oher coss fallng 7 percen and solar coss fallng 9 percen. An mporan pon s ha marke behavor n he model s ndependen of he assumpons abou he perceved energy effcency benef valuaon raes (β j ). Essenally, he model s calbraed o observaons or projecons of marke oucomes, beng agnosc abou he underlyng drvers n demand for energy effcency. These parameers, however, are mporan for calculang he welfare coss of polcy nervenons.

25 Resources for he Fuure Table 3. Baselne Resuls wh No Polcy Sage Sage Prce of elecrcy (P ) ( /kwh) Elecrcy demand (D ) (kwh/yr) Coal generaon (q x ) (kwh/yr, % of generaon).59 0, 37.3%.76 0, 36.8% Ol generaon (q ol ) (kwh/yr, % of generaon).8 0 0, 0.4% , 0.4% Naural gas generaon (q ng ) (kwh/yr, % of generaon).9 0, 7.9%.38 0, 8.9% Nuclear generaon (q nu ) (kwh/yr, % of generaon) , 0.% , 8.7% Hydro generaon (q ho ) (kwh/yr, % of generaon) , 7.3% 3.5 0, 6.6% Wnd/oher generaon (q w ) (kwh/yr, % of generaon) , 6.% , 7.5% Solar generaon (q s ) (kwh/yr, % of generaon) , 0.8% ,.% CO emssons (E ) (bllon merc ons CO /year) Rae of wnd/oher cos reducon (%) 7% Rae of solar cos reducon (%) 9% Emssons Prce and Opmal Polcy Combnaons In all subsequen comparsons, we requre each polcy (or combnaon hereof) o mee he same cumulave emssons arge, whch s 40 percen below baselne emssons. Alhough hs arge s more srngen han mos pledges for economy-wde emssons reducon over he me horzon, for hs sngle-secor model, reflecs he dsproporonae opporunes for emssons reducons n elecrcy generaon. The polcy scenaro resuls wll be repored n relaon o he baselne values; welfare consequences wll be repored relave o he benchmark polcy of an emssons prce whou supplemenary polces. Table 4 compares he effecs of an emssons prce program o opmal polcy combnaons, dependng on he EE benef valuaon raes. Agan, under he emssons prce alone, marke behavor s ndependen of hese valuaon raes, bu he welfare coss of he polcy are smaller n he presence of an EE marke falure. The addonal nvesmens n EE nduced by hgher elecrcy prces confer addonal benefs when hese mprovemens are undervalued. The cumulave emssons arge mples ha he emssons prce wll rse over me, from $4 per on CO n sage o $35 n sage n he sngle-polcy case. Wh only nnovaon marke falures (.e., no EE undervaluaon), he opmal polcy combnaon sll nvolves smlar emssons prces n he wo sages ($ and $30, respecvely). To nernalze he nnovaon 8 Ths ncludes all non-solar, non-hydro renewable generaon.

26 Resources for he Fuure spllovers, hese prces would be combned wh a subsanal 50 percen R&D subsdy. The opmal frs-sage subsdy for learnng s a modes 0.7 cens/kwh for wnd/oher, bu a more subsanal 4.9 cens/kwh for solar. Alogeher, he opmal combnaon of polces lowers coss 6 percen relave o he cap alone, agan assumng no EE marke mperfecons. Table 4. Emssons Prce Alone versus Opmal Polcy Combnaons Polcy Emssons prce alone Opmal polcy combnaon No EE falures 0% EE undervaluaon 0.9 No EE falures 0% EE undervaluaon 0.9 Emssons reducon arge 40% 40% 40% Emssons prce, sage ( ) ($/on CO ) Emssons prce, sage ( ) ($/on CO ) earnng subsdy (wnd/oher) ( /kwh) earnng subsdy (solar) ( /kwh) R&D subsdy (wnd/oher) 50% 50% R&D subsdy (solar) 50% 50% EE subsdy, sage (b S, b ) 0% 0% EE subsdy, sage (b S, b ) 0% 0% Elecrcy prce, sage (% change from baselne) 3.6%.5% 9.6% Elecrcy prce, sage (% change from baselne) 3.8% 8.7% 4.5% % Non-hydro renewables, sage 9.8% 0.9% 0.6% % Non-hydro renewables, sage 9.8%.% 0.5% % EE mprovemen, sage 9 3.9% 3.% 5.3% % EE mprovemen, sage 8.% 6.5% 0.0% Δ Welfare (bllon $, annualzed) %W mprovemen (from emssons prce alone) 6% 5% In he presence of marke falures n demand for EE mprovemens we model a 0 percen undervaluaon he opmal polcy mx changes more subsanally. The ncluson of EE subsdes nduces more demand-sde conservaon, allowng for lower emssons prces (over 5 percen lower han wh an emssons prce alone) o acheve he same emssons arge. The opmal subsdes for learnng among renewable energy sources also fall. Relave o an emssons prce alone, he opmal combnaon of polces lowers coss by 5 percen. 9 Ths s he percen reducon n he energy consumpon rae, relave o he baselne. 3

27 Resources for he Fuure Sensvy of Opmal Polces o Assumpons A srkng resul from hese resuls s ha he opmal renewable energy subsdes are relavely low, especally for he non-solar echnologes ha represen he majory of renewables generaon. I would appear ha he.3 cen/kwh Federal Renewable Elecrcy Producon Tax Cred (PTC) may be overly generous for wnd/oher energy, a leas n combnaon wh he oher polces. Feed-n arffs among many European counres far exceed hese levels of suppor. The comparson wh curren U.S. polcy s more dffcul for solar, whch s suppored a he federal level by a 30 percen nvesmen ax cred, alhough he per-kwh equvalen value of curren U.S. solar ncenves appears o be well-above he opmal levels denfed here n combnaon wh emssons and R&D polces. How sensve are hese resuls o our model assumpons? e us call he prevously descrbed parameerzaon he reference scenaro. Noe ha as we vary ceran parameers, we connue o calbrae he model o replcae he same baselne prces and generaon quanes. We nex consder he nfluence of dfferen assumpons on he levels of he opmal subsdes for learnng, as well as on he dsrbuon of he opmal echnology polcy porfolo. Tha s, wha should be he relave scale of publc spendng on learnng and R&D, as compared o each oher and o oal prvae revenues? Srngency of emssons arge. Frs, we consder a wder range of arges for emssons reducons. Indeed, much of he movaon for ambous alernave energy polces n EU counres s n preparaon for a ranson o a dramacally lower-carbon energy sysem. In our model, we fnd ha a more srngen arge does ncrease he opmal renewable subsdes; a an 80 percen reducon goal renewable subsdes are more han double hose of he 0 percen arge, bu hose levels are sll less han cen/kwh for non-solar renewables. Meanwhle, he opmal emssons prce ncreases by an order of magnude, ndcang ha becomes relavely more mporan as a polcy nsrumen (Fgure ). 4

28 Resources for he Fuure Fgure. Sensvy of Opmal Frs-Sage Polces o Emssons Targe (.9) 0 Opmal wnd subsdy Opmal emssons ax (rgh axs) Opmal solar subsdy cens/kwh Percenage reducon n emssons $/on CO Degree of knowledge spllovers. Nex, we consder he role of our marke falure parameers. As modeled, he opmal R&D subsdy ncreases one-for-one wh he spllover rae. In Fgure, we see ha he opmal renewable subsdy (for learnng) also rses proporonally wh he spllover rae, wh a seeper relaonshp for solar energy han for wnd/oher. Sll, exrapolang o even hgher spllover raes, 0 he opmal subsdy for solar energy remans under 0 cens/kwh. As larger knowledge marke falures are nernalzed, drvng larger ncreases renewable energy provson, he emssons prce needed o mee he arge falls (shown on he rgh axs). 0 Baselne R&D behavor becomes unreasonable a very hgh spllover raes, so we lm he range of exploraon. 5

29 Resources for he Fuure Fgure. Sensvy of Opmal Frs-Sage Polces o Knowledge Spllovers 0.06 Opmal wnd subsdy Opmal emssons ax (rgh axs) Opmal solar subsdy $ / kwh $ / on CO Spllover Rae 0 Degree of EE undervaluaon. Energy effcency demand falures have he oppose effec on learnng subsdes. As energy effcency subsdes ncrease o comba greaer undervaluaon, less renewable energy s needed. As a consequence, boh learnng subsdes and he emssons prce fall, and raher seeply a larger values of undervaluaon (Fgure 3). Of course, hese are opmal combnaons, and may be more dffcul n pracce o counerac demand-sde marke falures. Noneheless, n he case of unnernalzed energy effcency falures, opmal learnng subsdes also fall. By drvng down elecrcy prces, renewable subsdes exacerbae he preexsng EE marke falure. Thus, n eher suaon, greaer concern abou energy demand-sde falures ends o undermne he case for more generous subsdes for learnng hrough renewable energy subsdes. 6

30 Resources for he Fuure Fgure 3. Sensvy of Opmal Polces o Energy Effcency Undervaluaon 0.06 Opmal wnd subsdy Opmal emssons ax (rgh axs) Opmal solar subsdy $ / kwh $ \on CO Energy Effcency Undervaluaon Rae 0 Specfcaon of knowledge accumulaon. Oher mporan assumpons regard he knowledge parameers and he opporunes for cos reducons. In our reference scenaro, even wh dencal spllover raes for R&D and BD, a leas 80 percen of he welfare benefs of nernalzng knowledge exernales come from he R&D subsdy. The reason les n he assumed relave cos of achevng addonal generaon cos reducons hrough R&D versus BD. For BD, ha cos s rsng wh he frs-sage producon cos curve, whch s que seep, parcularly relave o he R&D nvesmen cos curve. Alhough our parameers are drawn from avalable daa, emprcal evdence, and modelng pracce, he rue values for hese specfc secors are far from ceran. Thus, we consruc several addonal scenaros o es her relevance. Among oher hngs, we wll compue he rao of oal spendng on BD and R&D subsdes, relave o oal revenues n he wnd/oher and solar secors. In all scenaros, we assume here s no undervaluaon of energy effcency, o focus on he knowledge marke falures. The frs wo alernae scenaros are varaons on he poenal for cos reducons. Frs, we assume ha he perod for knowledge applcaon s much longer, and exend he second sage 7

31 Resources for he Fuure o 00 years, before dscounng ( ong sage ). Wh dscounng, he effecve lengh of he second sage ncreases by a hrd, and he benefs o knowledge spendng ncrease accordngly, hough n somewha greaer proporon for wnd/oher han for solar, due o he larger marke share for wnd/oher. Second, we recognze ha we may have overesmaed he oal cos reducon poenal of second-sage generaon because we assumed appled o oal generaon ncludng prevously nsalled capacy. In realy, nnovaon may no brng down he supply coss for capacy already nsalled n he frs sage, bu raher only for capacy added n he second sage. If we suppose nsead ha oal second-sage coss equal he area under he supply curve for capacy bul afer he frs sage ( owers ncremenal capacy coss ), we fnd ha opmal learnng subsdes fall roughly 0 percen for wnd/oher and 5 percen for solar. The nex se of varaons regard he knowledge producon and cos funcons. The hrd alernave scenaro ( BD more mporan ) uses specfcaons ha ncrease he spllovers from learnng o 80 percen (whle holdng R&D spllovers a 50 percen), ncrease he cos reducons w s from learnng ( k 0.3, k 0.4 ), and ncrease he slope of R&D nvesmen coss ( ). In hs case, he BD subsdy conrbues roughly hree quarers of he welfare gans from nernalzng he knowledge exernaly, compared o less han 0 percen n he baselne scenaro. In hs case, he opmal learnng subsdy reaches 3 cens/kwh for wnd/oher and nearly 9 cens/kwh for solar. Meanwhle, of oal publc spendng on renewable energy subsdes, he poron gong o deploymen as opposed o R&D rses from 35 percen n he reference scenaro o 87 percen for wnd/oher, and from 65 percen o 9 percen for solar. However, our reference parameers may have been more lkely o err on he sde of overesmang he conrbuon of learnng o cos reducons, as few sudes have aemped o separae he effecs of deploymen from R&D. The fourh ( ow BD ) scenaro assumes w s learnng s less producve ( k 0.0, k 0.), makng R&D relavely more mporan (hough no ncreasng w s k, k ). Ths swngs he opmal R&D share of oal publc spendng o 95 percen for wnd/oher and jus over 50 percen for solar. The effecs on he opmal subsdes are much smaller han he changes n second perod coss (75% and 50% lower for wnd and solar, respecvely), because he nnovaon parameers mus be recalbraed o explan he projeced R&D and learnng n he no-polcy baselne. Noe ha equlbrum cos reducons n he baselne are fxed by our calbraon. 8

32 Resources for he Fuure Fnally, lackng reasonable daa on prvae R&D spendng for renewable energy, we consder a scenaro wh sgnfcanly hgher baselne nvesmen, parcularly for solar ( More baselne R&D ). Specfcally, we assume baselne R&D expendures are 5 percen for Wnd/Oher (double he reference case) and 5 percen for solar (fve mes he reference case). 3 The cos parameers adjus o make hs spendng jusfed n he baselne, mananng he same degree of cos reducons. The resul s more publc spendng on R&D n he opmum, bu far less han n proporon o he baselne ncrease (5 percen more for wnd/oher and 5 percen more for solar), and only a slgh complemenary enhancemen o BD. Fgures Fgure 4 and Fgure 5 compare he resuls of hese alernave ses of assumpons on he opmal supplemenary echnology polcy porfolo. They depc oal publc spendng on BD and R&D subsdes, measured as a share of he oal marke revenues from wnd/oher and solar generaon, respecvely. Fgure 4. Opmal Publc Spendng on BD and R&D as a Share of Toal Revenues from Generaon for Wnd/Oher 50% 45% % of annual marke revenues 40% 35% 30% 5% 0% 5% 0% BD R&D 5% 0% Reference ong sage owers ncremenal capacy coss BD more mporan ow BD More baselne R&D 3 Ths percenage represens he op end of R&D expendure shares across ndusres (Newell 00). 9

33 Resources for he Fuure Fgure 5. Opmal Publc Spendng on BD and R&D as a Share of Toal Revenues from Generaon for Solar % of annual marke revenues 00% 90% 80% 70% 60% 50% 40% 30% 0% 0% BD R&D 0% Reference ong sage owers ncremenal capacy coss BD more mporan ow BD More baselne R&D In sum, even wh raher exreme parameers for he producvy of BD, s dffcul o drve opmal subsdes up o he 0 cen/kwh mark, even for solar. Opmal overall publc spendng oward echnologcal nnovaon seems n he range of 5 30 percen of marke generaon revenues for wnd/oher and percen for solar. Meanwhle, n almos all scenaros, he rao of deploymen spendng o R&D spendng does no exceed one for wnd/oher. The excepon s he exreme case of BD more mporan, when ha rao goes o 6.5. In our reference scenaro, solar energy s assumed o be more sensve boh o R&D, bu even more so o learnng. Thus we fnd ha, excep wh ow BD, he rao of publc spendng on solar deploymen o R&D exceeds one, bu no by much; even n he BD more mporan scenaro jus reaches 0-o-. By conras, esmaes of publc spendng programs, ncludng ax breaks and mpled subsdes hrough oher polces, ndcae a much greaer fnancal suppor for deploymen. Indeed recen calculaons for sx EU counres ndcae a rao of deploymen o R&D spendng of more han 50-o- (Zachmann e al. 04). 30

34 Resources for he Fuure Sngle Polces Bearng n mnd hese opmal polcy combnaons helps for undersandng he effecs of sngle polces and non-opmal combnaons. Smlar o FN, we frs consder he relave cos effecveness of sngle polces for meeng he same 40 percen cumulave emssons reducons arge. In each case, polcy srngency s adjused over me o mnmze he presen value of coss. Wh he fxed-prce polces, a sngle nsrumen s appled, whou dfferenang among he covered generaon sources. For example, he fossl ax,, s mposed equally upon all fossl-fuel sources. The renewable subsdy (producon ax cred) uses a fxed subsdy pah for non-hydro renewables ha does no dsngush beween wnd/oher and solar. The EE subsdy s appled as a percenage of nvesmen coss, alhough does dsngush beween shor- and long-run nvesmens. We also consder hree revenue-neural polces wh self-adjusng prces. The emssons performance sandard ses an nensy arge; n essence, combnes a CO emssons prce wh a rebae o all generaon n proporon o he sandard, such ha above-average emers pay a ne fee and below-average ones gan a ne subsdy. Specfcally, s s, and s q q. The renewable porfolo sandard funds a common subsdy o he nnovang, non-hydro renewables wh a fee on all generaon, such ha sq q. 4 The clean w, s energy sandard (CES) s a hybrd of he precedng wo polces and s based on recen proposals. Alhough nomnally ses a arge of a ceran percenage of energy from clean sources, n essence offers full creds o renewable sources, 50 percen cred o naural gas generaon, and 0 percen cred o generaon from exsng nuclear and hydropower facles. Creds are n 4 Equvalenly, he ne subsdy o renewables s funded by an mplc fee on oher sources sˆ q q, where sˆ. w, s w, s s Snce hydropower producon s fxed as a baseload echnology, he defnon of he RPS s less mporan for deermnng generaon oucomes, alhough can have dsrbuonal effecs. 3

35 Resources for he Fuure effec funded hrough a revenue-neural fee on all generaon. 5 Table 5 repors he polcy arges for each sraegy. Sage Sage Table 5. Sngle Polces o Acheve 40% Cumulave Emssons Reducon Targe Emssons Prce ($/on CO ) Emssons Performance Sandard (on CO /GWh) Fossl Fuel Tax ( /kwh) Clean Energy Sandard (%) Renewable Porfolo Sandard (%) Renewable Producon Tax Cred ( /kwh) EE Subsdy (%) % shor run 63% long run % Fgure 6 presens he relave welfare coss of each sngle polcy opon for achevng he reducon arge, compared o he coss under an emssons prcng polcy (and for dfferen degrees of EE undervaluaon). For example, when no EE marke falure s presen, usng an emssons performance sandard or a fossl fuel ax ncreases welfare coss by less han percen, relave o an emssons prce. 7 CES and RPS polces resul n percen and 65 percen hgher coss, respecvely. On he oher hand, relyng solely on a renewable producon (or EE) subsdy coss 3 (8) mes as much as he emssons prce alone. The laer polces are especally cosly because hey do no encourage fuel swchng among convenonal energy sources or conservaon hrough hgher elecrcy prces. The relave coss change when EE mprovemens are undervalued by consumers. In parcular, he dscrepancy s larger beween polces ha rase elecrcy prces (and hereby 5 We model he RPS as rewardng he full subsdy value o boh wnd and solar caegores (.e., all non-hydro renewables), and he sum of generaon from hese sources as a share of oal generaon (whn a gven perod) mus mee he RPS percenage requremen. The Clean Energy Sandard operaes he same way, excep ha each kwh of naural gas generaon receves only 0.5 creds, hydro receves 0. creds/kwh, exsng nuclear receves 0. creds/kwh, and new nuclear generaon receves cred/kwh. Table 5 repors he nomnal CES percenage requremen,.e. he sum of all renewable, hydro, nuclear, and 0.5*naural gas generaon as a share of oal generaon. 6 Ths s he percenage of energy effcen nvesmens ha are fully subsdzed. 7 If no for he presence of he R&D knowledge approprably marke falure, boh he emssosn performance sandard and he fossl fuel ax would have srcly hgher coss han he emssons prce. 3

36 Resources for he Fuure nduce more of he underprovded EE mprovemens), and hose ha rely more on subsdes or renewable energy. Ineresngly, he fossl fuel ax becomes more cos effecve han eher he emssons performance sandard or he emssons prce, meanng he EE neracons are more mporan han dfferenang among fossl energy sources. Under he opmal polcy, he gans from reducng EE undernvesmen resul n a 5 percen reducon n welfare coss, relave o an emsson prce alone. Fgure 6. Welfare Coss of Sngle Polces, Relave o Emssons Prcng (=) 0 9 Welfare Cos, Relave o Emssons Prce EPS FosslTax CES RPS PTC EE subsdy Opmal No EE undervaluaon 0% EE undervaluaon Noably, even wh sgnfcan spllovers from echnologcal change n renewable energy or undervaluaon n energy effcency, polces ha focus solely on hose problems are sll much less cos-effecve han emssons prcng. Subopmal Polcy Combnaons Nex, we consder he effecs of polcy combnaons wh srngen arges for renewable energy and energy effcency, as nspred by he European Unon s 0/0/0 Drecve. In each case, we have an emssons prcng program ha ensures meeng he 40 percen cumulave 33

37 Resources for he Fuure reducon arge effecvely, an emssons cap. The EU arges call for a 0 percen reducon n greenhouse gas (GHG) emssons by 00 compared wh 990 levels, a 0 percen mprovemen n energy effcency by 00, and a 0 percen share of renewables n fnal energy consumpon by 00. Snce hese arges reflec economy-wde goals, we adjus our elecrcy secor arges o reflec he dsproporonae share of reducons ancpaed heren, and o ensure all arges reman bndng. Specfcally, as before, we assume a GHG arge of a 40 percen reducon from our baselne. 8 We model he 0 percen renewables arge as a bndng RPS for non-hydro renewables n boh sages, whle we approxmae he energy effcency sandard as a bndng 0 percen reducon n energy nensy n boh sages, reflecng ambons for near-erm deploymen as a echnology drver. Imporanly, he 0 percen renewables arge s close o he welfare maxmzng renewable share for he second sage. kewse, he 0 percen energy effcency arge s close o he welfare maxmzng level when undervaluaon s n he range of 0 percen n he second sage. However, he near-erm deploymen arges are more aggressve han s opmal. In a scenaro wh 50 percen knowledge spllovers and 0 percen EE undervaluaon (.e., 0.5 and x.9 ) here s some jusfcaon for complemenary echnology and energy effcency polces. However, hese marke falures do no jusfy he 40/0/0 combnaon, whch he model calculaes as beng almos wce as cosly as he emssons prce alone. We noe ha some oher varaons can mprove he cos effecveness of he 40/0/0 polces. For example, addng an opmal R&D polcy cus coss by over 0 percen. Offerng exra creds for solar, whch more closely mmcs he opmal producon subsdy profle, lowers coss somewha bu no subsanally. Recognzng ssues n he polcal feasbly of carbon prcng, we also consder he consequences of a echnology-only polcy. Ths sylzed polcy combnes he 0 percen EE arge, a 50 percen R&D subsdy, and an ncreasng RPS suffcen o acheve he 0 percen reducon n emssons (roughly percen non-hydro renewable share n he frs sage and 6 percen n he second). As shown n Fgure 7, he 40/0/0 polcy s he mos expensve of hese combnaons, followed by he echnology-only polcy. Noably, havng a beer dsrbued echnology polcy mx ha s, nernalzng he R&D marke falure and seng an RPS ha s less ambous n 8 Ths arge ensures ha emssons are equal across scenaros, allowng for conssen cos analyss.. 34

38 Resources for he Fuure he near erm has a sronger effec on reducng coss han losng he emssons prce componen of he 40/0/0 polces has n ncreasng hem. Sll, he echnology-only polcy s 68 percen more cosly han he emssons prce alone, and more han wce as cosly as he opmal combnaon. (See Fgure 7). Fgure 7. Welfare Coss of Combnaon Polces, Relave o Emssons Prcng (=) (0% EE Undervaluaon) Welfare Cos, Relave o Emssons Prce "40/0/0": Emssons prce + RPS + EE "Technology only": RPS + R&D + EE Opmal polcy: Emssons prce + subsdy + R&D + EE 0.6 Dsrbuonal Consequences Of course, cos-effecveness s no he sole merc of neres o polcymakers when choosng a clmae sraegy, whch may help explan he grea neres n polcy combnaons. Polcymakers are concerned abou he mpacs on specfc sakeholder groups, ncludng raepayers, axpayers, and owners of dfferen generaon echnologes. Fgure 8 presens he changes n welfare mercs for fve caegores of sakeholders, as well as he oal change n surplus. We use he caegory axpayers o represen he poenal 35

39 Resources for he Fuure flow of revenues o or from he governmen, recognzng ha addonal polces can deermne who s allocaed emssons revenues and how subsdes are pad for. 9 Fgure 8. Dsrbuonal Consequences of Polcy Combnaons We see ha, alhough he emssons prce polcy alone has low overall coss, has he larges dsrbuonal mpacs, parcularly for elecrcy consumers (who bear much of he cos), axpayers (or more generally hose who wll enjoy he sgnfcan revenues), and he clean baseload generaors (.e. nuclear and hydro, who enjoy hgher elecrcy prces). An opmal polcy combnaon would have smlar dsrbuonal mpacs, bu of smaller magnude. Noe, however, ha o he exen ha elecrcy consumers and axpayers are he same ndvduals, he dsrbuonal mpacs wll no be as severe a he ndvdual level. Alernavely, generous 9 We model an emssons prce by calbrang a carbon ax o acheve a 40% reducon from baselne emssons. Hence, axpayers revenues could equvalenly represen carbon ax revenues or aucon revenues under a cap-andrade sysem. 36