A first set of limitations of the obtained results

There are two aspects in which the described model could be extended, with both tending to weaken the results obtained in the previous section. The first extension concerns the demand for emission permits, as whereas until now it was assumed that they are only being demanded by the fossil electricity generating industry, in reality the ETS covers also other industries (see Section 3.2 on the EU ETS). Therefore, if these other industries were willing to buy a larger amount of emission permits when their price falls (namely if they have a downward sloping demand for permits), the number of permits is no longer fixed for the electricity sector. A reduction of the permit price resulting from a reduced demand for fossil electricity would thus induce that a higher number of permits are used in other industries. Hence, whereas the output of the other industries would tend to increase, the supply of fossil electricity would decrease. This latter effect presents the possible outcome of electricity consumers being faced with a lower electricity supply, which would lead to a higher equilibrium price and reduce their rent. Note that second-round effects stemming from the other industries are not considered.

A second limitation of the results obtained thus far can be drawn based on a model by Böhringer and Rosendahl (2010), which was also similarly formulated by Fischer and Preonas (2010). They emphasize that a change in the price of emission permits may have an impact on the composition of fossil electricity generation. Both papers consider fossil electricity generation from coal and from gas, and hence the total amount of emission permits is shared between coal and gas electricity producers. However, coal electricity is more emission intensive than gas electricity, and thus, as argued in Böhringer and Rosendahl (2010), coal electricity benefits more strongly than gas electricity if the permit price declines. Consequently, there would be a shift from gas electricity generation to coal electricity, which would reduce the total fossil electricity generation for a given amount of emission permits. Similar to the previous argument, increasing electricity prices following the implementation of a renewable energy support scheme becomes a possible outcome.

However, this discussion also highlights that combining renewable energy support with an ETS may actually imply another undesired effect, in benefitting the dirtier coal electricity relative to gas electricity.

In contrast to the analysis in the previous section, these two limitations already illustrate why electricity consumers might be giving up some of their consumer rent for the subsidizing of renewable energy. A further and possibly most important limitation of the results obtained in this chapter will be derived and discussed in Chapter 4. The analysis will be extended to a two-country set-up, explaining how the results change if the renewable energy subsidizing country shares a common electricity market and common ETS with other countries. This extension serves to bring the analysis closer to the actual institutional framework in Europe.

3.6CONCLUSIONS

Whilst the discussion in this chapter was thus far based on a positive analysis, some normative implications warrant mention in this section. Firstly, it is important to emphasize that the introduction of the ETS can improve allocative efficiency if the negative effects of using fossil energy are otherwise not being priced-in correctly. As illustrated in Figure 3.5, the electricity consumption shrinks and reaches the efficient level if the ETS is properly designed. Secondly, as previously argued at the end of Chapter 2, no renewable energy subsidy can be justified based on reasons related to the climate change externality if the ETS induces a correct pricing of carbon dioxide emissions. In such a case, the introduction of a levy-financed subsidy reduces total rents as renewable electricity is subsequently generated at costs higher than the social cost of fossil electricity. Simultaneously, the electricity consumption again becomes inefficiently high given the declining consumer price, for the underlying reason that the permit price decreases owing to the subsidy and because of the levy. However, it should also be emphasized that the levy itself does not create an inefficiency, rather it only transforms the producer surplus of firms generating fossil electricity into levy revenue. An inefficient allocation arises owing to the subsidizing of renewable energy, when it does not require support, which is the case when the market price of electricity already equals the social unit cost of fossil electricity.

In contrast to an imperfect carbon tax, as discussed in Chapter 2, in the case of an imperfect ETS no renewable energy subsidy can be justified, given that the ETS fixes the quantity of fossil electricity through an endogenous permit price, thereby making it independent of the generation of renewable electricity. Public policy supporting renewable energy can only be reasoned by the existence of other externalities in addition to the climate change externality, or simply because subsidizing renewable energy is a political choice even in the absence of non-internalized externalities.

4. Unilateral support of renewable energy within a common ETS