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CP361 RL 24.10.07

Coordination of carbon reduction and

renewable energy support policies

Pedro Linaresa,b, *, Francisco Javier Santosa, Mariano Ventosaa

a) Instituto de Investigación Tecnológica. Univ. Pontificia Comillas. Sta. Cruz de Marcenado

26,. 28015 Madrid, Spain.

b) JFK School of Government, Harvard U., and FEDEA

*Corresponding author: Tel. +34 91 5406257 Fax. +34 915423176. pedro.linares@iit.upcomillas.es

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Abstract.

The European Union is currently pursuing ambitious objectives regarding carbon emissions reductions and renewable energy (RES) deployment, as part of a comprehensive energy policy effort. However, significant interactions may arise between the policy instruments used (Emissions Trading Scheme and RES-specific support), such as double-counting incentives or geographical overlapping. This paper examines these interactions using analytical and simulation research and offers some policy recommendations. The major conclusions are that both instruments are required in order to meet the objectives, and that their combination may be advantageous regarding consumer cost. However, they must be carefully coordinated, since part of the carbon allowance price may be incorporated into the RES certificate price. This will produce a reduction in the strength of the emissions reduction signal, and also a different distribution of the cost of the policies. In addition, each policy needs focus at the geographical level appropriate for its objectives (carbon and security of supply policies at the regional level, and RES-induced local development at the national one).

Keywords: carbon emissions trading, renewable energy, electricity markets, policy

coordination,

1. Introduction

The EU is the world leader in renewable electricity development, thanks to the

effective support policies which have been set up in some member states. The

European Commission has certainly given this development political support by

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issuing the European Directive 2001/77/EC, which concerns the promotion of

electricity produced from renewable energy sources, establishing indicative targets

and some baseline regulation.

In addition, the EU is also playing a leading role in the action against climate

change, and is setting unilateral, ambitious targets for the reduction of CO2

emissions. Indeed, the EU introduced in 2003 a CO2 trading scheme, the European

ETS, supported by the European Directive 2003/87/EC. This scheme. will

indirectly encourage investments in “clean” technologies such as gas, nuclear

energy and renewables, while penalizing investments in other “dirtier” technologies

such as coal.

This indirect incentive for renewables may interact significantly with current

support schemes for renewable energies (especially with those based on premiums),

by adding to the profits of renewable producers through a higher electricity price.

Although it is debatable whether the support for renewables accounts for their

carbon reduction benefits or for their local positive externalities (which most of the

times is not so clear; see, e.g., Komor and Bazilian (2005) or Bergmann et al

(2006)), it is possible that the implicit carbon tax may in fact be double-counting

the carbon externality of renewables, because of the slow adjustment of support

schemes. This brings out the problem of how to avoid this double-counting and of

how to combine regional regulations such as the ETS Directive and national ones

such as RE support schemes. The objective of this paper is to provide some

insights, based on a theoretical and quantitative analysis of this interaction. This is a

timely discussion, given the recent statement of new goals for carbon reductions

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and RES deployment by the European Commission, and the expected review of the

ETS and the Renewables Directive.

Some analyses have already been carried out on the expected consequences of

carbon trading mechanisms on renewable support schemes. For instance,

Amundsen and Mortensen (2001), Boots (2001) or Jensen and Skytte (2003) have

assessed the interaction between carbon trading and tradable green certificates

using analytical models. Del Río et al. (2005) have looked at the impact of clean

development mechanisms and joint implementation on the deployment of

renewable electricity in Europe, although again from an analytical point of view.

Hindsberger et al. (2003) and Unger and Ahlgren (2006) used a simulation model to

obtain quantitative results for the Nordic electricity and energy sectors respectively

also under a tradable green certificate system. Linares et al (2006 a, b) have used

another simulation model to analyze the impact of carbon emissions trading for the

Spanish electricity market and renewable investments.

Compared to previous research, this paper presents a comprehensive overview of

the problem, shows more detailed and realistic results from a simulation model in

which both premiums and tradable green certificates are analyzed as renewable

energy promotion mechanisms, and provides some recommendations on how to

approach the required integration of carbon reduction and renewable support

policies in order to achieve an efficient support for renewable energies under the

new scenario.

The existing results are revised in section 2, while section 3 presents some results

from a simulation model for Spain. Finally, section 4 provides the conclusions and

recommendations from the study.

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2. A review of the interactions between RE promotion schemes and

carbon emissions reduction policies

The impacts of the interaction of carbon reduction and renewable promotion

policies on the electricity market are not trivial, even in some cases producing

counter-intuitive effects, as will be shown later. Both instruments may be used in

order to achieve the same objective: the support to renewable energies contributes

to a reduction in carbon emissions, by increasing the relative share of renewables in

the energy production mix (although this effect may be reversed in dynamic terms

under certain conditions1); and a carbon trading system (with an implicit price for

emissions) promotes to a certain extent a larger penetration of renewable energies,

since it reduces the cost gap existing between conventional and renewable energy

sources.

Therefore, it would be desirable that, since many European countries use both

instruments, this use would be as coordinated as possible, in order to achieve the

objectives sought at the least cost for society and the environment, and also in order

to send to the market the right signals.

Figure 2.1 (similar to the one presented by Jensen and Skytte, 2003) represents the

existing relationship between the instruments:

Figure 2.1. Relationships between carbon emissions trading, renewable promotion

and the electricity market

1 If renewables are promoted to the extent to which they substitute new investments in conventional technologies (new gas combined cycles, for example), then old and dirty power plants may continue in operation more time than desired, thus preventing large carbon emissions reductions in the conventional side of the energy mix.

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As can be seen, renewable producers participate in the electricity market and also in

the renewable market, considering as such the system by which an additional price

for renewables is generated, be it by selling and buying green certificates or through

premiums. Conventional producers go to the electricity market and also to the

carbon emissions market, where they buy and sell the permits required for their

emissions. Other economic sectors also participate in this market (in the European

case, the rest of industrial sectors). Finally, consumers participate in the electricity

market, where they buy their electricity, and in the renewable market, where they

pay the extra cost for these technologies. Therefore, all instruments are connected

through the different markets, and the final cost for consumers depends on the

interaction of all of them. It should be noted this analysis only considers those

impacts detectable by simulation models, and therefore no considerations of

investment risk, technology learning or such are included. This allows for most of

the conclusions to be valid both for price instruments (such as carbon taxes or

renewable premiums) and for quantity instruments (carbon trading or green

certificates). Therefore, from now on, we will consider both types of instruments as

equivalent without loss of generality, although in practical terms they may not be so

(see Weitzman (1974) or Menanteau et al (2003)).

2.1 Impact of carbon reduction policies

Carbon emissions trading (or rather, the limitation of the emissions on which it is

based) or carbon taxes produce an increase in the price of electricity, which in turn

produces an increase in the cost for the consumer in all cases. This increase will

depend on the regulatory framework: in marginal price markets the increase will

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always be larger than for those based on cost of service remuneration. This is

shown in Figure 2.2, where the supply curve is modified from (1) to (2) due to the

introduction of a carbon tax (or a permit price). The light grey area (a rectangle

which is partially overlapped by the dark grey area) is the cost increase in marginal

price markets, while the dark grey area is the one corresponding to cost-of-service

markets. The increase in marginal price markets is due to the existence of windfall

profits, which on the other hand, in theory, are the right long-term signal for

investment in less-polluting equipment (although they may be received by spent

technologies, and therefore may have to be regulated).

Figure 2.2. Impact of carbon reduction policies on electricity prices

The increase in electricity price also means a decrease in the price of the green

certificate (or premium) received by renewable energies, since the certificate or

premium is (or at least should be) the difference between the long-run marginal cost

of the renewable technology and the electricity price. If the electricity price

increases, the certificate price is reduced. According to Amundsen and Mortensen

(2001), the decrease in TGC prices is larger than the increase in electricity prices,

so the installation of renewable energy would be disincentived. However, this has

not been proved by simulation results, as will be shown later. Hindsberger et al

(2003) and Unger and Ahlgren (2006) argue that TGC prices would not be changed

significantly by carbon reduction policies, but this is because under their

assumptions, emission permit prices (or the equivalent carbon tax) are very low due

to large renewable quotas.

Finally, an increase in the reduction of carbon emissions brings forward an increase

in the price of the emission permit, with the corresponding increase of the price of

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electricity and the reduction in the price of the green certificate. In the limit, a very

high reduction of emissions might produce a permit price so high that it would

allow renewable energies to enter the electricity market without any need for

compensatory payments (and therefore without the need for a specific promotion

mechanism). However, as will be seen later, this is not a common situation for large

renewable energy quotas, since there are generally much cheaper options for

reducing emissions than renewable energies (as shown by Unger and Ahlgren,

2006).

2.2 Impact of the policies for promotion of renewable energies

Renewable energy promotion mechanisms have an ambiguous impact on the cost of

electricity for the consumer. Basically, these instruments imply an extra cost for the

consumer, since renewable energies are generally more expensive than

conventional ones. But at the same time, by requiring less conventional energy, the

price of electricity is reduced. This effect is due to two causes: first, with an upward

slope of the electricity supply curve, the reduction of demand for conventional

electricity may change the marginal unit in the system, and therefore the marginal

cost. But even if the supply curve is horizontal (as may happen when several

combined cycles are setting the marginal price), there may be a reduction in prices

if there is a certain price elasticity of the fuel price (if gas demand, for example, is

reduced, then gas prices might decrease and therefore the price of electricity, see

e.g. Wiser and Bolinger or Fischer (2006)). The final impact on the consumer will

depend on the amount of the extra cost (which in turn depends on the cost

differential between conventional and renewable energies and on the shape of the

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renewable energy supply curve), and on the amount of the decrease of the price of

electricity (which depends on the shape of the electricity supply curve, on the price

elasticity of conventional fuels, and on the remuneration system – marginal price or

cost of service –).

Indeed, Jensen and Skytte (2003) – later verified by the simulations of Hindsberger

et al (2003) and Unger and Ahlgren (2006) – conclude that, under certain

assumptions, it is possible to identify the solutions which minimize consumer costs:

when an increase in the renewable quota means a reduction in costs, then it is

feasible to find combinations of both instruments which minimize costs. In most

cases, this combination means using exclusively the renewables quota. In this way,

we may find a counter-intuitive result, in that it may be cheaper to reduce emissions

by promoting renewable energies (due to the cost reduction for the consumers),

even knowing that renewable technologies are much more expensive for carbon

reduction than others (e.g., gas combined cycles, energy saving measures). This

apparent paradox is due to the existence of windfall profits associated with the

carbon trading system, and therefore is more likely to happen in the short term,

since in the long term windfall profits, if well adjusted, will give the right signal to

the market in order to evolve towards a less-emitting electricity production mix.

To this extent, the coexistence with a carbon emissions trading system may have

some importance, since the emissions trading system changes the electricity supply

curve, and this may change the cost-benefit relationship.

Figure 2.2 shows a possible situation for the Spanish electricity market (for a

description of the Spanish electricity market see Crampes and Fabra, 2005), in

which gas combined cycles pass coal in the merit order when a carbon reduction

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scheme is introduced. The amount of renewables promoted is QR, A represents the

reduction in the cost of the electricity due to the introduction of QR and B

represents the extra cost of renewables to the system. As may be seen, this increases

the reduction of the costs of electricity (from A to A’), and decreases the extra cost

of renewable promotion (from B to B’). Therefore, it seems that in similar

situations the carbon trading system makes more favorable a larger introduction of

renewables, from the point of view of the consumer cost.

Figure 2.3. Impact on the costs and benefits of renewable promotion of a price for

carbon emissions

This impact will also depend on the amount of renewables promoted. The larger

this is, the larger will be the cost of the marginal renewable energy, the larger will

be the certificate price or the premium required, and therefore the larger the extra

cost. An increase in the participation of renewable energies may also have impacts

on the price of the carbon emissions permit, depending on the size of the permit

market compared to the renewable market. The relevant relationship here is the

volume of carbon reductions attainable by the RES market (which in turn depend

on the current electricity generation mix) compared to the total reductions possible

or requested by the carbon reduction policy. If the market is very large (as expected

under the Kyoto Protocol) then the impact will be minimal, since the promotion of

renewables in a country or region will not be enough as to influence the permit

price. However, if the trading system has a limited extent, or if renewable

promotion mechanisms are widespread, renewable energy promotion may have an

influence (e.g., for Europe in 2020 the expected reduction in CO2 emissions from

renewables is around 350 Mt, whereas the total reduction required is around 520

Mt). This influence is due to the fact that, when more non-polluting energies enter

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into the system, it is cheaper to achieve the same amount of emissions reduction,

and therefore the price of the permit decreases. This has been shown by

Hindsberger et al (2003) and Unger and Ahlgren (2006). This in turn may also

produce a reduction in the price of electricity, and thus in the cost for the consumer.

Figure 2.4 shows that when renewables are promoted through premiums or

certificates, their marginal cost is reduced, and the carbon marginal reduction costs

curve moves to the left (since now renewables have a lower reduction cost). This

results in a decrease of the marginal cost required to reach the reduction quota, and

the same happens with the permit price.

Figure 2.4. Impact of the promotion of renewables on the price of the carbon

emission permit

This situation is somewhat peculiar, since renewable producers are compensating

their larger costs compared to conventional energies by two ways: one part is

recovered through the emission permit price, and the other through the green

certificate price or premium. In the case where renewable energies were those

setting the marginal reduction cost, the equilibrium in this market would not be

determined, and then renewable producers might choose whether to recover their

costs in the renewable market or in the emissions market.

Hence, as shown in the diagram, the larger the renewable quota in a small

emissions market, the larger the green certificate price, and the lower the emission

permit. Consumer costs are reduced, as well as firm profits (since windfall profits

are also reduced).

Figure 2.5. Impact of the promotion of renewables on the emission permit price and

on the green certificate price

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To summarize: an increase in the renewable quota means an increase in the green

certificate price, and in small emission markets, a decrease in the permit price (this

may also be interpreted by assuming that a part of the permit price becomes part of

the certificate price). An increase in the reduction of carbon emissions means an

increase in the price of the emission permit and a decrease in the green certificate

price. This is shown succinctly in Figure 2.6, from the point of view of how the

renewable producer receives its income.

Figure 2.7. Impact of the promotion of renewables and carbon reduction from the

renewable producer’s point of view

Finally, the introduction of green certificates also produces additional impacts on

the electricity market: by reducing the amount of non-renewable energy required,

the demand becomes less elastic (the slope of the curve is the same, but the

intercept changes). This increases the market power in the non-renewable

electricity market, which would increase oligopoly prices compared to the perfectly

competitive case. However, this is compensated by the reduced prices for

allowances (as explained before), and also by the smaller size of the non-renewable

market.

2.3 Combined effects of the promotion of renewables and the reduction of

CO2

We have seen that the instruments interact, producing effects which are not easily

predicted in terms of consumer cost, electricity prices, green certificate prices, or

emission permit prices. Figure 2.7, shows that it is not possible to predict either the

sign or the quantity of the change in the price of electricity or consumer cost when

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the two instruments are combined and the emissions market is small. (If the

emissions market is large enough, then renewable promotion instruments do not

influence it, and therefore there is only an influence of the emissions market on the

renewables one).

Figure 2.8. Combined effect of the promotion of renewables and carbon reduction

Renewable energy producers and the share of renewables in the system may not be

affected by the interaction, since they would receive the long run marginal cost

through green certificates. If the support system is based on premiums, they may be

even better off if the premium is slowly adjusted. However, the rest of the

electricity sector will be affected by the change in the price of electricity, and the

same happens with the consumer cost. Therefore, this is a necessary analysis.

Thenext section presents the results from a simulation study carried out for the

Spanish electricity system. The advantage of this study compared to the previous

ones is that it uses a long-term (generation expansion) model which allows for

representing the oligopolistic conditions usual for electricity markets (and therefore

provides more realistic estimates of electricity prices, technologies, and carbon

emissions), and that it accounts for all industrial sectors covered by the EU ETS.

The ETS and RES-E markets are assumed to be competitive ones. More details

about the model and data used may be found in Linares et al (2007).

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3. Simulation results of the interaction between the European ETS

and national RE support schemes

3.1 Scenarios analyzed

In order to analyze the interaction between the carbon reduction and renewable

support policies, a number of scenarios have been simulated in which these policies

are considered independently or combined, plus a base case in which no such

policies are considered.

The common data underlying these scenarios are:

- The simulation has been carried out for a 23-year period (2005-2027).

However, in order to avoid wrong investment decisions, only the first 16

years have been considered (2005-2020)

- The existing technologies considered are: nuclear, domestic coal, brown

lignite, black lignite, imported coal, fuel, natural gas, gas combined cycles,

regulated hydro, run-of-the-river hydro, pumping units, biomass,

cogeneration, small hydro, wind and solar. Their installed power and cost

parameters have been taken from CSEN (1997).

- The new technologies that might be installed are: gas combined cycle,

advanced nuclear, supercritical coal, three types of biomass, cogeneration,

small hydro, three types of wind, and solar thermal. The parameters for

these technologies have been obtained from the SETRIS database

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(European Commission, 2004), except from the maximum power, which has

been obtained from the Spanish Ministry of Industry (MINER, 2002).

- Demand growth rate has been set at 2.5%, again following the Spanish

Ministry of Industry (MINER, 2002).

All cases have been simulated considering both a marginal-price and a cost-of-

service remuneration. In the following box we outline the cases simulated, with

their corresponding key names as will be used in the result tables.

In other already mentioned studies such as Hindsberger et al (2003) or Jensen and

Skytte (2003) another scenario is considered, which analyses the cost of a certain

emissions reduction scenario only with renewables promotion. However, this is not

possible in our study, since it is almost impossible to know beforehand the amount

of reduction from the electricity sector, since that is a variable amount contingent

on the price of the permit, which is formed endogenously to the model.

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In the following section results are presented and analyzed. It has to be remarked

that all monetary values shown correspond to 2004 euro, and that no inflation has

been considered in order to better observe the impact of the instruments analyzed.

3.2 Results

Table 3.1: Electricity market price (€/MWh)

First, it may be seen that under the base case there is an increase in the price of

electricity because of the increase in demand, which requires more expensive

technologies (such as supercritical coal) to enter into the system. Prices increase 5%

to 2012, and then stabilize from then on, since it is the same technology which sets

the system marginal price.

When carbon trading and TGCs are introduced, prices are reduced compared to the

case with emissions trading but without renewables promotion, since part of the

Case A: This is the base case: an oligopolistic electricity market without renewable support nor carbon emissions reduction.

Case B: The base case plus carbon emissions trading under the European Directive.

Case C: The base case plus renewable promotion schemes.

Case C1: Renewable promotion through green certificates, with a quota equal to the one resulting from the current situation in Spain (under premiums).

Case C2: Renewable quota of 17.5% in 2010.

Case D: Base case plus renewable promotion schemes plus carbon emissions trading.

Case D1: Idem C2 plus carbon emissions trading.

Case D2: Idem C3 plus carbon emissions trading.

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emissions reduction is achieved with renewables, and therefore the emission permit

price is lower, which in turn produces a lower price of electricity. This price

reduction is larger the larger is the renewable quota, as seen in case D2.

Table 3.2: Emission permit price (€/t)

The permit price under the emissions trading system rises from 6 to 22€. These

prices are consistent with other results presented in the literature, and with the

current emissions markets prices. It is interesting to note that the permit price is

negligible the first three years, because the emissions reduction required is not

significant.

When renewable promotion systems are included, then the permit price decreases

(and decreases more the larger the renewable quota), since renewables contribute to

emissions reductions, and therefore reduce the marginal cost of this emissions

reduction. As previously mentioned, what is really happening is that part of the

permit price is being incorporated into the green certificate price.

It should be noted that these prices correspond to a national emissions market, as

has been modeled. However, the emissions market should have a European scope

(or even global from 2008). But this European market has not been modeled

because of the difficulties in knowing the marginal abatement costs and emissions

reductions in other countries. In any case, it may be estimated that the enlargement

of the emissions market should result in lower permit prices, by making available

cheaper reduction options (including CDM or JI, which have not been considered

here).

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Table 3.3: Green certificate prices (€/MWh)

The green certificate price, as previously explained, is the difference between the

renewable energy marginal cost and the electricity market price, (e.g. the degree of

support required by the marginal renewable energy producer to recover his long-

term costs). In this table we may see two effects:

• the green certificate price rises as long as the renewable quota increases (the

quota may be observed in following tables), for two reasons. The marginal

production cost increases and the price of the electricity market decreases.

This may be observed in cases C1 or D1 from 2012 (when the renewable

quota increases).

• when an emissions trading system is implemented, the certificate price is

reduced, because the electricity price increases. This may be observed by

comparing cases C2 and D2.

The certificate price is similar to the current premiums (29€/MWh for wind and

biomass). The increase in the certificate price in cases C2 and D2 compared to C1

and D1 respectively indicates the extra cost due to the increase in the share of

renewables.

Table 3.4: CO2 emissions in the electricity sector (Mt)

In the base case we may see the expected evolution of emissions in absence of

environmental policies: emissions would increase 26% in 2012 compared to 2005,

and 53% in 2020 (86% and 225% respectively compared to 1990 emissions). This

large increase is due mostly to the high growth of electricity demand.

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When the limitation to carbon emissions is introduced, then emissions are largely

reduced, staying around 30% over 1990 emissions (except in the first three years in

which the required reduction is much smaller). When renewable promotion

mechanisms are introduced, emissions also decrease, because of their higher

participation in the system. But this reduction is not enough to achieve the expected

reduction objectives. Therefore, in 2012 emissions would be 62% higher than in

1990 and 203% higher in 2020. These percentages are similar even if the

renewables objectives are achieved. Therefore, we see that the current renewable

promotion policies are not enough to achieve emissions reduction objectives by

themselves.

The combined effect of both mechanisms on emissions is not significant; the

electricity sector keeps the same level of emissions as without renewable promotion

systems (the higher penetration of renewables is compensated by less investment in

combined cycles and higher use of domestic coals). Therefore, the combination of

mechanisms does not have an influence on emissions, although, as seen in the rest

of tables, it does have an influence in costs and renewable energy development.

Table 3.5: New investments up to 2020 per technology (MW)

Under the base case shown in Table 3.5, the expansion of the electricity sector is

performed by investing in gas combined cycles, and to a much lesser extent, in

supercritical coal. The introduction of a carbon trading scheme means that new coal

investments disappear, and are substituted by more combined cycles and by

agricultural residues and wind energy (these latter limited by their available

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potential). It may also be observed that the amount installed increases very much

(possibly due to the higher price of electricity).

Renewable energy promotion systems by themselves achieve a certain investment

in agricultural residues and wind energy (again, limited by the available supply).

When a larger quota is required (C2 case) then also energy crops, forest residues,

and all wind energy enters into the system. In the first case the investment in

combined cycles is maintained, and there is also a small investment in supercritical

coal, but when the renewable quota is increased the capacity installed of gas

combined cycles is reduced, and coal disappears.

The combination of instruments results in a larger installed power of renewable

energies, with the “worst” wind energy being installed from the start. In a certain

sense, the combined effect is very much the sum of the independent ones.

Table 3.6: Production costs (M€, net present value 2005-2020)

Production costs increase when the different instruments are introduced (it should

be noted that the total energy demand is the same for all scenarios, so this increase

can also be expressed in €/MWh). A 13% increase because of emissions trading, an

8% due to renewable energy promotion (15% if the quota is 17.5%), and 18% when

they are combined (21% if the renewable quota is 17.5%). The combination of

instruments has a lower extra cost than the sum of separate instruments, so in terms

of production costs, it is an interesting option. The renewables promotion systems

(which are cheaper than the emissions trading system) are not able to achieve the

required emissions reduction by themselves.

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Table 3.7: Consumer costs (M€, net present value 2005-2020)

Table 3.7 shows the different consumer costs of the different combinations of

instruments, assuming a marginal price retribution system (again, we must remind

that the total energy demand is the same, and therefore this analysis can also be

translated to specific costs). If the system were a cost-of-service one, then the costs

for the consumer would be similar to the production costs already mentioned.

The marginal price system always implies larger costs for the consumer. On the

other hand, it incorporates a long-term economic signal which, if well adjusted (that

is, if there are no redundant windfall profits) is required for adapting the production

system.

The cheapest case is the base one, but this also means a high level of emissions and

a low level of penetration of renewable energies. The introduction of a carbon

trading system increases costs 12%. Renewable promotion systems also increase

costs (10% to achieve a 17.5% quota). However, as already seen, these support

systems are not able to reduce emissions to the required level, so they cannot be

considered a cheaper option to reduce emissions, as was considered in the

theoretical analysis.

The combination of instruments features higher costs, although it shows some

synergies: the simultaneous achievement of the emissions reductions and high

penetration of renewable energies only increases costs by 15%, i.e, only 3% more

than under the emissions trading system only. Therefore, it presents an interesting

option, since it achieves both objectives at a lower cost than the sum of the two

extra costs by themselves.

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4. Conclusions and recommendations

4.1 Conclusions

This paper has analyzed the interaction of renewable energy promotion policies

with other environmental policies such as carbon trading systems, in order to assess

their impacts on electricity markets and to identify the requirements for a

coordinated use of these instruments.

The analysis was undertaken at a national level, due to the difficulties in modeling

in detail the European electricity market and its environmental policies. The

conclusions can be easily generalized to the regional scope.

When a carbon emissions trading system is added to a renewable promotion

scheme, then electricity market prices are reduced (whereas the carbon emissions

trading by itself would cause a significant increase). However, this does not imply a

reduction in consumer costs, due to the extra cost of renewable energy promotion.

Therefore, a reduction in the strength of the emissions reduction signal is sent to the

market, but a higher cost occurs for the consumer (although we do achieve an

increase in the penetration of renewable energies, which has added benefits).

Those most affected by these policies are consumers, since their costs increase

significantly, up to a 15% in some cases. Under a marginal price system, the extra

cost of increasing the renewable quota is quite low, unlike under a cost-of-service

system. In this case it may be observed to a certain extent the theoretical effect of

cost reduction for consumers by an increase in the renewable quota.

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The reduction of carbon emissions only through renewables promotion is very

complicated under the current growth of demand, even in a high-renewable-

potential country as Spain. But carbon trading systems are not able to stimulate

renewables growth to the level desired. Therefore, it seems practical to keep both

instruments in order to reach the objectives stated.

This combination of instruments provides some synergies in the cost of achieving

objectives: results show that the combination has a lower extra cost than the sum of

the two instruments. This synergy seems larger under a marginal price system.

As a final comment, this exercise has been carried out under a partial equilibrium

approach for the electricity sector (except for the exchange of emission permits),

and therefore, real effects may be somewhat different from those shown here. There

may be substitution effects between energy sources when their relative prices are

modified. In order to simulate these effects, a general equilibrium approach would

be required.

4.2 Policy recommendations

Some policy recommendations are made to identify the best ways to combine

renewable promotions schemes and carbon reduction policies. This is a relevant

issue, given the current policy process in the EU by which ambitious goals are

being set for carbon emissions reductions, RES deployment, and energy efficiency

(the 20/20/20 strategy). The way these policies will be finally implemented will

have a large influence on consumer costs and on the performance of the system.

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The relevant question here is: are these instruments compatible? And if they are,

how should they be combined in order to achieve objectives at the lowest cost?

The answer to the first question lies in the objectives of the two instruments. Are

they complementary or alternative? If we only looked at the emissions avoided by

renewable energy, then both instruments might be considered valid alternatives to

reach the same goal. But renewable energies have more benefits than just emissions

reduction: contribution to security of supply, industrial and rural development, etc.

Therefore, it seems evident that they have to be promoted by themselves, besides

controlling carbon emissions. Their objectives are complementary.

One possibility, raised by Jensen and Skytte (2003) is to use only one instrument to

achieve both objectives. We might use, as already mentioned, a single carbon

emissions reduction instrument to indirectly promote renewables. But current

carbon trading systems do not deliver the required level of renewables promotion,

since the reduction of the cost differential between conventional and renewable

energies is not enough. More ambitious reduction objectives (such as the 20%

reduction set by the European Commission) would increase carbon prices, and

therefore reduce this cost differential. But this would probably be too small for the

also large RES deployment sought.

It seems more feasible to use renewable energy promotion to reduce carbon

emissions, since, it may be a cheaper policy than keeping both instruments. But this

has two major drawbacks:

- its higher efficiency is not guaranteed, since it depends on the rest of

technologies. Our study has shown that the required carbon emissions

25

reduction cannot be achieved just by promoting renewables, and that costs

are not lower

- by not using carbon reduction policies, all possible emissions reductions not

related to RES deployment (and which might be cheaper than RES) would

lose their incentive

Therefore, it seems that both instruments must co-exist. This co-existence may be

“peaceful” whenever the emissions market is large enough compared to the

renewables market, so that an increase in renewables does not have influence on the

emissions permit price. This might be the current situation in Europe, with a

European emissions market (or global from 2008) and national renewables support

systems.

This way, renewable producers receive the benefits from carbon emissions

reduction through a higher electricity price, and the premiums or green certificates

would only convey the additional local benefits of renewables. In the case of green

certificates, the adjustment to changes in the emissions permit market is automatic,

although this is not the case of premiums, for which appropriate revision

mechanisms should be implemented.

There are other reasons which may explain more aggregated efforts for the

promotion of renewables: their benefits for security of supply, for example, might

justify a common European RES market, as the one currently proposed. In this

case, carbon and RES markets would have a similar size, and then green certificate

prices may incorporate some part of the emissions permit price. This makes the

permit price to be lower, and also the consumer cost. This seems beneficial for the

26

system (for the same electricity price and emissions, the total cost of the system is

lower). However, some problems exist:

- it may be impossible to know the shadow price of carbon, since now part of

it is integrated into the green certificate. Since green certificates are

addressing two different policy goals, the share between them will depend

also on other policies, so it is not clear whether the resulting carbon price is

the optimal one.

- Based on the same reasoning, there may not be an efficient signal to the

market for the reduction of carbon emissions

- This also happens with the cost of the two different objectives pursued by

RES deployment: security of supply (dealt at the EU level) and local

development benefits (usually addressed by national governments)

Therefore, a joint approach to carbon emissions reduction and RES deployment

such as the one currently being proposed by the European Commission, while

presenting several advantages in terms of the cost for the consumers, also requires

the consideration of two important aspects, because of the possible “cross-

subsidies” between policies: as we have seen, RES deployment policies may “pay”

partly for the reduction in CO2 emissions.

- since these policies may be financed from different sources (RES

deployment by electricity consumers, and carbon policies by general

consumers), then different policy configurations would also imply a

different distribution of the cost

27

- the objectives should be clearly defined, especially at the appropriate

geographical level. Whereas carbon reductions or security of supply issues

should be addressed (and therefore possibly financed equally) at the EU

level, local development benefits due to RES deployment basically accrue

to Member States, which should pay for them accordingly. This is

especially relevant for the definition of common RES markets, and for their

co-existence with national support schemes.

These aspects depend on the general economic and fiscal context of the market.

These recommendations may be valid within a first-best setting, the reality of the

markets and the current fiscal policies may require second-best regulations, which

therefore may require a joint assessment with other policies (e.g., using a general

equilibrium approach including other fiscal policies).

Acknowledgements

This work has been supported in part by Fundacion BBVA and by the European

Commission (Contract 4.1030/C/02 004/2002). Pedro Linares also acknowledges

the hospitality of Harvard Electricity Policy Group, and support from Fundacion

Repsol YPF, Unión Fenosa, and the Spanish Ministry of Education (SEJ2006-

1239/ECON).

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28

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31

LINARES. TABLE 3.1

Table 3.1: Electricity market price (€/MWh)

A B C1 C2 C3 D1 D2 D32005 25.94 26.78 24.90 24.80 25.03 24.90 24.80 25.032006 25.94 26.99 25.24 25.03 25.30 25.24 25.03 25.302007 25.95 27.03 25.79 25.49 25.66 25.79 25.49 25.662008 26.31 29.23 26.31 25.90 26.11 28.65 28.80 28.782009 26.96 29.41 26.96 26.74 26.68 28.85 28.95 28.922010 26.98 29.59 26.98 27.02 27.01 29.02 29.10 29.072011 27.01 29.80 27.01 27.07 27.05 29.18 29.27 29.232012 27.04 30.04 27.04 27.08 27.08 29.36 29.45 29.412013 27.10 31.47 27.10 27.09 27.08 30.10 30.15 29.692014 27.11 31.86 27.11 27.14 27.09 30.37 30.42 29.912015 27.11 32.30 27.11 27.21 27.14 30.65 30.71 30.152016 27.16 32.77 27.16 27.28 27.19 30.98 31.03 30.422017 27.23 33.28 27.23 27.28 27.26 31.33 31.39 30.712018 27.29 34.66 27.29 27.28 27.28 33.38 33.23 32.112019 27.30 35.39 27.30 27.28 27.28 33.92 33.80 32.562020 27.30 36.13 27.30 27.29 27.28 34.56 34.39 33.05

32

LINARES. TABLE 3.2

Table 3.2: Emission permit price (€/t)

A B C1 C2 C3 D1 D2 D32005200620072008 6.01 4.50 4.76 4.682009 6.01 4.50 4.76 4.682010 6.01 4.50 4.76 4.682011 6.01 4.50 4.76 4.682012 6.01 4.50 4.76 4.682013 12.77 8.68 8.90 7.492014 12.77 8.68 8.90 7.492015 12.77 8.68 8.90 7.492016 12.77 8.68 8.90 7.492017 12.77 8.68 8.90 7.492018 22.05 18.28 18.02 14.712019 22.05 18.28 18.02 14.712020 22.05 18.28 18.02 14.71

33

LINARES. TABLE 3.3

Table 3.3: Green certificate prices (€/MWh)

A B C1 C2 C3 D1 D2 D32005 28.01 14.98 15.21 14.982006 27.78 14.72 27.78 14.722007 27.32 14.36 27.86 14.362008 26.91 27.25 25.05 24.572009 26.07 26.68 23.86 24.432010 25.79 26.35 24.25 24.282011 25.74 26.31 24.09 24.122012 25.73 26.27 23.90 23.942013 25.72 40.73 40.25 38.122014 25.67 40.73 34.58 37.902015 25.60 40.68 33.91 37.662016 25.53 40.63 21.78 37.402017 25.53 40.56 50.20 37.112018 25.53 40.54 19.58 35.712019 25.53 56.59 19.01 51.312020 25.52 56.59 33.42 50.82

34

LINARES. TABLE 3.4

Table 3.4: CO2 emissions in the electricity sector (Mt)

A B C1 C2 C3 D1 D2 D32005 90.61 89.67 75.11 75.82 80.17 75.11 75.82 80.172006 94.77 92.28 79.93 80.07 83.18 79.93 80.07 83.182007 99.02 94.79 84.18 84.64 85.86 84.15 84.61 85.862008 103.00 80.48 88.15 88.90 88.33 78.70 79.81 81.372009 106.11 81.14 91.25 92.45 90.52 80.47 80.79 81.292010 108.89 80.85 94.03 95.38 92.44 81.85 80.90 80.582011 111.75 81.53 96.89 98.21 94.80 82.00 81.79 81.102012 114.68 82.24 99.82 101.08 97.15 82.82 82.62 81.542013 117.68 79.55 102.82 104.00 99.60 78.62 78.83 80.322014 120.71 81.05 105.86 106.89 102.09 79.78 79.85 80.672015 123.85 81.43 109.00 109.82 104.48 81.01 80.93 81.162016 126.93 82.39 112.07 112.74 106.98 82.72 82.66 81.862017 129.99 83.59 115.14 115.50 109.46 84.81 84.73 82.602018 133.01 80.50 118.15 118.33 111.87 80.60 80.60 80.202019 135.92 80.40 121.06 121.23 114.26 80.26 81.60 81.492020 138.90 81.09 124.04 124.21 116.71 81.38 80.49 81.72

35

LINARES. TABLE 3.5

Table 3.5: New investments up to 2020 per technology (MW)

A B C1 C2 C3 D1 D2 D3

Gas combined cycles 9988 18967 9988 9215 7310 16256 16028 12723

Supercritical coal 2333 213 266

Energy crops 1021 1021

Agricultural residues 1094 1094 1094 1094 1094 1094 1094

Forest residues 225 225

Wind-good 2206 2206 2206 2206 2206 2206 2206

Wind-average 3308 3308 3308 3308 3308 3308

Wind-poor 5513 2315 2315 5513

TOTAL 12321 22267 16808 16088 20676 25179 24950 26089

36

LINARES. TABLE 3.6

Table 3.6: Production costs (M€, net present value 2005-2020)

A B C1 C2 C3 D1 D2 D3

TOTAL 32661 36840 35216 34972 37578 38662 38528 39731

37

LINARES. TABLE 3.7

Table 3.7: Consumer costs (M€, net present value 2005-2020)

A B C1 C2 C3 D1 D2 D3

TOTAL 66462 74258 71007 70162 72783 77039 76380 76838

38

FIGURES

Renewable producers

ConsumersElectricitymarket

Renewablemarket

Other sectors

Emissionsmarket

Traditional producers

Figure 2.1. Relationships between carbon emissions trading, renewable promotion

and the electricity market

cost/price

energy

Demand

Carbon tax

Supply curve (1)

Supply curve (2)

pe

p’e

Figure 2.2. Impact of carbon reduction policies on electricity prices

39

cost

energy

QR

supply curve w/o CO2

supply curve with CO2

Qtrad QT

coal

combined cycles

A’

A

B

B’

Figure 2.3. Impact on the costs and benefits of renewable promotion of a price for

Reduction quota

Renewables

RMCRMC’

Pp’

Pp

Figure 2.4. Impact of the promotion of renewables on the price of the carbon

emission permit

40

Pcertificate

Ppermit

Renewable quota

Figure 2.5. Impact of the promotion of renewables on the emission permit price and

on the green certificate price

pe

pe

pre

pCO2

pre

pe

pre

pCO2 Δ RE.Δ Red. CO2 pCO2

pCO2

Figure 2.6. Impact of the promotion of renewables and carbon reduction from the

renewable producer’s point of view

41

Δ Renewablequota

? Consumercost

? Electricityprice

? Greencertificate

price

? Emissionpermitprice

ΔCO2

reduction

Δ

Δ

Figure 2.7. Combined effect of the promotion of renewables and carbon reduction