Elsevier

Resource and Energy Economics

Volume 51, February 2018, Pages 84-98
Resource and Energy Economics

Strategic technology policy as a supplement to renewable energy standards

https://doi.org/10.1016/j.reseneeco.2017.05.006Get rights and content

Abstract

In many regions, renewable energy targets are a primary decarbonization policy. Most of the same jurisdictions also subsidize the manufacturing and/or deployment of renewable energy technologies, some being sufficiently aggressive as to engender WTO disputes. We consider a downstream energy-using product produced competitively but not traded across regions, such as electricity or transportation. A renewable energy technology is available, provided by a limited set of upstream suppliers who exercise market power. With multiple market failures (emissions externality and imperfect competition), renewable market share mandates as the binding climate policy, and international trade in equipment, the stage is set to examine rationales for green industrial policy. Subsidies may be provided downstream to energy suppliers and/or upstream to technology suppliers; each has tradeoffs. Subsidies can offset underprovision of the renewable alternative by the upstream suppliers, but they allow dirty generation to expand as the portfolio standard becomes less costly to fulfill. Downstream subsidies raise all upstream profits and crowd out foreign emissions. Upstream subsidies increase domestic upstream market share but expand emissions globally. In our two-region model, strategic subsidies chosen noncooperatively can be optimal from a global perspective, if both regions value emissions at the global cost of carbon. But if the regions sufficiently undervalue global emissions, restricting the use of upstream subsidies can enhance welfare.

Introduction

Policymakers around the world are concerned about the problem of global climate change. Yet, while carbon pricing is considered the most cost-effective way to reduce carbon emissions, most if not all governments are hesitant to impose it in any form strict enough to produce the needed reductions. Rather, a variety of alternative instruments are introduced, including renewable energy targets, subsidies to CO2-free energy, efficiency standards, etc.

Examples of such policies are plentiful. In the United States (US), where the prospects for national CO2 pricing are weak, clean technology standards dominate the policy space. Fuel efficiency standards and biofuels requirements are imposed nationally for the transport sector. In the electricity sector, a large majority of states have imposed RPS (Palmer et al., 2011), and clean energy standards also form the backbone of the Obama administration's Clean Power Plan.1 In the European Union (EU), although a cap-and-trade system is in place (EU ETS), member countries have also jointly agreed upon ambitious renewable energy targets, both in total consumption and in the transport sector, as well as upon energy efficiency targets. The Renewable Energy Directive (2009/28/EC) in particular is being credited with driving the transformation of the electricity sector, while the price of CO2 in the ETS remains low, due in part to supplementary goals and instruments (OECD, 2011, Boehringer and Rosendahl, 2010). Lastly, China's Five Year Plan for 2011–2015 includes targets for the share of non-fossil fuels in primary energy consumption, in addition to targets regarding the energy intensity and emissions intensity of the economy (Birol and Olerjarnik, 2012).

Renewable energy targets can be achieved through market-based mechanisms such as blending mandates for biofuels and green certificates for renewable energy, known more generally as renewable portfolio standards (RPS). Note that introducing such targets does not imply any direct payments from the government to the renewable energy suppliers; indeed, this revenue neutrality may play an important role in their political acceptability. At the same time, most governments also provide direct subsidies to renewable energy, both in the forms of additional adoption incentives and manufacturing and innovation incentives. However, such subsidies are beginning to raise suspicions within the framework of the World Trade Organization (WTO) rules, which place restrictions on industrial policies that distort trade. In two cases regarding Ontario and India,2 the dispute settlement bodies ruled that domestic content requirements (DCRs) incorporated into a feed-in-tariff or preferential purchasing policy for renewable energy are prima facie violations of WTO rules. In the Ontario case, however, the rulings also considered (but did not resolve) whether the feed-in-tariff itself was a subsidy under WTO law, leaving substantial ambiguity about the leeway for governments to offer preferential treatment for certain technologies (Fischer and Charnovitz, 2015). In another set of cases, the EU and US have brought anti-dumping and anti-subsidy complaints against China, charging that large Chinese subsidies in the form of cheap loans, land, and capital to photovoltaic producers constitute illegal aid. According to the WTO, supporting the deployment and diffusion of green technologies is not hindered by WTO rules (World Trade Organization, 2011), but nonetheless concerns are growing about the need to properly define the appropriate parameters for green industrial policy.

In this paper, we examine the rationale for such supplementary subsidy policies when countries have already set in place renewable energy targets. By requiring that a certain share of energy be generated from renewable sources, renewable portfolio standards encourage deployment and create new profit opportunities for firms that supply renewable energy capital. They also reduce emissions to the extent they displace dirty energy sources. To what extent, then, do supplementary policies further contribute to these goals? In the EU and elsewhere, renewable support policies also reflect the belief that high environmental standards stimulate innovation and business opportunities, including for exports (European Union Environmental Policy Statement, 2006). With imperfect competition among technology suppliers, supplementary technology policy could be used strategically to achieve such goals. To our knowledge, our paper is the first to analyze the case for green industrial policy in this context.

Moreover, it may matter for industrial policy whether subsidies are provided downstream or upstream, i.e., to suppliers of electricity or transport fuels, or upstream, i.e., to suppliers of capital to produce renewable electricity or fuel. This is related to the demand pull versus technology push issue discussed with respect to innovation (see e.g. Nemet, 2009, Taylor, 2008).3 Our focus, however, is on industrial policy and CO2 emissions, and thus we disregard innovation externalities as well as other possible reasons to implement subsidies such as energy security (see e.g. Brown and Huntington, 2010).

We approach these questions with analytical methods. In our theoretical analysis, we assume a closed and competitive downstream market in each country, which is reasonable for thinking of either the electricity or the transport sector in large countries or jurisdictions (EU, US, China, etc.). On the other hand, we assume that upstream producers of technology equipment can both sell domestically and export to foreign regions. Furthermore, as the number of upstream suppliers is fairly small for most energy technologies, partly due to patent restrictions, the typical upstream market can hardly be considered competitive.4 In line with previous studies (Greaker and Rosendahl, 2008, Fischer et al., 2017, David and Sinclair-Desgagn, 2005, Pillai and McLaughlin, 2011), we assume Cournot competition between the upstream suppliers, with a uniform global price of technology equipment.

First, we find that a potential rationale for additional subsidies does exist. The rationale is partly due to imperfect competition among technology suppliers, which leads to underprovision if not corrected, and partly due to strategic interests in shifting the profit opportunities created by the renewable energy standards to national firms. Note that the renewable energy standard in itself implies a negative strategic effect, as it spurs foreign firms’ supply of renewable energy capital. From a national strategic perspective, optimal subsidies then involve taxes downstream and positive subsidies upstream. Positive subsidies upstream provide the national upstream industry with an advantage, and addresses the market power issue. A downstream subsidy, on the other hand, reinforces the negative strategic effect from the renewable standard, and the government might want to tax the use of equipment.

Note that subsidizing renewable energy technology equipment will make the renewable portfolio standard easier to meet, and reducing this burden allows total energy production—and emissions—to increase. If the shadow costs of emissions are sufficiently high, the emission effect dominates the profit-shifting effect and the market power issue, implying that the upstream supply of renewable capital should also be taxed.

Second, we compare globally optimal policies to national strategic policies. From a global perspective, it does not matter whether subsidies are introduced upstream or downstream. However, we show that the noncooperative Nash equilibrium between two regions can in fact lead to an optimal set of subsidies, provided that the individual countries each value the global consequences of their domestic emissions by the global social cost. Although each region wants to favor their own producers, each region also wants their downstream technology consumers to face efficient prices, and the combination of instruments results in a globally efficient outcome.

In this case, restricting the use of upstream subsidies can decrease global welfare. With only downstream subsidies (or taxes) available, strategic regions will undercorrect for market failures. However, if regions undervalue the transboundary effects of their pollution, they will oversubsidize the renewable energy technology, leading to excessive emissions. In this case, restricting the use of upstream subsidies may improve welfare and emissions outcomes. This possibility arises because the renewable energy target causes supplementary subsidies to lead to higher emissions.

To our knowledge, the issue of strategic subsidies to renewable energy together with renewable energy standards in the electricity sector has not been analyzed before. Overlapping renewable energy policies have been studied in a single-region context (see, e.g., Fischer and Newell, 2008, Fischer and Preonas, 2010, Boehringer and Rosendahl, 2010), and several contributions study subsidies together with blending mandates for biofuels (see e.g. De Gorter and Just, 2010). None of these contributions find positive welfare effects of subsidies; however, as they all assume perfect competition upstream and/or a single region, strategic aspects are absent. Brander and Krugman (1983) introduce oligopolistic firms in an international trade model, showing that the outcome will be “reciprocal dumping” of output in the other market, while Brander and Spencer (1985) consider strategic export subsidies in a similar setting, where countries find it optimal to subsidize exports in order to shift profit towards the domestic firm. Strategic use of abatement technology policy has previously been analyzed in Brander and Spencer (1985), Buchholz and Konrad (1994), Golombek and Hoel (2004) and Stranlund (1996). However, these papers do not model the market for abatement technology explicitly, which becomes important for our conclusions, and which allows us to study industrial policy. While Greaker and Rosendahl (2008) and Fischer et al. (2017) do make this distinction, they consider different kinds of abatement technologies and environmental policies, leading to contrasting results, particularly with respect to the emissions consequences of overlapping policies. In fact, the issue that a binding renewable energy target also implies a binding nonrenewable energy share drives significant aspects of our results and highlights the importance of considering the policy context in evaluating supplemental and strategic policies.

In the next section we describe our analytical model, and derive some results with respect to market effects of renewable energy technology subsidies. Then, in Section 3 we analyze optimal subsidy policies, both from a global and national perspective. Section 4 concludes.

Section snippets

The model

The structure of the model is depicted in Fig. 1 and is as follows: The world is divided into two regions, one domestic region (Region 1) and one foreign region (Region 2). Each region features a closed, downstream market for an energy product, which we can think of as, e.g., the electricity market.5 Both downstream markets consist of firms located and owned in the corresponding regions, and competition is perfect.

Optimal and strategic environmental technology policies

We now consider optimal technology policies, first from a global perspective and then from a domestic perspective in Region 1. As before, we assume that each region has committed to a fixed renewable standard ri for its downstream sector.

Total surplus in Region i then equalsTSi=ε(qi)22Consumersurplus+(Mεqi)qi(1ri)2(qi)22(wηi)riqiDownstreamprofits+(wρ+γi)yiUpstreamprofits(ηiriqi+γiyi)Subsidycosts=Mqiρyi+w(yiriqi)Ri(qi)22

Total damages in Region i equalTDi=(τi(1-ri)qi)Domestic

Discussion

Our analysis has demonstrated that the effects of subsidizing renewable energy technology depend critically on the larger policy context for the markets in which they operate. Specifically, the downstream context determines the relationship between changes in technology prices and emissions outcomes. In our case for analysis, when binding renewable energy targets are in place, supplemental policies that lower renewable technology prices make those targets easier to meet, and as a consequence

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    We would like to thank the Norwegian Research Council's RENERGI program and the Mistra Foundation's ENTWINED program for financial support. Fischer would like to acknowledge the European Community's Marie Curie International Incoming Fellowship, ‘STRATECHPOL – Strategic Clean Technology Policies for Climate Change’, financed under the EC Grant Agreement PIIF-GA-2013-623783, and the hospitality of the Fondazione Eni Enrico Mattei (FEEM). While carrying out this research, Greaker and Rosendahl have been associated with CREE – Oslo Centre for Research on Environmentally friendly Energy. The CREE centre acknowledges financial support from the Research Council of Norway.

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