Economic Efficiency of Renewable Portfolio Standards in the Presence of Cap-and-Trade

1. Economic Efficiency of Renewable Portfolio Standards in the Presence of Cap-and-Trade Kenneth Gillingham Yale School of Forestry & Environmental Studies Arthur van Benthem Stanford University

2. Motivation • Throughout the world, there has been a push for a cap-and-trade (CAT) system on carbon emissions at the same time as a renewable portfolio standard (RPS) • Recent US Senate and House climate bill proposals • Current EU climate policy (binding cap; voluntary RPS) Question: Why would we ever want an RPS if we already have a CAT?

3. Specific Questions • What would we have to believe for an RPS to be economic-efficiency improving if we already have CAT? • What market failures would need to be present? • How important would we have to believe those market failures are? • Does the RPS in current/proposed U.S. climate policy improve economic efficiency? • What is the loss in economic efficiency from not adopting a first-best policy?

4. Outline of Research Project • Theoretical Model • Modeling market failures • Simulation Model • Partial-equilibrium model calibrated to the U.S. economy • Market failures made more explicit than in previous work

5. Proposed ACES in the U.S.

6. Many state-level RPS policies already • An RPS was proposed in concert with ACES • Already numerous state-level RPS policies Source: US DOE EERE (2011)

7. Market Failures • Three Market Failures • Externality from carbon dioxide (and other) emissions • R&D spillovers • Learning-by-doing (LBD) spillovers • Starting point intuition: • If we only have an environmental externality and we internalize it, RPS must be efficiency-reducing • But RPS may help address R&D and LBD spillovers…

8. R&D Market Failure Intuition • Two period model • Cost functions • Profits • Competitive equilibrium vs. social optimum

9. R&D Market Failure Intuition • Competitive equilibrium underprovides R&D investment • Degree of appropriability is given by • By symmetry, r0i=R0,-i/(N-1), and we can specify • aR is fraction of R&D investment that is appropriable • This enables representative firm approach versus

10. Learning-by-doing Market Failure

11. Partial-Equilibrium Model • Simple partial equilibrium model • Two sectors: electricity (E) and industry (I) • Electricity can be renewable (R) or fossil (F) • Quantities qF, qR and qI • Carbon intensities bF, bI (bR = 0) • Marginal environmental damage t • Cost functions Ci(qi) (i = R,F,I) • Demand pE(qF+qR) and pI(qI) • For simplicity, assume:

12. Modeling Cap-and-trade and RPS • Cap-and-trade – emissions must be less than • RPS – fraction of electricity generation by fossil fuels must be less than

13. Social Planner vs Decentralized • More general social planner’s problem: • Compare to the representative agent problem with a cap-and-trade and an RPS:

14. RPS helps to address innovation market failures – but imperfectly • Let’s compare the first order conditions of the two problems: R&D overinvestment R&D underinvestment

15. Several Propositions If no innovation market failures exist: • Adding a binding RPS to an existing cap reduces the optimal permit price With both environmental and innovation market failures: • In the absence of R&D subsidies, the permit price should be set higher than the marginal damages • In the absence of a CAT, a small binding RPS will always be economic efficiency-improving • With a CAT, a small binding RPS will always be economic-efficiency improving

16. What Does this Mean for Policy? • This is where the simulation model comes in… • We parameterize and calibrate the model to the US economy *PRELIMINARY FINDINGS* • Under our base case set of assumptions: • We find that it is going to be very difficult to justify any large-scale RPS policy • Without a CAT, it appears that the socially optimal RPS policy may not be too far from some of the state-level policies

17. Acknowledgments • We would like to thank Larry Goulder of Stanford University for his thoughtful comments about this project