Classic diagram showing interdependency of policy instruments with

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					  Tradable Green certificates in combination with investment subsidies:
                          what does it change?
                                        Anna Krook, Selim Nouri
                              Göteborg School of Business, Economics and Law
                  Department of Energy and Environment, Chalmers University of Technology
                                             Göteborg Sweden.

                                                April, the 26th 2005


Abstract
Recently Tradable Green Certificates (TGCs) with quota targets have been deeply debated within the E.U
energy/environment strategy to increase the renewable energy sources electricity (RES-E) production. Like
many other policy instruments designed to help the RES-E to penetrate the market, TGC scheme has some
advantages and disadvantages. One of its weaknesses is that low cost RES-E technologies might push out of the
market more costly and more promising options. The combination of investments subsidies with TGC support
scheme could be a simple and effective solution to this problem. A short analysis of this combination and of
what could be the implications – good or bad – will be presented in this paper under the form of a pros & cons
matrix with following comments and discussion.

Keywords: Renewable electricity; Policy support schemes; Tradable Green Certificates




1 Introduction
One of the main goals within the environmental policy for the European Union is to increase the share of
renewable energy sources for electricity generation (RES-E) in the electricity grid. Primary driver for promoting
RES-E are climate change mitigation and lowering the local environmental pollutions, hence lower the negative
environmental externalities from energy consumption. In addition RES-E is believed to have some positive
externalities like increasing employment level, security of supply, technology development.

Externalities are external effects that cause costs/gains for a third party. Fuel cycle externalities are the costs
imposed on the society and the environment that are not accounted for by the producers and consumers of
electricity. The external costs are thus not included in the market price and constitute by definition a market
failure. By implementing a policy instrument, the intersection between supply and demand can be moved from
the ―market optimum‖ to the ―true optimum‖. A first-best instrument can generally be found, but due to political
consideration, distributional concern, lobbying, market structure, asymmetric information, etc.., the true, or first-
best optimum, is impossible to reach. A second-best policy instrument needs to be found. Notice that the first-
best instrument can also be the second-best instrument in order to reach the second-best optimum. Neither
theoretical nor practical instruments can be found that is the one and only to internalize the externalities, they all
have weaknesses and strengths.

At present there are several investigations in order to find the best policy instruments to reach the target.
Examples on investigations are studies by Sawin et al 2004, Schaeffer et al 1999 and Huber et al 2004. One
technical hitch when designing policy instrument to encourage new RES-E to enter the market is that RES-E is
not a homogenous group of technologies. Depending on how mature the technology they need different kinds of



                                                                                                            p.1(13)
support and depending on the relation between investments cost and running costs they are favoured from
different kinds of policy instrument. Most electricity from renewable energy sources, are characterised by high
investments cost and low running costs. The marginal costs of existing plants are normally lower than spot
market price. This in combination with weather-conditions depending output (wind, solar radiation, and
precipitation) result in an inelastic RES-E production to price. The exception is bio-energy based electricity
production. They are normally co-generation plants which at lower/normal price levels are mainly driven by heat
demand, but above a certain level the price of electricity can drive the production (require presence of
accumulator tank or similar). Some plants can substitute between bio-energy and fossil fuel depending on which
is more profitable.

In this paper we will examine tradable green certificates, in order to increase the share of electricity production
from renewable energy sources in Europe. First we analyse the pros and cons of TGCs. Thereafter we suggest a
policy instrument that can be combined with TGCs in order to reduce the market failure that still occur after
introducing TGCs. Finally, conclusions from the analysis, with personal reflection of preferable policy mix for
increasing RES-E will be presented.



2 Description of the TGC market
Before exploring the pros and cons of TGCs, we will have a short introduction to the TGC system. Under a TGC
system, RES-E is sold on as conventional electricity at market prices. The additional cost for generating RES-E
is covered by the sale of green certificates. This create a complete new market for green electricity (see Figure
1), a market for green certificates that is separated from the electricity market. Those certificates are bought by
electricity suppliers at a price that depends on a quota – targeted quantity - of green electricity (see Figure 2).
Without TGC system, RES-E would be produced to point A. Q is the quota (or target quantity of RES-E and PE
the price of conventional electricity. PC is the price of green certificates and is the difference between marginal
cost mc* at quantity Q and PE.




           Figure 1: The tradable green certificate market, from Lovinfossse and Varone (2002).




                                                                                                          p.2(13)
                      Figure 2: Tradable green certificate – Cost, Price and Quantity.




3 Analysis of Pros and Cons with TGCs
In the design of a policy instrument one have to consider not only the target but also the elements that are in
favor or not of the policy: elements, which might work in opposite direction and hinder the policy goal. An
illustration of important factors when designing policy instrument can be seen in Figure 3. The TGC system will
be analyzed regarding the elements we think are of main importance:
     - The economic efficiency
     - The environmental efficiency
     - The technology: technological development, grid capacity…
     - The geographic condition: rainfall amount, wind, nuclear industry…
     - The cognitive efficiency: public acceptance, compatibility with dominant believes…




                                                Environment


                                                                              Technology
                       Economics
                                                   Policy Inst.



                                                                   Cognitive
                                 Geography                        environment




   Figure 3: Classic diagram showing interdependency of policy instruments with societal parameters,
                                 inspired of Reiche and Bechberger (2004).


                                                                                                       p.3(13)
The pros and cons regarding important elements interacting with the outcome of implementing TGCs, are
presented in Table 1. In the analysis we have looked at the Swedish market under TGC scheme as a starting
point for our discussion, but we have also considered a possible European market (assuming the goal is to
increase RES-E in order to reduce CO2-emissions).


Table 1. Pros and cons regarding important elements interacting with the outcome of the
implemented policy instrument.
      Factor                            Pros                                        Cons
    Economic               A cost efficient instrument to             Uncertainty for the investors due
    efficiency              increase RES-E (1).                         to: a) Legislative dependent
                           Lower cost for the collectivity and         market; b) No premium price set
                            stronger equity within the society.         for green electricity so no
                           Lead to both static and dynamic             guaranteed income for the
                            economic efficiency (2)                     investors; c)Uncertainty in the long
                           Flexibility for the operator to reach       term.
                            the quotas                                 Price fluctuation, instability and
                           Creates indirect tax on fossil              gaming (3)
                            energy. (10)                               Concentrate development in best-
                           Divide the group of producers. (9).         resources areas
                                                                       High indirect administrative and
                                                                        institutional cost
                                                                       More effective if implemented at a
                                                                        large level (E.U for instance) (4)
                                                                       Increased electricity price for the
                                                                        consumers
 Environmental             TGC could be the best a posteriori         TGC not the best a priori (other
   efficiency               if well regulated.                          technologies might meet the CO2-
                           Guaranteed quota of green                   target in a more cost efficiency
                            electricity                                 way)
                                                                       Need to be linked with an adjusted
                                                                        penalty, see (5) and Cognitive
                                                                        perspective.

   Technology              Does not exclude any technology,           TGC threatens the emergence of
   perspective              but opens up for a broad rang of            innovative technologies and the
                            technologies and fuels (cf. ethanol         diversity of supply
                            in Brazil).                                Creates cycles of stop-and-go
                           International TGC: Concentrate              development, (ex collapse of
                            development in best-resources               Swedish wind-power industry).
                            areas. (11)

   Geographic              Has to be implemented in a larger          Risk of industrial development
   perspective              level in order to be efficient (4).         concentrated geographically (6)
    Cognitive              More consistency compared with             Relatively new type of policy,
   perspective              many other policy instruments.(7)           actors are not familiar with the
                           Perceived as being compatible with          concept.
                            open markets (E.U deregulation             No acceptance for a quota system
                            perspective). (8)                           without roof, but the roof weakens
                                                                        the policy instrument.




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Comments to the benefits and limitations of TGCs

(1) Pros: A cost efficient instruments to increase RES-E
Simulations from the model used in the Green-x report (Hubert, 2004) shows that TGC system is cost efficient; it
leads to minimization of RES-E system cost (cf. Figure 4)




Figure 4: Resulting impact on the dynamic development of generation costs of new RES-E capacities (Huber, 2004)


(2) Pros: Lead to both static and dynamic economic efficiency
In addition to cost efficiency, TGC system allows a more static and dynamic efficiency due to the fact that
pressure on cost applies both on current electricity producer and on future investments.



(3) Cons: Volatility on the market
Price fluctuation could be considered as an obstacle from an investor point of view. Many theories and ideas
have been developed to reduce this negative impact on TGC, among them: min and max price, banking and
borrowing (cf. Figure 6). It could be argued that a better consistency of TGC system with a long term planning
horizon is the first obstacle for producers to invest in RES-E.

The price of TGCs is likely to have a large price fluctuation. Short-term price fluctuations are mainly due to the
inelasticity of price. Inelasticity to price due to; a big share of the production from RES-E are inelastic to price
and instead driven by the weather or heat demand. The price fluctuation from wind power is described in
Vogstad et el (2003) and illustrated in Figure 6. Jumps in price can be caused by new entrances of capacity (new
investments) that decreases the TGC price. While the price will go up significantly each time the quota level
increases. Price fluctuations create instability in the market and gaming, thus an absence of stability which new
investments depend on. All effects will be greater in smaller markets compared with larger, which rises the
importance’s of a larger markets.




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          Figure 6: Short-term RES-E could be assumed inelastic (from Vogstad et al 2003, fig 12)


In Kåberger et al (2005), the volatility risk of the Swedish market for TGC is measured as the standard deviation
on past returns1. They analysed the prices and returns for the first year and concluded that there are an extreme
volatility in return, partly due to institutional effects and partly due to the fact the instrument is new. We have
compared their result with statistics from 2005. Their result at presented in Table 2 and statistics one month in
2005 are presented in Table 3. Looking at the statistic for last month we can strengthen the last hypothesis, the
volatility in return seems to have decreased. The number of traded permits has also increased from less than 1
billion per month to more than 3 billion. The instrument seems to have past the phase with greatest uncertainty.


Table 2. Descriptive statistics on the transactions basis for GC during the first 11 month in the
Swedish system of TGC (with start in May 2003), Kåberger et al 2005.
                                           No weighted figures                Weighted figures
                    Total GC              Price      Return                Price       Return
        Total       9 005 774
         Min                1                62         -1.0136               95         -0.0321
         Max          220 000               320          1.0658              217          0.5437
      Std dev           8 195                39          0.2352                6          0.0076
     Average            1 649               204         0.00020              208         0.00020




Table 3. Descriptive statistics on the transactions basis for GC during 2005-03-15 to 2005-04-08
(less than one month) in the Swedish system of TGC.
                                     No weighted figures                Weighted figures
                  Total GC*            Price*        Return              Price        Return
 Total             3 546 818
 Min                       1                 95         -0,7444              215         -0,0306
 Max                 131 201                293          0,9309              236          0,0254
 Std dev               7 519                 15          0,0884              3,7          0,0021
 Average               2 912                224        -0.00008              226        -0.00003
* Source: Svk, 2005.



1
 The return for transaction at time t, Rt, is defined as a function of weighted average price at transaction time t
and t-1: Rt  ( LnPt  LnPt 1 ) . Weighted prices are calculated as the average purchasing price of TGC up to
any time t.



                                                                                                            p.6(13)
(4) Cons: More effective if implemented at a large level (E.U for instance)
Implementing a TGC scheme at a national level is already a challenge, and harmonization at an international
level gives additional complexity. A whole international trade should be preferred to a national one. One of the
reason for this lies within the main features of TGC system: the separation of the electricity market from the
certificate market (cf. Figure 8: The tradable green certificate market) facilitate the international trading of RES-
E.

 Moreover, theoretically if harmonisation of TGCs scheme is implemented at an international level like the E.U,
the total cost for reaching the RES-E set target Q will be lowered. Indeed, for instance in the case of 2 countries
A and B, with respectively national MC curves MC A and MCB and national quota target QA and QB (QA = QB to
be more simple), if an international TGC system is implemented, an international TGC price (P*) would result
from the intersection of the aggregated MC curve for both countries MC A+B and the overall target Q = QA+QB.
In a harmonised TGC scheme, it would be interesting for country A to produce RES-E only-up to QA’<QA,
where QA’ is defined by: MCA(QA’) = P*, since it would be cheaper once QA’ reached to buy TGCs within an
amount of |QA’-QA|, to reach the target QA. By doing this country A would save area 1 (cf. Fig 7.b) compared to
a continuation of national policy to reach Q A (cf. Fig 7.a). On the contrary due to its large RES-E potential (the
price of TGCs is below P* in country B), B would increase RES-E production up to QB’>QB since the additional
cost of producing this renewable electricity will be more than compensated by the revenues generated from the
selling of certificates to country A at a price P*. This additional revenue is area 2 in Fig 7.b.




                    Fig. 7.a Cost for reaching the target under national policies (Del Rio, 2005).




                      Fig 7.b Harmonisation combined with an aggregate TGC scheme.
                          Total marginal cost curve and TGC price (Del Rio, 2005)




                                                                                                           p.7(13)
One can conclude that theoretically both countries would take advantage of an international harmonised TGC
support scheme since country A would save cost and country B would obtain additional revenues.

In some particular situations (if the social gain for national trade in country A exceeds the social loses in country
B), national trade is preferable to international trade (see fig.8).




           Figure 8: Comparison of benefits from national and international trading (Haas, 2001)


However the simulations cases run with the ELgreen model (cf. Action plan for a green European market),
results shows that international trade is preferable. Indeed the conditions for RES-E differ widely between
different countries within the European Union, and the larger the difference between the MC curves the larger
the potential cost saving for the high-cost country and the larger the revenues from exports for the low-cost one.
Thus a potential for cost savings when international trading occur is high (Rio 2005).

It is to note that instead of increasing the market geographical one can combine the market for green certificated
from electricity and heat.



(5) Cons: Need to be linked with an adjusted penalty
TGCS allow for a guaranteed amount of electricity demand to be supplied by renewable sources (the quota), but
to be reached, the quota needs to be linked with a penalty which level has to be adjusted regarding the market.
The penalty level defines the maximum price for tradable certificates (see Figure 9).




                                                                                                            p.8(13)
                                      Figure 9: Penalty level (Hjerpe 2002)


Since the penalty level defines the upper boundary level of TGCs, the lowest penalty level should exceed the
marginal generation cost or else it could lead to the collapse of at least part of the market. This is particularly
true in a system with differentiated penalties: in regions with a very low non-compliance penalty there will be
tendency to pay the penalty rather than to buy (the more expensive) certificates. Thus, total demand will not be
sufficient to actually reach the targeted quota-volume, and the instrument will failed to help achieve the set target
level (cf. Figure 10).




Figure 10: Influence of the penalty on the electricity generation: high penalty (left) and low penalty
(right); Source Huber et. al. (2001a)




(6) Cons: Risk of industrial development concentrated geographically
Because of its cost-efficiency criteria, the TGC system could lead to a concentrated development in best
resources regions. This is in contradiction with many benefits associated to RES-E (economic development in
rural areas, reduction of local pollution.). (Sawin, 2004).

(7) Pros: More consistency compared with many other policy instruments
More consistency compared with many other policy instruments. TGC system is complex in design and it is
expensive to build up the administration around the system. There are big initial costs. But once it is there it is
difficult to remove. There is a kind of inertia of the system.

(8) Pros: Perceived as being compatible with open markets
Today tradable certificates are perceived as being with open markets. At present in Europe, the actors on the
markets are in favor of market based instruments. Thereby it easier to implement the policy

(9) Pros: Divide the group of producers
Divide the group of producers. Producers of RES-E will gain from the TGCs, while producers of non RES-E will
loose. The lobbying effect will then be lower in such a system because of the non-unity of producers and there
will be easier political acceptance for raising the quota to a further level.

(10) Pros: Creates indirect tax on fossil energy
Creates an indirect tax on fossil energy. See Fisher and Newell (2004)

(11) Pros: Concentrate development in best-resources areas
Concentrate development in best-resources areas can create technology cluster of firms working with the same
kind of technology, which in turn can give faster technology learning and lower the marginal cost of the
technology.



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4 Disadvantage of TGCs and combination with subsidies
To avoid the main disadvantage of TGCs that they tend to reduce the diversity of RES-E technology by
favouring low-cost (and maybe low-promising) options and thus push out of the market some higher-cost more
promising option, many strategies have been discussed (introduction of technology bands, issuance of
certificates by socio-economic-ecological impact…), each of them having also pros and cons (for instance the
introduction of technology bands would increase the diversity of supply - one thing TGCs lack or even threaten –
as a function of the number of bands but also add complexity to an already very complex and costly system to
implement). Here we will look at the possible combination of TGCs with investment subsidies to specific
investors (i.e. those technologies which are not expected to be ―cost-efficient‖ under TGC alone).

It is to note that some policy instruments seem to fit particularly to some specific technology stage. For instance
on a learning curve scale, R&D subsidies, Investment subsidies and TGC could respectively help a radical
innovation, an emerging system or a new cluster to succeed (cf. fig 11).




Phase:                     ―Incubation‖               Diffusion                   Mature technology
Policy instrument:         R&D-subs                   Investments sub             TGC
Figure 11: Learning curve illustrating the different phases for technology from the incubation phase to
      mature technology. Picture from Sánden, 2004.




The combination of TGCs with investments subsidies has of course some pros and cons, some of them specific
to the very combination of those to policy instruments:

Table 4. Pros and cons regarding important elements interacting with the outcome of the
implemented policy instrument, TGC with targeted investments subsidies.


Key: purple = what the combination of TGCs with investments subsidies adds; grayed = what the combination of
TGCs with investments subsidies could reduce.




                                                                                                        p.10(13)
                                   Pros                                           Cons
   Economic              Cost efficiency                        Price fluctuation, instability and gaming
   efficiency            lead to both static and                In the case of international market and
                          dynamic economic efficiency             national subsidy scheme there are a risk of
                         Lower cost for the                      severe market distortions due to
                          collectivity and stronger               international effect of this combination
                          equity within the society               TGC+subsidies (1)
                         More flexibility for the               Concentrate development in best-resources
                          operator to reach the quotas            areas
                         Increase the market by                 Strong indirect administrative and
                          combining Green certificates            institutional cost
                          for both electricity and heat          Uncertainty for the investors due to: a)
                          market.                                 Legislative dependent market; b) No
                         Creates indirect tax on fossil          premium price set for green electricity so
                          energy                                  no guaranteed income for the investors;
                         Divide the group of                     c)Uncertainty in the long term
                          producers. Producers of                More effective if implemented at a large
                          RES-E will gain, while                  level (E.U for instance)
                          producers of non RES-E will            No expansion of the economic potential for
                          loose.                                  new RES-E production (from the investor’s
                                                                  point of view), due to the pre-defined
                                                                  quota.
                                                                 Increased electricity price for the
                                                                  consumers
Environmental            guaranteed quota of green              TGC not the best a priori (other
  efficiency              electricity                             technologies can meet the CO2-trget in a
                         TGC could be the best a                 more cost efficiency way)
                          posteriori if well regulated           Need to be linked with a regularly adjusted
                                                                  penalty


  Technology             can be used for a broad rang           TGC threatens the emergence of innovative
  perspective             of technologies and fuels (cf.          technologies and the diversity of supply
                          ethanol in Brazil)                     Creates cycles of stop-and-go
                         Targeted subsidies allow the            development, (ex collapse of Swedish
                          emergence of innovations                wind-power industry).
                          under TGCs system
  Geographic             Has to be implemented in a             Risk of industrial development
  perspective             larger level in order to be             concentrated geographically
                          efficient
   Cognitive             Perceived as being                     Contradicts the polluter payer principle
  perspective             compatible with open                    since there is a shift of the financial burden
                          markets (E.U deregulation               from the electricity consumers to the
                          perspective)                            taxpayers
                         A lower price on RES-E, due
                          to subsidy will increase the
                          acceptance to raise the quota
                          level

Key: purple = what the combination of TGCs with investments subsidies adds; grayed = what the combination of
TGCs with investments subsidies could reduce.




                                                                                                     p.11(13)
 With an international TGC system, a careful design of investments subsidy has to be done. Indeed, the
following figure 12, shows the interaction between an International TGC system (between countries A and B)
with an investment subsidy in country A:




Figure 12: International effect of TGCs and investment subsidies in one of the countries, from


It is assumed (for simplification) that both countries A and B are at the same equilibrium price ―mc‖ before the
implementation of TGCs combined with subsidies. The subsidy in country A leads to a reduction for the
marginal cost curve of country A but also for the sum A + B. The new equilibrium price for RES-E ―mc’‖ for
both countries A is found from the intersection between the new shifted MC curve of the sum A+B and the
quotas QA + QB.
This has for consequence to increase the RES-E generation in country A to GA’ and to reduce the RES-E
generation in country B to G B’. Thus a trading of certificates from country A to B is likely to appear due to
investments subsidy in country A. Moreover the tax payer of country A is subsidising not only the certificates
price in country A, but in all the countries involved in the international TGC scheme. In this example, the
subsidy in favour of consumers B is proportional to the hatched area.
This shows that investment subsidies under international TGCs should be handle carefully (targeted subsidies,
low volume compared to TGCs market) to avoid these market distortions.




5 Conclusions and discussion
The main conclusion is that TGC system like many policy instruments has pros and cons like any other policy
instruments used to promote RES-E. What is clear, however, is that it ensures competition among generators and
that if largely applied (at a European level for instance) could lead to a fair burden sharing for the consumer.
The fact that TGC system is cost efficiency based can be considered as an advantage and a disadvantage in itself
thus leading to additional support for less cost efficient instrument - like investment subsidies - in combination
with TGCs.
Targeted investment subsidies are of great interest since they can reduce the inherent threat to emerging
innovative technology and diversity of supply that TGCs represents, especially in a small market/country.
Indeed, the effects from targeting investments subsidies will differ depending on the geographic area for TGC!
In a small market, like Sweden, under TGCs, only the technology on the marginal will be developed further at
the absence of subsidies. Immature technologies will not get any support under the TGC and will not be able to
develop. However with a larger TGC market, for instance Europe, the technology diversity will occur even
without subsidies, due to different conditions (wind, solar, tidal, bio) which make the price of the same
technology to differ depending on where it is located.
Thus the two options of combining targeted investment subsidies with TGCs and harmonise the TGC scheme for
RES-E to a bigger market like the EU should be carefully examined and/or maybe combined. Again one of the
most important issues lies within the question economist/politicians want to answer more than in the answers
some complex scientific models can give. If the question to be answered is: ―what kind of policy instrument can
certainly allow a penetration of RES-E with a given percentage of green electricity in the grid - or quota -
without compromising too much the diversity of supply for innovative RES-E technologies?‖ then a combination
of international TGCs combined with targeted investments subsidies, seems promising.




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