To tackle climate change, many governments have implemented large-scale subsidy schemes to encourage investments in renewable energy technologies. Understanding how these subsidies affect producers’ pricing incentives in the electricity market is key to evaluating the full costs and benefits of such policies.
In recent research, Kajsa Ganhammar explores this issue by focusing on a common policy tool: quota-based green certificate schemes. These schemes – used in countries like Sweden, Norway, and a majority of U.S. states – work by awarding certificates to producers of electricity from renewable sources (“green electricity”) in proportion to their generation. These certificates can then be sold in a specific market, where electricity providers are legally required to purchase a certain number of them. In a perfectly competitive market, green certificates should therefore put downward pressure on electricity prices as they reduce the net cost of producing green electricity (i.e., the cost of producing one unit of electricity after accounting for the extra income from certificate sales). However, Ganhammar’s research suggests that this effect is weakened, at least in the short term, when there are large, dominant producers who can strategically bid above their cost in the electricity market auctions that set prices.
The study uses a simplified model of a market with two producers, both with enough capacity to meet the entire demand. One producer generates green electricity and earns income from certificates, while the other, a conventional producer, does not. Based on this setup, numerical calculations show that if the green and conventional producers have the same expected costs of producing electricity, the green producer only passes on about 57% of the cost savings from the certificate income through lower bids – the rest becomes added profit. This is bad news for consumers, who end up paying more than they otherwise would when producers are able to take advantage of the subsidy to bid higher for a given net cost. Meanwhile, the study shows that this negative effect can be mitigated if the green producer has a higher expected cost than the conventional producer. In this case, green certificates can help improve competition and efficiency in the electricity market, which implies lower prices and overall costs of producing electricity.
As in this model, real-world electricity markets are not perfectly competitive. A few large producers typically have a considerable market share and the ability to strategically influence prices (Tanaka and Chen, 2013; Wilson, 2002). The findings of this study suggest that regulators should be concerned if such dominant producers are entitled to green certificates, especially when they compete against technologies with a similar cost range. This could be the case in markets that already have a considerable share of non-subsidised mature renewables with low variable costs (e.g., in markets with a lot of hydropower), or if the cost of biofuels should fall to a similar range as fossil fuels or vice versa.
Most previous theoretical research on the effect of green certificate schemes on electricity market outcomes assumes perfect competition. Some studies allow for strategic behaviour, but within frameworks that do not fully mirror how electricity markets are organised. The main contribution of this study is therefore that it relies on an auction model, which more closely resembles the actual organisation of electricity markets, and accounts for the fact that producers often do not have perfect information about their competitors’ production costs. However, this approach adds complexity, which comes at the cost of requiring some other simplifying assumptions. More research is therefore needed to fully understand how these policies affect electricity market outcomes and hence their overall costs and benefits.
References
Tanaka, M. and Chen, Y. (2013). Market Power in Renewable Portfolio Standards. Energy Economics, 39: 187–196.
Wilson, R. (2002). Architecture of Power Markets. Econometrica, 70(4): 1299–1340.
