Renewable Electricity Policy and Market Integration.

• Author: Tangeras, Thomas P.

1. INTRODUCTION

   A cornerstone of energy policy in the European Union (EU) is to create a well-functioning European internal market for electricity. Another fundamental objective is to transform the EU into an economy based upon a reliable and environmentally sustainable supply of energy.

   To facilitate the transformation into a greener economy, the EU has imposed national targets for the renewable share of energy consumption, but delegates to the individual member states how to fulfil them (Directive 2009/28/EC). Electricity makes up a significant share of final energy consumption; the EU average is roughly 20 per cent. (1) To achieve the renewable targets, many EU member states have thus implemented policies to promote the production of electricity from renewable energy sources, RES-E.

   RES-E support mechanisms are now main drivers of investments in new generation capacity in many countries and thereby exercise a substantial influence over electricity wholesale prices. These price changes affect not only generation investment and consumption, but also transmission investment. Buying electricity in one country and selling it at a higher price in another allows network owners to earn a congestion rent. Support policies affect the profitability of expanding transmission capacity through the effect on electricity prices and the congestion rent. The capacity of cross-border transmission lines in turn determines the degree of market integration by limiting the volume of electricity trade between countries. Market integration, as measured by the volume of trade, and RES-E support mechanisms are therefore linked through the electricity market. (2) The questions of how RES-E policies affect market integration and what are the outcomes of decentralized policy making have largely remained unexplored. The research on RES-E mechanisms mostly neglects transmission constraints and treats policy as given (e.g. Jensen and Skytte, 2002; Fischer and Newell, 2008; Bohringer and Rosendahl, 2010; Fischer, 2010; Fischer and Preonas, 2010), even the analyses of multinational markets (e.g. Amundsen and Mortensen, 2001; Morthorst, 2003; del Rio, 2005; Unger and Ahlgren, 2005; Soderholm, 2008; Amundsen and Bergman, 2012). (3) Here, I develop a theoretical model of a multinational electricity market with transmission investment to analyze the effect of RES-E policies on market integration and national policy makers' incentives for implementing such policies. (4)

   A key result is that the twin goals of increased RES-E production and market integration may oppose one another when implementation is decentralized to the individual member states. Policy makers in an electricity importing country, concerned with the maximization of domestic surplus, have an incentive to implement support mechanisms such as certificates and feed-in-tariffs which reduce the import price of electricity to the benefit of domestic consumers. In an electricity exporting country, production taxes on non-renewable electricity increase the export price of electricity to the benefit of domestic producers. These national policies drive down cross-border price differences with negative consequences for congestion rent, transmission investment and market integration. (5)

   Terms-of-trade effects alone are sufficient to induce policy makers to unilaterally implement RES-E policies. Ulterior motives such as trade policy can thus explain why countries, or groups of countries in a global context, would find it beneficial to implement renewable policies even in cases when these policies do not correct any obvious externality. (6) Naturally, environmental or other externalities to renewable electricity sometimes justify RES-E mechanisms. (7) Still, decentralized RES-E policies reduce overall welfare by distorting consumption, production and transmission investment. (8) An apparent solution would be to correct distortions by imposing renewable targets on the individual member countries, as is currently done in the EU. However, binding targets are not enough to eliminate trade policy concerns. The electricity importing (exporting) country could still suppress import (inflate export) prices by taxing electricity consumption (non-renewable electricity production) while achieving any RES-E target, for example by means of a feed-in tariff with a cap on total revenue. Binding national targets and ulterior motives can thus explain why countries would apply multiple instruments to achieve what appears to be a single objective, RES-E production in this case.

   RES-E support mechanisms, as pursued by the EU and elsewhere, largely focus on incentives to invest in renewable generation. But decentralized policies distort prices, so that price differences undervalue the marginal social benefit of additional transmission capacity. Hence, centralized subsidies to transmission investment can increase welfare under decentralized policy making. A harmonization of RES-E policies and a reduction in the set of available instruments is another way of increasing market efficiency by limiting the scope for trade policy. One possibility is to follow the example of Norway and Sweden and create an integrated certificate market. Certificate trade improves efficiency by reallocating renewable investment to its most socially beneficial location.

   The remainder of this paper is organized as follows: Section 2 analyses the effects on prices, production, transmission investment and welfare of introducing certificates in a multinational electricity market. Section 3 introduces positive RES-E externalities and considers corrective policies for transmission investment and harmonization. Section 4 studies the properties of an integrated certificate market. Section 5 contains an example of the EU and discusses the robustness of the results. Section 6 concludes the paper. The analysis in the main body of the text rests on an informal graphical exposition of the model. The full model specification and mathematical proofs are relegated to the Appendix.

2. CERTIFICATES IN A MULTINATIONAL ELECTRICITY MARKET

   Certificates, or renewable portfolio standards, are a common policy instrument for promoting electricity generation from renewable energy sources. Retailers are obliged to cover a share of sales by certified renewable electricity production. Certificate supply represents a source of income additional to the revenue producers earn by selling the electricity itself and creates an incentive to invest in renewable electricity production. (9)

   Figure 1 illustrates the effects of introducing a national market for certificates in a two-country model with electricity trade and transmission investment. The right-hand side of the figure depicts country I, which imports electricity from country E on the left-hand side. Production and consumption are on the horizontal axis. The vertical axis returns the wholesale price of electricity. Electricity is competitively supplied in both countries. Let [S.sub.i] = [c'.sub.t] be the supply/marginal cost curve of renewable electricity in country i=I,E, while [Q.sub.i] = [D.sub.i-h'i] is the inverse residual demand for renewable electricity in country i, where total consumption [D.sub.i] is constant, and [h'.sub.t] is the supply/marginal cost curve of non-renewable electricity. Restricting the attention to constant total demand simplifies the graphical exposition without affecting the results in any substantial way. The Appendix presents a formal analysis of the model under the more general assumption of price elastic demand. Gains from trade render export from country E to I profitable, but bottlenecks in cross-border transmission capacity prevent full price equalization. Hence, electricity is more expensive in the import country than the export country even under full utilization of all transmission capacity.

   Assume first that there are no support systems. The producers in the import country supply [s.sub.I] terawatt hours (TWh) renewable electricity at equilibrium price p. Excess demand I - [s.sub.I] for renewable electricity at wholesale pricep is covered by imports [T.sub.I]. Producers in the export country supply [s.sub.E] TWh renewable electricity at equilibrium price r, [T.sub.I] of which is exported, while the remaining [q.sub.E] is domestically consumed. Transmission gives rise to a congestion rent (p-r)TI. The socially optimal transmission capacity is found at the point at which the marginal transmission cost equals the wholesale price difference between the two countries: [c'.sub.T](TI) = p-r. This is also the equilibrium if transmission is competitively supplied. (10)

   Let the import country introduce a certificate system with the purpose of increasing renewable electricity production from [s.sub.I] to [q.sub.I]. The support system for RES-E production depresses the wholesale price of electricity in the import country from p to [p.sub.I] . At the wholesale price p, a certificate price of [a.sub.I] is required to maintain the profitability of the targeted [q.sub.I] RES-E production. The congestion rent falls as the price difference between the two markets falls: [p.sub.I]-rp-r. An increased congestion rent renders transmission investment more profitable, resulting in increased trade between the two countries. Increased imports reduce the electricity wholesale price of electricity in the importing country from p to [p.sub.I].

   Proposition 1 A unilateral introduction of certificates for renewable electricity production (or increase in the quota obligation) in the home country

1. reduces the electricity wholesale price in both countries;

2. reduces the production of non-renewable electricity in both countries;

3. reduces (increases) the transmission capacity and thereby market integration if the home country is importing (exporting) electricity;

4. has ambiguous effects on domestic RES-E production;

5. reduces RES-E production abroad if the foreign country does not have any RES-E...