Environmental Engineering Reference
In-Depth Information
4 Climate Policy Instruments: A Simple Model
We develop a simple theoretical stylized model to analyse the interaction between
the different policies in the power sector and the implications for policy design. We
focus on the electricity sector that amounts for close to 40 % of the emissions of the
economy and where emissions reduction policies and renewables polices concur.
The model is deliberately kept simple to identify the key features of the arguments
(a more comprehensive stylized model can be found in [
11
,
12
].
4.1 Supply and Demand
Assume there is a monopolist that produces electricity using two technologies: a
fossil-fuelled technology and a renewable technology.
The cost of producing q
1
units with the fossil-fuelled technology is
c
1
(
q
1
). The
conventional technology emits
e
1
=
f
(
q
1
) carbon units when producing
q
1
, where
f
′
(
q
1
)>0.
The cost of producing
q
2
units with the renewable technology is
c
2
(q
2
)
, where
c
′
2
(q)
>
c
′
1
(q)
for all
q
,
13
the associated emissions
e
2
are zero.
Assume the inverse demand for electricity is P(Q) where Q is the quantity
demanded and P is the price for electricity. Renewable energy and fossil-fuelled
generation are assumed to be perfect substitutes.
4.2 Policies
We initially consider two policies: a renewables subsidy and a carbon market. The
renewables policy consists of a subsidy
r
per unit of electricity produced from
renewable sources up to a target
R
. The carbon market consists of a cap
E
on the
total carbon emissions of the economy and tradable certi
cates which are priced
according to supply and demand. Carbon emissions of the rest of the economy are a
function of the carbon price,
p
e
, and are determined by the equation
eðp
e
Þ¼H hp
e
13
Strict marginal cost of renewables is close to zero. However, since renewable generation plants
are of a smaller scale, the cost of increasing fossil-fuelled capacity at a given point in time will be
lower than the cost of increasing renewable capacity. To simplify, we embed marginal capacity
costs into the renewable energy cost function such that marginal costs include not only operational
costs but also the investment costs to increase capacity.
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