Interactions Between Climate Policies in the Power Sector - Green Energy and Efficiency: An Economic Perspective - page 276

where H is the level of emissions from the rest of the economy for a emissions price
equal to zero and h re ects how emissions from the rest of the economy react to

changes in the carbon price.
The market clearing price is determined from equalling the demand for certi

-

cates from the power sector, e 1 , and from the rest of the economy, eðp e Þ , to the

emissions cap, E :

e 1 þ eðp e Þ¼E
e 1 þ H hp e ¼ E

Under this setting, the monopolist will maximise its pro ts subject to the policy

incentives and constraints:

Max PðQÞ q 1 þ q 2 ð Þ c 1 ðq 1 Þc 2 ðq 2 Þþrq 2 p e e 1

S t

: e 1 þ H hp e E

:

where r is such that q 2 R .
Rearranging,

Max PðQÞ q 1 þ q 2 ð Þ c 1 ðq 1 Þc 2 ðq 2 Þþrq 2 p e f ðq 1 Þ

S t

: fqðÞþH hp e E

:

4.3 Optimal Policy

The primary reason for the existence of environmental policies is the existence of a
negative externality. In particular climate policies are designed to reduce GHG
emissions that constitute a negative externality. Fossil-fuelled energy producers
emit GHGs. If the cost of such emissions is not internalized, there will be an
excessive production of the externality affecting negatively welfare. Conventional
economic theory teaches us that a tax on the externality (or a subsidy on the
“ ciency. 14

The introduction of a tax on emissions from fossil-fuelled electricity generation
restores ef

avoided ” externality) can restore social ef

ciency. Carbon markets and carbon taxes aim at internalizing the cost of

14 Under the presence of a negative externality from the production of a product, a tax on the
externality or a subsidy for not producing the externality are equivalent. A subsidy to green energy
can however affect negatively the price of fossil-fuelled energy and cause an inef cient increase in
its consumption. Gelabert et al. [ 13 ] estimate that an increase of 1 GWh in the production of
renewable energy implies a fall in the price of 2 per MWh. Also, given the heterogeneity of

energy sources, it is not trivial to design a subsidy that re ects avoided emissions (while in the case
of a tax, the identi cation of the object of the tax is easier). See Borenstein [ 6 ] for a discussion on
this issue.

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