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THE ECONOMIC EFFICIENCY OF RENEWABLE PORTFOLIO STANDARDS IN THE
PRESENCE OF CAP-AND-TRADE
Kenneth Gillingham, Stanford University/Yale University, 650-353-6578, [email protected]
Arthur van Benthem, Stanford University, 650-644-6120, [email protected]
Overview
Cap-and-trade programs to reduce carbon dioxide emissions are a key element in both U.S. and European climate policy, with an
EU cap-and-trade in place and several recent proposals in the U.S.. Interestingly, many proposals envision a cap-and-trade
alongside a renewable portfolio standard (RPS), a requirement that a certain percentage of all electricity be generated from
renewable sources. The main question addressed in this paper is: If we already have a cap-and-trade, what would we have to believe
for an RPS to be economic efficiency-improving?

Can we find circumstances under which adding an RPS can actually increase economic efficiency by helping to correct for
innovation market failures not addressed by the carbon policy?

When is an RPS likely to improve efficiency most?

What is the loss from introducing an RPS rather than other innovation policies?
We show that an RPS can improve economic efficiency only in cases where there is cap that is not sufficient to internalize the
externality and important innovation market failures. These innovation market failures may be non-appropriable knowledge
spillovers from learning-by-doing (LBD) or research and development (R&D) knowledge spillovers that are not already
internalized by innovation policy. The aim of this paper is to elucidate the conditions under which an RPS may be an economic
efficiency-improving second-best policy to address these innovation market failures.
Methods
The paper consists of a theoretical component that derives results about economic efficiency in the presence of interacting policy
instruments (such as an RPS and a cap-and-trade system), and an empirical component with a partial equilibrium simulation model
that illustrates the theoretical results and quantifies the impact of a potential future combination of RPS & cap-and-trade in the
United States. This scenario is not unlikely to occur, given its appearance in many past (failed) climate bills, such as WaxmanMarkey.
In the theoretical part, we start by formalizing the key market failures: (1) the environmental externality from carbon emissions, (2)
spillovers from non-appropriable learning-by-doing (LBD), and (3) spillovers from R&D. The degree to which these market
failures are present determines how the hypothetical social planner should choose the first-best policy instruments. They also
determine the performance of a less-than-optimal policy, such as an RPS. We prove a number of propositions regarding the
efficiency of various combinations of RPS & cap-and-trade in the presence of these market failures.
The simulation model is based on the theoretical model, but covers many periods to reflect the dynamic nature of the market
failures. It is calibrated to study the most recent U.S. climate bill (Waxman-Markey). The model aims to determine if the proposed
RPS is efficiency-improving. Even though this specific climate legislation did not pass the U.S. Senate, similar bills are likely to
reappear in the future, and also feature in many European climate policy proposals.
Results
In the theoretical part, we prove the following results. When only a carbon externality is present:
1.
Adding a binding RPS to a pre-existing cap leads to a reduction in the permit price, as long as the cap remains binding.
Conditional on having introduced a binding RPS, the constrained-optimal cap is tighter than the original (optimal) cap.
When both a carbon externality and an uncorrected innovation market failure are present:
2.
3.
In absence of R&D subsidies and an RPS, the permit price should be set higher than the marginal environmental damage.
In absence of cap-and-trade, a small binding RPS will always be efficiency-improving. This holds both whenever there are
optimal or sub-optimally low innovation subsidies.
With a cap-and-trade, a small binding RPS will always be efficiency-improving if there are unaddressed innovation market
failures.
With an inefficienctly lax cap, a small binding RPS will always be efficiency-improving.
4.
5.
In the empirical simulation part, we collect data about the size and emissions from two main energy-intensive sectors: electricity
generation and industry. We then impose the RPS and cap-and-trade as proposed by Waxman-Markey. Figure 1 shows the
proposed cap-and-trade. The corresponding RPS prescribed that 20% of electricity be generated by renewable sources by 2020,
starting from 6% in 2012. Using various estimates from the literature of the size of environmental and innovation externalities, we
show the range of parameters under which adding an RPS improves economic efficiency relative to only a cap-and-trade.
Proposed Coverage and Cap (Waxman-Markey)
Conclusions
8000
We conclude that an RPS is never a first-best
instrument for combined climate change and
innovation policy, but it can be efficiency-improving
when the initial policy is suboptimal. The numerical
simulations will shed light on whether RPS policies
in recently proposed legislation should have been
included. These results generalize and further clarify
the insights in the literature on the choice of policy
instruments in the presence of both a greenhouse gas
externality and an innovation market failure
(Goulder and Schneider 1999, Fullerton and Metcalf
2001, Fischer and Newell 2007, Holland et al. 2009,
Nordhaus 2009).
7000
Tg CO2 equivalent
6000
5000
4000
3000
2000
1000
total emissions covered
cap level
2050
2048
2046
2044
2042
2040
2038
2036
2034
2032
2030
2028
2026
2024
2022
2020
2018
2016
2014
2012
0
2005 emissions
Figure 1. Coverage and stringency of the cap-and-trade system
as proposed by the Waxman-Markey climate bill.
References
Fischer, C. and R. Newell (2007) . “Environmental and Technology Policies for Climate Mitigation.” Journal of Environmental
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Economics 80(2): 249–267.
Goulder, L.H. and S.H. Schneider (1999). “Induced technological change and the attractiveness of CO2 abatement policies.”
Resource and Energy Economics 21: 211-253.
Holland, S.P., J.E. Hughes and C.R. Knittel (2009). “Greenhouse Gas Reductions under Low Carbon Fuel Standards?” American
Economic Journal: Economic Policy 1(1): 106-146.
Nordhaus, W. (2009). “Designing a Friendly Space for Technological Change to Slow Global Warming.” Snowmass Conference on
Technologies to Combat Global Warming.