Implementing the EU renewable target through green certificate markets.

Implementing the EU renewable target through green certificate markets. by Finn Roar Aune, Hanne Marit Dalen and Cathrine Hagem Statistics Norway, Research Department, PO Box Dept., N-0033 Oslo, Norway Abstract The European Parliament has agreed on a target of a 20% share of renewables in the EU s total energy consumption by 2020. To achieve the target, the European Council has adopted mandatory differentiated national targets for each of the member states. In this paper, we consider the use of green certificates to reach the renewable targets and we analyze the potential for cost reductions by allowing for trade in green certificates across member states. We show that differentiated national targets cannot ensure a costeffective implementation of the overall target for the EU s renewable energy consumption. Trade in green certificates can ensure a cost-effective distribution of renewable energy production, but the national targets prevent a cost-effective distribution of energy consumption. Nevertheless, our numerical model indicates that EU-wide trade in green certificates may cut the EU s total cost of fulfilling the renewable target by as much as 70% compared with a situation with no trade. However, the design of green certificate markets may have a large impact on the distribution of costs across countries. Keywords: Energy policy, green certificate markets, renewable targets JEL codes: Q48, Q54, Q58 Corresponding author. E-mail: cah@ssb.no, telephone: +47 21 09 43 13, telefax: +47 21 09 49 63

1 Introduction In December 2008, the European Parliament agreed on a climate and energy package that is designed to achieve the EU s overall environmental target of a 20% reduction in greenhouse gas (GHG) emissions and the renewable target of a 20% share of renewables in the EU s gross final energy consumption by 2020 (see EU, 2009a, and EU, 2009b). EU (2009b) is henceforth referred to as the Renewables Directive, whereas the term EU s Energy and Climate Package covers both EU (2009a) and EU (2009b). A green certificate system, also known as renewable portfolio standards or renewable obligations, requires consumers, retailers or producers to derive a certain percentage of final energy consumption/production from renewable sources. The purpose of this paper is to analyze the cost-effectiveness of various designs of green certificate systems to achieve the EU s renewable target. In the light of our findings, we discuss the EU s adopted policy of differentiated renewable national targets across member states. As the GHG reduction target is not our main focus, we assume as a starting point for our analysis that all GHG emissions within the EU are restricted through a uniform price of emissions, which ensures that the GHG emission reduction target is met. According to the literature, if the goal is to secure a certain share of renewables in final consumption, a green certificate market provides a cost-effective achievement (Bye, 2003, Haas et al., 2004, and Aune et al., 2008). Green certificates are currently used in several European countries (EU, 2008a). However, the literature also shows that if the purpose of the regulations is to achieve GHG emissions reductions, a green certificate market is not the first-best policy, either alone (Palmer and Burtrow, 2005) or in combination with an emissions trading scheme (Böhringer and Rosendahl, 2010, and del Río González, 2007). 1 Stimulating renewable energy production can of course be motivated by objectives other than GHG emissions reductions. The EU argues that the renewable target means a boost for high-tech industries, new economic opportunities and jobs (EU, 2008b). It is a well-known result that private markets will underinvest in R&D because of firms inability to appropriate the social returns of investment (Stoneman and Vickers, 1988). Hence, some kind of governmental R&D funding may be appropriate to make investors internalize the positive externalities associated with R&D. These objectives could nevertheless be met more cost-effectively by R&D subsidies than by setting a fixed renewable target. As pointed out in 1 For other studies on the performance of green certificates, see e.g. Amundsen and Nese (2009), Amundsen and Mortensen (2001), Morthorst (2001), Fischer (2010) and Bertoldi and Huld (2006). 2

Sorrell and Sijm (2003), the objectives must be explicit in order to design efficient policies. In this paper, we do not question whether a renewable target is a part of an efficient policy or the motivations for stimulating renewable energy production. 2 We simply take the renewable target as a premise for our study. For a discussion on rationales for promoting renewable energy, see e.g. Fischer and Preonas (2010). To achieve the target of a 20% share of renewables in the EU s total energy consumption, the European Council has adopted mandatory differentiated national targets for each of the member states. The national targets range from 10% to 49%, but are consistent with the EU s overall renewable target. According to the Renewable Energy Directive (EU, 2009b, article 5), the consumption of renewables is defined as electricity and heat produced from renewable sources, plus the consumption of other renewable energy sources, such as biofuels. Hence, the renewable target can be interpreted as a target for renewable energy production plus net imports of renewable energy, relative to final energy consumption. The EU s climate and energy package sets no restrictions on how countries may stimulate their renewable energy production. Currently, there is a wide range of policy instruments aimed at promoting renewable energy use in the EU countries. See EREC (2011) for a detailed description of the different support schemes for renewable energy in the EU member states and EU (2008c) for a brief overview of European support schemes. As a point of departure for our analysis, we consider a situation where the policy instrument to achieve the renewable target is a green certificate system in all countries. However, it is worth noting that the market solution following from the green certificate system can be mimicked through a subsidy on renewable energy production and a tax on energy consumption under the restriction of budget neutrality (Aune et al., 2008, chapter 6.2). Subsidies of renewable energy production through so-called feed-in tariffs are common in Europe. Feed-in tariffs are price-based policy instruments that guarantee different producers of renewable energy a minimum price. With no uncertainty, green certificates and uniform feed-in tariffs financed by an end-user tax are equivalent instruments for reaching a specific renewable target (see Böhringer and Rosendahl, 2010). 3 2 Although a properly designed green certificate system leads to cost-effectiveness when the policy goal is to increase the share of renewables, it is not an efficient instrument for correcting for externalities (see Aune et al., 2008, chapter 6.2). 3 Uncertainty about production costs may make it difficult to reach a specific renewable production level by the use of feed-in tariffs. On the other hand, a green certificate system may leave the investors with a higher investment risk than feed-in tariffs because of uncertainty about the certificate price. For more on the effects of feed-in tariffs versus green certificates, see e.g. Gan et al., 2007, Menanteau et al., 2003 and Böhringer et al., 2007. 3

The Renewables Directive states that the member states may meet their national renewable targets by financing renewable energy production in other countries, so-called statistical transfers. 4 The option for statistical transfers is a means to reduce the total cost of meeting the renewable target by distributing renewable energy production across member states more cost-effectively, compared with a situation where each country has to meet its target by domestic renewable energy production. It is, however, as yet unclear to what extent this option will be utilized by the member states. According to EU (2010), only five EU countries will rely on nondomestic measures to meet their targets, and less than 1% of the renewable production will be traded between member countries or between EU countries and third-party countries. A potential system that fully exploits the benefits of a cost-effective distribution of renewable energy production is an EU-wide green certificate system: all producers receive a green certificate for every unit of renewable energy produced, and all consumers of energy must purchase green certificates corresponding to their countries specified shares of renewable energy. transfers can be seen as a first step toward a full green certificate system in the EU. To explore the impact of EU-wide trade, we compare a situation of full trade in green certificates with no trade in green certificates across member states. Furthermore, to explore the impact of differentiated national renewable targets, we also consider a cost-effective policy that is ensured by a common renewable target for all EU members and full trade in green certificates. This leaves us with an evaluation of three different relevant policy scenarios; i) a common renewable target for all member states with EU-wide trade in green certificates, ii) differentiated national targets for each of the member states with EU-wide trade in green certificates, and iii) differentiated national targets for each of the member states with domestic trade in certificates only. To our knowledge, this paper is the only study that theoretically and empirically evaluates the cost-reducing potential of allowing for trade in green certificates across countries by comparing all of these three scenarios. 5 The EU s system of statistical 6 4 See article 6 of EU (2009b). 5 In this paper we do not discriminate between old and new renewable energy, as is done in some green certificate markets. Plumb and Zamfir (2009) give a comparative analysis of different green certificate markets in the EU. 6 Aune et al. (2008) calculate the outcome of national certificate markets in the EU and compare this with a common certificate market in the EU. EU (2008a) and Capros et al. (2008) compare a cost-effective implementation of the renewable target versus national renewable targets. However, their numerical simulations differ from ours in several ways: they do not employ a green certificate market, which implies that they do not have financial transactions across agents through a certificate market. Furthermore, they introduce several restrictions on the implementation of the renewable target. For instance, their simulations on national renewable targets restrict the renewable share of the individual countries exactly to the targets in the EU proposal, which imply higher greenhouse gas emissions reduction costs than without that restriction. In Amundsen and Nese (2009), a general analytical model is set up to, 4

Using a theoretical model, we find that the use of differentiated national targets is not a cost-effective policy to reach a certain renewable share. This conclusion also holds when there is EU-wide trade in green certificates. In a green certificate market, the consumers marginal costs of energy differ if the renewable targets vary across countries. This violates the conditions for a cost-effective distribution of energy consumption. Cost-effectiveness is only achieved by imposing a common renewable target for all countries and allowing for free trade in green certificates. However, we show that EU-wide trade can ensure efficiency in total production of renewable energy, regardless of the distribution of national targets across countries. We employ a numerical multi-market energy equilibrium model to assess the impact of the various designs of green certificate markets. The model simulations indicate large gains from trade in green certificates. Given the differentiated national targets set by the European Council, the overall cost of achieving the EU s renewable target can be cut by almost 70% by EU-wide trade in green certificates. The efficiency loss related to differentiated targets, and hence differentiated increases in consumer prices across countries, is more modest. Given trade in green certificates, the EU s total cost can be further reduced by almost 4% by having a common renewable target compared with differentiated national targets (scenario (ii) versus scenario (i)). The various designs of green certificate markets have large impacts on the distribution of costs across countries, and not all countries are better off with trade. Section 2 presents our theoretical model to illustrate the qualitative results. Thereafter, in Section 3, we present the numerical model and the results. Concluding remarks are given in Section 4. 2 The Theoretical Model To analyze the scenarios theoretically it is sufficient to consider a two-country case. We also simplify the analysis by ignoring trade in energy with third countries, and by ignoring energy taxes other than CO 2 taxes. Our numerical model provides a more realistic presentation of the energy market in the EU, including trade with countries outside the EU, and comprises real-life taxes on energy consumption. Let e 1 and e 2 denote the consumption of energy from the two countries, 1 and 2. Let x i and y i denote inter alia, analyze the effects of having a common green certificate system compared with national systems. Their numerical results focus on the effects of a tradable green certificate market in Norway and Sweden. 5

country i s production of renewable and fossil energy, respectively. For the consumers, we assume that both types of energy are perfect substitutes. Furthermore, let c i(x i) and f i(y i) be country i s cost functions for producing renewable and fossil energy, respectively, whereas B i(e i) denotes country i s benefit of consuming energy. We assume free trade, no transportation costs, and the following properties of the cost and benefit functions: c i(x i) > 0, c i(x i) > 0, f i(y i) > 0, f i(y i) > 0, B i(e i) > 0, and B i(e i) < 0. The market equilibrium condition is: e1+ e2 = x1+ x2 + y1+ y2. (1) As a starting point we consider a situation where the two countries jointly have a target for emissions of CO 2 from the combustion of fossil fuels. As we only consider one type of fossil fuel in this theoretical part of the paper, this corresponds to a target ( Y ) for total consumption of fossil fuels: y1+ y2 Y. (2) The countries have a common target for the share (α) of renewable energy in their final consumption: x1+ x 1 α (e1+ e 2), 0 <α< 1. (3) Throughout this theoretical analysis we only consider situations where both constraints are binding. Hence, (2) and (3) are satisfied with equality. Total welfare (W) is given by: i i i i i i. (4) i W= B(e) c(x) f(y) Maximizing (4) w.r.t. e i, x i and y i subject to (1), (2) and (3) yields the following optimality conditions: B αε= B αε= c ε= c ε= f +σ= f +σ=λ, (5) 1 2 1 2 1 2 where λ is the shadow cost of the market equilibrium constraint (1), σ is the shadow cost of the fossil fuel target constraint (2), and ε is the shadow cost of the renewable target constraint (3). Let e, x, y, λ, σ and ε denote the outcome of the optimal solution following from (1), (2), (3) and (5), i * * * * * * i i i = 1, 2. 6

We see from (5) that the marginal cost of producing renewable energy must exceed both the marginal benefit of consuming energy and the marginal cost of producing fossil fuels in the optimum (as ε and σ 0, and 0<α< 1 by assumption). Furthermore, we see that the marginal benefit of consumption is equalized across consumers, the marginal cost of renewable energy production is equalized across renewable energy producers and, finally, the marginal cost of fossil fuel production is equalized across fossil fuel producers. In the next sections we consider three different scenarios for achieving the renewable target by the use of a green certificate system, given a common competitive energy market and a common competitive tradable emissions permits market. The scenarios correspond to i) to iii), described in the introduction. 2.1 Scenario i): Common target Common certificate market The countries have a common target for the share (α) of renewable energy in their final consumption. This implies that all consumers of energy are obliged to purchase α green certificates for each unit of energy they consume. Let β denote the unit price of certificates. Renewable energy producers have the right to sell one green certificate per unit of renewable energy produced. Let p denote the market price of energy and let t denote the market price of emissions permits. The net benefit from consumption (w) in country i is: wi = B i(e i) (p +βα )e i, i = 1,2. (6) As we have assumed that both types of energy are perfect substitutes for the consumers, the consumer price cannot differ across energy types. The producer price of each energy source equals the market price less any net taxes (taxes minus subsidies). The producers of renewable energy also gain β on each unit of energy, whereas the fossil energy producers have to pay t on each unit of energy produced. Hence, the renewable and fossil energy producers profit functions, denoted πix and π iy, are, respectively: π ix = (p +β)xi c i(x i) i = 1,2, (7) π iy = (p t)yi f i(y i) i = 1,2. (8) 7

The producer price of energy for fossil fuel producers equals p t, whereas the producer price of renewable energy equals p + β. The first-order conditions for consumers welfare optimization and producers profit maximization are found by maximizing (6) w.r.t. e i, maximizing (7) w.r.t. to x i, and maximizing (8) w.r.t. to y i : B αβ= B αβ= c β= c β= f + t = f + t = p. (9) 1 2 1 2 1 2 Let e i(p + αβ ),x i(p + β) and y i(p t) denote the demand and supply functions following from (9). The renewable target constraint, (3), sets the market equilibrium condition for the certificate market: α (e 1(p +βα )) +α (e 2(p +βα )) = x 1(p +β ) + x 2(p +β ). (10) By inserting the demand and supply functions following from (9) into (1) and (2) we find the equilibrium conditions for p, t and β, denoted * p, * t and * β, respectively, from (1), (2) and (10). Hence, * β ensure that the constraints regarding total consumption and production (eqs. (1) (3)) are satisfied. * p, * t and Furthermore, we see from (9) that a common green certificate market also ensures the optimal distribution of production and consumption across countries. Thus, it follows from (9) that: e (p +αβ ) = e,x (p +β ) = x and y (p t ) = y. * * * * * * * * * i i i i i i Hence, the renewable energy certificate market ensures the optimal solution, given a target for the share of renewable energy in final energy consumption (eq. (3)). 2.2 Scenario ii): Differentiated targets Common certificate market In this situation, each country has an individual target for its share of renewable energy in final consumption, α i, and there is a common green certificate market. This implies that the producer price of renewable energy equals p +βin both countries, as in scenario i), whereas the consumer prices of energy ( p +βα i ) differ. Replacing p +βα with maximization and producers profit maximization are given by: p +βα i in (6), the first-order conditions for consumers welfare 8

B αβ= B αβ= c β= c β= f + t = f + t = p. (11) 1 1 2 2 1 2 1 2 We see from (11), that B 1 B 2for α1 α 2 and c 1 = c 2. Hence, we can derive the following proposition. Proposition 1: Consider a group of countries with an aggregate target for a specific share of total renewable energy in overall energy consumption. A common green certificate market does not lead to a cost-effective achievement of the overall target if the individual countries are assigned differentiated targets. However, the production of renewable energy is cost-effectively distributed across producers. When the green certificates are tradable across countries, all renewable energy producers face the same producer price and a cost-effective distribution of renewable energy production is ensured. Differentiated targets lead to differentiated consumer prices for energy across consumers, and the consumption of energy is thus not distributed optimally across consumers. 2.3 Scenario iii): Differentiated targets National certificate markets In this situation, each country has an individual target for its share of renewable energy in final consumption α i, and each country has an individual certificate market. Let β i denote the market price of certificates in country i. The consumer price of energy in country i is p +βα i i. Replacing p +βα with p +βα i i in (6) and replacing β with i maximization and producers profit maximization are given by: β in (7), the first-order conditions for consumers welfare B αβ = B α β = c β = c β = f + t = f + t = p. (12) 1 1 1 2 2 2 1 1 2 2 1 2 We see from (12) that the marginal benefit of energy is not equalized across consumers (countries), except 1 2 by chance, as B 1 B 2for α β. Furthermore, the marginal cost of renewable energy production is α β 2 1 9

not equalized across producers, except by chance, as c 1 c 2 for β1 β 2. This leads to the following proposition. Proposition 2: Consider a group of countries with an aggregate target for a specific share of total renewable energy in overall energy consumption. Individual green certificate markets lead to an inefficient distribution of renewable energy production and an inefficient distribution of energy consumption. We also see from (12) that even if all countries have the same target, α 1 =α 2, neither consumption nor production is efficiently distributed across countries, as β1 β 2 (except by chance). As long as there is no common market for certificates, the certificate prices vary across countries, which again leads to differentiated consumer prices of energy, even though the renewable targets are identical. Given national certificate markets, a replacement of differentiated targets with common targets may or may not increase the total cost depending on the impact on renewable production costs across countries. 2.4 The efficiency of green certificate markets From the propositions and discussion in the previous subsections, we can state the following. Corollary: Consider a group of countries with an aggregate target for a specific share of total renewable energy in overall energy consumption. A common certificate market can ensure efficiency in the total production of renewable energy, regardless of the distribution of national targets across countries. However, a common certificate market does not ensure efficiency in energy consumption if the targets are differentiated across countries. A common certificate market leads to the same certificate price in all countries, and makes all renewable energy producers face the same producer price (energy price plus certificate price). Hence, marginal production costs are identical across all producers, which ensures a cost-effective distribution of 10

renewable energy production across countries. In this respect, a common certificate market resembles a permit market; efficiency in production (emissions reductions) is the same whether a system of grandfathering or auctioning is adopted (Montgomery, 1972). However, a common certificate market implies a distortion of the efficiency in energy consumption if targets differ between countries. Differentiated targets lead to differentiated consumer prices of energy between countries. Thus, differentiated targets have the same impact as differentiated energy taxes; when national consumer prices of internationally traded goods differ, marginal benefits of consumption differ, and efficiency in consumption is not ensured. In the theoretical model, we ignored any existing energy taxes, subsidies and other energy policy instruments. However, at present, there is an extensive use of energy policy instruments in European countries. The introduction of a common certificate market is likely to replace most of the existing domestic policy instruments aimed at stimulating renewable energy production. However, the existing differentiated domestic consumer taxes are partly motivated by fiscal reasons, and will most likely (partly) remain under a common certificate market. Hence, it is not obvious whether differentiated national targets will actually increase or decrease the already existing inefficiency in total energy consumption. As stated in the introduction, in case of no uncertainty, feed-in tariffs financed by end-user taxes can be designed to yield the same outcome as green certificate systems. In Appendix A, we derive the designs of feed-tariff systems that yield the same outcomes as in scenario i), ii) and iii). 3 Numerical Illustrations In order to evaluate the qualitative impact of the alternative scenarios, we need an energy market model that captures the main features of the different alternatives and quantifies the impact on main economic variables, such as total cost, consumer surplus, producer surplus, energy production and prices. To conduct this qualitative evaluation, we use the multi-market energy equilibrium model LIBEMOD. The model s focus is on the electricity and natural gas markets of Western Europe, but it also covers global markets for coal and oil. See Golombek et al. (2011) for a documentation of the present version of LIBEMOD, and Aune et al. (2008) for a more detailed description of LIBEMOD, including data sources. 7 7 The version of LIBEMOD used in the present paper LIBEMOD 2000 CCS differs somewhat from the one documented in Aune et al. (2008), the main differences being i) electricity is traded in two (not six) periods over the 24-hour cycle, ii) more electricity technologies are available (CCS technologies for coal and gas power plants), and iii) a more aggregated representation of coal markets is used. 11

3.1 Detailed description of the numerical model LIBEMOD distinguishes between 16 endogenous Western European model countries, 8 three exogenous model countries that are important for the Western European gas market, 9 and an exogenous region containing the rest of world. Only the endogenous model countries have a full set of energy markets. However, the exogenous model countries possess endogenous supplies of one or more fossil fuels. The model includes real-life taxes for each energy type and user. The taxes included are value-added taxes (VAT), CO 2 taxes and other excise taxes. Base-year taxes are mainly taken from IEA (2002). See Aune et al. (2008, Appendix B) for more details on included taxes. LIBEMOD also includes transportation tariffs. 10 As the EU s Energy and Climate Package covers all of the 27 current EU members, (EU-27), whereas LIBEMOD only reports CO 2 emissions and renewable energy production from the Western European countries, LIBEMOD has limitations when it comes to simulating the full effects of EU policies. However, we believe that LIBEMOD simulations still provide a good picture of the impact of the various designs of green certificate markets in the EU, as LIBEMOD s endogenous model countries cover 85% and 84% of the EU-27 s energy consumption and production, respectively (Eurostat, 2008). 11 We have made some adjustments to the targets specified in the EU s Energy and Climate Package to take into account the fact that LIBEMOD s endogenous model countries differ from those in the EU-27. The 8 Austria, Belgium (incl. Luxembourg), Denmark, Finland, France, Germany, Greece, Great Britain and Northern Ireland, Ireland, Italy, the Netherlands, Norway, Portugal, Spain, Sweden and Switzerland. 9 Algeria, Russia and Ukraine. 10 In the base year (2000) real transportation tariffs in the electricity and gas networks varied significantly from country to country. When constructing the transportation tariffs data set in LIBEMOD, we have assigned some of these differences to market power and others to market inefficiencies. Instead of using the existing tariffs from the base year, we have used a cost-based method to assign transportation tariffs in the electricity and gas networks (see Appendices B.4 and B.6 in Aune et al., 2008). 11 The Renewables Directive is relevant for the European Economic Area (EEA). Norway is not an EU member, but is a member of the EEA. Therefore, it is reasonable to include Norway among countries covered by the EU s climate and energy package. Switzerland on the other hand, is not a member of the EEA. While Switzerland is not yet a part of the EU-ETS trading scheme, they aim to merge their national trading scheme with the European emissions trading scheme (see Federal Department of the Environment, Transport, Energy and Communications (2009)). The Renewables Directive (EU, 2009b), article 9 allows for joint projects in production of renewable electricity between EU member states and third-world countries. We therefore also include Switzerland among countries covered by the EU s climate and energy package in our numerical analysis. 12

Renewables Directive sets differentiated national targets for the increase in renewables in each of the member states, which are consistent with a target of at least a 20% share of energy from renewable sources in the EU s final consumption (see Appendix B). When we sum up the Renewables Directive s national targets for LIBEMOD s endogenous model countries, we find that these targets are consistent with a target of a 19.7% share of energy from renewable sources in the final consumption in LIBEMOD. 12 We have also made an adjustment to incorporate the EU s target of a 20% reduction in GHG emissions relative to 1990 levels. This target is achieved partly by a 21% reduction below 2005 levels from sources covered by the EU s emissions trading scheme (EU-ETS), and partly by differentiated national targets for emissions from sources not covered by the EU-ETS. We find the total target for LIBEMOD s endogenous model countries by assuming a 21% reduction, relative to 2005, of emissions covered by the EU-ETS in these countries. The sum of emissions reductions for sectors outside the EU-ETS are found by summing the differentiated national targets for the LIBEMOD s endogenous model countries, given in EU (2009a). 13 As the Renewables Directive is the main focus of this paper, we have simplified the GHG emissions policy by assuming that all sources of emissions face the same emission price, in terms of a common CO 2 tax, and this tax ensures that the target is fulfilled. Furthermore, we only consider emissions of CO 2, and assume that the percentage GHG emissions reduction targets holds for CO 2 emissions. All markets in LIBEMOD are competitive. In each endogenous model country there is investment in energy infrastructure, as well as production, consumption and trade in energy. In equilibrium all arbitrage possibilities are exploited, and thus price differences for each good reflect cost differences only. Seven energy goods are included; electricity, biomass, oil, natural gas, lignite, steam coal and coking coal. Natural gas and electricity are traded between endogenous model countries, as well as a few exogenous model countries such as Russia. Oil, steam coal and coking coal are traded in global markets. LIBEMOD offers a detailed description of the production of electricity in each model country. In general, there are a number of technologies available for the production of electricity in existing plants or in new plants. For 12 For Norway, the national renewable target is set to 68%. This is found by using the same method as that employed by the EU for setting the national targets for EU member states (see EU, 2008a, Annex 6). Point Carbon (2008) finds by using this method that Norway should increase its renewable share by 14.5 percentage points. We apply the same increase in the renewable share for Norway in our numerical simulations. The national renewable target for Switzerland is set to zero (see footnote 11). 13 For both Norway and Switzerland, the national goals are set to a 20% reduction in national non-eu-ets CO 2 emissions in 2020 compared with 2005. 13

steam coal power and gas power, a producer can install carbon capture and storage in an existing plant, or build a new power plant with CCS. There are several power technologies based on renewable sources in the model: wind power, bio power and hydropower are the most important among these. The Western European power system comprises a vast number of technologies, not all of which are specified in LIBEMOD. For instance, power plants may use more than one fuel, such as e.g. co-firing coal and biomass, which may be a possibility for many coal power plants. In LIBEMOD, however, there are no such options. Each power plant may use one fuel only, and multi-fuelled power plants are grouped together with single-fuelled power plants according to main fuel use. There are four groups of users of energy: power producers, households/services, industry and transport. The first group represents intermediate demand; power plants demand a fuel as an input in the production of electricity. This fuel could be steam coal, lignite, natural gas, oil or biomass. The three latter groups represent end-user demand. LIBEMOD ignores the use of biomass in sectors other than the electricity sector. As we know that the use of biomass (biodiesel and bioethanol) can substitute for fossil fuels in the transport sector and biomass can substitute for gas or coal for heating, we have decided to exogenously determine the use of biomass in the transport sector and in the stationary energy sector. EU statistics provide information about the use of biomass in 2005 in these sectors for all endogenous model countries. 14 We have extended this use of biomass to 2020. Furthermore, based on the EU Renewable Energy Directive we assume that the use of biomass in the EU transport sector increases to 10% of the total energy use in that sector in 2020. For the stationary energy sector, we assume that the percentage share of biomass in 2020 corresponds to the renewable targets (19.7%). The distribution across countries is determined by assuming the same percentage point increase from 2005 to 2020 across all countries. In total, this gives us a use of renewables in the stationary energy sector in 2020 approximately in line with the EU s projections. 15 The absolute values of biomass in the transport sector and stationary energy sector are identical in all scenarios. However, the biomass used as an input factor in the production of electricity is endogenously determined in the model. For every model country, we have constructed a biomass supply function to power plants. The marginal cost for each country increases with increased supply, and the steepness of the supply function approaches infinity when supply approaches the estimated capacity. Total possible biomass supply to power plants is 91 Mtoe, with Germany, Spain and France having the largest resources. We do 14 For each country, see Table 7, category Final consumption of RES (excl. electricity) in Eurostat (2008). 15 See the figure titled Renewables growth: Heating and cooling projections by 2020 on p. 20 of EU (2007). 14

not consider any trade in biomass to power plants across countries. The main source for the biomass supply function to power plants is Nikolaou et al. (2003). See Aune et al. (2008), Appendix B.2 for more information regarding the construction of the biomass supply function. The CO 2 emissions from the use of biomass are assumed to be zero, in line with the accounting regulations in the EU s emissions trading system (EU-ETS) (see EU, 2009c, Annex IV). 16,17 3.2 Simulations Using the LIBEMOD model, we compare the costs of implementing the EU s renewable target through the three different scenarios described in the theoretical model: i) an equal percentage renewable target for all countries and EU-wide trade in green certificates, ii) individual renewable targets and EU-wide trade in green certificates, and iii) individual renewable targets and no EU-wide trade in green certificates. As a starting point for our analysis, we first simulate a base scenario with no renewable target, but with a common EU-wide carbon tax sufficiently high to ensure a 20% reduction of emissions of carbon dioxide in 2020. The EU-wide carbon tax necessary to reach the emission target, 59 per tco 2, also has a significant effect on the renewable share. The increased wholesale electricity prices as a result of the carbon tax imply that renewable electricity production becomes more profitable with increased wind power, biomass power and hydropower production. In total, the renewable share increases to 17.1%. Hence, the increase in renewable energy following from the carbon tax is not sufficient to meet the EUwide renewable target. Thereafter, we simulate the three different scenarios for green certificate systems, given both the target for CO 2 emissions and the renewable target. In all four scenarios the energy taxes, except CO 2 taxes, are set at the same real level for every country as in the base year of the model (year 2000). Table 1 presents the impact of introducing a renewable target through the three different scenarios for green certificates. The absolute numbers represent the changes relative to the case with no renewable target (base scenario), whereas the percentage numbers in brackets represents the percentage change in the 16 As our model only covers CO 2 emissions from the combustion of fossil fuels, we ignore net emissions of CO 2 because of land use changes in the production of biomass. 17 See Searchinger et al. (2009) for a critical view of the current accounting methods for emissions from bioenergy in the Kyoto Protocol and in the EU-ETS. 15

outcomes of scenarios i) and ii) relative to scenario iii). Hence, the percentage numbers show the effects of allowing trade in green certificates, given a renewable target. From Table 1 we see that allowing EU-wide trade in green certificates strongly reduces the cost of introducing a renewable target compared with domestic certificate trade only. The cost of meeting the overall EU target is reduced by 69% under scenario ii) compared with scenario iii). The cost-effective solution with a common renewable target and EU-wide trade in certificates (scenario i) reduces the cost by 71% compared with scenario iii). This tells us that the main driving force of reducing the cost of the renewable target is to allow for trade in green certificates. 18 Given free trade in green certificates, shifting from differentiated national targets to common national targets only reduces the costs further by approximately 4%. 19 From Table 1, we also see that the introduction of the Renewables Directive causes large changes in the producer and consumer surpluses. 20 The large increase in the producer surplus is mainly caused by increased incomes from green certificates. The producers of renewable energy receive an income from the green certificate system and this increases their producer surplus. We see that the producer surplus is very similar under scenarios i) and ii), but is much higher under scenario iii). This is mainly driven by the higher prices of green certificates under scenario iii). The average price of green certificates is 47 in scenario iii), whereas the common certificate price falls to 26 in scenarios i) and ii) because of the EUwide trade in green certificates. 21 The consumer surplus is substantially reduced in all three scenarios. Introducing a renewable target is costly for the consumers as they have to pay for green certificates in order to be able to consume energy. 18 Our estimated gains from trade in certificates are somewhat higher than the estimate in EU (2008a), where the costs involved in achieving the renewable and greenhouse gas targets are based on simulations using the PRIMES and GAINS models. They find that trade in green certificates, given differentiated renewable targets, can reduce costs by 8 bn compared with no trade in certificates (see Table 36 in EU (2008a)). Their results are not directly comparable with ours because of different countries being included in the analysis and different assumptions about the carbon costs in the non-eu-ets sector. 19 As discussed in Section 2, in a situation without a common certificate market, a replacement of differentiated targets with common targets may or may not increase the total cost. We have also simulated a scenario with a common renewable target, but no green certificate trade between countries. This simulation shows a significantly higher cost than the no-trade scenario with individual renewable targets (scenario iii). The main explanation for the cost increase is that when every EU country has the same renewable target, some countries will have to invest in very expensive power plants. Indeed, this highlights the importance of having an EU-wide green certificate market to reduce total cost. 20 Consumer surplus is here understood as the surplus for all end-users of energy (households, service industries, other industries and transportation). 21 One MWh of renewable energy production gives the producer one certificate. 16

However, Table 1 shows that the loss in consumer surplus is considerably lower when the green certificates are tradable EU-wide. Again, this follows from a lower certificate price with EU-wide tradable green certificate systems compared with national green certificate systems. In all three scenarios there is also a clear decrease in tax income. The renewable target leads to lower energy consumption in general, and especially lower consumption of fossil energy. Hence, revenues from energy taxation are reduced because of a smaller tax base. Furthermore, the renewable target increases the cost of consuming fossil energy. The level of the carbon tax necessary to achieve the target for CO 2 emissions is therefore lower in a situation with a renewable target compared with a situation without. In our model simulation, the carbon tax sufficient to achieve the 20% reduction in the carbon emissions target falls from 59 to 52 per tonne CO 2 when the renewable target is introduced. As green certificate schemes are revenue neutral, there is no green tax income to compensate for the loss in energy and carbon tax revenues. 22 From Table 1 we see that the choice of scenario for green certificate markets also affects total gross consumption of energy. By the introduction of the renewable target through scenario iii), the final gross consumption of energy is reduced by 60 Mtoe, which corresponds to a reduction of 4% relative to the base scenario. With EU-wide trade in green certificates, the reduction in gross final consumption is 50% less. The amount of renewable energy consumption is slightly larger under EU-wide certificate trade than under domestic certificate trade only. There is a significant increase in electricity production from renewable sources in all scenarios with renewable share targets compared with the baseline scenario with a target for CO 2 emissions but no renewable target. The main sources for the increased renewable electricity production are wind power and bio power. Electricity production from wind power increases by between 95% and 113%, whereas electricity production from bio power increases by between 36% and 43% in the three scenarios. There is a modest increase in hydropower of around 2%. The average producer price of electricity, weighted by each country s production share, is reduced by between 2 and 3 per MWh, equivalent to a reduction of between 4% and 4.5% in all three scenarios. The green certificate market can be viewed as a subsidy to renewable energy production and a tax on 22 Note that our simulation does not take into account how the loss of energy and CO 2 tax revenues must be compensated by an increase in other producer or consumer taxes, or reduced governmental spending. 17

energy consumption. Both renewable energy production subsidies and taxes on consumption reduce producer prices (exclusive of the certificate price), and the results are thus in accordance with theory. The effect on the end-user electricity price (electricity price plus certificate price) from introducing the green certificate market is not given from theory (see e.g. Amundsen and Mortensen, 2001, Bye, 2003, and Fischer, 2010). Depending on the slope of the nonrenewable energy supply curve relative to the renewable energy supply curve, the combination of a tax and a subsidy might lead to both increasing and decreasing end-user electricity prices. In our numerical model, the average end-user price of electricity, weighted by consumption, increases as a result of the renewable target being implemented. The increase is more than twice as large with national targets and no trade in green certificates as with trade in certificates. 18

Table 1: Effects of different implementations of the Renewables Directive in 2020 compared with no renewable target (annually). Domestic certificate trade only EU-wide trade in certificates Numbers in brackets express the percentage changes relative to scenario iii) Scenario iii) Differentiated national targets and no EU-wide trade in green certificates Scenario ii) Differentiated national targets and EU-wide trade in green certificates Scenario i) Common renewable target and EU-wide trade in green certificates Cost of introducing the renewable target (M ) 19522 5968 ( 69%) 5745 ( 71%) Change in producer surplus (M ) 134851 73002 ( 46%) 72847 ( 46%) Change in consumer surplus (M ) 120535 49401 ( 59%) 48761 ( 60%) Change in taxes (M ) 33838 29569 ( 13%) 29831 ( 12%) Change in carbon tax rate ( per tonne CO 2 ) 7.50 7.44 ( 0.8%) 7.44 ( 0.8%) Change in renewable energy consumption (Mtoe) 30 34 (11%) 33 (11%) Change in gross final consumption of energy (Mtoe) 60 29 ( 51%) 30 ( 50%) Change in electricity production (TWh) 90 34 ( 62%) 26 ( 71%) Change in end-user electricity prices ( MWh) 7.39 3.35 ( 55%) 2.81 ( 62%) Change in wholesale electricity prices ( /MWh) 2.49 2.74 (10%) 2.73 (9%) M = million 2007. 19

All our numerical results regarding different ways to implement the renewable target depend heavily on our assumptions about available technologies to ensure both the carbon reduction and renewable energy targets. Our numerical model comprises the potential for using CCS technologies, and the technologies will be implemented on all new coal-fired power plants for CO 2 taxes above around 30 per tonne CO 2. Obviously, there are uncertainties related to the performance of these still immature technologies. If it turns out that the CCS will be too costly to implement or that it is not an accepted abatement technology because of the uncertainties related to safe storage of CO 2, the cost of reaching a 20% reduction in carbon emissions increases substantially. Because of the corresponding high carbon prices, renewable energy becomes more profitable and there is no added cost by implementing the renewable target as long as there is EU-wide trade in green certificates (the certificate price is zero). Without trade in certificates the total cost of reaching the renewable target is 4225 million, i.e. the added cost of the renewable target is substantially lower than with CCS. 3.3 Results by country The costs of the different ways of implementing the renewable target differ substantially between countries. Figure 1 presents the cost reduction across countries from having EU-wide trade in green certificates. Costs in scenarios i) and ii) are compared with the situation under scenario iii). In scenarios ii) and iii), the differentiated national renewable targets are identical, but scenario ii) allows for EU-wide certificate trade, whereas scenario iii) does not. Access to an EU-wide market is in itself beneficial for all countries. It is particularly beneficial for countries that become large traders in the certificate market. However, EU-wide trade in green certificates affects the equilibrium prices of all energy sources. Because of these terms of trade effects, some countries are worse off in scenario ii) compared with scenario iii). From Figure 1 we see that, for example, Spain experiences a loss when allowing for EU-wide trade in green certificates. Spain is a large importer of gas. In scenario ii) the gas price increases compared with scenario iii) and because Spain is a large importer of gas, this contributes to the increased national costs with EU-wide trade in certificates. Finland, Italy, Norway and Sweden will benefit most from a shift from scenario iii) to scenario ii). We see from Figure 2 that Italy has a high national price of green certificates in scenario iii). The high price reflects the high domestic costs of renewable energy production. Hence, the cost of meeting their renewable target is substantially reduced when they get access to green certificates at a much lower price 20

in scenario ii). For Finland, Norway and Sweden, the gains from an EU-wide market for certificates follow from their capacity to produce renewable energy at low costs. We see from Figure 2 that their price of green certificates is zero under scenario iii), even though they have national targets way above the average (see Appendix B). This indicates that these countries will become large sellers of certificates in scenario ii) and exploit the gains from trade. Whether a country is better off in scenario ii) than in scenario i) depends mainly on whether its national target in scenario ii) is above or below the common target in scenario i). Sweden and Norway have the highest national targets, set at 40% and 68%, respectively, in our model. Surely they will both benefit substantially by a replacement of their national targets with the common target of 19.7% in scenario i). Figure 1: Countries yearly cost reduction in scenarios i) and ii) compared with scenario iii) as a share of their GDP. 0,010 0,008 0,006 0,004 0,002 0,000-0,002-0,004 Austria Belgium Switzerland Germany Denmark Spain Finland France Great Britain Scenario i) Scenario ii) Greece Ireland Italy The Netherlands Norway Portugal Sweden 21

Figure 2: Green certificate prices ( /MWh). 140 120 100 80 60 40 20 0 Austria Belgium Switzerland Germany Denmark Spain Finland France Scenario iii) Great Britain Greece Ireland Italy The Netherlands Norway Portugal Sweden Scenario i) and ii) 4 Concluding remarks The EU has agreed on differentiated renewable targets across member states to achieve a renewable target of a 20% share of renewables in the EU s total final energy consumption by 2020. An important result from our numerical model is that, given the differentiated national targets, the overall cost of achieving the EU s renewable target can be cut by almost 70% if the member states are allowed to trade green certificates. The Renewable Energy Directive (EU, 2009b) allows for so-called statistical transfers, which means that member states may meet their national renewable targets by financing renewable energy production in other countries. Our paper shows the great potential for cost savings by developing this system into a well-functioning green certificate market. A common certificate market does not ensure efficiency in energy consumption if the targets are differentiated across countries (see propositions 1 and 2). However, our numerical model shows that, given a common certificate market, shifting from the differentiated national targets to common national targets only reduces the total costs by approximately 4%. One can therefore argue that the EU-wide green certificate market is more important than common national targets in lowering costs. On the other hand, our numerical model also shows that allowing for trade in green certificates (or statistical transfers) alters the distribution of costs across countries significantly. If the EU also has a target for distribution of costs across countries, the development of a green certificate market may also necessitate a redistribution of the 22

differentiated renewable targets across countries if financial transfers/compensations are excluded. Then again, a redistribution of national targets affects the efficiency loss following from the corresponding differentiated consumer prices of energy. A redistribution of targets because of distributional concerns may therefore lead to a higher total welfare loss than that following from the present target distribution. This is the well-known result that distributional concerns must (in general) be separated from efficiency concerns when designing cost-effective policy instruments. Acknowledgements The authors would like to thank Annegrete Bruvoll, Torbjørn Hægeland, Knut Einar Rosendahl and two anonymous referees for their helpful comments and valuable suggestions. The financial support of the Norwegian Research Council s RENERGI program (project no. 183345/S39) is gratefully acknowledged. 23

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EU, 2010. http://europa.eu/rapid/pressreleasesaction.do?reference=ip/10/265&format=html&aged=0&language=en&g uilanguage=en (17.06.10). Eurostat, 2008. Energy Yearly statistics 2006. Federal Department of the Environment, Transport, Energy and Communications, 2009. http://www.uvek.admin.ch/dokumentation/00474/00492/index.html?lang=en&msg-id=28680 (26.08.2009). Fischer, C., 2010. Renewable portfolio standards: when do they lower energy prices? The Energy Journal 31, 101 119. Fischer, C., Preonas, L., 2010. Combining policies for renewable energy: is the whole less than the sum of its parts? International Review of Environmental and Resource Economics 4, 51 92. Gan, L., Eskeland, G.S., Kolshus, H.H., 2007. Green electricity market development: lessons from Europe and the US. Energy Policy 35, 144 155. Golombek, R., Greaker, M., Kittelsen, S.A.C., Røgeberg, O., Aune, F.R., 2011. Carbon capture and storage technologies in the European power market, The Energy Journal, Forthcoming. Haas, R., Eichhammer, W., Huber, C., Langniss, O., Lorenzoni, A., Madlener, R., Menanteau, P., Morthorst, P.E., Martins, A., Oniszk, A., Schleich, J., Smith, A., Vass, Z., Verbruggen, A., 2004. How to promote renewable energy systems successfully and effectively. Energy Policy 32, 833 839. IEA, 2002. Energy Prices & Taxes, Quarterly Statistics, Third Quarter 2002, OECD/IEA, Paris. Menanteau, P., Finon, D., Lamy, M.-L., 2003. Prices versus quantities: choosing policies for promoting the development of renewable energy. Energy Policy 31, 799 812. Montgomery, W.D., 1972. Markets in licenses and efficient pollution control programs. Journal of Economic Theory 5, 395 418. Morthorst, P.E., 2001. Interactions of a tradable green certificate market with a tradable permits market. Energy Policy 29, 345 353. Nikolaou, A., Remrova, M., Jeliazkov, I., 2003. Biomass Availability in Europe, Lot 5: Bioenergy s Role in the EU Energy. Market Report for the European Commission, December 2003, http://ec.europa.eu/energy/res/sectors/doc/bioenergy/cres_final_report_annex.pdf. Palmer, K., Burtraw, D., 2005. Cost-effectiveness of renewable electricity policies. Energy Economics 27, 873 894. Plumb, I., Zamfir, A.-I., 2009. A comparative analysis of green certificates markets in the European Union. Management of Environmental Quality: An International Journal 20, 684 695. Point Carbon, 2008. Fornybarmål for Norge 2020 i lys av EUs energi- og klimapakke, En rapport for EBL Kompetanse, 6. mai 2008. (Renewable target for Norway 2020 in light of EUs energy and climate package, a report for EBL Kompetanse, May 6. 2008.) Searchinger, T.D., Hamburg, S.P., Melillo, J., Chameides, W., Havlik, P., Kammen, D.M., Likens, G.E., Lubowski, R.N., Obersteiner, M., Oppenheimer, M., Robertson, G.P., Schlesinger, W.H., Tilman, G.D., 2009. Fixing a critical climate accounting error, Science 326, 23 October, 527 528. Sorrell, S., Sijm, J., 2003. Carbon trading in the policy mix. Oxford Review of Economic Policy 19, 420 437. 25

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Appendix A: In this appendix, we show the equivalence of green certificate systems and feed-in tariffs systems financed by end-user taxes. We ignore the impact of uncertainty by assuming that all market participants and the regulator(s), who conduct(s) the green certificate systems/feed-in tariff systems, can correctly anticipate the market equilibrium outcomes. Let the feed-in tariff for producers of green energy in country i be given by fi = p+ si, where p is the market price of energy, and si is the subsidy element of a feed-in tariff. Furthermore, let qi denote the end-user tax on energy in country i. Hence, in the case of feed-in tariffs and end-user taxes we can write the benefit from consumption (see eq. (6) in Section 2.1), and the renewable and fossil energy producers profit functions (see eqs. (7) and (8) in Section 2.1) as: wi = B i(e i) (p + q i)e i, i = 1,2. (13) π ix = (p + s i)xi c i(x i) i = 1,2, (14) π iy = (p t)yi f i(y i) i = 1,2. (15) Recall that * ** β is the common equilibrium certificate price in scenario i). Furthermore, let β denote the common equilibrium certificate price in scenario ii), whereas and the certificate price in country i in scenario iii). *** β i denote the equilibrium outcome for Below, we show three designs of feed-in tariffs that yield the same outcome as the three scenarios for green certificates considered in this paper. 1) By setting the consumption tax ( q i ) equal to * αβ for all consumers and the subsidy ( s i ) equal to * β for all renewable energy producer, we find that the benefit and profit functions are the same as under a common green certificate system (scenario i). Hence, the consumers and producers optimization problems lead to exactly the same outcome for production and consumption as the green certificate system considered in Section. 2.1. 28

2) By setting the consumption tax ( q i ) equal to ** αβ i in country i, and the subsidy ( i s ) equal to ** β for renewable energy producers in both countries, we find that the benefit and profit functions are the same as under a system with differentiated targets and a common certificate market (scenario ii). Hence, the consumers and producers optimization problems lead to exactly the same outcome for production and consumption as derived in Section 2.2. 3) By setting the consumption tax ( q i ) equal to αβ in country i, and the subsidy ( s i ) equal to i *** i *** βi for renewable energy producers in country i, we find that the benefit and profit functions are the same as under a system with differentiated targets and national certificate markets (scenario iii). Hence, the consumers and producers optimization problems lead to exactly the same outcome as derived in Section 2.3. In each of the feed-in tariffs systems considered above, there are financial transfers from consumers (through taxes) to producers (through subsidies). In each of the systems, these transfers are equal to the financial transfers that occur through the certificate markets in the corresponding certificate systems. Hence, both 2) and 3) above implies financial transfers across countries. 29

Appendix B: National renewable shares in LIBEMOD for 2005 and overall national targets in LIBEMOD for the share of energy from renewable sources in gross final consumption of energy in 2020 Renewable share (2005) Renewable target share (2020) Austria 26.4% 37.1% Belgium 1.8% 12.6% Switzerland 20.2% 0.0% Germany 4.4% 16.6% Denmark 12.1% 25.1% Spain 7.5% 18.8% Finland 23.9% 33.4% France 8.6% 21.3% United Kingdom 1.2% 14.9% Greece 6.8% 17.9% Ireland 2.1% 15.0% Italy 4.4% 16.2% The Netherlands 1.3% 12.9% Norway 53.4% 67.9% Portugal 17.8% 28.3% Sweden 30.9% 40.1% 30