Energy Economics

Energy Economics

Your readings this week discuss the natural gas crisis of 1974-1975 as created by faulty policy. Discuss the exact cause of this crisis and how might it have been avoided. Then, reread example 8.4 (Renewable Energy Credits) and example 8.5 (Feed-in Tariffs) in your text. Which of these strategies do you believe will more effectively increase the use of renewable energy and result in better economic benefits to the nation as a whole? Make sure to back up your decision with at least one scholarly source.

EXAMPLE 8.4 Renewable Energy Credits: The Texas Experience

Texas has rapidly emerged as one of the leading wind power markets in the United States, in no small part due to a well-designed and carefully implemented government directive known as a renewable portfolio standard (RPS) coupled with renewable energy credits. The RPS specifies targets and deadlines for producing specific proportions of electricity from renewable resources (wind, in this case) while the credits lower compliance cost by increasing the options available to any party required to comply.

The early results have been impressive. Initial RPS targets in Texas were easily exceeded by the end of 2001, with 915 megawatts of wind capacity installed in that year alone. The response has been sufficiently strong that it has become evident that the RPS capacity targets for the next few years will also be met early. RPS compliance costs are reportedly very low, in part due to a complementary production tax credit (a subsidy to the producer). Additionally, especially favorable wind conditions in Texas and an RPS target that was ambitious enough to allow economies of scale to be exploited have contributed to the program’s success. The fact that the cost of administering the program is also low, due to an efficient, Web-based reporting and accounting system, also helps.

Finally, and significantly, retail suppliers have been willing to enter into long-term contracts with renewable generators, reducing exposure of both producers and consumers to potential volatility of prices and sales. Long-term contracts ensure developers a stable revenue stream and, as a result, access to low-cost financing, while offering customers a reliable, steady supply of electricity.

Source: Langniss, O. and R. Wiser, “The Renewables Portfolio Standard in Texas: An Early Assessment,” Energy Policy 31, 2003: 527–535.

Another quite different approach is promoting the use of renewable resource in the generation of electric power. Used in Germany this approach, known as a feed-in tariff, focuses on establishing a stable price guarantee rather than a subsidy or a government mandate (see Example 8.5).

Energy Efficiency

As the world grapples with creating the right energy portfolio for the future, energy efficiency policy is playing an increasingly prominent role. In recent years the amount of both private and public money being dedicated to promoting energy efficiency has increased a great deal.

The role for energy efficiency in the broader mix of energy policies depends of course on how large the opportunity is. Estimating the remaining potential is not a precise science, but the conclusion that significant opportunities remain seems inescapable.

The existence of these opportunities can be thought of as a necessary, but not sufficient condition for government intervention. Depending upon the level of energy prices and the discount rate, the economic return on these investments may be too low to justify intervention. Additionally, policy intervention could be so administratively costly as to outweigh any gains that would result.

EXAMPLE 8.5 Feed-in Tariffs

Promoting the use of renewable resources in the generation of electricity is both important and difficult. Germany provides a very useful example of a country that seems to be especially adept at overcoming these barriers. According to one benchmark, at the end of 2007, renewable energies were supplying more than 14 percent of the electricity used in Germany, exceeding the original 2010 goal of 12.5 percent.

What prompted this increase? The responsible economic mechanism is called a “feed-in tariff.” This mechanism determines the prices received by anyone who installs qualified renewable capacity that feeds electricity into the grid. In general, a fixed incentive payment per kilowatt-hour is guaranteed for that installation. The level of this payment (determined in advance by the rules of the program) is based upon the costs of supplying the power and is set at a sufficiently high level so as to assure installers that they will receive a reasonable rate of return over the life of their investment. While this incentive payment is guaranteed for 20 years for each installed facility, each year the level of that guaranteed 20-year payment is reduced (typically in the neighborhood of 1–2 percent per year) for new facilities to reflect expected technological improvements and economies of scale.

This approach has a number of interesting characteristics:

● It seems to work.

● No subsidy from the government is involved; the costs are borne by the consumers of the electricity.

● The cost of the electricity from feed-in tariff sources is typically higher in the earlier years than for conventional sources, but lower in subsequent years (as fossil fuels become more expensive). In Germany the year in which electricity becomes cheaper due to the feed-in tariff is estimated to be 2025.

● This approach actually offers two different incentives: (1) it provides a price high enough to promote the desired investment and (2) it guarantees the stability of that price rather than forcing investors to face the market uncertainties associated with fluctuating fossil fuel prices or subsidies that come and go.

Source: Jeffrey H. Michel (2007), “The Case for Renewable Feed-In Tariffs” Online Journal of the EUEC, Volume 1, Paper 1, available at

The strongest case for government intervention flows from the existence of externalities. Markets are not likely to internalize these external costs on their own. The natural security and climate change externalities mentioned above, as well as other external co-benefits such as pollution-induced community health effects, certainly imply that the market undervalues investments in energy efficiency.

The analysis provided by economic research in this area, however, makes it clear that the case for policy intervention extends well beyond externalities.3 Internalizing externalities is a very important, but insufficient policy response.

Consider just a few of the other foundations for policy intervention. Inadequately informed consumers can impede rational choice as can a limited availability of capital (preventing paying more up front for the more energy efficient choice even when the resulting energy savings would justify the additional expense in present value terms). Perverse incentives can also play a role as anyone who has lived in a room (think dorm) or apartment where the amount of energy used is not billed directly, resulting in a marginal cost of additional energy use that is zero.

A rather large suite of policy options has been implemented to counteract these other sources of deficient levels of investment in energy efficiency. Some illustrations include the following:

● Certification programs such as Energy Star for appliances or LEED (Leadership in Energy and Environmental Design) for buildings attempt to provide credible information for consumers to make informed choices on energy efficiency options.

● Minimum efficiency standards (e.g., for appliances) prohibit the manufacture, sale, or importation of clearly inefficient appliances.

● An increased flow of public funds into the market for energy efficiency has led to an increase in the use of targeted investment subsidies. The most common historic source of funding in the electricity sector involved the use of a small mandatory per kilowatt-hour charge (typically called a “system benefit charge” or “public benefit charge”) attached to the distribution service bill. The newest source of funding comes from the revenue accrued from the sale of carbon allowances in several state or regional carbon cap-and-trade programs (described in detail in Chapter 16). The services funded by these sources include supplementing private funds for diverse projects such as weatherization of residences for low-income customers to more efficient lighting for commercial and industrial enterprises.

The evidence suggests that none of these policies either by themselves or in concert are completely efficient, but that they have collectively represented a move toward a more efficient use of energy. Not only does the evidence seem to suggest that they have been effective in reducing wasteful energy demand, but also that the programs have been quite cost effective, with program costs well below the cost of the alternative, namely generating the energy to satisfy that demand.