Incentive Scheme for Efficient Generation Investment in Renewable Energy Sources

Abstract

The way energy is produced has a massive effect on the sustainability of a system, necessitating a shift towards renewable energy sources. Therefore, the behaviour of producers in electricity markets is central to achieving any sustainability goals. In this article, we identify two problems to overcome. First, electricity markets typically follow competitive market clearing with a least-cost dispatch which does not include negative externalities due to pollution. We argue that these externalities cannot be incorporated into the price and propose a Pigouvian tax to overcome this. Second, renewable energy sources have low operational costs and therefore, when they are utilised, prices in the system are low in turn resulting in lower profits for producers. Coupled with low profits, producers would incur high investment costs to install renewable energy units. This encourages producers to invest strategically. To overcome this, we propose to grant producers a subsidy equal to their marginal contribution to the consumer surplus. Since the consumer surplus would increase with decreasing prices, producers would be incentivised to install socially optimal generation capacity. Finally, we show that the proposed tax and subsidy can be implemented without increasing the regulator's information burden.

Keywords: Renewable Energy, Electricity generation capacity, Market power, Environmental externalities, Incentives