JOBNAME: Earthscan−renewenerg PAGE: 1 SESS: 34 OUTPUT: Wed Jul 14 08:17:26 2010 SUM: 51A949C3 /production/earthscan/books/renewenergy/chap05 5 Market Failure and the Structure of Externalities Kenneth Gillingham and James Sweeney olicy interest in renewable energy technolo- Advocates of strong policy incentives for Pgies has been gathering momentum for the renewable energy in the United States use a vari- past several decades, and increased incentives and ety of arguments to justify policy action, such as funding for renewable energy are often described ending the “addiction” to foreign oil, addressing as the panacea for a variety of issues ranging from global climate change, or creating new technolo- environmental quality to national security to gies to increase U.S. competitiveness. However, green job creation. Sizable policies and programs articulation of these goals leaves open the ques- have been implemented worldwide to encourage tion of whether renewable energy policy is a sen- a transition from fossil-based electricity genera- sible means to reach these goals, or even whether tion to renewable electricity generation, and in particular renewable energy policy helps meet particular to fledgling green technologies such as these goals. Furthermore, many different policy wind, solar, and biofuels. instruments are possible, so one must evaluate The United States has a long history of policy what makes a particular policy preferable over activity in promoting renewables, including state- others. level programs, such as the California Solar Initia- tive, which provides rebates for solar photovoltaic Economic theory can provide guidance and purchases, as well as federal programs, such as tax more rigorous motivation for renewable energy incentives for wind. Even in the recent stimulus policy, relying on analysis of the ways privately package, the American Recovery and Reinvest- optimal choices deviate from economically effi- ment Act of 2009, $6 billion was allocated for cient choices. These deviations are described as renewable energy and electric transmission tech- market failures and, in some cases, behavioral fail- 1 nology loan guarantees (U.S. Congress 2009). ures. Economic theory indicates that policy (See Chapter 11 for further discussion of the U.S. measures to mitigate these deviations can improve experience.) Moreover, such policies are not net social welfare, as long as the cost of imple- restricted to the developed world. For example, menting the policy is less than the gains if the China promulgated a National Renewable deviations can be successfully mitigated. Energy Law in 2005 that provides tax and other Under this perspective, policy analysis incentives for renewable energy and has suc- involves identifying market failures and choosing ceeded in creating a burgeoning wind industry appropriate policy instruments for each. While an (Cherni and Kentish 2007). almost unlimited number of different possible Kerrypress Ltd – Typeset in XML A Division: chap05 F Sequential 1 JOBNAME: Earthscan−renewenerg PAGE: 2 SESS: 34 OUTPUT: Wed Jul 14 08:17:26 2010 SUM: 6A43C373 /production/earthscan/books/renewenergy/chap05 70 Kenneth Gillingham and James Sweeney policy instruments can be envisioned, an analysis either the availability of a substitute energy source of relevant market failures allows us to identify or scarcity of the resource. The greater the rate of which instruments are most likely to improve use relative to the size of the resource stock, the economic efficiency.This endeavor is complicated shorter the time until this ultimate depletion can by the complexity of some market failures, which be expected. may vary intertemporally or geographically. These simple facts about the nature of This chapter explores these issues in the con- depletable and renewable resources point to a text of renewable energy, with a particular focus seemingly obvious conclusion: the United States on renewable energy used for electricity genera- and the rest of the world will eventually have to tion. It first sets the stage with a brief background make a transition to alternative or renewable on the fundamental issues inherent in renewable sources of energy. However, the knowledge that energy. Next, it elaborates on the concepts of the world will ultimately transition back to competitive markets and resource use, and how renewable resources is not sufficient reason for the deviations found in reality from the assump- policies to promote those resources. Such transi- tions of perfect markets may result in market fail- tions will happen regardless of policy, simply as a ures. This leads naturally to articulating the classes result of market incentives. of possible deviations from perfect markets. A dis- The fundamental question is whether markets cussion follows of the use of policy instruments to help mitigate or correct for these market failures, will lead the United States and the rest of the with a particular focus on how the structure of the world to make these transitions at the appropriate failure influences the appropriate policy approach. speed and to the appropriate renewable resource conversions, when viewed from a social perspec- tive. If not, then the question becomes, why not? And if markets will not motivate transitions at the Fundamental Issues in appropriate speed or to the appropriate renewable supplies, the question becomes whether policy Renewable Energy interventions can address these market failures so Renewable energy, including wind, solar, hydro, as to make the transitions closer to the socially geothermal, wave, and tidal, offers the possibility optimal. of a large, continuous supply of energy in perpe- The question of why not may seem clear to tuity. Analysis of the natural energy flows in the those who follow the policy debates. Environ- world shows that they provide usable energy mental and national security concerns are fore- many orders of magnitude greater than the entire most on the list of rationales for speeding up the human use of energy (Hermann 2006). For transition from depletable fossil fuels to renewable example, the amount of sunlight reaching the energy. Recently there have also been claims that earth is more than 10,000 times greater than the promoting new renewable technologies could total human direct use of energy, and the amount allow the United States, or any country, to of energy embodied in wind is at least 4 times become more competitive on world markets or greater (Archer and Jacobson 2005; Da Rosa could create jobs. 2005; EIA 2008). In principle, renewable energy But much national debate often combines offers the possibility of a virtually unlimited sup- these rationales and fails to differentiate among ply of energy forever. the various policy options, renewable technolo- In contrast, most of the energy sources we rely gies, and time patterns of impacts. The rest of the on heavily today, such as oil, natural gas, coal, and chapter explores these issues in greater detail in uranium, are depletable resources that are present order to disentangle and clarify the arguments for on the earth as finite stocks. As such, eventually renewable energy policy. these stocks will be extracted to the point that they will not be economical to use, because of Kerrypress Ltd – Typeset in XML A Division: chap05 F Sequential 2 JOBNAME: Earthscan−renewenerg PAGE: 3 SESS: 34 OUTPUT: Wed Jul 14 08:17:26 2010 SUM: 74887430 /production/earthscan/books/renewenergy/chap05 Market Failure and the Structure of Externalities 71 Resource Use and Deviations tion renewable energy (e.g., residential solar pho- tovoltaic investments) and energy efficiency deci- from Perfectly Functioning sions.5 These could imply an underuse of distrib- uted generation renewable energy—or an overuse Markets of all energy sources (including renewables) if Welfare economic theory provides a framework energy efficiency is underprovided. for evaluating policies to speed the transition to Both market failures and behavioral failures renewable energy. A well-established result from can be distinguished from market barriers, which welfare economic theory is that absent market or can be defined as any disincentives to the use or behavioral failures, the unfettered market out- adoption of a good (Jaffe et al. 2004). Market bar- come is economically efficient.2 Market failures riers include market failures and behavioral fail- can be defined as deviations from perfect markets ures, but they also may include a variety of other due to some element of the functioning of the disincentives. For example, high technology costs market structure, whereas behavioral failures are for renewable energy technologies can be systematic departures of human choice from the described as a market barrier but may not be a choice that would be theoretically optimal.3 market failure or behavioral failure. Importantly, A key result for analysis of renewable energy is only market barriers that are also market or that if the underlying assumptions hold, then the behavioral failures provide a rationale based on decentralized market decisions would lead to an economic efficiency for market interventions. economically efficient use of both depletable and Similarly, pecuniary externalities may occur in renewable resources at any given time. Moreover, the renewable energy setting and also do not lead the socially optimal rate of transition from to economic inefficiency. A pecuniary externality depletable energy supplies to renewable energy is a cost or benefit imposed by