CLEAN ENERGY TECHNOLOGY BUYDOWNS: ECONOMIC THEORY, ANALYTIC TOOLS, AND THE PHOTOVOLTAICS CASE Richard D. Duke A DISSERTATION PRESENTED TO THE FACULTY OF PRINCETON UNIVERSITY IN CANDIDACY FOR THE DEGREE OF DOCTOR OF PHILOSOPHY RECOMMENDED FOR ACCEPTANCE BY THE WOODROW WILSON SCHOOL OF PUBLIC AND INTERNATIONAL AFFAIRS November, 2002 © Copyright by Richard D. Duke, 2002. All rights reserved. Abstract The conventional responses to the market failures that constrain energy innovation include market tuning (e.g. pollution taxes) as well as supply-push (i.e. public support for research, development, and demonstration). There is no similar consensus favoring demand-pull programs, but this dissertation develops an economic rationale for subsidies to pull emerging clean energy technologies down their respective experience curves. Even with optimal pollution taxes in place, such buydowns can improve welfare—primarily by correcting for learning-by-doing spillover that discourages firms from forward pricing (i.e. pricing below the short-term profit maximizing level to reduce costs through production experience). Learning spillover also occurs in other sectors, but the case for clean energy buydowns is unique. Governments wisely seek a broad supply-push portfolio, but only the most promising clean energy options merit demand-pull support because individual buydowns are costly and generate scant spin-offs absent successful commercialization of the targeted technology. Moreover, governments have more information about technologies at the deployment stage and failure to screen out poor prospects can yield entrenched corporate welfare programs (e.g. grain ethanol). The buydown selection criteria proposed herein favor support for photovoltaics (PV), and the recommended implementation strategy optimizes this support. Conventional analyses assume markets fully materialize as soon as the technology reaches financial breakeven, suggesting buydowns should be implemented as quickly as possible. The optimal path method introduced in this dissertation more accurately iii models demand and defines the welfare-maximizing subsidy/output schedule. An optimal PV buydown would triple current demand subsidies and sustain declining per- unit support for over four decades. Such a buydown (initially targeting residential markets in industrialized countries) need never raise electricity rates by more than 0.5 percent while delivering roughly $50 billion in long-term net benefits (relative to a no- subsidy scenario) and allowing PV to provide over 5 percent of industrialized country electricity by 2030 (vs. less than 1 percent without subsidies). Finally, implementing buydowns at the regional level bypasses the international collective action problem and reduces the disruption from the failure of any single program. A decentralized approach also facilitates program innovation and reduces free rider subsidy costs—a crucial determinant of buydown economics. iv Table of Contents Abstract.............................................................................................................. iii Table of Contents.................................................................................................v Acknowledgements..............................................................................................x List of Figures.................................................................................................. xiii List of Boxes......................................................................................................xv List of Tables ....................................................................................................xvi List of Acronyms ............................................................................................ xvii Chapter 1: Introduction.....................................................................................1 Motivation ...........................................................................................................1 Approach ...........................................................................................................11 Chapter 2: The rationale for clean energy buydowns.....................................13 Market failures attributable to learning-by-doing................................................14 Imperfect spillover.........................................................................................15 Perfect appropriability ...................................................................................21 The perfect spillover assumption ...................................................................22 Summary.......................................................................................................26 The unique buydown potential of the clean energy sector...................................27 The buydown advantages of clean energy technologies..................................27 The buydown disadvantages of technologies from other sectors.....................31 Summary............................................................................................................38 Appendix ...........................................................................................................39 No discounting case.......................................................................................39 v Discounting case............................................................................................42 Chapter 3: Implementing clean energy buydowns .........................................44 Quantifying learning-by-doing ...........................................................................44 Learning curves .............................................................................................44 Experience curves..........................................................................................46 Cost-benefit analysis of buydowns .....................................................................47 The conventional breakeven method..............................................................48 The optimal path method ...............................................................................53 Technology selection criteria..............................................................................57 Analytic challenges ............................................................................................61 Relation of experience curves to supply curves..............................................62 Experience curves and causality ....................................................................63 Microstructure in experience curves ..............................................................66 Implementation challenges.................................................................................71 Subsidy targeting, regressivity, and the marginal excess burden.....................71 The politics of buydowns...............................................................................73 Lessons from the U.S. Grain Ethanol Program...............................................75 Summary............................................................................................................82 Chapter 4: Background on PV technology and markets ................................83 PV Technology ..................................................................................................84 PV market segments...........................................................................................86 Off-grid markets............................................................................................88 Grid-connected markets.................................................................................91 vi Summary.......................................................................................................94 PV and the buydown technology selection criteria..............................................95 Criterion 1: Competitive market structure ......................................................95 Criterion 2: Strong experience curve with a low price floor ...........................96 Criterion 3: Low current sales but strong market acceleration with subsidies.............................................................................98 Criterion 4: Low market risk from substitutes ................................................98 Criterion 5: Public benefits ..........................................................................100 Synthesis .....................................................................................................105 Public sector support for PV technology development and deployment ............106 The Japanese PV buydown ..........................................................................108 The German PV buydown ...........................................................................112 The U.S. context ..............................................................................................113 Market tuning ..............................................................................................115 Buydowns ...................................................................................................119 Residential PV market potential...................................................................120 Summary..........................................................................................................126 Chapter 5: Buydown analysis for distributed grid-connected PV................127