Returns to scale in the electricity supply sector, imperfect competition, and efficiency of climate change policies

Abstract

Climate change policies often contain the dual objectives of trying to reduce the level of CO2 emissions from the use of fossil-fuels while at the same time encouraging the use of renewable energy. In the area of electricity generation, these two objectives can be considered either as complementary or competing with each other. In this paper we show that this depends on the structure of the electricity market and the characteristics of the generation technologies. If the market is perfectly competitive with all technologies subject to constant returns to scale then climate change policies may require only one instrument to achieve the single objective of CO2 emissions reductions. If on the other hand some fossil-fuel based electricity generation technologies are subject to increasing returns to scale which gives rise to some degree of natural monopolistic power in the electricity generation market then to correct for both the environmental externality which is caused by un-priced CO2 emissions and the market imperfection caused by the existence of increasing returns to scale, policy makers may need two rather than just one policy objectives (and instruments). The first objective is to correct for the environmental externality and reduce CO2 emissions while the second objective is to correct for the imperfection in the electricity market. Whether the secondary objective can help or hinder the first objective will depend on how it is designed. In this paper, we illustrate this analysis with an examination of the European Union 20-20-20 climate change policies.