Environmental Taxation and Subsidization in an Oligopolistic Wholesale Market of Electricity with Intermittent Renewable Energy Sources

Abstract

I investigate how environmental taxation and subsidization impact investment in non-polluting, intermittent renewable power plants such as wind power and photovoltaics in a wholesale electricity market where oligopolistic firms produce electricity from both polluting fossil fuel inputs and non-polluting renewable energy (RE), and a competitive fringe produces electricity only from non-polluting RE. An emission tax imposed on fossil fuel use such as carbon pricing (CP) is expected to discourage firms from operating the fossil fuel power plants, thereby promoting the substitution of RE for fossil fuel inputs. A subsidy provided to firms building and operating renewable power plants such as feed-in tariffs (FIT) and feed-in premiums (FIP) is expected to reduce setup costs, thereby promoting RE use. This study’s findings indicate that, among FIT, FIP, and CP, a unit increase in subsidy rate under FIT has the greatest impact on RE investment, while a unit increase in tax rate under CP has the smallest impact. Furthermore, if no correlation exists between available renewable power plants at different locations, the wholesale electricity price in an oligopolistic market with FIP or CP is less volatile than that with FIT. This result occurs because the market power of oligopolists facing FIP or CP mitigates the merit order effect, which indicates how much RE lowers the electricity price. The key insight from the model application to a wholesale electricity market in Japan is that the market demand function for wholesale electricity and RE investment costs are among the crucial factors in the achievement of welfare-optimal allocation through environmental taxation and subsidization.