1. Reads
  2. Deep Dives

A Comparative Study on Environmental Economics Using Carbon Pricing and Subsiding Renewables

Jan 22, 2022 3:42 AM 8 min read

By the time we see that climate change is really bad, your ability to fix it is extremely limited… The carbon gets up there, but the heating effect is delayed. And then the effect of that heat on the species and ecosystem is delayed. That means that even when you turn virtuous, things are actually going to get worse for quite a while. - Bill Gates

It is, I promise, worse than you think. If your anxiety about global warming is dominated by fears of sea-level rise, you are barely scratching the surface of what terrors are possible, even within the lifetime of a teenager today. And yet the swelling seas — and the cities they will drown — have so dominated the picture of global warming, and so overwhelmed our capacity for climate panic, that they have occluded our perception of other threats, many much closer at hand. Rising oceans are stormy, in fact very bad, but fleeing the coastline will not be enough.

This article would be about environmental economics or the idea that countries would be better off economically if they focused on improving their environmental policies. This could incentivise more businesses to come to a country, but it could also push away pro-environmental business. The article will examine how different countries might fare within environmental economics and what guiding principles they can use as guidelines for developing more thoughtful environmentally-friendly economic policies for their country.


What is Environmental Economics?

Environmental economics is an applied branch of economics that considers the effects of economic activity on the environment. It seeks to identify and quantify both the costs and the benefits of economic development projects on natural capital. It has been argued that "environmental issues are best addressed by investing in sustainable growth rather than taking punitive measures after some environmental damage has occurred." The most widely spread example of environmental economics is the trade and cap system. Companies buy carbon offsets from environmental organisations to make up for the carbon emissions. Another prominent example is the imposition of a carbon tax to penalise carbon-emitting industries.

Today, people worldwide have realised that the environment is not just studying flora and fauna, but a combination of learning different branches of knowledge, such as science, economics, philosophy, ethics, anthropology, etc. Therefore, a review of environmental economics calls for a detailed understanding of various environmental causes, their effect on the economy, their roles on the environment, and their influence on the present and future people's lives.

The core question is how to allocate the finite amount of resources of the Earth to meet “the needs of the present, without compromising the ability of future generations to meet their own needs''. Economics, combined with earth system sciences, is crucial for understanding the positive and negative effects of alternatives and the tradeoffs involved. Applying economic principles and factual findings becomes imperative to meet the rising demands for a decent standard of living given the limited resources. Although economic activities generate pollution, it is not an inevitable consequence.


The State's Role

The role of the government comes into play here. Governments implement policies to regulate environmental damage and effluent through various command and control measures like tax or subsidies or pollution standards. The market can also maintain environmental standards through incentive-based steps such as tradable pollution permits and Coase Bargaining. Generally, though these measures will involve some costs, there is a tradeoff between a cleaner environment and economic costs.

This seems to be the right time to segway into the following critical segment of the article, which revolves around the effectiveness of Climate Policies. This can be understood by talking about two essential terms, i.e. Carbon Pricing and Subsidising Renewables.


Climate Action: Carbon Pricing and Subsidising Renewables

Numerous efforts have been undertaken to combat existing climate change, whereas global emissions have increased steadily, threatening future economic activity, agriculture, and health. The economic theory clearly emphasises that putting a price equal to the social damages on greenhouse-gas (GHG) emissions internalises their negative externality via market-based incentives. Many economists often argue that pricing emissions may represent a first-best policy, leading to effective emissions reduction at the lowest possible costs. Other policies, including subsidies for "green technologies" (e.g. Wind, solar, electric cars, etc.) and administrative measures, popular among law-makers and widely applied in the climate change agendas of many countries, represent only second-best options. However, alternative opinions argue that a mix of policies may best lead to deep decarbonisation at an accelerated pace or even argue against carbon pricing. Given that many policy-makers do not view carbon pricing as the single most vital tool to tackle climate change and that administrative policies and subsidies are widely applied to these, it is critical to understand not only if carbon pricing comes out as the most efficient policy in an overall evaluation, but also to know the order of magnitude of costs related to different climate policies, as well as their mutual effects on the environment.  This knowledge needs to be determined for taking any sort of political action in future.

Our primary goal here is regarding subsidising renewable energies (RE). Our focus throughout this article will be on Germany's and Britain's power sectors – the sector behind a significant chunk of emissions – because their power sectors follow the same qualitative principles. In contrast, the two countries pursue completely different climate actions and policies. However, the power sectors are comparable since prices are determined in wholesale day-ahead markets by "merit order curves", i.e. Bid schedules determined by marginal costs. Moreover, electricity generation sources (e.g. Renewables, nuclear, gas, and coal) and patterns – while quantitatively different – are qualitatively comparable. This comparability allows us to estimate an econometric carbon emissions model using the same set of determinants for the two contrasting yet similar countries.  Germany's power sector emissions revolve around the price for emission certificates (EUA) as determined by the EU Emission Trading System (ETS), which was low for an extended period, whereas Germany heavily subsidises RE. In contrast, Britain's overall support for RE is less pronounced, and this number is falling over time.

In contrast, the country placed a significant unilateral tax, the "Carbon Price Support" (CPS), on its emissions in the power sector which is parallel to the EUA price. Notably, despite its heavy RE subsidies, Germany's power sector emissions only declined modestly in recent years. In contrast, Britain's emissions fell by an astonishing 55% in only five years since the introduction of the CPS.

In the first step, we analyse emissions reduction associated with carbon pricing and RE subsidies using a database of daily electricity generation data at the plant of all gas and coal power stations in Germany and Britain, together with essential plant characteristics to calculate CO2 emissions. In the second step, we seek to estimate the directly attributable costs of a marginal reduction in terms of carbon pricing and subsidies for RE.

It is essential to emphasise the strengths and limitations of our cost analysis. Intuitively, we ask how much reduction the state/consumers/taxpayers "buy" with, for example, one billion euro when pricing carbon or subsidising wind and solar. Here, We do not count for any external inefficiencies (e.g. Increased costs of production by switching from (cheap) coal to more expensive gas), nor for the effects following from changes in the wholesale electricity price induced by the policies, nor for other general equilibrium effects (e.g. Redistribution of tax revenues, etc.). We thus acknowledge that our approach of measuring costs is far from perfect yet informative for policy making.

One of our significant findings from the research that is carried out is that the comparatively low EUA price in Germany only led to a moderate reduction of emissions (by 10% on average). In contrast, for higher carbon prices, reduction tends to increase significantly. On the other hand, Britain's much higher effective carbon price (due to the CPS) resulted in significant carbon reduction (up to 31%). Another important finding is that wind and solar power have also significantly contributed to emissions reduction in both member nations (wind and solar in Germany account for 18% and 6%, respectively, on average; wind in Britain by 17%).

Moreover, we find that the effectiveness of RE depends heavily on the level of the carbon price that it carries. Thus, whether carbon pricing and RE subsidies reinforce or weaken each other's abatement effectiveness depends on which technology ("dirty" coal or "cleaner" gas) is replaced at the margin.

Our results highlight the workings of the carbon price in the power sector, suggesting that even relatively modest carbon prices of around €30/tCO2 may bring about substantial emissions reduction in the short run – as long as relatively "clean" gas-fired power plants are available to displace "dirty" coal. In contrast, high carbon prices well beyond €35 are associated with lower marginal reduction because many of the coal-fired electricity generated will already be replaced, leaving only emissions from gas to be offset, and hence the costs associated with this are substantial.

Although a unilateral climate policy (e.g. A national carbon tax or subsidies for RE) will lead to significantly higher emissions elsewhere under an emissions cap-and-trade program , knowing the reduction and costs associated with unilateral climate policies may well allow for conclusions about internationally coordinated climate strategies. Firstly, if many countries adopted effective unilateral policies and stopped the associated emissions allowances, total emissions would be reduced automatically, and the waterbed effect would be avoided. Secondly, our research is reassuring for those countries that take unilateral measures (so-called "nationally determined contributions", NDCs) to reach their national emission reduction targets at a manageable cost, such as Britain.

The existing research has not yet achieved such a feat or comparison of any sort in a well-defined setting. Key results of this study are that carbon pricing is more effective than other supply-side instruments despite its lack of popularity and that even a relatively moderate carbon price can already induce a significant reduction in the power sector within a short period. At the same time, we ponder and argue that pre-existing capital stocks and readily available substitutes are essential for this conclusion. Second, we extend the scope of analysis beyond one country. We compare a country that emphasises carbon pricing (Britain) with a government that puts more relative weight on command-and-control measures (Germany). While this appears to be a trivial or small contribution, at first sight, careful analysis and comparison of the different potential options available to politicians across other countries are pivotal and central to combat climate change. Finally, we contribute methodologically. Climate change policy is "active" in that many actions are set ranging from carbon pricing over supply-side measures, such as subsidising various forms of renewables, to other more interventionist measures, such as setting emission standards or (essentially) prohibiting some types of plants altogether (e.g. The LCPD). We disentangle the effects of the carbon price and wind and solar electricity from the impact of these other measures by emphasising their covariance with emissions.

Our study extends the growing literature, which estimates the emissions offset from different climate policies. One strand analyses only second-best climate policies concerning their abatement effects via wind and/or solar power. While others take both the EU ETS price and wind and solar power into account, yet only derive conclusions for renewables, leaving the carbon price to serve merely as a control variable. No study empirically investigates the pricing of CO2 and compares this policy to other policies, such as direct supply-side subsidisation of RE. Although it may be intuitive to expect similar (but opposite) effects from natural gas price changes and carbon price changes, the quantitative results may differ. We thus prefer to directly include a carbon price compared to indirect methods (e.g., assuming that the cost of gas mimics the effect of a CO2 price) to infer the effectiveness of the respective policies.


Written by Vinamra Harkar


Interested in more such fun facts and trivia to nudge you towards stimulating conversations? Subscribe to TRANSFIN. E-O-D to keep them coming!