Torstein Bye is director of Dept. of Economics, Energy and the Environment, Statistics Norway. Michael Hoel is professor at Dept. of Economics, University of Oslo.

This is a translation of their Norwegian article " Grønne sertifikater - dyr og formålsløs fornybar moro" , published in Samfunnsøkonomen 7/2009:

Green certificates

- expensive and pointless renewable fun

The Norwegian government has entered into an agreement with the Swedish government on a common green certificate market for electricity, and the political parties in Norway are pointing to such a market as the answer to the energy and climate problems. In their eagerness, it seems that the government has completely forgotten commonplace economic points. By studying the market effects of such certificates, it will quickly be discovered that the effect will not be anything like that anticipated, neither for the energy market nor for the climate.

What are green certificates - and what effect do they have on the energy market?

We will first give a brief review of the general characteristics of green certificates, before examining special conditions that are relevant to Norway.

The purpose of green certificates is to get more renewable electric energy into the energy market at the expense of traditional energy, which in most countries is based on fossil fuel. These renewable technologies are too expensive to enter the market on commercial terms. A key feature of the scheme is that producers of energy based on new renewable energy sources receive certificates from the authorities, proportional to their output. The users of electric energy are required to buy a certain amount of these certificates when they buy electricity.



Thus, we have a market for electricity and a market for green certificates. For the producers of energy based on new renewable energy, this certificate represents a subsidy, and for users of electric energy, it represents a tax on the use of electricity. Both tend to reduce the energy price for the sellers. Both taxes and subsidies are redistributed between the supplier and consumer through market effects. Who ultimately pays the costs depends as usual on the price elasticities. Amundsen and Mortensen (2001), Bye (2003) and Golombek and Hoel (2005) show that in the event of rising marginal costs in the supply and decreasing demand curves, the redistribution can be so strong that the consumers actually get cheaper electricity, in which case the existing producers of electricity have to pay more than the cost of the subsidies to the new producers.

Regardless of whether consumers pay more or less for their electricity, the introduction of green certificates has three important effects:

- The producer price of electric energy will decline

- Production of traditional energy will decline, unless the supply of such energy is completely price inelastic.

- Production of renewable energy will increase

If the purpose of the scheme is to increase the production of renewable electric energy, the scheme serves its purpose. However, two questions remain: (1) Are there alternative instruments that would be more effective and/or have lower costs for achieving the goal of increased renewable energy? (2) Why should increased production of renewable energy be a goal in itself? One of the arguments for a large-scale focus on renewable energy in the EU is that the EU wants to be less dependent on imported energy (particularly gas from Russia and other countries that are considered to be unreliable suppliers). Another argument for focussing on renewable energy, which is also used in Norway, is that this contributes to technology development that is crucial for large future reductions of greenhouse gas emissions. One key question, however, is whether these two goals could not be met using more targeted instruments. This is covered in NOU 2009:16 (Ministry of Finance 2009, chapter 10 and appendix 2). One of the main points is that a distinction should be made between environmental externalities and R&D externalities when devising the instruments. The green certificates break with this.

Green certificates may in principle contribute to a recuction of the production of traditional energy. Depending upon elasticities and to the degree this energy is based on fossil fuel, green certificates therefore may contribute to reduced greenhouse gas emissions from fossil-based power production. We will return to this argument in a later section.

Special conditions in the Norwegian energy market

The Norwegian energy market has a number of features that distinguish it from corresponding markets in most other countries:

- Traditional electric energy in Norway is almost 100% hydropower, not fossil power as in most other countries.

- The supply of power from existing hydro-electric power stations is extremely price inelastic.

- Norwegian hydropower is largely (at least 90 %) owned by the state and local authorities.

As explained above, the producer price will decline with the introduction of green certificates. Since the supply of existing hydropower is almost completely inelastic, the effect on this production will be very little if any, but the producers' profits will fall. Since most of the profit will be taxed or collected in dividends, the public sector will be left with the bill. It will be interesting to see what parts of the economy must be taxed harder or what public expenses must be reduced. Is increased renewable energy the right prioritising of public funds?

One feature of the Norwegian certificate market is that manufacturing will be exempt. The Ministry of oil and energy (MOE) estimates that the market will cover 80 TWH (70 percent of the Norwegian market)- which means that the power-intensive manufacturing is expected to be exempt, while the rest of manufacturing must be included. Since the requirement  to buy certificates is on Norwegian consumers, foreign buyers will not be covered by the Norwegian scheme. Foreign users will therefore benefit from the introduction of green certificates since the producer price of energy will fall. Power-intensive manufacturing, which is a large consumer of electric power, and manufacturing that supplies producers of renewable energy will therefore both benefit from the introduction of green certificates. Consequently, it is not surprising that the Norwegian manufacturing industry strongly supports such a scheme.

The climate effect of green certificates in Norway

The complete climate effects of such a scheme can normally be broken down into i) effects in the part of the economy that is exposed to green taxes and ii) effects in the part that is within the European permit market for emission allowances.

In Norway, large parts of the greenhouse gas emissions are regulated through taxes, e.g. green taxes are charged on heating oil and transport. If, as discussed above, the subsidy effect of renewable energy is stronger than the tax effect (through the certificate requirement), the electricity price for the buyers will fall. Consequently, we will use more electricity and less oil, and this will reduce greenhouse gas emissions in Norway. To the extent that Norway has a quantitative target for domestic emission reductions, green certificates help achieve this target. However, the use of oil in Norway is controlled far more effectively through the CO2 tax than through the indirect effect via the price paid by the users of electricity. If we want to reduce the use of oil that is competing with electricity, we can therefore increase the tax on such oil instead.

The MOE's prediction is that the price of electric power for the buyers will increase. Consequently, we will use less electricity and more heating oil, and greenhouse gas emissions will increase in Norway, which was certainly not the intention. Higher prices will make it profitable to use more energy-efficient solutions at home and at work. The latter is no doubt a desired effect, but is it necessary to use such a long-winded method to achieve this?

In recent years, Norway has been a net exporter of electric power. The power production that is triggered by the certificate market will increase this export. Questions may indeed be asked as to why we should subsidise renewable power production in Norway, which implies an export subsidy. Many seem to believe that an increase in the export of electricity will replace coal-based power production in Denmark and other North European countries. The European power market is, however, regulated through the EU's permit market for greenhouse gas allowances. This permit system has a cap on the total emissions that are covered by the permit system, regardless of how much renewable electric energy is being produced in Norway. While increased export of Norwegian power might initially reduce the production of coal power in Denmark, these producers of power would use fewer emission permits than they would without the Norwegian export. The price of permit would fall, as would the costs of power production, and power production could in principle be sustained at a higher level. It seems more likely that the production of coal power will decline somewhat. But if this is the case,  more emission permits will be available for other participants in this market, for example cement producers and other manufacturing in Germany. Since the permit price in the allowance market will decline, emissions from these companies will increase. Total emissions in the permit market will remain the same, but there will be a shift from Danish coal-fired powered plants to other companies within the permit market in the EU.

If all greenhouse gas emissions in Europe were regulated by a permit system and there was a positive price in the permit market, no other extra measures to reduce emissions would have any effect on total emissions. Neither cleaning gas power plants, subsidising windmills, nor providing support for energy-efficient measures for companies and households will have any effect on the emissions in a permit system. The initial emission reductions will only affect the permit price, not the total emissions. For instance, even the financial crisis has no effect on the total emissions in the permit market. The permit price remains positive, i.e. the market is binding. If companies demand less initially, this will be fully offset by the fall in the permit price and increased emissions from other polluters. Only in the event of a zero permit price - i.e., where the permit market is not binding - will such extra measures as outlined above work. The only way to reduce total greenhouse gas emissions is to tighten the  permit market. All focus should therefore be aimed at achieving this. A good example would for Norway to buy emission allowances in this market, but not use them. An effect of this would be to make the permit market tighter; the price of permits would go up and renewable technologies might become profitable, and R&D on such technologies would become more profitable.

A low price in the permit market implies that it is inexpensive for market participants to reduce emissions. Consequently, there may be a strong political will to tighten the permit market, which can seem desirable. However, if this low price is as a result of numerous expensive measures, such as the green certificate market, then we shouldn't be fooled as it is not inexpensive at all. Reducing emissions is expensive, but we are fooled into thinking that it is cheap. We are fooled into paying for it through other taxes (cf public budget) instead of charging those who are responsible for the pollution (cf. Polluter Pay Principle).

A low price in the permit market is not necessarily good for the climate in a long-term perspective. In the debate on future climate policy, the importance of research and development is highlighted. A lower price on CO2 emissions will make it less commercially viable to carry out research and development in new energy technologies. It is technology development itself that is vital to making it cheaper to reduce emissions in the future, and to making it easier to include more countries in more stringent agreements. Paradoxically, subsidy schemes such as green certificates may actually make it more difficult to carry out R&D, reduce emissions, and achieve a tighter climate policy after 2020.

Better to buy discharge permits through the EU permit market?

The MOE estimates in its press release on the green certificate scheme that the certificate price could be around NOK 0.24/kWh, and that almost 12 TWh of new power production (billion kWh) can be realised through this scheme. This therefore entails major subsidising in the region of billions, and as explained above, most of this power will probably be exported. The current price of emission permits in the European permit market is just below NOK 120/t CO2. This means that for every NOK 1.2 billion in subsidies today, we could alternatively buy 10 million tonnes worth of emission permits (almost 20 per cent of emissions in Norway), cast these aside and thereby reduce Europe's emissions correspondingly. Even if the quota price rises, this will represent emission reductions on a scale that has never been seen before, ref. for example that the cleaning of gas power stations only generates around 1 million tonnes of emission reductions. The government has never indicated how much the greenhouse gas emissions abroad can be reduced as a result of Norway's power export through the green certificate scheme. Perhaps they know that the conclusion is that the emissions will not be reduced. Or, where can we find the analyses showing how subsidising exported electric energy on a large scale can achieve a greater reduction in emissions abroad than through buying emission permits that we don't use?

The green movement

Why is such a large part of the green movement positive towards green certificates and other subsidies for wind power and other renewable energy? This is most likely due to a confusion of cause and effect. A strict climate policy aimed directly at CO2 emissions will make renewable energy more profitable, and non-fossil energy will partly replace fossil energy. However, it is not the case that the opposite is true. Subsidies for renewable energy will not in themselves give lower emissions of CO2. This particularly applies to Norway with its special power sector (almost exclusively hydropower) and affiliation with the EU's permit market. However, it also applies in a more general sense: subsidies can generate renewable energy which mainly comes in addition to, and not instead of fossil-based energy. Moreover, the emissions in the permit market remain unchanged.

REFERENCES:

Amundsen, E. S. and J. B. Mortensen (2001): The Danish Green Certificate System. Some simple analytical results. Energy Economics 23 (99), 489-509.

Bye, T. (2003): On the Price and Volume Effects from Green Certificates in the Energy Market, Discussion Paper 351, Statistics Norway.

Golombek, R. and M. Hoel (2005): Pliktige elsertifikater ("Taxable el-certificates" - in Norwegian only). Report 1/2005, Ragnar Frisch Centre for Economic Research.

Ministry of Finance (2009): Globale miljøutfordringer - norsk politikk. Hvordan bærekraftig utvikling og klima bedre kan ivaretas i offentlige beslutningsprosesser. ("Global environmental challenges - Norwegian policy. How sustainable development and the climate can be better protected in public decision-making processes" - in Norwegian only) NOU 2009:16.