Steering the energy transition in a world of intermittent electricity supply: Optimal subsidies and taxes for renewables and storage

Spurred by substantial subsidies, renewable energies have reduced their costs and captured a steadily growing market share. However, the variability of solar and wind power leads to new challenges for power systems. Policy instruments for steering the energy transition towards a zero-carbon future must account for this. We consider an economy in which competitive firms use pollutive fossils, intermittent renewables, and storage for electricity production. A Pigouvian tax is still efficient, because price fluctuations that result from intermittent renewables provide sufficient incentives to invest in storage capacities. However, governments have proved reluctant to impose carbon taxes. Therefore, we examine second-best subsidies when carbon pricing is imperfect. The optimal subsidy rate for renewables decreases as electricity production becomes less reliant on fossils. The storage subsidy is usually negative as long as fossils are dispatched while filling the storage, but turns positive thereafter. This is because more storage capacity reduces the price when stored electricity is supplied to the market, but raises it when storage adds to demand. This has countervailing effects on firms’ incentives to invest in fossil capacities. A numerical simulation illustrates that substantial subsidy payments are required even after fossils have been completely driven out of the market.