First-Best Policy and Decentralized Mechanisms

ExternalitiesExternalitynegative stemming from greenhouse gas (GHG) emissionsGreenhouse gas emissions may drive a wedge between social and private incentives concerning investment and operations in the power sector. While a central planner who internalizes GHG emissionsGreenhouse gas emissions via a Pigouvian taxTaxPigouvian to curb consumption may yield a first-best policy, decentralized mechanisms are typically deployed in OECDOrganisation for economic co-operation and development countries’ power sectors in order to align the incentives of private power companies with those of society. Using a bi-level modelingBi-level model approach, we develop a framework in which a welfare-maximizingSocial welfare policymaker at the upper level sets the renewable portfolio standard (RPS)Renewable portfolio standard target for industry, which takes it as a regulatory parameter at the lower level when making its profit-maximizing capacity-expansion and generation-operation decisions. We demonstrate that even in the case of perfect competition, RPSRenewable portfolio standard cannot fully align social and private incentives in mitigation of GHG emissionsGreenhouse gas emissions since consumption is not curbed to the same extent as under the first-best policy. Consequently, “too much” renewable energy (RE)Renewable energy technologies investment takes place. This distortion is less pronounced when power companies behave à la Cournot because the exercise of market power already diminishes consumption, thereby reducing the need for RERenewable energy technologies investment. We illustrate these principles using case studies based on a stylized network and provide techniques for resolving the bi-level problemsBi-level model. Extensions to these cases are explored in the end-of-chapter exercises with implementation of the problem instances in GAMSGeneral algebraic modeling system.