Interaction between CO2 emissions trading and renewable energy subsidies under uncertainty: feed-in tariffs as a safety net against over-allocation

We study the interactions between a CO2 emissions trading system (ETS) and renewable energy subsidies under uncertainty over electricity demand and energy costs. We first provide evidence that uncertainty has generated over-allocation (defined as an emissions cap above business-as-usual emissions) during at least part of the history of most ETSs in the world. We then develop an analytical model and a numerical model applied to the European Union electricity market in which renewable energy subsidies are justified only by CO2 abatement. We show that in this context, when uncertainty is small, renewable energy subsidies are not justified, but when it is big enough, these subsidies increase expected welfare because they provide CO2 abatement even in the case of over-allocation. The source of uncertainty is important when comparing the various types of renewable energy subsidies. Under uncertainty over electricity demand, renewable energy costs or gas prices, a feed-in tariff brings higher expected welfare than a feed-in premium because it provides a higher subsidy when it is actually needed i.e. when the electricity price is low. Under uncertainty over coal prices, the opposite result holds true. These results shed new light on the ongoing switch from feed-in tariffs to feed-in premiums in Europe.