An Option Analysis of the European Union Renewable Energy Support Mechanisms

We examine the economic efficiency of incentive mechanisms used to promote RenewableEnergy (RE) across the European Union (EU) by looking at returns toinvestors along with any negative externalities or social costs. Using electricity pricedata from 2009 to 2013, we evaluate the RE support mechanisms adopted by someof the largest EU economies. We explain the limitations of various metrics used toinform incentives for RE and propose an alternative metric reflecting investor requirements.Our results show that while the EU schemes were effective in deliveringRE capacity, the incentives provided were overly generous and economically inefficient.To assess the indirect costs of RE in liberalized electricity markets we employreal option theory to quantify the costs of hedging and pricing the exposure facedby conventional fossil fuel generators required to accept RE under dispatch priority.We find that the cost of hedging against random RE output under dispatch priorityis expensive while increasing RE in liberalized markets, by depressing prices andincreasing price volatility, may place greater burden on conventional, dispatchablegenerators. As support for RE is presented as a public good, we argue that economicallyefficient RE support mechanisms require recognizing both their directand indirect costs.