Emissions reduction in a second-best world: On the long-term effects of overlapping regulations

Industrialized countries around the world have set ambitious climate targets and face the challenge that existing mechanisms for CO2 pricing alone are not sufficient to achieve the desired level of ambition. In a multi-level electricity market model that captures investments in grid and generation capacities as well as electricity trading, we analyze different policy approaches to curb emissions by phasing out emission-intensive technologies, expanding renewables, or by simply tightening CO2 pricing. We extend existing modeling approaches to endogenize (welfare-optimal) expansion of renewable energy capacities, taking into account the respective grid expansion necessary for a particular expansion path. Applying the approach to the German electricity market shows that both, the strengthening of the incentives from emissions trading through a minimum CO2 price as well as a forced complete coal exit, lead to a significant additional decrease in emissions. The stepwise coal phase-out as decided in Germany, on the other hand, does not come close to achieving this reduction in emissions, largely due to the sequence of the phase-out decided (first hard coal, then lignite). The avoided CO2 emissions are accompanied by significant welfare gains in the respective scenarios. Further welfare gains can be achieved through a system-optimal expansion of renewables, especially because grid expansion can be avoided. We also consider different ways to remunerate renewables for all scenarios. It turns out that the renewable generators’ revenues from the electricity market together with the revenues from CO2 pricing are fully sufficient to finance renewables.