Market Failure and the Structure of Externalities

Policy interest in renewable energy technologies has been gathering momentum for the past several decades, and increased incentives and funding for renewable energy are often described as the panacea for a variety of issues ranging from environmental quality to national security to green job creation. Sizable policies and programs have been implemented worldwide to encourage a transition from fossil-based electricity generation to renewable electricity generation, and in particular to fledgling green technologies such as wind, solar, and biofuels. The United States has a long history of policy activity in promoting renewables, including statelevel programs, such as the California Solar Initiative, which provides rebates for solar photovoltaic purchases, as well as federal programs, such as tax incentives for wind. Even in the recent stimulus package, the American Recovery and Reinvestment Act of 2009, $6 billion was allocated for renewable energy and electric transmission technology loan guarantees (U.S. Congress 2009). (See Chapter 11 for further discussion of the U.S. experience.) Moreover, such policies are not restricted to the developed world. For example, China promulgated a National Renewable Energy Law in 2005 that provides tax and other incentives for renewable energy and has succeeded in creating a burgeoning wind industry (Cherni and Kentish 2007). Advocates of strong policy incentives for renewable energy in the United States use a variety of arguments to justify policy action, such as ending the “addiction” to foreign oil, addressing global climate change, or creating new technologies to increase U.S. competitiveness. However, articulation of these goals leaves open the question of whether renewable energy policy is a sensible means to reach these goals, or even whether particular renewable energy policy helps meet these goals. Furthermore, many different policy instruments are possible, so one must evaluate what makes a particular policy preferable over others. Economic theory can provide guidance and more rigorous motivation for renewable energy policy, relying on analysis of the ways privately optimal choices deviate from economically efficient choices. These deviations are described as market failures and, in some cases, behavioral failures.1 Economic theory indicates that policy measures to mitigate these deviations can improve net social welfare, as long as the cost of implementing the policy is less than the gains if the deviations can be successfully mitigated. Under this perspective, policy analysis involves identifying market failures and choosing appropriate policy instruments for each. While an almost unlimited number of different possible