More birds than stones – A framework for second-best energy and climate policy adjustments

Carolyn Fischer, Michael Hübler*, Oliver Schenker

*Corresponding author for this work

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A well-known principle in public economics states that at least as many policy instruments as market failures are required to achieve an efficient outcome. In practice, however, regulatory power is often constrained, making implementing the first-best policy portfolio difficult or impossible. We analyze analytically and numerically how available policy instruments should be adjusted vis-à-vis the first-best to account for under-internalized secondary market failures. Consider, for example, the power sector: alongside the external costs of emissions, evidence suggests that consumers undervalue energy efficiency investments, and knowledge spillovers hamper research and development (R&D) and learning-by-doing in low-carbon technologies. By exploring the potential and limits of policy instrument substitution, we provide suggestions for adjusting policies in second-best situations. We calibrate the theoretical model to the European electricity sector and find that, compared with the first-best policy portfolio, relying on carbon dioxide (CO2) pricing alone increases the policy cost of the EU CO2 emissions target by about 30%. Uninternalized R&D spillovers contribute the most to this increase, and are the most difficult to address indirectly, even with subsidies supporting learning-by-doing. By contrast, almost 40% of the additional cost created by the absence of optimal energy efficiency subsidies can be recuperated by a second-best electricity tax.

Original languageEnglish
Article number104515
Pages (from-to)1-18
Number of pages18
JournalJournal of Public Economics
Early online date21 Oct 2021
Publication statusPublished - Nov 2021

Bibliographical note

Funding Information:
Despite the EU-wide renewable energy targets, the choice and design of instruments to reach these targets are at the discretion of individual member states ( RES Legal, 2018 ). Sweden, for example, promotes renewable electricity mainly through a quota system. Germany is currently moving from a Feed-in-Tariff (FiT) system (guaranteed electricity price above the market price for generators) to a system with market premia (a guaranteed fixed subsidy rate on top of the market price for electricity) granted through mostly technology-specific auctions. The Netherlands differentiates the support of renewable energy technologies through the Sustainable Energy Production (SDE+) program. Although the European Commission advocates moving toward technology-neutral renewable deployment schemes, many countries continue to differentiate their support across technologies. 2 2 Furthermore, not only is there considerable variation in the type and level of support schemes, but also in funding methods, whether by electricity surcharges or taxpayer resources. Hence, renewable generation is generally subsidized, and sometimes combined with an implicit or explicit tax on electricity.

Funding Information:
The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors. They do not necessarily represent the views of the World Bank and its affiliated organizations, or those of the Executive Directors of the World Bank or the governments they represent. We are very grateful to the editor and three anonymous reviewers for very helpful comments. Furthermore, we are grateful for support under the Strengthening Efficiency and Competitiveness in the European Knowledge Economies (SEEK) Grant. Fischer is grateful for the support of the MISTRA Foundation Program, Instrument Design for Global Climate Mitigation (INDIGO), U.S. EPA (STAR Grant #83413401), the European Community's Marie Sk?odowska-Curie International Incoming Fellowship, Strategic Clean Technology Policies for Climate Change (STRATECHPOL), financed under the EC Grant Agreement PIIF-GA-2013-623783, the hospitality of Fondazione Eni Enrico Mattei (FEEM) and the Marks Visiting Professor Program at Gothenburg University. H?bler gratefully acknowledges financial support by the Lower Saxony Ministry of Science and Culture and the Volkswagen Foundation as well as the German Federal Ministry of Education and Research (BMBF, project ROCHADE, Grant No.: 01LA1828C). Schenker is grateful for the support of the Fritz Thyssen Foundation and the Robert Bosch Foundation. Our work benefited from discussions at the Colorado School of Mines, the Center for Development Research (ZEF) in Bonn, the University Oldenburg and the annual conferences of the AERE, AWEE and AEA ASSA. We particularly thank Derek Lemoine and Christoph B?hringer for very helpful comments. We also thank Svenja H?fler and Susanne Becker for valuable research assistance as well as Sally Atwater and Huon Morton for carefully proofreading the manuscript. We thank Andreas L?schel and Victoria Alexeeva-Talebi for making the initial project possible.

Publisher Copyright:
© 2021 Elsevier B.V.


  • Climate and energy policy
  • Multiple market failures
  • Second-best policy


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