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The Internalization of Externalities
in The Production of Electricity:
Willingness to Pay for the
Attributes of a Policy for
Renewable Energy
Alberto Longo, Anil Markandya
and Marta Petrucci
NOTA DI LAVORO 132.2006
NOVEMBER 2006
IEM - International Energy Markets
Alberto Longo, Queen’s University Belfast and University of Bath
Anil Markandya, Department of Economics and International Development,
University of Bath and Fondazione Eni Enrico Mattei
Marta Petrucci, Department of Economics and International Development,
University of Bath
The Internalization of Externalities in The Production of Electricity:
Willingness to Pay for the Attributes of a Policy for Renewable Energy
Summary
This paper investigates the willingness to pay of a sample of residents of Bath, England,
for a hypothetical program that promotes the production of renewable energy. Using
choice experiments, we assess the preferences of respondents for a policy for the
promotion of renewable energy that (i) contributes to the internalization of the external
costs caused by fossil fuel technologies; (ii) affects the security of energy supply; (iii)
has an impact on the employment in the energy sector; (iv) and leads to an increase in
the electricity bill. Responses to the choice questions show that our respondents are in
favour of a policy for renewable energy and that they attach a high value to a policy that
brings private and public benefits in terms of climate change and energy security
benefits. Our results therefore suggest that consumers are willing to pay a higher price
for electricity in order to internalize the external costs in terms of energy security,
climate change and air pollution caused by the production of electricity.
Keywords: Non Market Valuation, Choice Experiments, Willingness to Pay,
Renewable Energy, Energy Security, Greenhouse Gases Emissions
JEL Classification: Q42, Q48, Q51
Address for correspondence:
Alberto Longo
Institute of Agri-Food and Land Use
School of Biological Sciences
Queen’s University Belfast
David Keir Building Stranmillis Road
BT9 5AG, Belfast
Northern Ireland
Phone: +44 0 28 90976537
Fax: +44 0 28 90976513
E-mail: a.longo@qub.ac.uk
3
1. Introduction and motivation
Over the last fifteen years there has been a significant research effort in measuring the
external costs caused by electricity production (ExternE 1998; Friedrich and Bickel, 2001;
Krewitt, 2002; European Commission, 2003; Markandya, 2003; NewExt, 2004; ExternEPol,
2005, European Commission, 2005). It is well established that air pollution, acid deposition,
risk of accidents borne by the production of electricity have negative effects both on human
health and on the environment. For example, human health is affected in terms of reduced life
expectancy and respiratory hospital admissions, while the environment is affected through
yield change of crops and global warming.
Using a bottom-up impact pathway approach,
1
the team of researchers of ExternE has
quantified in monetary terms most of the damages to human health and the environment
caused by different fuels and technologies that generate electricity. The external costs
estimates are substantial; for example, ExternEPol (2005) has estimated that the external costs
are in the range of 1.6 – 5.8 c€/kWh for current fossil systems, with figures at the lower end
for gas based generation technologies and the upper end for traditional coal technologies. The
results of the ExternE research also indicate the importance of the effects in terms of human
health and global warming: at the end of the 90s ExternE identified that health impacts
comprised 98% of the external costs from SO
2
and 100% of those from particulates (European
Commission, 1999), with mortality impacts accounting for at least 80% of those health
impacts. The costs associated specifically with global warming range widely and differ for
fuel. The current phase of ExternE uses the abatement cost methodology for valuing the
external costs of global warming because, according to ExternE, the current monetary
1
“The impact pathway assessment is a bottom-up-approach in which environmental benefits and costs are
estimated by following the pathway from source emissions via quality changes of air, soil and water to physical
impacts, before being expressed in monetary benefits and costs. The use of such a detailed bottom-up
methodology – in contrast to earlier top-down approaches – is necessary, as external costs are highly site-
dependent (cf. local effects of pollutants) and as marginal (and not average) costs have to be calculated”
(European Commission, 2003, page 8).
4
valuations of global warming externalities have not yet been satisfactory. ExternE has chosen
the value of 19 €/tCO
2
because that is the abatement cost in the EU implied by the
commitment to the Kyoto protocol (European Commission, 2005).
Economists would suggest that when externalities are present, markets are not efficient
as long as these external costs are not internalized and economic agents do not take into
account these costs. The internalization of the externalities caused by the production of
electricity should therefore target different fuels and technologies in different ways, according
to the externalities caused: policy instruments, such as taxes, voluntary agreements, command
and control measures or emission permits should target polluting fossil fuels, while subsidies
could be used to stimulate the production of renewable energies that have a lower impact in
terms of external costs, but are more expensive than traditional fossil fuels in terms of private
costs. Subsidies to support the production of renewable energy have also been proposed by the
recent ‘Community guidelines on State aid for environmental protection’ of the European
Commission. The guidelines allow Member States to “grant operating aid [limited to a
maximum of 5 c€/kWh] to new plants producing renewable energy that will be calculated on
the basis of external costs avoided” (European Commission, 2001).
A second major reason to stimulate the production of renewable energy comes from the
increasing demand for electricity, and moreover a demand for secure electricity. Already ten
years ago, in the White Paper on Energy Policy, the European Commission identified the
security of energy supply as one of the objectives on energy policies (European Commission,
1995). Two years later, with the White Paper for a Community Strategy and Action Plan –
Energy for the future: Renewable Sources of Energy (European Commission, 1997) – the
European Commission highlighted the goal of doubling the share of renewable energy from
6% to 12% in gross inland production by 2010 to cope with the increasing demand of energy.
More recently, the Green Paper on Security of Energy Supply has tackled the growth in energy
demand with measures to curb the growth in demand and manage the dependence on foreign
5
supply, by also fostering the development of less polluting energy sources (European
Commission, 2000).
The current debate on the promotion of renewable energy has focussed on the
identification of the policy instruments that are more effective in stimulating the production of
renewable energy. Given that the private, or internal, costs of producing electricity are higher
for renewable energy than for fossil fuel energy, governments need to identify effective
instruments to promote the production of renewable energy. Policy instruments currently in
use in the European Union are either investment focused, such as rebates, tax incentives,
competitive bidding design, or generation based, such as feed-in-tariffs, rate based incentives
and tradable green certificates.
2
Whatever instrument is chosen, it is clear that either
consumers or the tax payer will have to pay for the extra cost of producing renewable energy.
The focus of this paper is on the characteristics of a policy for the promotion of
renewable energy in the UK. In 2002, the share of renewable electricity production in the UK
was only about 3% and the government aim is to increase the share of consumption of
renewable energy to 10% of UK electricity in 2010 (DTI, 2003). Another major target for the
UK energy policy is to comply with the commitment under the Kyoto Protocol that requires
the UK to reduce the greenhouse gases emissions by 12.5% below the 1990 levels during the
period 2008-2012. The increase in the production of renewable electricity is highlighted in the
UK Energy White Paper that reckons that “renewable energy will also play an important part
in reducing carbon emissions, while also strengthening energy security” (DTI, 2003, page 11).
The electricity supply industry has been liberalised in Great Britain in 1999 (Batley,
2001); today consumers have the opportunity to decide their supplier and the mix of energy,
whether traditional or ‘green’ electricity. This means that the demand for specifically
renewable electricity might contribute to an increase in its production. As Ek (2002) points
out, if people’s willingness to pay for renewable is positive then we can expect that an increase
2
For a review of the policy instruments for the promotion of renewable energy see ENER, 2002; Haas et al, 2004;
Haas, 2001; Menanteau et al, 2003.
