It’s easy for people to have a knee-jerk reaction and support policies like the ecoEnergy Retrofit Initiative or US Production Tax Credits for Wind Energy. After all, we want people to have more efficient houses, and we want more renewable energy, don’t we? Well, yes, we probably do. Environmentalists and fiscal hawks should agree that each dollar spent on programs targeting these changes in our energy production and consumption decisions be spent effectively. Unfortunately, broad subsidies and tax credits do not meet that criterion very often.
These policies are meant to change behavior. The first problem with them is that they often end up paying people who haven’t changed their behavior from what it otherwise would have been – something called the free rider effect by many economists. As an aside, I personally don’t like the term. To me, free riders are defined as those who consume but do not pay for a public good. Take the example of the ecoEnergy Retrofit Initiative which refunds part of the cost of energy-improving renovations. There are really four types of renovations. First, there are those which would have occurred absent the policy. Funding these renovations has no effect, other than to provide a pat on the back for good behaviour, and does nothing to alter the emissions trajectory of the economy as houses are no more energy efficient than they would otherwise have been. Second, there will be renovations which occur earlier than they otherwise would have because of the policy. Funding these has a benefit on our near-term emissions trajectory since it shifts energy-efficiency of the building stock forward in time. Third, some renovators will make more energy-efficiency-improving modifications than they otherwise would have, and fourth, some renovations will happen only because of the subsidy. These types of renovation are where you really want to be, since these are real and lasting changes to the efficiency of the building stock. It would be great if we could target our money to these renovations only, but that is very difficult to do since you can’t easily observe what people would have done, and people are not often willing to report back to the Government that they were free riders, so please don’t propose a survey!
There are some policy design tools which can help. For example, the Canadian ecoEnergy for Renewable Power program contained a claw-back provision on the production subsidy if the funded project earned greater than a threshold rate of return. This is great policy at the industrial level, since those projects with a viable financial outlook without the subsidy will not bother applying to get the grant only to have to repay it in the future. That leaves more money available for those projects which have a marginal financial model and might not otherwise be built. These types of tools are harder to impose at the residential level.
The second reason you might want a policy like a subsidy or a tax credit is to mitigate commodity price risk, for example in an electricity market. Energy projects can be difficult to finance because they can find themselves underwater financially very quickly in commodity price swings – just ask anyone who has been operating a wind farm or a natural gas field in Alberta for the last couple of years. The subsidy or tax credit reduces the effective operating cost of the plant and therefore the investment is bankable under lower expected prices than would otherwise be the case, and the downside risk is muted. Subsidies or tax credits have to be set really high in order to take all of the downside risk out of an investment, and governments often end up paying out the tax credit in good times or in bad. In some research that I have done recently here, we look at the performance of different subsidy and tax credit vehicles in a commodity-risk-exposed industry. We find that the use of a capital grant up front with a claw-back in good times improves leverage ratios and reduces the risk-exposure of the facility at a cost up to 50% lower than the use of subsidies alone.
There is a subtle result in that paper which I think is often overlooked relating to the role of political risk. If you are trying to finance a facility, guaranteed future income matters and banks know that tax credits can disappear. Ontario has attacked this directly with a 20 year fixed price contract under their Feed-in tariff program, but their program is subject to the free-rider problem discussed above. An upfront capital grant allows you to go to the bank with cash-in-hand, not the promise of future tax savings, and so you are more likely to secure financing. This is critical, since facilities which cannot get financed do not get built. If the bank doesn’t believe the tax credit to be stable, then the bank won’t lend you money unless you don’t need the tax credit to be profitable – i.e. unless you are a free rider. The facilities that we want to target are those which are otherwise not bankable and thus would not otherwise be built. Political risk lands you exactly the opposite result. David Roberts (@drgrist) at Grist has a recent post on the use of up-front financing versus deferred tax credits which makes some of the same points..
Long story short – the more checks the government is writing (or the more tax they are not collecting) to reward people for things they would have done anyway, the less money is available to entice people to make the changes we want to see. Further, the more government financing is delivered through short-lived and politically risky measures in the tax code, the less people are going to be able to borrow against them to build facilities which would not otherwise have been built.
If you are one of those people who wants more renewable power, more energy efficient buildings, and more green jobs, you should want to drive changes in behaviour, not simply reward those which would have been there in the first place. If you are a fiscal hawk, you should want your government to use revenue and tax levers to achieve policy goals effectively. No matter which of these groups you belong to, you should be wary of broad tax credits and subsidies.