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Is government funding for innovation effective, and how can we spend it wisely?

31 Mar 2017

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Economists have long argued that carbon pricing is the most efficient mechanism for reducing greenhouse gas (GHG) emissions and the world’s reliance on fossil fuels. However, price signals alone will not be enough to incentivize the shift towards renewable energy (RE) and other zero-carbon technologies within the urgent timeframe, and at the scale, required to avoid detrimental climate change impacts. While RE will be critical in meeting future energy supply needs, significant innovation is needed now to drive down costs so that RE can achieve cost-competitiveness globally.

Common mechanisms to induce innovation include government investment in research and development (R&D) as well as subsidies for the adoption of RE technologies. These are often deployed through direct grants and subsidies or tax incentives. Ensuring the effectiveness of innovation policies such as these is critical in the context of driving down the cost of RE. However, with multi billions being spent, it is stunning how little we know about what works and why.  The Oxford Martin Programme on Integrating Renewable Energy is currently addressing gaps in knowledge about the effectiveness of different mechanisms to induce innovation, aiming to provide evidence for how we can spend government innovation funding more wisely.

In addition, the Programme has undertaken work to determine whether direct subsidies for RE technologies actually benefit customers by reducing the prices they face, such as the price of installing a residential solar system. While this is not a direct measure of innovation outcomes, increased deployment often induces cost reductions. Some studies have focused on how subsidies affect adoption rates, but how subsidies affect the prices consumers face becomes complex in the face of evolving RE technology ownership business models. This is a question we are seeking to address in our research.

While RE will be critical in meeting future energy supply needs, significant innovation is needed now to drive down costs so that RE can achieve cost-competitiveness globally.

Consider the market for residential solar photovoltaic (PV) systems, which has experienced tremendous growth over the last decade. Some of this growth can be attributed to the use of third-party ownership (TPO) models, which have become particularly popular in the U.S. Under the TPO model, customers sign a lease with little or no money down. Installers claim lump-sum rebates and may (or may not) pass through the benefits to the customer in the form of lower monthly lease payments. On the other hand, in the case of host-ownership (HO), solar adopters claim rebates directly. However, the prices consumers face do not necessarily decrease dollar-for-dollar as a result of a subsidy because of the ways in which prices are determined.

In collaboration with colleagues at Wharton, we conducted one of the first studies of solar subsidy pass-through (i.e., the amount by which prices decrease as a result of a $1 increase in subsidy) with a focus on California. Surprisingly, our results consistently show that the subsidy pass-through rate is much higher for TPOs than it is for HOs. Subsidies reduce prices by about 80 to 90 cents per $1 increase in subsidy for HOs while this number is $1.5-$1.8 per $1 increase in subsidy for TPOs. In other words, TPO customers are benefitting from subsidy “over-shifting”.

This result is surprising for several reasons. First, we find a large difference in the pass-through of solar subsidies to HO vs. TPO consumers despite the markets offering very similar products. There are numerous potential explanations for this, however, such as the characteristics of the solar adopters in each market (i.e., differing market demand curve shapes). Second, perhaps more surprisingly, we find that pass-through is very high. Third-party companies are extremely generous, reducing prices by more than 100 percent of the subsidy amount. We show that this occurs because the market is not perfectly competitive.

Understanding how subsidies are passed through to consumers is just one aspect of understanding the impacts of government-funded innovation programs and policies. There are still many open questions that we hope to tackle around the effectiveness of deployment incentives as well as R&D support when it comes to inducing innovation.

This blog was first published on the Oxford Martin Programme on Integrating Renewable Energy website.

This opinion piece reflects the views of the author, and does not necessarily reflect the position of the Oxford Martin School or the University of Oxford. Any errors or omissions are those of the author.