Understanding the Indirect Costs of Renewable Energy using Real Option Theory

We examine the economic efficiency of incentive mechanisms used to promote renewable energy (RE) as a policy in the European Union. We evaluate the financial performance of RE investments and employ real option theory to model and analyze their impact in liberalized markets for electricity. Our analysis concerns key European countries and uses five years of most recent historic electricity price data from 2009 to consider sensitivities around key parameters. As RE policies are presented as public goods to address environmental concerns, we explain how the financial performance of these policies strikes a balance between social costs and private benefits. We discuss the impact which RE may have upon market conditions under liberalized markets for electricity generation and whether incentive mechanisms should be re-calibrated in light of these results. For other regions, our research offers useful lessons on both the effectiveness and cost-efficiency in the design of schemes to incentivize RE.