Incentives for cost reduction and cost padding in electricity markets with overlapping “green” regulations

•“Overlapping” regulations can have perverse and unintended effects.•We study cost reduction incentives facing renewable energy producers.•Exploitation of full cost reduction potential is a Nash Equilibrium.•Paradoxically, emissions will increase.•Cost padding can increase profits while simultaneously maintaining the green quota.

We examine overlapping regulations in electricity markets. Using an example based on a stylized model of a competitive energy market, we study cost-reduction and cost-padding incentives by “green-energy” producers in an electricity market employing an emissions tax and the simultaneous use of a green quota for the generation portfolio and a fair rate-of-return constraint implemented via a system of feed-in tariffs. We show inter alia that when subsidies are phased out, exploitation of the green technologies full cost-reduction potential is a Nash Equilibrium but emissions will increase. In addition, green-energy producers can engage in collusive cost padding to increase profits even as they satisfy the policymaker's desired green quota.