Subsidies for electricity production are often administered through Feed-in Tariffs (FITs). FITs offer guaranteed prices for electricity generation and let markets work out the amount to supply. In most cases, tariffs are contracted over multiple years to ensure revenue stability for investors. By setting clear goals through a fixed, known payment schedule, FITs dramatically reduce uncertainty about the return on investments, allow the market to work out the best solutions, and encourage private sector investment and innovation.
FITs have been successful at increasing renewable capacity. For example, in recent years countries with FITs accounted for more than 80 percent of newly-built solar capacity and 60 percent of newly-built wind capacity. Reduced uncertainty and guaranteed returns can also lead to substantial private sector investment in research and development, helping drive innovation in renewable generation. FITs should include provisions for continuous improvement by allowing rates to decline over time to reflect likely cost improvements in energy-generating technologies.
Most FIT programs base rates on the levelized cost of electricity (LCOE), which includes a targeted rate of return on investment, for each technology. While this promotes a diverse mix of sources rather than promoting only that with the lowest LCOE, it also reduces flexibility and efficiency by creating markets for each generation source rather than a single overall market (and price) for renewable sources. An alternative approach is to use a reverse auction in which the buyer solicits bids for FIT rates from interested suppliers. Bids with the lowest prices are awarded power purchase agreements, leveraging competition on price to drive down overall FIT costs.
This policy lever can also be used to represent tax credits, such as the Production Tax Credit in the United States, which supplies a credit per kilowatt-hour electricity generated by certain technologies.
For a more detailed discussion, see the applicable chapter of Designing Climate Solutions, our book on smart energy and climate policy design.