Green electricity investments: Environmental target and the optimal subsidy

We investigate the optimal investment decision in renewables under market demand uncertainty, in the context of the Italian strategy for renewable deployment under the EU policy. The firm has to decide about the time and size of the investment. We find that a higher subsidy level induces the firm to invest earlier with a smaller investment capacity. This implies that a given environmental target cannot be reached by a too high (too low) subsidy level since this will cause the investment level to be too low (too late). We show that there exists an optimal (intermediate) subsidy level. Due to uncertain demand, in some cases ensuring to reach the environmental target in time requires an additional (conditional) subsidy. We propose a heuristic for policy makers stating when and how much subsidy to provide. Furthermore, we find that in a more uncertain economic environment the subsidy adjustment to maintain the target level of investment results in the firm investing earlier, which is opposite to the standard real options result.