The Economics of Decarbonizing Houses
by severin borenstein
severin borenstein holds the E.T. Grether Chair in Business Administration and Public Policy at the University of California’s Haas School of Business and is the faculty director of the Energy Institute at Haas.
Illustrations by daniel baxter
Published July 25, 2022
In talking about reducing greenhouse gas emissions, most people veer toward technology fixes: when will we have electric cars that can recharge in minutes, or small modular nuclear reactors that are cheap and safe, or machines that can suck CO2 out of the air and deposit it in underground caverns? But progress in fighting climate change in some sectors may depend more on administrative, regulatory and political changes than on gee-whiz technological advances.
Residential energy use is a perfect example. Most energy experts see decarbonizing dwellings as one of the less daunting tasks ahead. Then why is it going so slowly? The good news is that we really do know how to greatly reduce household GHG emissions at reasonable cost. The bad news is that the current halting pace makes all too clear that the non-technology barriers to getting there are formidable.
Most of those barriers exist because we are still paying for household energy the way we did when costs, technologies and consumer options were very different. Households now have access to a much wider variety of technologies for meeting their energy needs. That would be great news if prices and other incentives that drive household energy choices actually reflected true costs and benefits, which would align what is best for households with what is best for society. But they don’t. As a result, we are effectively ignoring most of the low-hanging fruit when it comes to cutting household carbon emissions.
What Decarbonized Household Energy Use Looks Like
Households emit GHGs directly by burning fossil fuels and indirectly by consuming electricity. Because the emissions sources are so dispersed that ensnaring them is not a serious option, there is no realistic pathway to decarbonize fossil fuel combustion in houses. Substituting “renewable” gas (such as methane captured from landfill emissions) works in theory, but it’s far behind electrification in terms of cost-effectiveness.
Of course, electricity is only a means to the desired end if it is generated from low-carbon resources, such as wind and solar, as well as geothermal, nuclear and hydropower. Those last three are great resources because they can be utilized at will and, in the case of hydro, on very short notice. But the outlook for expanding them rapidly in the near term is not good.
Long ago, economists figured out that people are more likely to do what is best for society as a whole if their consumption decisions reflect the costs and benefits of their actions to society as a whole.
A very brief digression here to address the nuclear advocates who have no doubt turned beet-red after reading that last paragraph. There is no getting around the reality that new nuclear power is very expensive today, as demonstrated by the recent attempts to build plants in South Carolina and Georgia. Boosters argued that those plants would demonstrate nuclear can be done at low cost. But, alas, they showed the opposite.
Some fans of nuclear claim that is because of over-regulation. Maybe, but you can’t keep touting the outstanding safety record of nuclear and at the same time chant “excessive regulation,” unless you can explain how to drastically lower regulatory costs without increasing the risk of another Fukushima. New technologies such as small modular reactors are promising [see the article in this issue on page 30], and I hope the promise delivers. But that isn’t going to happen at any scale this decade.
The most credible pathway to substantially decarbonizing U.S. households is to electrify everything possible, and then generate that electricity with a lot more wind and solar power than currently exists. Wind and solar costs have plummeted over the past decade and can now generate grid-scale power as cheaply as gas-fired generation — but only when and where nature permits. That’s why these intermittent-generation sources don’t solve the problem on their own. To make their production firm, we need some combination of the following:
- clean, dispatchable resources (nuclear, hydroelectric, geothermal or gas-fired generators with carbon capture and sequestration)
- batteries or other forms of mass energy storage
- great locational diversity for the intermittent resources, combined with abundant transmission capacity
- programs to adjust demand as supply fluctuates.
The first option is great, but limited in the near term. It does argue for keeping existing nuclear power plants alive if their maintenance costs remain manageable. Gas-fired generation with carbon capture and sequestration is in the same category as small modular reactors: intriguing, but unproven. The second option is pretty expensive, especially for the long-term storage needed to get an industrialized economy through the night and multi-day periods without much solar or wind power. The third option will play a major role if we can overcome jurisdictional disputes and local landowner holdup associated with attempts to build transmission lines. The fourth could prove critical — but only if we get incentives right, as I discuss below.
Importantly, the first three components above combined — all supply-side components — won’t be sufficient to smooth out generation costs in the teeth of changing weather and market conditions. So the incremental cost of providing electricity, and thus the wholesale market price, is nearly certain to become more volatile in the years ahead with more wind and solar in the generation mix. We already see very low wholesale prices when renewables generation is abundant and, on occasion, very high prices when demand is brisk and renewables are scarce. That creates an important role for the fourth option, demand response, to help balance the system and partially mitigate price fluctuations.
What’s the Right Retail Price, and Why Is It So Important?
Micromanagement of household energy use by a regulator dictating, say, when you can run your air conditioning, would certainly be a political non-starter, so the most feasible approach to reducing household GHG emissions is through consumer incentives. And when it comes to energy, prices are the most straightforward, transparent incentives for encouraging households to do their bit — that is, to avoid emissions-creating activity when low-emissions alternatives are available at little extra cost or hassle.
Long ago, economists figured out that people are more likely to do what is best for society as a whole if their consumption decisions reflect the costs and benefits of their actions to society as a whole. That’s the fundamental basis for intervening in markets so that prices equal what economists call “social marginal cost” (SMC).
This is pretty intuitive. When consumers can buy a product for much less than its SMC, they have an incentive to buy more of it than is good for society because they don’t bear the full cost of its production and use. That’s the problem in many parts of the United States where electricity is priced below its SMC because power plants don’t bear the societal cost of emitting large quantities of GHGs (as well as other pollutants). And consumers who get to buy the electricity below cost have little incentive to invest in energy efficiency — insulation, energy-efficient appliances and the like — that would help to contain the damage.
On the other hand, when consumers face a price that is greater than SMC, they tend to buy less than is good for society as a whole because the price pushes them to substitute more expensive energy-sparing goods or to over-invest in conservation. And this is not as rare a bird as you might guess.
Indeed, that’s the more common price distortion in California and a number of other states, where electricity rates are used to cover costs beyond electricity — everything from subsidies to rooftop solar buyers to compensation for victims of wildfires that were triggered by grid failures. One major consequence: excessive electricity prices encourage households to stick with natural gas for heating and with gasoline for transportation, even when the full cost to society of switching to electricity would be lower.
The Problems With Household Energy Pricing
Gasoline is sold in unregulated markets that are typically fairly competitive, and thus market forces drive prices to track cost. But that only means private costs. It does not include the cost of pollution from production and combustion of gasoline and diesel fuel. On the other hand, transportation fuels are taxed at both the federal and state levels to pay for roads. Those taxes help to offset the underpricing by market forces due to pollution externalities, but it turns out that in most of the U.S., the externalities are still larger than the taxes tacked on (which we’ll get back to in a minute). The same is generally true for oil and propane where those are used for heating houses.
Electricity and natural gas are delivered by utility infrastructure that is quite expensive to build, but then relatively cheap to use. Indeed, these huge fixed costs are what make electricity and natural gas “natural monopolies” in serving households — it would, for example, be immensely wasteful to build two sets of gas pipes or string two sets of wires to go past one residence. In fact, if there were no pollution concerns, the main problem with electricity and natural gas would be overpricing to cover the fixed costs when the cost of delivering additional fuel or power to a household was quite modest.
The overpricing problem preoccupied regulatory economists until a few decades ago. But as the environmental impacts of electricity and natural gas consumption have moved front and center, there has been growing concern in some (typically blue-leaning) regions that rates are below the full societal cost of consuming these fuels. So in these regions, the path of least political resistance was to add fees to cost-based rates in order to pay for social programs related to energy, such as helping low-income households pay their bills and insulate their houses. Ironically, those are the areas that have also most aggressively moved to reduce emissions in electricity generation, so they generally create less pollution cost per kilowatt-hour than the areas that have kept rates quite low while burning high-emissions coal.
My own research with Jim Bushnell (an economist at the University of California- Davis) has analyzed where electricity prices are above the social marginal cost and where they are below and has also done the same for natural gas and gasoline. The upshot is shown in the figure on page 55. Gasoline is priced below societal cost nearly everywhere. The exception: rural areas where the local pollution doesn’t affect as many people. Natural gas, for its part, is generally priced pretty close to societal cost because the charges tacked onto consumers’ bills to cover the high fixed costs of the distribution infrastructure are roughly offset by the pollution costs of burning the natural gas.
There is growing recognition that high prices stand in the way of residential electrification. Electricity has an additional pricing problem that doesn’t affect petroleum products or natural gas: extreme cost volatility at the wholesale level.
Electricity is trickier. One sees both prices far above average SMC in areas with cleaner grids and tangential costs paid for through electric bills, and prices far below average SMC in areas with lots of coal-fired generation.
The “California problem” of prices way above SMC is a major barrier to electrification and decarbonization of household energy use. In the past, advocates of energy conservation argued that higher electricity prices were good because they encouraged energy efficiency. But there is now growing recognition that high prices stand in the way of residential electrification.
Electricity has an additional pricing problem that doesn’t affect petroleum products or natural gas: extreme cost volatility at the wholesale level. Because electricity is very expensive to store, the cost of supplying it can be many multiples higher on days with extreme hot or cold weather than on average days. Even within a day, the cost can be 10 times higher during the afternoon peak than early in the morning. But households in the U.S. don’t see those cost variations in their retail prices. While this prevents sticker shock, it also means households lack incentives to take even easy steps to reduce electricity use when it is scarce.
What About Fairness?
It’s not unusual for economists to focus on efficiency and lose sight of the equity concerns that come to mind when others talk about decarbonizing. However, it’s also easy for people to talk past each other when they talk about equity because the word means different things to different people.
To me, the primary issue of fairness as the energy transition moves forward is making sure that households already struggling financially are not further burdened by the imperative of addressing climate change. But translating that wish to effective action is problematic because the energy needs of lowincome households vary widely. Some live in small dwellings in high-density cities, while others are in rural areas. Some are highly dependent on fossil fuels for driving, heating and cooking, while others have already mostly electrified. So, offsetting the cost burden from decarbonization is not a matter of sending the same rebate to every poor household.
A related concern is whether individuals, regardless of income, who are harmed by new climate policies should be compensated. Both politics and legal precedent in America tend to default to treating the status quo as a right, regardless of how that status quo came to be. But how far should this go? If middle- or upperincome drivers are harmed by high gasoline prices linked to decarbonization initiatives, should the government come up with the cash to offset that driver’s losses? Further complicating the issue, it’s worth remembering that some people live much more emissions-intensive lives than others — driving more in larger vehicles, occupying bigger houses that use more energy, living far from public transit.
To some, this may seem like trivializing the concept of equity. But it certainly doesn’t to the people who are most affected, regardless of how wealthy they are. Moreover, in many cases it is hard to see how we move forward politically without confronting the issue of who ends up worse off.
There is, I think, a more compelling equity argument for minimizing the degree to which climate policies are allowed to disrupt life as usual. The vast majority of Americans are not thinking about climate policy when they make decisions that create more or fewer emissions. They’re just trying to cope as best they can with the constraints imposed by family, work, income and society. That’s not a reason for holding fast to outdated policies, but it has helped me to see that the equity argument for compensating losers — possibly by making transitions more gradual — generally has more than one side.
Three policy debates playing out in the U.S. today illustrate how failure to create efficient incentives — and the equity concerns in altering those incentives — now risk undermining the changes we need to decarbonize residential energy.
Behind-the-Meter Generation and Storage
About half of all residential rooftop solar in the continental U.S. is in California. Is that because California is so sunny? Because it is so politically liberal? Because it is a tech center? All of these surely play a role, but the biggest factor is likely because solar saves more money for homeowners in California than elsewhere.
The savings that California solar adopters enjoy isn’t because rooftop panels are a lowcost way to generate electricity. While much cheaper than two decades ago, rooftop solar is still many times more expensive than gridscale solar or wind production. It is because solar adopters avoid California’s extremely high retail electricity prices. What’s more, under a policy called “net metering,” they get paid the retail price for the excess power they send back to the grid. A typical solar home exports about half of its panels’ output to the grid, so it really matters that they receive 20 to 35 cents for each kilowatt-hour they send into the grid, rather than the amount the utility actually saves by reducing wholesale power purchases and related costs — which is in the neighborhood of 8 cents.
An ultimately ineffective, initiative to incorporate demand response is to pay consumers — mostly commercial and industrial customers — to lower their use when demand is straining grid capacity.
Much of the revenue that utilities collect goes to covering fixed costs, which are not reduced when a household installs solar. So solar users are getting a big benefit from net metering, which must be covered by raising everyone else’s retail rates. Consider, too, that households with solar have average incomes about 50 percent higher than the non-solar households absorbing the cost shift.
Rooftop solar in California is perhaps the best example of what goes wrong when price incentives are not aligned with the value the service creates for society. In this case, a gold rush to install subsidized solar is followed by outraged protests from solar companies and solar homeowners when the regulator moves to ratchet down the subsidy.
And why not? Solar homeowners installed the panels thinking they would save boatloads by avoiding skyrocketing retail power rates. Rooftop solar companies, for their part, made investments in equipment, training and marketing based on regulations that made their products hugely attractive to homeowners. Both parties believe they have a right to continuing subsidies — which they argue are not subsidies at all, but fair compensation for the expensive steps they’ve taken to fight climate change even when much less expensive approaches exist.
The Challenge of Modulating Demand
Demand-side adjustment constitutes the greatest missed opportunity in decarbonizing household energy use. At any point in time, houses are using electricity for many different purposes — some very high value and timespecific, some much lower value or easily time-shiftable. Yet in an hour when supply is straining to meet demand and the cost of buying power in the wholesale market is skyhigh, electricity rates typically give customers no incentive to reduce consumption.
There once was a good reason for this: electric meters just recorded total usage, and all the utility ever learned was how much power was purchased since last time the meterreader came by. “Advanced” meters just consisted of two separate meters and a mechanical clock that switched them back and forth at fixed times every day regardless of whether demand was straining the grid on that particular day. So these meters didn’t offer any way to adjust to system-wide supply/demand conditions.
Today’s smart meters can record consumption in blocks as short as a few minutes. When tied to sophisticated controls, they can enable variable pricing that gives customers the incentive to save power when it is most valuable to the grid. This isn’t rocket science. But we aren’t doing it for residential customers, or even for the vast majority of industrial and commercial customers.
Why not? In part due to regulatory inertia; in part because customers like predictable prices. Well, of course they do, when they don’t see the link between their own behavior and utilities’ need to maintain expensive reserve capacity to meet peak demands. And now they don’t see the link to the cost of integrating renewables into the grid.
A simple solution would be to give households a choice between a traditional rate structure with constant pricing but a tackedon premium to cover higher peak costs, and a rate structure that more closely reflects the real cost variation. “Critical-peak pricing” is one option, allowing the utility to raise prices by three- to five-fold on perhaps 15 days of the year when the grid is most strained in return for charging lower base prices the rest of the year. More sophisticated schemes that vary pricing in 15- or 30-minute intervals would be appropriate (and efficient) for more sophisticated customers, such as warehouses and factories.
These approaches have been tested and shown to be effective. But, to date, they haven’t gotten much traction with regulators or utilities. Instead, regulators have been drawn to “time-of-use” pricing, which simply sets a higher price for power during some hours than others every day. The problem is that’s not how electricity supply costs work. Typically, there are just 10 or 20 days per year when the grid is strained and demand response could really show its value. So raising prices every afternoon or evening for set hours doesn’t help protect against blackouts or keep down the cost of delivering power.
Another well-meaning, but ultimately ineffective, initiative to incorporate demand response is to pay consumers — mostly commercial and industrial customers — to lower their use when demand is straining grid capacity. But the incentive schedule has to start from some baseline, which is generally calculated from the customer’s usage on previous days. Where these programs exist, an army of consultants has sprung up to teach the customers how to manipulate their baselines to minimize liabilities. These customers are, of course, just responding to the price incentives they’ve been given. They aren’t the problem — badly designed price incentives are.
Phasing Out Natural Gas
The “electrify everything” movement is raising the question of how to phase out natural gas usage — and, in particular, how to pay for all of the underused pipeline infrastructure that will be left behind. The path of least resistance would be to spread “stranded infrastructure” costs across remaining gas customers when others shift to electricity. That would rapidly drive up prices and accelerate the pace of the natural gas phase-out.
This approach may seem satisfactory from an environmental perspective. But the gas customers who lag behind along the way — whether because they are renters with less control over their energy sources or homeowners who have recently invested in gas-based heating, cooking and clothes drying — will end up paying for a disproportionate share of the legacy infrastructure investments that were made for the benefit of all.
If households that switch to electricity won’t pay for stranded infrastructure and it’s deemed unfair to penalize those still stuck buying natural gas, who’s left? Many environmental and consumer advocates argue that utility shareholders (and bondholders) should just be required to eat the costs through bankruptcy when public policy changes.
That’s a solution of sorts, but nobody who knows much about utility regulation believes that’s how it will play out. In both electricity and natural gas cases, utilities have consistently won lawsuits and political fights over recouping costs that they prudently incurred (often under orders from regulators) at the time the investment was made.
But regardless of what share of these “sunk” costs shareholders absorb, shouldn’t we cover the remaining — likely very large — shortfall through a more equitable process than slamming whoever is last out the door? As we phase out natural gas for heating and cooking, incentives reflecting social marginal cost should guide us. But, once again, that begs the question of how to recover billions invested in property made worthless by the transition to clean fuels.
A Path Forward
Thanks to astounding advancements in technology, it is now economically feasible to greatly reduce residential carbon emissions. But we could still screw this up by giving customers indirect incentives to stick with fossil fuels. And, unfortunately, that seems to be the direction the train is heading.
In part, that’s because the majority of one political party doesn’t see climate change as a major problem and won’t engage in hard choices about the transition. Still, even among those who recognize the magnitude of the coming climate crisis, there seems to be little appreciation of the need to get the transition incentives right. In the best of entirely feasible worlds, people making everyday decisions about energy uses — from buying a dishwasher to deciding when to charge the family Tesla — would, without prompting, choose what’s best for society as they choose what’s best for themselves.
The two major barriers to getting incentives right are the revenue shortfall some utilities will face when they set prices to reflect social marginal cost and the losses some people will suffer from the transition to a lowcarbon economy. Overcoming these barriers will be expensive, but there is also opportunity to use the transition to help change pay for itself.
For example, taxing emissions from fossil fuels would generate substantial revenues, which could help pay for electric industry infrastructure and a variety of public-purpose programs currently driving electric rates well above social marginal cost in some states. These taxes could also help pay for obsolete infrastructure in the natural gas sector, which could speed the phaseout by avoiding drawnout legal battles over who will be stuck with the stranded costs. Using some of the revenue to reduce other tax burdens on low- and middle- income families could also make this a progressive change in the overall tax structure.
Taxing greenhouse emissions, however, won’t cover the full cost of household decarbonization, particularly as the transition advances and there are ever-fewer emissions left to tax. Luckily, the costs of the transition will also decline with time.
Still, paying for the grid, supporting lowincome customers, mitigating and adapting to climate change and managing other fixed costs will be substantial. It’s worth noting that imposing taxes on related harmful activities beyond emitting GHGs could also help pay for the transition and move prices closer to social marginal cost. Local pollution — from vehicles, industry and other sources — is generally controlled through technical standards imposed on polluting devices, but avoids fees on the substantial pollution the sources still emit. Traffic congestion has huge negative costs, but individual drivers don’t bear the cost of the congestion they create for others.
Opponents of pricing these activities have pointed to technological challenges and the costs imposed on the policy losers. The technology problem is largely solved today. As with residential decarbonization, we now face the question of whether institutions can address the economic, political and equity concerns — not whether the policy is feasible. At some point it will come down to a question of whether we tax clean energy or we find other sources of revenue to cover the bill. Given the clear evidence that taxing clean energy is extremely regressive and undermines decarbonization, we need to find better solutions.
related topics: Energy