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To Make Decarbonization Work, We Need Prices

by richard schmalensee

dick schmalensee is professor emeritus of economics and management at MIT and a senior fellow at the Niskanen Center in Washington.

Published May 25, 2021


Forgive the acronym salad — alas, it’s important.

Thirty states and the District of Columbia have Renewables Portfolio Standards (RPSs), and five have Clean Energy Standards (CESs). Under these programs, retailers of electricity (i.e., power companies) are required to generate or buy specified portions of electricity from sources deemed to be renewable or clean. A national CES or RPS might seem a natural next step to accelerate the reduction of carbon emissions, and the idea has attracted a good deal of attention recently as an option for President Biden and the newly greener Congress. Here I argue that, ironically, adopting such a national standard could set climate policy on a path that would make it harder than necessary — perhaps even impossible — to achieve the ultimate goal of full economy-wide decarbonization.

To decarbonize the economy, electricity generation must be decarbonized, and fossil fuels must be replaced by electricity in “downstream” energy use, like commercial and residential heating. But there’s a little remarked tension here. A national CES phasing out fossil fuels in power generation would be bound to increase the average cost of electricity. And that cost would be passed downstream to users in the form of higher prices, making it more expensive for them to replace fossil fuels for, say, space heating, with electricity.

True, this conflict could be resolved by subsidizing the transition sufficiently to make the process of meeting a national CES costless to end users. But such a subsidy would have to be substantial to accomplish the task. And in an era of vast competing demands on the federal budget, it seems a problematic route — especially since there in an alternative means to the same end that would reduce the budget deficit rather than increase it — namely, a national tax on carbon emissions.

A Closer Look 

Wind and solar generation have gotten lots cheaper in recent years in terms of the average cost per kilowatt-hour (kWh) generated. But the output from both sources is slave to the weather and is thus both variable and imperfectly predictable. Accordingly, wind and solar are not as valuable to electricity retailers as predictable generation from, say, the natural-gas combined-cycle plants now commonly used for peaking power because retailers dependent on renewables must keep reserve capacity at hand. So even as renewable prices fall, wind and solar will require either government mandates or taxes on carbon emissions to accelerate decarbonization.

Under a CES, when a generator certified to be clean produces a kilowatt-hour of electricity, it also produces a one-kWh “clean energy certificate” (CEC). Retailers of electricity, generally regulated utilities, turn over the required number of CECs to the relevant authority each period to demonstrate compliance with a CES. By selling CECs, clean generators are subsidized by electricity retailers (the power company), and this subsidy makes it more economical to switch away from fossil fuels.

In order to pay for CECs, or to create their own through in-house clean generation, retailers must raise prices. Since many residential and commercial customers now pay a constant price per kWh at all times, the path of least political resistance for power companies is to raise prices across the board for all of their customers. But as a recent study by Lucas Davis at the University of California (Berkeley) confirms, the price of electricity is the main determinant of whether customers use fossil fuel or electricity for heating. Thus, the higher the price of electricity, the higher the subsidy needed to persuade households to switch to electric heat. Consider, too, the politics: higher electricity prices driven by CECs would make a ban on oil and gas heating more painful, and thus increase resistance to forcing the switch by means of regulation.

Pay for What You Cost

To be clear, while the impact may be more modest than conventional wisdom suggests, the transition from fossil fuels to renewables will likely raise the average cost of producing electricity. But an average increase in monthly bills is not inevitable. That’s because the actual cost of producing electricity on the margin in systems with high penetration of wind and solar generation will vary enormously from hour to hour and day to day. And a price structure reflecting this reality would give consumers the flexibility to save a lot of money.

Take the case of Hawaii, one of the national leaders in clean energy. There are times when there is excess solar generation (typically around noon) and, in the absence of sufficient battery storage, the utility must throw away kilowatt-hours to balance supply and demand. At other times, often as the sun is setting and residential demand is increasing, the utility must run expensive gas-fired generators to obtain enough power to meet demand. Despite these variations, my son in Hawaii pays around 30 cents per kWh to charge his electric vehicle, whether there is a surfeit of electricity or a scarcity.

A carbon tax would generate revenue that could be spent on cutting other taxes or paying for programs that increased public acceptance of an aggressive decarbonization program.

Now imagine if Hawaii switched to a pricing structure that reflected the current cost of producing power. My son could arrange to charge his car at noon, when electricity would generally be (nearly) free, and not charge it when he comes home in the evening, when it would generally be expensive. Many other consumers of electricity are similarly flexible, and, if prices varied to reflect generation costs on the margin, they could arrange to pay considerably less for electricity than if the price were the same at all times.

Where time-of-use pricing is in effect, large retailers cool their facilities when prices are low and make minimal use of air conditioning when prices are high. Enabling more electricity consumers to buy at cost-based prices would encourage innovation and make it more attractive to electrify sectors now dependent on fossil fuels.

It’s true that a national CES wouldn’t completely rule out pricing electricity correctly on the margin. A retailer that buys electricity in an organized spot market (like Consolidated Edison in New York or Pacific Gas and Electric in California) or that generates its own electricity with machinery with varying production costs could charge consumers accordingly.

But since every kilowatt-hour of clean generation, whenever it occurs, produces one CEC, and all that matters for compliance with the national standards is the total CECs a company has acquired, the price of CECs would be determined on a national market. Any individual electricity retailer would pay a constant per-kWh price for the CECs it would need to comply with the national standard. This constant cost would reinforce the historic pattern of charging a constant per-kWh price at retail and make it more difficult for reformers to change.

Enter the Carbon Tax

There is a better way. Economists have long argued that a national carbon tax would be more cost-effective than a national CES in spurring the transition to renewables in electricity production. Moreover, unlike a national CES, a carbon tax would act directly to incentivize decarbonization downstream. All else (including other environmental effects) equal, we shouldn’t care how carbon emissions are reduced. And it is almost always better to tax what’s bad than to subsidize an invariably incomplete set of substitutes for it. Moreover, subsidies require a revenue source. A carbon tax would generate revenue that could be spent on cutting other taxes or paying for programs that increased public acceptance of an aggressive decarbonization program.

Consider, too, that with a national carbon tax, state RPS or CES regimes would retain their effectiveness. If, despite the existence of a national policy, California wanted to be greener than Wyoming, it could set a tighter RPS or CES.

• • •

A journey of 1,000 miles always begins with a single step, but if that step is in the wrong direction, the journey could end up being 10,000 miles. A national CES may seem like a good first step on the tortuous route to a fully decarbonized economy. But it could put climate policy on a path that would make that journey longer and more costly than it needs to be, and perhaps make it impossible to finish.

main topic: Climate Change