How Much Energy are We Flushing Down the Drain?

California is in the middle of a drought. In the Bay Area, that has meant day after day of glorious, uncharacteristically sunny winter weather. But, I am haunted by media images of dry creek beds and by my own mental images of driving by the Rim Fire near Yosemite last summer. Who knows what this summer will bring.

The drumbeat of media coverage on the drought had led me to think harder about the water-energy nexus. At a high level, that phrase encapsulates two profound facts: energy production is extremely water intensive and water provision is extremely energy intensive. (At this point, we can’t really say “water production,” but as we add more desalination capacity, production becomes more apt.)

I’ll focus on the second of those two facts, but this article on the water used for fracking relates to the first.

Providing Water to Homes, Businesses and Farms Requires A LOT of Energy

The energy intensity of water delivery hit home to me several years ago when my husband, who works for an electricity generator, spent the day at a California Public Utilities Commission workshop on low-flow toilets. Why would an electric generator care about toilets?! It turns out that pumping, conveying, heating, and treating water are all highly energy intensive.

An Energy Efficient Toilet?

An Energy Efficient Toilet?

In fact, several years ago, the California Energy Commission calculated that 19 percent of the state’s electricity and nearly 30 percent of its natural gas consumption went to moving, heating and treating water.

I’ve delved into these calculations, and not all of the energy attributed to water is in my view actually driven by decisions that we would normally think of as water-usage choices. For instance, the calculations include things like heating water for sterilization in food processing. I can imagine a sterilization technique that didn’t use water but still used energy, and sterilization is ultimately driven by decisions about processed food consumption.

A recent paper from the University of Texas similarly calculates the share of U.S. energy related to water. The authors distinguish between “Direct Steam Uses,” which includes things like sterilization and “Direct Water Services,” which are driven by what I think of as water-based decisions. The authors estimates that the two categories together account for 13 percent of the nation’s energy and Direct Water Services account for 8.5 percent of the nation’s energy.

The energy cost of H2O also depends on where you live. Californians use more energy-intensive water because we use more groundwater and less surface water, and we move it over longer distances. My water provider, East Bay Municipal Utilities District, charges an, “Elevation Surcharge,” which they describe as, “based on the energy costs of pumping water to higher elevations.” For households in the hills above 600 feet, the surcharge adds more than $1 per hundred cubic feet to a base price of roughly $2.50 per hundred cubic feet. Not all utilities have this adder.

Solutions?

As an energy economist, I hear a lot about positive  – in the sense of reinforcing – feedback loops that could result from climate change. Rising temperatures, for example, will require more electricity to power air conditioners, and, right now, electricity production is the country’s main source of greenhouse gas emissions. A drier California climate might be an example of a negative feedback: more droughts will force us to rationalize the ways we use water—and save energy, in the process.

But, how do we rationalize our water use? We should start by rationalizing water pricing. I know this might sound like the knee-jerk economist answer, but the water world has many examples that violate simple Econ-101 principles. In a nutshell, water is a scarce resource, and we treat it as though the basic input were free. In Los Angeles, for instance, the Department of Water and Power subsidizes houses on bigger lots by giving them more cheap water. Water usage in the agriculture sector, which accounts for 80% of California’s total water consumption, is a whole mess in and of itself, symbolized in my mind by the rice paddies in the Central Valley.

Rice Paddies in the Central Valley

The water economist, David Zetland, has made scarcity pricing for water his battle cry and has written a book on Living with Water Scarcity. As Timothy Egan in the New York Times has said, we cannot “out-engineer a fevered planet.” But, we can move towards rational pricing policies that help us make better decisions about our planet’s scarce resources.

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A Small Bet with Big Stakes

Back in November 2011, I made a bet with economist Geoff Rothwell about the future of nuclear power.  By making a bet we weren’t trying to trivialize the issue. To the contrary.  We had different predictions, and we saw this as a way of standing behind our beliefs, albeit in a modest way.

Our bet is about how much it costs to build a nuclear power plant. This might not seem very important, but I have grown to believe that this is the single most important number when it comes to determining the prospects for nuclear power, the only large-scale source of baseload electricity generation that does not emit carbon dioxide.

Geoff and I were at a conference, and I referred to an MIT study that estimated a cost of construction of $4,200 per kilowatt of capacity. Geoff thought this was too high.  So he challenged me to a $20 bet.  We agreed that we would use the two new reactors currently under construction at the Vogtle Plant in Waynesboro, Georgia as our measure. The new reactors will have a combined capacity of 2200 megawatts. So at $4,200 per kilowatt this is $9.2 billion in total construction cost. I went easy on Geoff and agreed to exclude financing costs and focus only on the “overnight” cost of construction.

The Vogtle project is extremely interesting because it is the first new nuclear construction in the United States in three decades. The Southern Company received a construction license from the U.S. Nuclear Regulatory Commission (NRC) in February 2012 and began construction officially in March 2013, though “pre-construction” has already been going on for several years.

It is not clear yet who will win the bet. There have been some delays, but construction is moving forward. Photos from January 2014 from the Southern Company’s website (below) document continued progress on the containment vessels and cooling towers. Click here for the complete set of photos.

Vogtle 1

Vogtle 2

According to a recent article by Reuters, the projected cost of the reactors is now $14 billion. This includes financing costs, however, so it is not clear how this compares to $4,200 per kilowatt. The new reactors are scheduled to come online in 2017 or 2018 so more-detailed budget information will become available soon.

Geoff is the Principal Economist at OECD Nuclear Energy Agency and has worked on nuclear energy his entire career so this bet would seem to be a risky move. I am not a nuclear engineer nor am I an expert on construction budgets. But I have looked closely at the history of nuclear construction projects in the United States, and the empirical evidence is not encouraging.

Construction Costs

Source: Lucas Davis, “Prospects for Nuclear Power”, JEP, 2012.

The figure above plots overnight construction costs for U.S. nuclear reactors by year of completion. While one might have hoped to see evidence of “learning-by-doing” the data actually show a pronounced increase in construction costs over time. Reactors that were ordered during the 1950s were built quickly and at relatively low cost, while reactors ordered during the 1970s ended up taking much longer and costing more.

Part of the story is a rapidly evolving regulatory process. A joke in the industry was that a reactor vessel could not be shipped until the total weight of all required paperwork had equaled the weight of the reactor vessel itself. The NRC has new procedures intended to streamline the regulatory process, but it remains to be seen how well these reforms will work in practice.

But even ignoring potential regulatory delays, nuclear power plants are still enormously challenging projects. The sheer scale of these facilities means that most components must be specially designed and constructed, often with few potential suppliers worldwide. These components are then assembled on site, and structures are built to house the assembled components. All stages of design, construction, assembly, and testing require highly-skilled, highly-specialized engineers and managers.

So it will be very interesting to continue to follow the experience at Vogtle.  From the point-of-view of the planet, I hope I am wrong, and that the reactors end up costing much less than expected. To address climate change we need as many technological alternatives as possible, and if nuclear power could be done cheaply it would transform energy markets. But we also need to be honest about the costs and these large construction costs make it difficult to make an economic argument for nuclear power.

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On the inefficiency of fuel efficiency standards

Imagine you have just been pulled over for exceeding the speed limit. The officer explains that the penalty for speeding decreases with engine size. Why?  Because it is relatively more difficult for drivers of high performance cars to exercise restraint and drive the speed limit. What?!

blogp1          Ma’am, if you had more horsepower,  this fine would not be so high.

Photo credit: http://www.dmv.org/articles/traffic-stop-dos-and-donts/

Of course, this is not how speeding ticket fines are actually determined. But this scenario serves as a metaphor for how the fuel economy standards faced by automakers are actually set.

The bigger the car, the lower the bar

The U.S. Corporate Average Fuel Economy (CAFE) standards establish a minimum average fuel economy limit for each manufacturer’s domestic vehicle sales.  Historically, all passenger cars were held to the same fuel economy standard (27.5 miles per gallon in 1990-2010).  Light trucks faced a less stringent standard.

This all changed when Congress mandated attribute-based standards as part of the Energy Independence and Security Act.  The graph below illustrates how fuel efficiency standards are now determined based on vehicle “footprint” (i.e. the area defined by the points where the four wheels touch the ground).  Each company calculates the CAFE requirements for every model it brings to market. Company-specific fuel economy limits are defined as the sales-weighted average across vehicles sold.  In other words, companies selling bigger cars are held to a less stringent fuel economy standard.

car-and-truck-stds

Source:http://blog.ucsusa.org/what-makes-a-car-a-truck-and-why-it-matters-for-fuel-economy

Why un-level this playing field?

One possible argument for moving from a one-size-fits-all to a size-based standard has to do with minimizing the costs of meeting fuel efficiency targets. In general, it is more costly for firms that make larger, heavier cars to meet a given fuel efficiency target. An attribute-based standard could- in principle- be designed to equate marginal compliance costs across firms. This would ensure that fuel economy targets are being met at least cost.

In the U.S., however, the ability of firms to trade credits eliminates this efficiency-advantage. Instead, the National Highway Traffic Safety Administration (NHTSA) offers the following justifications for the current footprint-based standard (details can be found in the final rule and public hearing transcripts).

  • Reduce disparities of manufacturers’ compliance burdens”: U.S. manufacturers produce relatively large vehicles.  Footprint-based standards reduce the compliance costs borne by US automakers vis a vis their international competitors.
  • “Preserve consumer choice”:  It is more costly for larger vehicles to meet a flat standard.  Drivers who prefer/need larger vehicles would either need to pay a higher price for their vehicle or choose a smaller vehicle. Reduced demand for large vehicles could reduce supply. NHTSA has been very concerned about mitigating these kinds of impacts.

NHTSA has also argued that “attribute-based standards reduce the incentive for manufacturers to respond to CAFE standards in ways harmful to safety.”  This presumes that downsizing vehicles would make driving less safe. But recent studies have found that, once the safety externalities associated with driving larger vehicles are accounted for, the current vehicle fleet looks inefficiently large.

Looking out for the big guys….at what cost?

The problem with using attribute-based standards to reduce impacts on the producers and consumers of larger vehicles is that it creates an incentive for firms to game the system. More specifically, attribute-based standards provide an incentive for manufacturers to adjust the attributes of the vehicles they sell in order to reduce the stringency of their firm-specific targets.  This is potentially problematic because bigger, heavier vehicles tend to consume more gas, emit more pollution, and are associated with higher traffic fatalities.

A recent working paper by economists Koichiro Ito and Jim Sallee provides a striking example of how this kind of gaming can play out in practice. They focus on firms’ response to Japanese fuel economy standards. The stair-step pattern in the graph below shows how the Japanese fuel efficiency standard drops discretely at pre-determined vehicle weight thresholds.

blogp3

Weight of cars sold under Japanese fuel economy regulations 

Koichiro and Jim note that, for firms manufacturing vehicles that are close to a weight threshold, a small increase in weight will deliver a relatively large reduction in the fuel economy standard.  They cleverly use these notches to test whether Japanese automakers have in fact  “upweighted” in response to the standard.

The green bars in the graph summarize the distribution of weight among vehicles sold in Japan. The height of each bar tells you the percentage of vehicles that fall within the corresponding 10 kg weight range. Looking at the bunching of vehicles just to the right of each cut-off, it sure looks as though automakers are upweighting in response to this policy. The authors build a very convincing case for this interpretation. And they argue that the costs associated with this policy-induced upweighting are substantial.

Are we being super-sized?

There are reasons to think that manufacturers’ response to Japanese standards will be more dramatic than anything we will see here in the U.S.  For one thing, Japanese standards are based on vehicle weight which is more easily manipulated.  And there is no trading of compliance obligations in Japan.

But there is anecdotal evidence that cars are getting bigger under the new CAFE standards here in the United States:

blogp4

Range Rover features a new “long wheelbase” at the 2014 Detroit Auto Show.                 Photo credit: Catie Hausman

A recent news article reports that sales of large cars and trucks are up.  My co-author Kate Whitefoot has done terrific work investigating the potential design response to footprint-based standards. She has more recently been looking at the 2013 data and finding that the sales-weighted average footprints of cars and light trucks are larger than was projected in the regulations.

Attribute-based standards are a potentially costly way to allocate compliance costs more equitably. If auto manufacturers are significantly increasing the size of the vehicles they sell in response to the current size-based standards, fuel economy targets will not be met efficiently. Calls to flatten the curve that maps footprint to efficiency standards should be taken seriously. Or we should find an altogether different way to redistribute costs. Think pollution permit trading programs that use free permit allocations to achieve distributional objectives without undermining market efficiency.  There are ways to mitigate the cost impacts of fuel efficiency standards on the big guys without creating an incentive for them to get even bigger.

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What wood smoke has taught me about fighting climate change

While much of the U.S. has been dealing with severe winter weather, California is experiencing a record dry spell.    The clear skies have also brought some cold nights and, with them, wood smoke.  What I’ve noticed in my neighborhood is that the desire for a cozy wood fire cuts across political lines.  And as the local air quality authority has called a record number of no-burn days due to poor air quality (high levels of PM 2.5, the fine particulates that can get through the respiratory system and lodge in lungs), the anger at restrictions on those cozy fires has also cut across political lines.

Many of these neighbors are friends of mine.  They are caring people who recycle their newspapers and bring home their groceries in reusable bags.    Most are concerned about pollution in general and believe that greenhouse gases are causing potentially devastating climate change.  Yet, they ignore warnings about the pollution from their wood fires, in some cases even blatantly violating the burning bans that have been called on nearly half of all days in the bay area since November 1.

The science on local particulate air pollution is settled – both that wood fires are the primary source in winter and that the health threat is significant.  And it takes much less imagination to understand the danger from wood smoke than the danger from carbon dioxide and other greenhouse gases.  Particulates are visible in higher concentrations and your nose, eyes and throat tell you that there is a problem with the air.  GHGs are invisible and odorless.

FireInFireplace

Addressing the wood smoke problem does not require a fundamental shift in the way we live.  Sure there is a sacrifice – even I enjoy a wood fire on occasion – but it doesn’t mean living in a colder house, traveling less, reducing electricity consumption or anything else that has a broad impact on standard of living.  The houses around me already have natural gas furnaces that are a less-expensive way to heat.

Yet, judging from news reports, letters to the editor in the local papers, and discussions with my neighbors, there is widespread resentment that the air quality district is restricting wood fires.  Many of the excuses are of the “my contribution is so small it doesn’t matter” variety.   One recent letter in the local paper dismissed policies that are designed to reduce pollutants so small that they aren’t even visible, a “what I can’t see couldn’t be that dangerous” attitude that I bet is more widespread that we’d like to admit.

My point here is not to scold my neighbors.  I think they are just as public-spirited as other people.  What I take away from this is that people have a strong ability to deny uncomfortable truths about pollution (and externalities more broadly) when the implication is that they need to change the way they live, even if the change is fairly small.  The changes we will have to make to address climate change are going to be much more challenging than just substituting a cleaner, easier and cheaper heating source for a dirtier one that is also a hassle to use.

This realization has helped move me in the last few years to argue for much greater emphasis on subsidies for R&D to reduce the cost of substitutes for fossil fuel.  The renewables advocates are right that we have the technology today to address climate change, but we don’t have the technology to address climate change without sacrifice.

ChimneySmoke

There are people who will voluntarily sacrifice to reduce their pollution, but that’s not most people.  Even among the upper middle-class households in my neighborhood (by world standards, quite wealthy), most people react by denying the problem or denying their ability to have any impact on it.

Broad support for national or international strategies to reduce carbon emissions quickly dissipates if those policies turn out to be expensive (see Spain’s abandoning renewable subsidies) or if other priorities come to the fore (see how Germany’s decision to ditch nuclear power has led to increased coal-fired generation).  In the developing world, where incomes are much lower and the other threats to life are more immediate, sustained support for more-expensive alternative technologies will almost certainly be even more scarce.

These political realities also point out another, related, reason to lean towards greater R&D funding.  Any shift away from fossil fuels will create losers (think coal miners, oil drillers, Big Carbon shareholders).  If the loss is directly attributable to regulation (or even pricing GHGs) there will be tremendous pressure to loosen the regulation.  If it’s due to a new technology then all the government needs to do is step back and let the market have its way.  “Regulation is killing our industry” carries a lot more political heft than “A new lower-cost technology is killing our industry and we need government regulation to slow it down.”

Digital photography destroyed the film industry without a murmur of government intervention.  If the shift had been due to expensive regulations on film (even if they were good public policy), we’d still be getting our photos developed at the local drug store.

With apologies to Donald Rumsfeld (now there’s a phrase I didn’t ever imagine I’d be writing), we have to go to war against climate change with the human and political constraints that exist, not the benevolence, rationality, and far-sightedness that we wish existed.

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The Politics of Renewable Energy

I found yesterday’s NY Times article on the shifting politics of renewable energy morbidly fascinating on both a political and economic level. Basically the article pieces together anecdotes of odd-couple political alliances between renewable energy boosters and Republicans, Libertarians (e.g. Barry Goldwater Jr.), or Tea Party stripes. My reaction was that the Times seems to have found a collection of Republicans who want to support renewable energy for all the wrong reasons. Barry Goldwater seems to see renewable energy as a freedom issue and solar panels as sticking it to the man – where the man in this case is the electric utility.

solar panels on a houseA new political twist on this is the perception of utilities as extensions of the government, with “prices set by bureaucrats.”  In fairness, some of these folks probably supported electricity competition (which still has its share of bureaucrats). Ironically, with competition, when there is a different company billing you for the energy, it’s pretty clear that your utility bill is just for the grid infrastructure part – and we still need to pay for it.  Sorry, there is no escaping these bureaucrats unless you are willing to go off the grid completely.

Others attempt to bring national security into the picture, which requires some impressive rhetorical gymnastics. Tom Morrisey of the Arizona Republican Party links solar energy to the war in Afghanistan. In the past, Energy Institute bloggers have had to complain when electricity subsidies were justified as somehow reducing our dependence on foreign oil, which fuels only a trivial fraction of US electricity production.  At least Morrisey avoids that mistep, as there is no oil in Afghanistan. Perhaps he is focused on our dependence on foreign lithium.

The economics in the article is really nothing new. The fights being played out across the country are about the fairness, and sustainability, of solar policies that shift the fixed costs of network infrastructure to customers without solar. I am frustrated how verifiable facts are reported as “arguments” instead of checked and reported as true or false. The Edison Foundation “argues” that non-energy charges account for 55% of an electric bill on average. The fact that a big part – usually a majority – of a residential electric bill covers costs other than generation is not an “argument,” it’s a truth.  Only 31% of the electric charges on my last bill are for generation.  The EIA website says that over all customers (including commercial and industrial) generation accounts for 58%.  That’s a lot higher because for commercial and industrial customers T&D costs are much lower.  Your percentage may vary but the underlying point – that your bill covers a lot more than energy – does not.

The counter-argument, articulated by an Arizona Republican, is that this implies that if he conserved energy by using less air-conditioning, he would also be free-riding on these grid charges. Yes! That is exactly right!

We have been recovering fixed costs with variable rates for so long that people do not realize what the costs really are.  At one time it was perhaps reasonably fair and financially viable to pro-rate fixed charges according to a home’s energy use. As some homes approach very low levels of net energy use, that is no longer fair or financially viable.

The “freedom from the utility argument” would carry a lot more weight if folks were in fact not using the expensive grid infrastructure they complain about paying for. However the vast majority of solar installations do not allow one to even power a house during a black-out, let alone disconnect from the grid completely.

Liberals have come to embrace the notion that the costs of health-care risks should be pooled and shared by the general population. They do not seem to feel that way about energy infrastructure.  The Republicans in this piece don’t want to pay (or don’t recognize) the costs of the grid either. Neither side of this “green-tea” coalition has the economics right.

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Why Would Google Pay $3.2 Billion for Nest?

(This blog is co-authored by Howard Chong)

Google’s acquisition of Nest Labs Inc. is puzzling. It’s nice that Nest is about reinventing previously “unloved things” like thermostats and smoke detectors. But is it really worth $3.2 billion? To put it into context, assuming a 20% profit margin (Nest’s profits are opaque and will remain so as a subsidiary to Google), selling a $250 Nest thermostat to all 132 million U.S. households comes out to $33 billion in revenue and $6.6 billion in profits. So, you break even only if you sell to about 50% of all homes in the United States. This seems unlikely. Of course there is also scope for increased market share internationally, but this will take time. Plus, unlike the iPhone, after someone buys a Nest, they aren’t going to upgrade every 18 months.

nest-thermostat-featured

Google is a smart company. So what is their angle? How will Google monetize Nest? We think the answer is data. Remember, Google is a media company. They sell ads. For most of its revenue, Google doesn’t sell the “thing”, it sells to sellers a way to find buyers. Nest data will help it do this. The $250 you pay for a Nest thermostat is only a small part of a much larger stream you spend on electricity, natural gas, and all the appliances in your home that use this energy.

Nest data give Google a strategic advantage in these other markets, immediately creating opportunities for selling targeted advertising for companies that operate in this space. In some ways, targeting will be straightforward. If 19 Pine St. has its air conditioner on three times as often as 21 Pine St., Google can suggest a local air conditioning repair specialist or salesperson. A new central air conditioner can cost thousands of dollars, so it is reasonable to think that local retailers would be willing-to-pay substantial amounts for these connections. And it is not just air conditioners.  Google can sell targeted advertising for furnaces, roof and wall insulation, energy-efficient windows, and other parts of the building shell.

In fact, Nest data can allow Google to perform a complete audit of the energy used in your home for cooling and heating. This is not as good as an in-home energy audit, but it also is much less expensive. After all, it is not cheap to send a technician to your home, have them set up instruments and spend the afternoon blowing air around your house. In-home energy audits cost both money and homeowner time.  Nobody wants to wait around all day for a technician to crawl around their attic.  In contrast, an audit performed with Nest data does not require anyone to ever step foot in your home. A Nest audit is necessarily more limited than an in-home audit, but with smart data analytics and high-quality weather data it can still provide important information.

And at the end of the audit, Google can provide a set of tailored recommendations aimed at improving the thermal comfort in your home. No need to stop at generic suggestions – these recommendations could come with real quotes from local service providers. We think it is this sales lead generation potential (AKA advertising) that Google hopes to monetize. In addition to energy audits, the same data can be used to monitor changes in behavior after retrofits, and/or to verify savings guaranteed by product retailers.

In many cases, energy utilities will be the one driving these sales. Utilities would like to be better able to target their energy-efficiency programs, and to verify savings after energy-efficient investments have been made. This is a large enough market, and the incentives strong enough, that one could imagine utilities like PG&E and NYSEG paying hefty licensing fees to access Nest data. If the data are valuable enough, these utilities might even be willing to subsidize the Nest thermostat itself, in order to include more households in their data analytics.

These services would beat the status quo technology, not because it is better, but because it is good enough, fast, and convenient. This is the classic Silicon Valley entrepreneurial story: find something that was expensive to do before, disrupt, offer a higher quality of service for a 10th of the price. And make it much more convenient. This is transaction cost economics. What the service Google/Nest can sell is convenience and a smarter way to interact with everything having to do with your home energy use.

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Slutsky strikes again: Greece’s air pollution problem

Greece is currently in one of the worst recessions in post war history and incomes are down across the board. Air pollution levels, however, are at their worst levels in decades. Major Greek cities like Thessaloniki and Athens are experiencing repeated spikes in the levels of PM10 exceeding 150 micrograms per cubic meter (50 is the standard). We often think that deteriorating air quality accompanies a growing and industrializing economy. Here the opposite is true. What happened?

In order to increase government revenue to service debt, several changes to the tax code were made. Gasoline taxes were raised to nearly 60%. Greece used to have some of the cheapest gas in Europe and all of the sudden they were amongst the highest in the world. As a consequence, VMT dropped since there are few competitive short run substitutes for gasoline as a transportation fuel. This should have improved air quality, not worsened it.

A little bit later, taxes on heating oil were raised to match the tax rate on gasoline. Property tax rates were raised significantly and are being collected via electricity bills. If you don’t pay, you run the risk of having your power turned off. These tax increases are unusual as we usually use income tax as the major source of government revenue. Yet in Greece, income taxes are hard to collect. Hence the strategy to collect taxes on necessities.

From the perspective of an environmental/energy economist this is interesting since what we are seeing here are significant changes in the price of liquid fuels (and maybe perceived changes in the price of electricity service). This is all compounded by a whopper negative shock to incomes. What Greeks have done in response to these changes is switch to wood as their major source of heating fuel. It’s cheap, yet incredibly dirty from a local air pollution perspective. Several bloggers have blamed a typical recession type income effect for this response. The story is appealing. Greeks have no money, hence they switch to lower per heating unit sources of fuel. As is often the case, this is not the whole story.

The basic economics of this are somewhat simple, yet it requires going back to one of the most dreaded lectures in any intermediate microeconomics class: the one dealing with the Slutsky equation, which decomposes a price change into two effects: An income effect – essentially as one good becomes more expensive you have less “real income” available overall. And a substitution effect – which implies that for a given level of happiness you substitute away from the more expensive good. Undergraduates question each year why they have to learn this. Here is why:

The higher tax on heating oil raised its price relative to that of fuelwood. If we assume that heating oil is a normal good (which is economics for you consume more of it if your income rises – holding everything else constant), its higher price means that  people are substituting away from it and are consuming even less of it because of the price and crisis induced income effect. The story for fuelwood is similar. It is the relatively cheaper good and people are substituting towards more fuelwood consumption. If it is a normal good, then this substitution effect must be larger than the income effect (as they are working in opposite directions). If it is an inferior good (which is economics for you consume less of it if your income rises holding everything else constant) then you are consuming even more of it because of the price and crisis induced income effect. Either could be the case, but I would put my money on the latter explanation. The higher your income, the less likely you are to want to chop wood and lug it into your living room.

Why do we care? First off, air pollution is really bad for children, seniors and other  populations. Michael Greenstone and many others have written about this. Second, this has implications for a carbon tax. If you tax carbon at the mine or well head and do a  good job of increasing the price of coal, oil and natural gas you will in theory shift the fuel mix towards a lower carbon intensive mix. Since natural gas is cleaner than coal in terms of local air pollutants in most cases, you not only get carbon savings but also improved local air quality. However, in low income countries, where there is ample supply of hard to tax biofuels in the form of biomass and dung, a carbon tax might lead to increases in ambient air pollution concentrations which have significant and immediate negative consequences for the local and regional economy. Greece is just one example of this. I would like to see some of Greece’s excellent environmental economists use their connections to estimate these elasticities and quantify the overall welfare implications of this form of quasi Pigouvian, yet definitely not revenue neutral, taxation.

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