Fat margins in rail shipping are likely to partially absorb a price on carbon.
Discussions of U.S. coal policy generally focus on coal mining or coal burning, but hardly ever on coal transportation, the critical link between the two. Yet, transportation is a significant percentage of the total cost of electricity from nearly all coal-fired generators. And hidden in that link between mining and generation is a protective layer that is likely to slow the decline of coal in the American energy system.
That is one conclusion of an important new Energy Institute at Haas working paper by Louis Preonas, a PhD student at EI, who will be finishing his dissertation this year. The paper, “Market Power in Coal Shipping and Implications for U.S. Climate Policy” shows that rail transportation of coal to many power plants comes with fat margins for the railroads. In those markets, Preonas demonstrates that new profit pressures — such as would come from a price on carbon that raises the cost of coal generation relative to other sources — are partially absorbed by the railroads in order to keep from losing coal-shipping business.
That’s good news for coal-fired generation, but bad news for the goal of reducing GHG emissions in the electricity sector. Researchers studying climate policy typically translate a carbon price into a cost increase for coal generation by assuming that the generator’s costs rise by the price of their GHG emissions. But Preonas shows that such pressures on generator profits cause charges for coal transportation to fall in many areas, keeping coal in the money to a greater extent than the standard calculations would suggest.
This cushioning effect doesn’t impact all coal generation, but it is clearly present at plants served predominantly by a single railroad, which constitute about 44% of all U.S. coal-fired power plants. At plants served by multiple railroads, or those located on a river or lake that allows them to receive shipments by water, margins of the transportation companies are already thin so they have little room to lower their charges to keep the customer’s coal plant running.
Of course, the price of GHG emissions is zero, or very close to zero, in most of the country, so it’s not possible to measure the impact of pricing GHGs on coal-fired generation directly. But the fracking boom over the last decade has cut natural gas prices, imposing pressures on coal from the demand side, as cheap gas has taken an increasing share of electricity generation. The response of railroads suggests how they are likely to respond if coal plants are hit by a significant carbon price.
Like a carbon price would do, the decline in gas prices has had heterogeneous impacts on the demands of coal generators for fuel. Some have operating costs well below the wholesale electricity prices in the markets where they sell, so most of their sales are not at risk. At those plants, shipping charges have been less responsive to falling gas prices, Preonas finds, presumably because the railroads know these plants will still have a strong incentive to run.
It’s at the plants whose costs put them closest to the margin that the railroads have adjusted their pricing the most to keep those generators running. As gas prices have fallen, these coal plants have lost share in electricity markets. But they have not lost as much share as they would have if railroads hadn’t lowered coal transportation costs for those very plants most threatened by the declining costs of competing gas-fired plants.
Overall, Preonas estimates that railroads’ practice of lowering prices to keep selected coal plants in the money means that the fracking boom has reduced GHG emissions 8% less than would have occurred if the railroads had not helped cushion the impact.
OK, the effects of fracking are interesting, but what should really grab the attention of policymakers is what this implies for the effects of carbon pricing on coal plants. The estimates of the response to natural gas prices can be applied to forecasting the possible response of coal generation to a carbon price. Preonas shows that for the most captive coal plants as much as one-quarter of a carbon price would be absorbed by shippers, meaning that those plants would effectively be responding to a 25% lower carbon price than other generators or any other producers of GHGs.
The idea of using market mechanisms to correct environmental externalities is nearly 100 years old, but we only have a few decades of experience with actual implementation of such programs. And even today they play a much smaller role than direct pollution control regulation. As we gain more experience with market mechanisms, it will be critical to continue to assess whether they work as we expected and where they can be improved. The effect of additional market failures, such as market power on the supply side, is an important part of that research area.
The paper by Louis Preonas contributes to a growing literature evaluating the potential uses and complexity of market mechanisms for pollution control. The challenges are significant.The world is a much more complicated place than exists in economic theory. But the alternative approach of direct pollution control has been shown in many cases to reduce pollution at much higher costs than necessary. This sort of insightful, unbiased, and transparent analysis, applied to all policy options, will be needed to effectively respond to the enormous challenge of climate change.
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Severin Borenstein is E.T. Grether Professor of Business Administration and Public Policy at the Haas School of Business. He has published extensively on the oil and gasoline industries, electricity markets and pricing greenhouse gases. His current research projects include the economics of renewable energy, economic policies for reducing greenhouse gases, and alternative models of retail electricity pricing. In 2012-13, he served on the Emissions Market Assessment Committee that advised the California Air Resources Board on the operation of California’s Cap and Trade market for greenhouse gases. Currently, he chairs the California Energy Commission's Petroleum Market Advisory Committee and is a member of the Bay Area Air Quality Management District's Advisory Council.