Setting prices too low is a climate problem, but so is setting prices too high.
We didn’t hear much about electricity pricing at last week’s Global Climate Action Summit in San Francisco. But when it comes to sub-national entities addressing climate change (as well as local pollution), electricity prices are one of the most powerful policy tools they have.
The Importance of Getting Price Right
A major part of the pollution problem is that we don’t make polluters pay for the emissions. As a result, final goods don’t reflect the full incremental costs that producing them imposes on all of society, what’s known as “social marginal cost” (SMC) in Econspeak (sadly, a language that Google Translate still can’t handle). Pricing electricity below SMC encourages wasteful use, such as computers left on all the time, cranking up the air conditioning rather than installing better insulation, and sticking with inefficient lighting and old refrigerators when more efficient versions would save money if the owner were paying the full SMC for electricity.
Where will a plug-in hybrid get “charged”?
But while ignoring pollution will drive the price of a kilowatt-hour (kWh) too low, an age-old issue for utilities pushes prices in the opposite direction – recovery of their fixed costs. For instance, if the cost of transmission and distribution lines does not vary with how much electricity you consume, then the SMC principle says that recovering that cost in the per-kWh price of electricity will tilt prices too high. That will cause consumers to cut out some usage that would have been worthwhile.
Paying the full SMC for each kWh of electricity, you might decide to leave some lights on for safety or comfort, watch an hour of silly cat videos, or heat your hot tub for a nice soak. More importantly, you might decide to switch from gas to electric hot water or space heating or look into an electric vehicle. But if the price of electricity is way above SMC, you will be discouraged from doing so, and society will be worse off.
If that sounds pretty abstract, it’s not to the three different California owners of plug-in hybrid cars who recently told me they never plug them in. Their electric rates are so high that it is cheaper to just run them on gasoline (while still getting access to the carpool lanes). But those electric rates are vastly higher than the SMC of the electricity. These drivers are “conserving” too much electricity.
New Research on the Gap Between Price and Social Cost
How do I know that their electric rates are too high? Research! In a new Energy Institute working paper that Jim Bushnell and I are releasing today — “Do Two Electricity Pricing Wrongs Make a Right? Cost Recovery, Externalities, and Efficiency” — we compare the residential rates of nearly all the utilities in the US with the social marginal cost of the electricity they provide.
You’ll have to read the paper to get into the gritty details, but our calculations incorporate both the generators’ direct costs of producing the power and the external costs imposed on society by the associated pollution from greenhouse gases (at $50 per ton…figured you’d want to know) and local pollution. In fact, for much of the country, we find that the societal costs from pollution are actually larger than the direct cost of generating electricity. We also adjust for the fact that some of the electricity is dissipated as heat between the generators and the houses, known as line losses.
Failing to price pollution makes electricity too cheap, which is a big problem in the Midwest where a lot of coal generation is still putting out massive quantities of carbon dioxide and, just as important, sulfur dioxide, which causes acid rain and other local pollution problems. But it is a much smaller problem in California, where the majority of electricity comes from zero-GHG sources like solar, wind, geothermal, hydro and nuclear, and nearly all of the rest from relatively-low-GHG gas-fired generation.
On the other hand, all utilities have fixed costs that they recover at least partially through their price on each kilowatt-hour. This turns out to be a bigger problem in California and parts of New England, where electric rates are paying for energy efficiency programs, development of new alternative generation technologies, and rooftop solar panels, as well as the usual fixed costs like transmission and distribution lines. In addition, the large investor-owned California utilities have miniscule or no monthly fixed charge for residential customers, so they collect all of their revenue in the per-kilowatt-hour charge, which further pushes up the price.
The map above summarizes our findings on the average gap between price and SMC. In some states – the lighter colors on the map – unpriced externalities are largely cancelled out by fixed cost recovery, so the gap between the standard residential electricity rate and the utility’s average social marginal cost is small. In other words, prices are – almost by coincidence – about right on average.
However, in the upper Midwest, where residential electricity prices are very low and pollution is high, prices are well below social marginal costs on average. By contrast, in California and the northeastern US, electricity rates are way above SMC, more than twice as high in much of California.
Yes, California, we can encourage too much electricity conservation. We are doing it. We have among the highest electricity prices in the country and among the cleanest electricity generation. It is a barrier to electrification of home heating and hot water, electric vehicle adoption, and other uses of electricity that create value in our lives greater than the full social cost of the power.
Meanwhile, the states in red on the map – many of which are politically “purple” or even “blue” – are pricing electricity well below the full social marginal cost, thereby encouraging excessive use: relying on more A/C rather than more insulation or shading, and discouraging upgrades to more energy-efficient A/C, refrigerators, lighting, and even hot tubs.We also find – frustratingly, but not surprising politically — that those states that are pricing electricity too high are also the ones spending the most through other programs to reduce electricity demand – particularly subsidies for energy efficiency and rooftop solar, as shown in the maps above and below. Most of those customers in the darker areas are already getting excessive rewards for cutting their usage, because they are avoiding high electricity prices that don’t reflect real costs to society. The lighter areas of these maps correlate closely with the redder areas of the previous map: both price and policy give those households little incentive to conserve.
Timing Matters Too
Our study also looks at the hourly variation in SMC, due to both generation marginal costs and the associated pollution, which residential rates almost never reflect at all. We find that for many utilities charging a constant price is probably an even bigger problem than its level. The price may be close to average SMC, but in some hours it is much too low and in other hours much too high. As information and control technologies improves – think smart charging that Nissan Leaf (bestselling EV globally) when the sun is shining or the wind is blowing – these differences suggest another set of opportunities to reduce greenhouse gases by aligning prices with the true social marginal cost of providing electricity.
Last week’s climate summit was a crisp reminder that even with the U.S. federal government AWOL on climate policy, there is strong commitment at state and local levels to reduce greenhouse gases. Direct support for new technologies should play a major role. But let’s not forget that a market economy runs on its prices. Getting the price right for electricity is something that every local jurisdiction can do.
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Severin Borenstein is E.T. Grether Professor of Business Administration and Public Policy at the Haas School of Business and Faculty Director of the Energy Institute at Haas. 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. He chaired the California Energy Commission's Petroleum Market Advisory Committee from 2015 until its completion in 2017. Currently, he is a member of the Bay Area Air Quality Management District's Advisory Council.