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Decarbonization Will Require Pricing Reform

When it comes to electrification, all energy prices matter.

While a lot of behavior that harms the environment is due to misguided libertarianism or selfishness, much of it also comes from time constraints and decision overload. A parent on a tight budget who is shopping for food with kids in tow has a hard enough time focusing on the shopping list and the cost of each item, let alone their environmental impacts.

Energy decisions are even more challenging. Not many people have the time or background to dig into the complex environmental consequences of their energy choices. If we are going to address the climate crisis – as well as the other environmental imperatives created by our modern standard of living – incentives and regulations will have to be the primary mechanism. And even if you don’t think pricing carbon is the sine qua non of confronting the climate crisis, you probably still recognize that prices matter when consumers make choices.

TwoPathsDiverged

(Source: https://sites.psu.edu/mgeppingerpassionblog/2015/09/10/two-roads-diverged-in-a-yellow-wood/)

A few years ago, I blogged about a study that Jim Bushnell and I had carried out determining how far residential electricity prices were from the economic ideal: social marginal cost (SMC). For those who have spent their lives doing something more exciting than becoming an economist (is there anything more exciting?), marginal cost is the additional cost of producing a little more of a good, or the savings from producing a little less.  It omits costs that don’t change when a customer buys more or less, such as the cost of maintaining power poles and distribution lines if you’d still have to spend the same amount on them regardless of how much electricity they carry. The “social” part means that it counts not only the private marginal costs incurred by the seller, but also the pollution damages and other spillovers onto people who are not part of the transaction.

In that study, we found that in California, and a number of other parts of the country, the residential price for electricity was waaay above SMC. When that happens, customers are discouraged from consuming the product, even if they value it more than the social marginal cost of such consumption. That’s particularly troubling if we want electrification – i.e., substituting electricity for other fuels to provide energy services – to be an effective weapon in reducing greenhouse gas emissions.

Fuel switching, however, depends on not just the price of electricity, but also the prices of the alternative energy source.  Crazy high electricity prices might discourage you from buying an EV, but so might low gasoline prices.   Figuring we were halfway down the rabbit hole, so why stop now, Jim and I dug into pricing of the primary alternative fuels, natural gas and gasoline. Meanwhile, over the last couple years, the momentum for fuel switching picked up. Enthusiasm for electrifying space and water heating grew along with continued technological improvements in heat pumps. While at the same time, federal commitments to electric vehicles accelerated.

Last month, we released the results of this expanded study in a new Energy Institute working paper (which is forthcoming in a volume from the National Bureau of Economic Research). As in the previous study, we pieced together the SMC of each fuel by combining wholesale prices and distribution costs with measures of the associated damages from local air pollution and greenhouse gas emissions. Then we compared the SMC of each fuel to its retail price. Lastly, we put all three fuels into the same units of delivered energy to compare the price gaps.

The surprising (to me) results are summarized in the three maps below from the paper.  All three maps use the same legend and units (cents per kWh) – redder areas have price below SMC and bluer have price above SMC.  The percentage numbers on the right are the share of customers in each category.

PvSMC2Fig

To oversimplify slightly, gasoline is underpriced (P<SMC) to almost all of the population (particularly so in major metropolitan areas).  Natural gas prices deviate only modestly from SMC[1].  And electricity is overpriced to most households, greatly overpriced in California and much of the Northeast.  Furthermore, as more coal-fired generation shuts down, which will lower externalities, the electricity map will turn even bluer, that is, retail price even further above SMC.

These results assume the cost of CO2 emissions to society is $50 per metric tonne. The differences between the mispricing gaps of the fuels grow even larger at a higher cost of CO2 emissions, because the gasoline map gets redder faster than the others, as shown in the paper. California’s grid is so clean these days that doubling the cost of CO2 emissions has a pretty small impact on the SMC of electricity.

In the second part of the study, we drill down on these results for California and ask how big a difference the gaps between energy prices and their SMCs might make in choosing how to fuel vehicles and heat homes and water.  We use state and federal surveys of California households to determine how much energy they use for each of these activities. Then we compare the cost of energy for electric versus gas water heaters and space heaters and electric versus gasoline vehicles, first at current prices, and then if prices were reset to reflect SMC.

To do this, we need a representative comparable device of each fuel type, but we recognize that electricity delivers different performance than fossil fuels in all three of these energy uses.  For water heating, we compare natural gas tank water heaters to electric heat pump tank water heaters. Similarly, we compare gas furnaces with electric heat pump furnaces.  The vehicle comparisons highlight most clearly the differences in the experience delivered. We compare the electric Nissan Leaf to its gasoline “twin”, the Nissan Versa, but these are definitely more fraternal than identical twins when one recognizes the differences in performance, maintenance and fueling constraints.

NissanLeafvVersa(Source: https://insideevs.com/news/317230/how-do-evs-and-ices-compare-really/)

Nonetheless, as one factor that will drive choices in these markets, these fuel cost calculations are eye-opening.  For both space heating and water heating, we find that moving natural gas and electricity prices to equal their SMCs would increase the incentive for electrification by about $160 per year on average.  In California, setting these prices at SMC would lower natural gas costs, but it would lower electricity costs much more.  The change would eliminate the current cost advantage of natural gas for space and water heating, about equalizing their fuel costs with the heat pump alternatives.

Estimates of upfront capital and installation costs vary a lot for these alternatives, but median estimates suggest heat pump furnaces cost about $3000 more installed, though, importantly, they include air conditioning. The median of the estimates we saw for water heaters suggest heat pumps cost about $1000 more. These numbers are changing every year as the technology changes.

For the vehicle comparison, moving price to SMC makes the EVs about $500 per year more attractive, not yet enough to cover the entire cost difference, but still a significant bite out of it.

The story isn’t the same everywhere. In Louisiana, for example, electricity is underpriced and natural gas is overpriced, so moving prices to SMC would actually discourage space and water heating electrification.  That will change if/when Louisiana cleans up its grid, but it highlights that the electrification strategy depends on a clean grid.

Our new study, however, highlights that a clean grid isn’t enough. We need dramatic change in energy pricing as well as energy technologies.  In previous blogs, we have discussed how to accomplish those pricing changes in an equitable way.

If we make progress on technologies, but ignore the pricing barriers, we could end up with solutions that consumers refuse to adopt, or are simply unaffordable for America’s disadvantaged families.

I still tweet mostly energy news/research/blogs @BorensteinS .

Keep up with Energy Institute blogs, research, and events on Twitter @energyathaas

Suggested citation: Borenstein, Severin. “Decarbonization Will Require Pricing Reform” Energy Institute Blog, UC Berkeley, August 16, 2021, https://energyathaas.wordpress.com/2021/08/16/decarbonization-will-require-pricing-reform/

[1] It’s not data that are missing in all of the gray area, but natural gas itself. Only about half of all U.S. households have access to natural gas and a far smaller proportion of the space on the map as natural gas available.

Severin Borenstein View All

Severin Borenstein is Professor of the Graduate School in the Economic Analysis and Policy Group at the Haas School of Business and Faculty Director of the Energy Institute at Haas. He received his A.B. from U.C. Berkeley and Ph.D. in Economics from M.I.T. His research focuses on the economics of renewable energy, economic policies for reducing greenhouse gases, and alternative models of retail electricity pricing. Borenstein is also a research associate of the National Bureau of Economic Research in Cambridge, MA. He served on the Board of Governors of the California Power Exchange from 1997 to 2003. During 1999-2000, he was a member of the California Attorney General's Gasoline Price Task Force. In 2012-13, he served on the Emissions Market Assessment Committee, which advised the California Air Resources Board on the operation of California’s Cap and Trade market for greenhouse gases. In 2014, he was appointed to the California Energy Commission’s Petroleum Market Advisory Committee, which he chaired from 2015 until the Committee was dissolved in 2017. From 2015-2020, he served on the Advisory Council of the Bay Area Air Quality Management District. Since 2019, he has been a member of the Governing Board of the California Independent System Operator.

17 thoughts on “Decarbonization Will Require Pricing Reform Leave a comment

  1. Getting to marginal cost based pricing won’t be particularly easy given all of the institutional inertia behind today’s regulated markets. Our last try on “freeing” retail electricity and fossil methane prices didn’t go all that well, so maybe we need to look elsewhere on how to move toward socially beneficial policies and actions. Perhaps we need to seriously discuss constructing subsidies and fees that move us toward similar incentives that look like the right type of pricing. If we keep suggesting the same policies over and over that aren’t being heard, it might be time to change out tune.

  2. “We do not include in our estimates the upstream emission…for energy production. Emissions from extraction of fossil fuels are likely to be the largest of these factors, and are almost certainly greater for gasoline and natural gas than for electricity, because a large share of electricity is produced from sources other than fossil fuels.”

    Severin, in 2019 31% of CA electricity was generated at in-state gas plants; 8% was imported from out-of-state gas plants, and 7% came from out-of-state coal plants. 7% came from imported, “unspecified” sources – and because nearly all unspecified electricity trades hands in 5-minute-ahead spot purchases, we can assume it’s generated by burning fossil fuel – most likely, simple-cycle gas plants.

    Thus, it’s reasonable to believe at least half of California electricity is generated by fossil fuel. If 46% comes from gas plants, and we assume the mean efficiency of simple-cycle vs. combined-cycle turbines as an approximation, ~45% of the free energy in the natural gas fuel used to power them is wasted as heat, and ~8% of the overall total electricity production is wasted in transmission losses. Altogether, more than a quarter of California electrical energy is wasted by system losses.

    As we electrify California homes and businesses, most of the gas we’re replacing is used for space heat. Next in line would likely be water heaters, then ovens and stoves. For over a century, gas has continued to perform these roles because it’s very good at getting things hot, quickly and efficiently – far more efficiently than generating electricity, transmitting it through wires, running it through a resistive element at point-of-use, then touching it to whatever we’re trying to heat.

    By any analysis: to perform the functions performed by gas now with electricity is increasing carbon emissions. That means raising California’s SMC, and locking in higher prices – or worse, raising them. I understand that the goal in California is to generate all of our electricity with renewables, but when a full half of our electricity is generated by fossil fuels it’s uncertain (I would argue unlikely) whether it will ever be practical, or even possible.

    Would it not be prudent to prove that renewables are capable of generating even half of our electricity – reliably – before we invest hundreds of $billions in infrastructure, only to discover we’re worse off than we were before?

    • The appropriate metric is to look at what power plants are added to serve load building such as electrification, not at hourly marginal generation, of which also none of those resources meet added long term load. In California, that means those those resources are renewables. New natural gas plants are not being belt, and none has been approved since 2010. That’s why natural gas generation fell more 40% from 2010 to 2019.

      • “New natural gas plants are not being belt, and none has been approved since 2010. That’s why natural gas generation fell more 40% from 2010 to 2019.”

        Bad timing. Today:

        “California to Build ‘Temporary’ Gas Plants to Avoid Blackouts

        California, a state that has been aggressively weaning its power grid off of fossil fuels, is now working on adding several natural gas-fired plants in an effort to keep the lights on this summer.

        The California Department of Water Resources is in the process of procuring five temporary gas-fueled generators that have individual capacities of 30 megawatts, said spokesman Ryan Endean. The units will be installed at existing power plants and are expected to be operating by the middle of September.

        The move comes after California Governor Gavin Newsom declared a state of emergency for the power grid on concern about supply shortages during hot summer evenings when solar production wanes. The order, issued last month, aimed to free up energy supplies and speed up power plant development to help avert blackouts. It also temporarily lifted air-quality rules.

        Earlier this year, California regulators balked at ordering utilities to add new gas-fired generation after environmental groups said it would run counter to the state’s decarbonization goals. Officials have been scrambling to shore up power resources ever since brief blackouts hit in August 2020 during an extreme heat wave.”
        https://www.bloomberg.com/news/articles/2021-08-19/california-to-build-temporary-gas-plants-to-avoid-blackouts

        • Important words in that: “temporary” and “five” times “30 MW” (in other words, 0.3% of CAISO peak load or trivial ). Of the 11,500 MW of new capacity ordered to be built by the CPUC, only 500 MW will be fossil methane fueled, or 4.3%. I guess I’m willing to live with 95.7% green capacity and energy to supply our electrification.

      • “New natural gas plants are not being belt, and none has been approved since 2010. That’s why natural gas generation fell more 40% from 2010 to 2019.”

        Bad timing. Yesterday:

        “California to Build ‘Temporary’ Gas Plants to Avoid Blackouts

        California, a state that has been aggressively weaning its power grid off of fossil fuels, is now working on adding several natural gas-fired plants in an effort to keep the lights on this summer.

        The California Department of Water Resources is in the process of procuring five temporary gas-fueled generators that have individual capacities of 30 megawatts, said spokesman Ryan Endean. The units will be installed at existing power plants and are expected to be operating by the middle of September.

        The move comes after California Governor Gavin Newsom declared a state of emergency for the power grid on concern about supply shortages during hot summer evenings when solar production wanes. The order, issued last month, aimed to free up energy supplies and speed up power plant development to help avert blackouts. It also temporarily lifted air-quality rules.

        Earlier this year, California regulators balked at ordering utilities to add new gas-fired generation after environmental groups said it would run counter to the state’s decarbonization goals. Officials have been scrambling to shore up power resources ever since brief blackouts hit in August 2020 during an extreme heat wave.

        The situation has become more dire this summer as a historic drought has reduced California’s hydroelectric supplies. The state has been retiring gas plants under a goal to have its grid carbon-neutral by 2045.”

        https://www.bloomberg.com/news/articles/2021-08-19/california-to-build-temporary-gas-plants-to-avoid-blackouts

    • re: “far more efficiently than generating electricity, transmitting it through wires, running it through a resistive element at point-of-use” Actually, heat pumps are what is being recommended for space and water heating. Even some dryers. Induction for cooktops. Resistance heating would be left just for ovens I guess. In any case, these other technologies are a lot more efficient. A lot.

      • Chris, that heat-pump water heaters are more efficient, or being recommended, matters little if consumers must wait six times longer for their hot water heater to refill (up to 8 hours for a 40-gallon tank). If it takes an hour for their heat-pump air conditioner to cool their home after work, no one will buy one. Nor will anyone buy a heat-pump clothes dryer that takes two hours and 45 minutes to do a single load.

        “In any case, these other technologies are a lot more efficient.”

        At point of use, an induction stove is 85% more energy-efficient than a gas stove. But that’s not including system losses: the 45% wasted in converting gas to electrical energy at the power plant, or the 9% of energy wasted in transmission. The 30% in energy savings of your induction stove almost makes up for system losses, plus waiting for the stove to heat up, plus the 30%-higher energy cost for California electricity. Almost.

        In general, renewable-energy advocacy is remarkably tone-deaf to the fact their energy-saving toys exact a disproportionate toll, in both cost and convenience, on less-fortunate members of society. For example: maybe some homeowners on the other side of the tracks wash their own cars to save money. Could it be they don’t have 8 hours to wait for their water heater to refill so they can take a shower before dinner?

        Maybe homeowners with solar panels and a Tesla PowerWall can afford to store solar energy, and cook dinner with zero carbon emissions. South-of-the-tracks homeowners – the ones with solar panels, but no PowerWall – if they work overtime, they should get used to dinner being a cold bowl of soup. Right?

        • First, almost no one drains a 40 gallon tank. But even so, a HPWH only takes about twice as long as a standard electric WH:
          https://products.geappliances.com/appliance/gea-support-search-content

          As I pointed out before, the incremental energy source for electrification is NOT fossil methane–it will be renewables as the grid goes green. Thus the comparison to fossil methane efficiency loss is irrelevant. And thanks for pointing out the significant transmission losses from central power plants that are avoided by distributed energy resources. (And those losses increase during peak load periods.)

          The solution for lower income households is to force utility shareholders to do the same as almost any other investor in corporations–reduce their income as their market share decreases, rather than taxing ratepayers to sustain utility returns. Decoupling has been an utter failure.

          • Richard, your use of G.E.’s advertisement as a reference is given all due credit. Anyway, we were comparing gas water heaters to HPWHs. And mistakenly, the recovery rate I provided was for a hybrid one – the recovery rate of HPWHs is even slower:

            “A gas water heater provides a higher level of comfort because it has a faster recovery rate. The recovery rate of a water heater refers to the time it takes a water heater to reheat its entire supply of hot water. This is a huge advantage for homes that use large and frequent draws of hot water.
            The recovery rate of a water heater is based on its BTU (British Thermal Unit) input. BTU measures the amount of energy needed to heat one pound of water by one degree Fahrenheit. For comparison’s sake, let’s look at the average BTU/hour input of both systems:
            Hybrid water heater- 6,000 to 8,000 BTUs
            Gas water heater- 32,000 to 50,000 BTUs”
            Making the convenient assumption a hybrid has twice the recovery rate of a heat pump, the heat pump variety will take 12 times as long to refill its tank. Bad, to worse:
            https://georgebrazilplumbingelectrical.com/heat-pump-water-heater-vs-gas-water-heater-which-is-better/

            “As I pointed out before, the incremental energy source for electrification is NOT fossil methane–””

            Given almost half of all electrical energy in California is born at gas plants, fossil methane is very much an incremental energy source for electrification. Caps-lock, notwithstanding.

            “….it will be renewables as the grid goes green.”

            (yawn…) The U.S. grid has been going green for half a century. No more time to waste trying to integrate medieval sources of energy into a 21st-century electrical grid.

            “The solution for lower income households is to force utility shareholders to do the same as almost any other investor in corporations–reduce their income as their market share decreases, rather than taxing ratepayers to sustain utility returns.”

            Let’s allow the generous assumption that a utility’s shareholders can be forced to reduce their income by other shareholders, and that most corporations are monopolies, and that most corporations have captive ratepayers to tax…nahh, that’s insanity!

            “And thanks for pointing out the significant transmission losses from central power plants that are avoided by distributed energy resources.”

            You’re welcome. I should add, though, that significant transmission losses from power generated at nuclear plants are all but irrelevant. The fuel is so cheap, and the plant generates so much reliable energy (and there are no carbon emissions anyway), it renders all this efficiency/hybrid/demand-response/heat-pump/distributed-energy-resources/time-of-use/cost-of-service/balancing-account/capacity-factor squabbling pointless.

    • re: ” I understand that the goal in California is to generate all of our electricity with renewables, but when a full half of our electricity is generated by fossil fuels it’s uncertain (I would argue unlikely) whether it will ever be practical, or even possible.”

      This logic doesn’t hold up: because something isn’t done yet, it isn’t possible?

  3. If we could get a RELIABLE metric about the TOTAL environmental ‘cost’ of a item consumers might be able too make choices when they buy a product.
    A relatively simple way is to consolidate ALL environmental ‘costs’ into energy used in producing and mitigating the effects of a product. How much energy does it take to get to market a pound of hamburger? Dont confuse us with mixed measures, ie energy AND water AND emissions. We can, at the regulatory level, deal with the emissions differences of the various types of energy sources. Water usage can be converted too energy equivalent in accessing, processing, transporting, etc.
    The generation of renewables must factor in related infrastructure and disposal energy used. The mitigation of the end-of-life disposal, for example, of solar panels and batteries, can also be converted to energy.
    When we do this we might find that vegetables are not that much ‘better’ than hamburger. That EVs may not be that much ‘better’ than IC engines on TOTAL emissions, but do serve a purpose in WHERE they are generated and dispersed.

    Not everything is ‘marginal’. We need economists AND others [engineers?] to work together to develop models.

  4. EVs at this point seem like nothing more than expensive toys for rich people. One gets the feeling, as Climate Change elitists ban fossil fuels, piston cars, and dismantle the national grid, millions of us, specially in the northern states, will be stranded, freezing inside our houses in winter, and living with frequent brownouts and blackouts.

    • Come up with an alternative solution to eliminating GHG emissions from our vehicles, which is the single biggest source driving global warming and ocean acidification, we can discuss how to implement that solution.

      • Agree, Richard. Even in coal-friendly southeastern states (“Duke Country”), driving a standard two-door electric sedan emits less CO2/mi than a comparable spark ignition, internal combustion vehicle. Barring a global shortage of lithium, they could be price-competitive with ICVs in five years or less.

        They’re not great for road trips, and may never be. By 2030, though, it may be harder to find a gas station than an empty charging station in metro centers.

    • re: “EVs at this point seem like nothing more than expensive toys for rich people.” Isn’t this true for most new technology in a consumer economy? That’s how production works. As volume increases, costs & prices drop. Phones, refrigerators, cars, etc.

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