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.
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.
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. 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.
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.
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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/
 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 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.