UPDATE: Thanks to the commenter who alerted me that I mis-labeled my graph, and that equilibrium B should be at the intersection of S’ and D’. I may not get to update the graph Monday, my apologies.
There’s been an interesting discussion going on this week building off of a Sean Casten post at Grist, in which he states
For climate law to work, it must put a price on CO2 emissions. But there is no logical reason why that must imply an increase in energy costs, for the simple reason that energy is not CO2.
Rich Sweeney then picked it up at Common Tragedies, and the conversation in the comments on both posts has been good. The substance of what I wanted to add is already reflected in the conversation, but I’m going to say it in a different way, based on how I interpret Sean’s comment from his perspective.
For those who don’t know Sean, he is the President and CEO of Recycled Energy Development, which has a business model of capturing and recycling waste energy that occurs in large-scale industrial processes. Waste energy recovery reduces a firm’s energy costs by reducing the amount of electricity it uses per unit of production; consequently, it reduces GHG emissions. This chain leads to RED’s claim to reduce greenhouse gases profitably.
The value creation potential here, both economic and environmental, is enormous. Our energy efficiency of converting fuel into electricity is 33%, which means that 100 units (I’m going to be general here to stay away from getting too techy) of fuel go into the generator and 33 units worth of electricity is produced (then the losses continue down the supply chain, where ultimately that 100 units of fuel results in the use of 4 units of electricity to power an incandescent light bulb). That means that there is a lot of room to increase generation energy efficiency by recovering waste heat, using combined heat and power, district heating, and so on to put the waste energy to productive use.
I interpret Sean’s comment through this waste energy recovery lens, and I think he is making what I would call a general equilibrium point about how fuel markets could evolve and adapt to the carbon policy. Please also note here that I am abstracting from transportation and focusing solely on the use of carbon-based fuels to generate electricity for resale and for use in industrial processes. If we price carbon (for now assume away any difference between tax and C&T), the chain of effects consistent with his argument are
- The fuel supply curve shifts to the left, reflecting the increasing marginal cost effect of the carbon policy
- In expectation, seeing this potential effect, firms increase their energy efficiency and engage in more actions like waste heat recovery, shifting the demand for fuel to the left
- Thus in equilibrium, fuel prices could be lower than they were before the initial equilibrium, if the magnitude of the demand shift is larger than the magnitude of the supply shift
Thus I think Sean’s point is that there is so much potential energy efficiency because the amount of wasted energy in the electricity generation system right now is enormous; this potential translates into a large demand shift response to carbon policy in carbon-based fuel markets. But that’s the unknown: if firms don’t respond to carbon policy by sufficient waste heat recapture and other methods that increase energy efficiency, then carbon policy would lead to an increase in fuel prices. I even drew a graph!
Thus I agree with the commenters who pointed out that we have to be really careful in distinguishing between costs and prices; carbon policy will unambiguously increase marginal costs in fuel markets, but if firms respond by shifting their demand, that cost increase need not translate to higher prices in fuel markets, which means that the firm’s fuel costs in their budget may not go up.
The other variable here is long-run population growth. As population grows, for how long will this potential energy efficiency potential be available to suppress the translation of carbon policy into higher fuel prices? But I do think that Sean is right, and that we have a lot of gains and value creation opportunities to capture.
So the big remaining challenge is that there are huge regulatory and cultural barriers to implementing the kind of energy efficiency and waste heat recovery techniques Sean advocates. Electricity generators are heavily invested, literally and metaphorically, in these inefficient large-scale central generation assets. The existing regulatory apparatus is built precisely to ensure that those firms earn a cost-plus rate of return on those assets, so they have little incentive to engage in waste heat recapture. Pricing carbon is likely to change that, but I’m skeptical that those are the places we will see big improvements in generation energy efficiency.
The other areas are places like Sean’s industrial customers, who have good economic incentives, and in areas where buildings can connect together to do distributed generation and combined heat and power within a microgrid structure. But there we run up against the century-old prohibition against anyone building distribution wires, especially across public rights-of-way, except for the government-granted monopoly regulated distribution utility. The potential energy efficiency gains from CHP in microgrids are substantial, and will enable the kind of effect that Sean’s describing to happen … but the distribution utility has every incentive to fight such innovations tooth and nail. They even go so far as to argue that consumers should not be allowed to do this because it will increase the costs of the system to all of the other customers who stay with the utility.
This is the pernicious conflict we now face between a cost-based regulatory system and energy efficiency. Until we have regulatory reform that breaks this vicious incentive cycle, Sean’s vision cannot become a reality.