Will pricing carbon raise electricity prices?

Lynne Kiesling

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.

4 thoughts on “Will pricing carbon raise electricity prices?

  1. I do not disagree with any of the above. However, I would argue that the perspective needs to be broadened.

    The Administration appears to be focused on an “80% by 2050” carbon emissions reduction “wish”. (“A goal without a plan is just a wish.”, Antoine de St. Exupery) As Lynne suggests, that must be viewed against the backdrop of US population growth to 450-500 million by 2050.

    Most of the recent discussion regards the “pricing of carbon”, either through an emissions allowance auction or a carbon tax. That element of cost is the “tip of the iceberg”. The investment required to reduce US annual carbon emissions by 80% in absolute terms by 2050 is on the order of ~$700 billion per year over the period. That is the “iceberg”.

    The avowed purpose of the process is to reduce annual carbon emissions, though I am sure our legislators are drooling over the prospective revenue stream. Certainly, the revenues being discussed are worthy of some focus. However, the major focus must eventually shift to how various industries would actually reduce carbon emissions, rather than just how they would deal with allowance costs or taxes.

    The issue could be particularly difficult for electricity generators, since many industries and almost all commercial and residential direct users of fossil energy could simply switch their end uses to electricity, thus shifting the carbon emissions reduction burden, as well as massive incremental energy demand, to the electricity generators.

    If “cap & trade” is to achieve the carbon reduction “wish”, as opposed to just the revenue generation “wish”, the “cap” must initially be set equal to the current actual annual carbon emissions rate; and, a schedule of “cap” reductions toward the ultimate reduction “wish” must be published and enforced. Once this is done, fossil energy consumers can begin planning their strategies for dealing with the mandated reductions.

    However, if the carbon emissions reduction “wish” is actually 80% in absolute terms over the next 40 years, rejected energy recovery and reuse must be viewed as merely short term measures, since they do not have the potential to achieve the ultimate reduction percentage which would be required.

    It is also important to note that, even if all of the nations of the globe were to reduce annual carbon emissions by 80% by 2050, that reduction would be insufficient to halt AGW, though it would slow it by about 60%. Halting CO2-driven climate change would require 100% capture and sequestration of carbon emissions from fossil fuel combustion or the total cessation of fossil fuel use; and, population controls for both humans and domesticated animals, both of which are GHG emitters.

    Hopefully, we will identify commercially viable zero carbon emissions technologies and begin implementing them before we begin shuttering the facilities they would replace. Otherwise, life could become cold and dark and hard.

  2. Lynne,

    Thanks for the shout-out. I want to offer one point of clarification:

    I quite agree with your economic assessment and the way in which new, low-carbon energy supply could come on line in response to a carbon price signal to drive price down. (Skip Laitner, former economist at EPA and now at ACEEE has written eloquently and frequently about this issue, framing as our “strategic energy efficiency reserve”, both to sail head on into the belief – implicit amongst too many economists – that we have already fully tapped this particular resource and to force folks to recognize that a Btu saved has the same supply impact as a new Btu discovered.)

    That said, it was not the point of my initial post, which is ultimately more about policy structure than economics. There is an idea, innate to the framing of almost all cap & trade discussions that (a) all carbon emissions will be priced at an equivalent amount per ton of emissions and (b) the proceeds of those payments will be redistributed by some government body. Within this framing, it’s quite reasonable to assume that a carbon policy will raise the cost of energy. But there are more thing in heaven and earth than are dreamt of in your philosophies, Horatio. Let’s take the two assumptions separately:

    (a) is inconsistent with every carbon policy (and indeed, every environmental policy) that has ever been passed or proposed. Not only are they rife with grandfather rights – inevitably created for political reasons – to existing sources, but all realize that there is some point at which it simply isn’t cost-effective to tax every source. (My dog, for instance, is unlikely to be taxed every time he farts under any pricing regime.) In an idealistic sense, one can certainly make the case that all carbon tons should be priced equivalently to ensure capital allocation efficiency and avoid regulatory arbitrage. But as a practical matter, the question really isn’t “should we give away some free pollution permits”, but rather “how should we give away those free pollution permits such as are required to ensure political passage?”

    (b) is again common to all carbon pricing models I’m aware of, but is entirely inconsistent with the whole idea of cap & trade. (Indeed, if the payment for CO2 release comes into a government agency for reallocation, that means it’s a tax, no matter what you might call it.) When we hear Speaker Pelosi argue that a cap & trade bill can help provide economic stimulus, it’s not because she’s been reading my posts, but because Congress truly believes that you can set up a system where the proceeds come back inside the beltway for distribution and call it cap & trade. (And why shouldn’t they? After all, that’s exactly what Lieberman-Warner did, and RGGI does.)

    All of which gets to my larger point. If we insist that a carbon pricing model must include free allocations to existing sources, inefficient allocation of capital in response to carbon pricing and eliminate and/or substantially reduce the ability for bilateral trades between sources and sinks to take place (e.g., cut the regulator intermediary out of it), then yes, putting a price on carbon will raise the price of energy. But none of those defects is essential to carbon policy; why set such a low bar for ourselves?

    For those of a wonky bent, see here for a better policy idea that creates incentive for CO2 reduction without increasing energy costs.

  3. Lynne:
    There is an important additional way that pricing carbon promotes lower cost electricity – by overcoming sub-optimal regulations. To illustrate the point, consider the 1,600 gas pipeline compressor stations and the equivalent number of midstream compressors that feed gas into the pipelines. These stations use engines – gas turbines or piston engines – to boost the natural gas pressure, with one station about every one-hundred miles. The engines convert one third of the energy they burn into compressor power, and then vent the remainder as hot exhaust.

    Recycling the hot exhaust to drive a turbine could produce 20 million megawatt-hours per year of pristine electricity with no incremental carbon dioxide. To pencil, the plant recycling plants need contracts for about $90 per MWh. This leads us to pricing carbon.

    In a static situation, the clean new power will displace a fossil-fueled existing generator. Each MWh will displace 11 million British thermal units (Btus)of coal ($30 to $45 displaced cost) or during peak times, 7 to 13 Btus of natural gas, ($35 to $130 displaced costs). Recycling plants will not be built.

    In the world of growing electricity use, the new clean energy will displace a new coal or gas plant. Prior to carbon pricing, these new plants will require $110 per delivered MWh, which will cost society $20/MWh more than recycled energy from gas compressor stations. But rate commissions offer only blended rates for power – a mixture of the installed base costs and the cost of new power, and the prices offered to distributed generation largely do not justify recycling otherwise wasted energy. Society looses, but it has proven politically difficult to fix these barriers to efficency.

    Now assume that all generators receive an equal allowance of CO2 per MWh of power, about .6 tons CO2 that was emitted per MWh in 2008. The plants with more than this amount must purchase allowances and those with less can sell allowances. Bingo!

    The recycled energy from gas compressor stations has no incremental emissions and sells .6 of a ton per MWh at say $30 per ton of CO2, yielding $18/MWh. The old coal plant emits 1.2 tons of CO2 per delivered MWh and has to pay an added $30 per MWh. The new coal plant is only slightly better. Even with hugely sub-optimal regulations, the resulting contract prices for power cause four gigawatts of new carbon-free capacity to be built by profit-seeking entrepreneurs. Society receives over 20 million MWh per year at $90 instead of paying $140 per MWh for delivered power from new coal plants ($110 plus $30 / MWh for CO2). This saves society $800 million per year from just one recycled energy sector – pipeline compressor stations.

    In other words, carbon pricing does much more than promote fossil fuel efficiency. By pricing the externality of CO2, society economically enables a series of options that would save society money anyway, but are not being built due to regulatory barriers. In a perfect world, one might modernize regulations and remove barriers to efficiency. This regulatory modernization would lower CO2 emissions and save money. But perfect worlds exist only in economic theory, never in practice, and certainly not in the practice of energy regulation.

    At least, there is a chance to get carbon regulations right, enact output based standards, and thus spur reductions in the costs of energy services.

    Tom Casten

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