Is Taxing Carbon Really the Best Way to Decarbonize the Grid? – Energy Institute Blog

Our new research suggests clean electricity standards or subsidies might be more beneficial.

Today’s blog post is co-authored with Ryan Kellogg.

Some economists and policy advocates present a carbon tax  (or its close sibling, cap and trade) as the singular answer to climate change, but it’s been clear all along that pricing carbon is not a complete solution. It does little to address innovation, which will be critical to tackling global emissions, particularly from lower-income countries. And it creates large income transfers that in some cases harm the least affluent, and in other cases harm politically powerful market participants who will throw their weight against it. Variations of these critiques can be leveled at alternative policies as well.

But until we wrote our recent paper, Carbon Pricing, Clean Electricity Standards, and Clean Electricity Subsidies on the Path to Zero Emissions, we at least thought that what sets a carbon tax apart is that it is the most economically efficient intervention for decarbonizing a market. Our new paper demonstrates that even this common belief about the benefits of a carbon tax doesn’t always hold, and may not hold in one of the most important industries, electricity.

OK, economics-minded readers, hear us out.  Our finding is not some strange mathematical case that would never occur in the real world or something that depends on quirky beliefs about how people behave.  

In electricity, the alternative climate policies on the table are some form of mandating zero-emissions generation shares (typically called something like a “clean electricity standard” or CES) or subsidies for zero-carbon generation (such as investment and production tax credits).  Among these choices, there are three standard arguments for carbon pricing.

1. Carbon pricing doesn’t just favor zero-carbon sources over others, it also penalizes extremely-high carbon-emitting sources (e.g., coal) more than other carbon-emitting sources (e.g., natural gas generation). The other two policies promote zero-carbon, but  don’t prioritize eliminating coal before gas or eliminating high-emitting gas plants before low-emitting plants.
2. Carbon pricing adds an explicit cost to electricity, reflecting the true negative externality.  A CES, by requiring that every megawatt-hour of dirty power be accompanied by a certain amount of clean power, effectively imposes a cross subsidy from the dirty to the clean power. The net effect is a smaller overall cost increase than a carbon tax, or in some cases, a cost decrease. Zero-carbon subsidies paid out of the federal treasury just push prices down.  Only a carbon tax increases the cost of fossil generation by an amount that reflects the actual damage.
3. A carbon tax raises revenue for the federal coffers without the economic distortions of an income  or sales tax, and it could finance reduction of those other taxes. It does well for the federal budget while doing good for the planet. A CES, by design, just transfers funds from dirty to clean power without raising any money for the government. Subsidies for zero-carbon sources mean the government has to crank up other distorting taxes.

What we show in the paper is that the first argument probably doesn’t make a lot  of difference to total emissions from electricity over the pathway to zero or near zero emissions.  The second argument turns out to be a bug rather than a feature due to other distortions in retail electricity. And the third argument, well, that one remains a star in the carbon tax column.

Why doesn’t the carbon tax tendency to kill coal first set it apart?  Because a CES or zero-emissions subsidies are also likely to do that. A carbon tax internalizes the GHG externality, so it incentivizes producers to first drop the sources that have the highest social cost, which would be coal. The other two policies tell producers to get rid of fossil plants but without the extra incentive to get rid of the big polluters. In that case, companies dump the most expensive plants first. But, if the private ongoing cost of running a plant is positively correlated with emissions, then the CES or clean subsidy policies also get rid of coal plants first.

We do an empirical analysis of all of the fossil plants in the US in 2019, with the energy prices of 2019, and find this correlation is strongly positive. At those prices, we show that a CES or zero-emissions subsidies would pick off existing fossil plants in almost the same order as a carbon tax. Over the full energy transition to near zero emissions, a carbon tax only saved a few percent of industry emissions more than the other policies.

That result holds, however, only if gas is reasonably inexpensive. You may have noticed that isn’t the case right now. But if we are really phasing out fossil fuels, natural gas is almost surely going to get cheap as its scarcity premium plummets. Maybe that’s why even with gas prices at $7/MMBTU today, the natural gas futures market is pointing to $4 in a few years. (Or maybe that’s just the belief there’s still loads of gas that can be fracked and burned on the road to planet cataclysm.)

The second argument goes up in smoke, so to speak, based on a paper Severin wrote with Jim Bushnell a couple years ago. It found that in much of the country – the places that are most effectively decarbonizing – retail electricity prices are already way above their full social cost, which includes the cost of pollution emissions.  Those utilities still have to pay for grid infrastructure and other non-fuel costs. California is the poster child, as previous blog posts here have discussed at length, but any grid that decarbonizes is very likely to end up with retail electricity prices that are well above social marginal cost.

In those locations, driving up the retail price with a carbon tax would further over-price electricity. This is a particular problem if we think that “electrify everything” is the way that we take the biggest bite out of climate change.  A CES would have less effect on retail electricity prices during the transition, though at full decarbonization, prices would be just as high under a CES as under carbon pricing since at that point both policies are zero-carbon mandates. Zero-emission subsidies, however, would lower wholesale electricity prices and thus would actually help get retail prices in line with social cost.

So, does “carbon taxes ain’t so efficient after all” carry over to gasoline and decarbonizing transportation? NO! The two key arguments that make a carbon tax problematic in electricity are points in its favor when it comes to cars.  What sort of autos does a “clean car mandate” or EV subsidies crowd out? So far, at least, they look to be substituting for other small and medium sedans, rather than substituting for gas-slurping SUVs, muscle cars, and trucks. Is gasoline already overpriced? Another paper by Severin and Jim last year showed just the opposite: almost everywhere in the US, gasoline is priced below its social cost.  And gas being too cheap not only means EVs are less attractive, it also means that people drive more than they would if gas prices reflected the full social cost. The same logic applies to large industrial users of coal and natural gas, for which they pay well below social cost. 

For years, many in the environmental community have said that we need multiple arrows in the quiver to tackle climate change. Taxing carbon, mandating clean energy shares, and subsidizing clean energy each has pros and cons, from both economic and political perspectives. Our paper shows that the economic case for carbon pricing in the US electricity sector isn’t as strong as we and many others once thought. But it still has an important place in the quiver—especially for decarbonizing transportation and industrial energy—and implementing any of these three policies would be far better than sitting on our hands and doing nothing.

If you would like to hear more about this research or discuss it with the authors, please join us for a webinar this Thursday, July 28, at 9:30 AM PDT.

On Twitter, follow Severin @BorensteinS and Ryan @RyanMKellogg

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