Common Tragedies

Thoughts on Environmental Economics

Self-serving entities

Posted by Daniel Hall on October 24, 2007

Free Exchange muses on the emerging opposition to coal-fired electric generation in response to concerns about greenhouse gas emissions, expressed most recently in the cancellation of plans for three new coal-fired plants in Kansas. After noting that environmental concerns could constrain new capacity, he scores an excellent point here:

…electric power demand is growing, which suggests that reduced power supply growth should result in increased power prices. Final consumers of electricity must be made to feel these price increases. If retail consumers are shielded from such increases, then capacity shortfalls will lead to brown- and blackouts, and the incentive to build new, clean capacity will be limited. If retail rates go up with demand, however, then rising prices will encourage households to economise on energy use when they can. Higher prices will also incentivise new investment in efficiency technology and will increase the competitiveness of alternative power sources.

This is a key point, because politicians frequently think they can have their cake and eat it too: they can implement an efficient market-based policy (read: carbon tax or cap-and-trade program) for reducing GHG emissions at the least-cost to society, but at the same time shield energy consumers from price increases. But they can’t. To reduce emissions with maximum efficiency, all actors in the entire supply chain of energy must face incentives to change their behavior, including end consumers. Policymakers may want to move away from this efficiency optimum for other reasons — shielding low-income households from energy price increases, for example — but should do so recognizing the larger costs they impose.

The just-released Lieberman-Warner bill provides a perfect illustration. Their proposal for a cap-and-trade program includes specific measures designed to shield energy consumers from price increases.

The bill does so by freely allocating 10% of the total emission allowances to load-serving entities (LSEs), which are the distributors and sellers of retail electricity. Basically, LSEs are who you write your electricity check to each month. The LSEs aren’t required to submit allowances in the bill, so the reason they are given allowances freely is so that they can go sell the allowances on the open market and then pass along this money along to consumers in the form of lower electricity prices — indeed, the bill requires that they do so.

This is nice if you are an electricity customer: you get shielded from the price impacts of GHG regulation. It is also perhaps useful if you are a politician, since it looks like you are sticking up for the little guy. But failing to give customers incentives to conserve energy comes at a price.

The key point is stated by Free Exchange above, and I’ll repeat it here for emphasis:

…rising prices will encourage households to economise on energy use when they can. Higher prices will also incentivise new investment in efficiency technology…

In other words, there are two responses that consumers have to higher prices: they can use less, literally accepting a lower level of service, or they can use more efficient technologies to get the same level of service while using less electricity. The former is the major component of short-run price responsiveness; the latter is the major driver of long-run declines in energy demand.

Saving customers money in the short-term in such a system is a fundamentally Faustian bargain: it prevents customers from shifting over their “capital stock” — long-lived energy-using devices like air conditioners, refrigerators, and such — to more efficient models, and so makes future reductions in energy use and emissions that much harder. And when we fail to squeeze out whatever relatively cheap opportunities for energy savings exist among the end-use sector it just means that other sectors will be squeezed that much harder, having to make more expensive cuts elsewhere to make up the difference.

Having said that, there are equity concerns about the impact that rising energy costs will have on low-income households, who spend a higher percentage of their income paying for energy (even if they use less overall). But the best way to address these concerns is not to shield all consumers from price increases, but to provide lump-sum transfers that compensate consumers. One possibility would be to give all households a tax credit, say $100, for energy use. All consumers would still face increased incentives at the margin to both conserve energy and use more efficient technologies, while the lump-sum tax credit could be set at a level designed to more than cover the increased energy costs of the typical low-income household, but would be less than the increased costs of large energy consumers. The tax credit could be financed by auctioning off a portion of allowances.

I would guess that the decision to prevent electricity consumers from seeing price increases is not just political calculus — although that certainly must loom large — but also reflects underlying skepticism that consumers respond to prices. This may be somewhat true in the short-run: end-use electricity demand is not very elastic day-to-day. (You and I would use roughly the same amount of electricity tomorrow even if prices jumped by 10%.) But over the medium- and long-term consumers are more sensitive to price, because they can shift how they use energy, by moving to more efficient appliances. As we craft legislation that will alter how energy producers and manufacturers make and use energy, we should give consumers the same incentives to do so.

2 Responses to “Self-serving entities”

  1. Tmoney said

    If the point is to encourage consumers to upgrade their appliances to more energy efficient ones, then why not just provide tax credits for such appliances? You can fund them with a general tax on trading profits from emissions permits, or simply a tax on the initial auction proceeds. No need to gift away 10% to the consumers.

  2. Daniel Hall said

    If the point is to encourage consumers to upgrade their appliances to more energy efficient ones…

    I would say the point is to achieve emissions reductions at the least cost. It may be that some of the cheapest reductions will come through consumers buying more efficient appliances. In other cases it may be too “costly” to design more efficient appliances. Imagine, for example, a washing machine that uses half the energy but doesn’t really get your clothes clean. Your preference for having clothes that are actually clean is going to make you choose a more energy-intensive washer.

    The great part about a price signal is that it is passed to all actors — producers, consumers, etc. — who then collectively through the market discover where the cheapest reductions are. Relying on regulators to pick in advance which appliances should be upgraded and by how much is fraught with so much uncertainty that it will likely be inefficient and potentially even counter-productive.

    My other observations is that subsidizing efficiency alone might get you somewhere, but it doesn’t encourage people to actually use less. This is the classic problem with CAFE standards for cars: a more efficient car is less expensive to drive around, and so you end up driving more miles because your cost per mile is now lower. (Price of driving goes down, quantity of driving demanded rises.) You lose some of the benefit to what economists call the rebound effect.

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