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Climate change: We should rethink the best tools for energy transition, new paper argues

For years, economists championed carbon pricing as the most economically efficient way to transition the energy sector to net zero — but that may no longer be the case.

According to a new NBER working paper, carbon pricing policies such as carbon taxes and cap-and-trade programs may not be better than other options.

Using 2019 data to model the U.S. electricity grid, researchers found that energy intensity standards and clean energy subsidies may be just as efficient as carbon pricing policies.

“I think the first thing it should do is end the mantra among some environmental economists that carbon taxes are the best mechanism or the even more extreme view, which is carbon taxes will solve the problem entirely,” Severin Borenstein, one of the paper’s co-authors and a professor at UC Berkeley’s Haas School of Business, told Yahoo Finance. “I think that neither of those is true. And so we need to take a more nuanced look.”

Putting a price on carbon emissions, setting clean electricity standards, and subsidizing clean energy are all ways the market can nudge power producers toward generating electricity from clean sources like wind, solar, and hydropower while eliminating emissions that come from burning fossil fuels.

Experts say there is a narrow window of opportunity to act to limit “irreversible” shifts in the climate, which are already costing global economies billions and harming human health.

In the U.S., electricity generation accounts for at least a quarter of emissions, with 60% of electricity coming from fossil fuel sources like coal and natural gas. Borenstein emphasized that this paper specifically addresses the electricity sector, and that the model doesn’t apply to other sectors like transportation.

“I think the real question is: If the goal was to get to the clean electricity grid and then use clean electricity to decarbonize other sectors of the economy… a nice virtue of a subsidy-driven route to decarbonizing the grid is that it actually results in low electricity prices for consumers,” Ryan Kellogg, the paper’s co-author and professor at the University of Chicago Harris School of Public Policy, told Yahoo Finance.

‘The cost of natural gas plays a big role’

If climate change is the result of a market failure, as some experts argue, then carbon pricing aims to correct that failure.

Carbon pricing policies tend to fall into two categories: a carbon tax which puts price on each ton of greenhouse gas emissions, or a cap-and-trade program that sells emissions permits and allows businesses to trade among themselves.

By making pollution more expensive for operators, carbon pricing is seen as a particularly compelling tool because it targets the biggest polluters first — namely, coal plants.

That may also be true of other policy options like clean electricity standards and subsidies, the researchers argued, due to a correlation between emissions and operating costs. They found that overall emissions throughout an energy transition are just 2.2% higher under a clean energy standard policy than under a carbon tax.

“One of the things that we found — and this was actually a little bit surprising to us just how stark the result — was that plants that have very high emissions rates — coal plants — also tended to have much higher ongoing operating costs than combined cycle gas turbines,” Kellogg said.

This “happy coincidence,” as Kellogg put it, means that when gas prices are relatively low, private operators would be incentivized to shut down coal plants first anyway because they’re more costly to run.

However, “the cost of natural gas plays a big role,” Borenstein said. “Because if natural gas is expensive, then a clean energy standard will have companies shutting down natural gas plants while still running coal plants. So then the correlation between the pollution and the private cost falls apart.”

Though high natural gas prices have been a key theme in 2022, due to the Russian invasion of Ukraine and pandemic recovery, they’re unlikely to stay that way, Borenstein argued. In particular, as decarbonization gains a stronger foothold, it will in all probability drive gas prices down over time.

“The futures market is predicting prices will be down in the $4 range within a few years,” he said. “And if we really start to decarbonize rapidly, I think they’ll be a lot lower than that because there will be very low demand for natural gas. So I think that if we’re going to talk about a scenario going to zero or near zero emissions, that scenario will almost certainly be accompanied by cheap natural gas.”

The markup on electricity prices

There is a second argument in favor of carbon pricing, which is that it shapes behavior and encourages the biggest power consumers to reduce their energy usage — thereby driving down carbon emissions.

The paper suggested this particular argument may also be flawed because many consumers already pay marked-up electricity prices — a trend which will likely increase throughout the energy transition.

The amount of energy a household consumes makes up just one portion of what they pay the utility. Electricity bills also incorporate the utility’s procurement costs and fixed costs for building infrastructure like transmission lines. Utilities charge consumers for these other costs per kilowatt hour rather than as a fixed fee.

As a result, in many areas of the country, the prices consumers are paying already exceed the social cost of electricity generation. Carbon pricing would likely add on to price increases without necessarily sending an accurate price signal to consumers.

“What I pay to consume electricity is already quite a bit more than the cost of that what it actually costs to generate that electricity,” Kellogg said. “So that function of carbon pricing of increasing prices isn’t one that we actually need.”

Borenstein explained that the effect is more pronounced in states that have already put decarbonization policies in place. In California, for instance, the cost of electricity is much higher than the social cost of burning fossil fuels. In the Upper Midwest, prices tend to fall below that cost due to higher rates of burning coal.

The model found that during the energy transition, a carbon pricing scenario would result in the highest wholesale energy prices while clean energy subsidies would result in the lowest prices.

“In fact, if anything, we’d like electricity to cost less in order to encourage electrification and substitution away from other fossil fuels,” Borenstein noted.

Distributing green transition costs

As state and federal governments move to accelerate the energy transition, the question of who pays is becoming more salient.

These policy tools vary in how they distribute those costs across consumers, private enterprises, and governments, and they all have tradeoffs that policymakers will need to carefully consider.

“One way to maybe put a really fine point on it,” Kellogg said, “is if you want to have a green transition, there’s a question of: Do we want to pay for that green transition through retail electricity prices, which is what carbon pricing would do, … or do we want to pay for that green transition through the public budget, which is what the clean energy subsidy would do?”

The authors stressed that these findings don’t mean that carbon pricing is a less efficient tool but that other tools like subsidies and clean energy standards might be more economically efficient options than previously thought.

Carbon taxes have other added benefits. For instance, they are the only policy tool that brings in revenue, which governments can use to fund other clean energy projects, tax credits, or send rebates to households to offset higher electricity prices, as Canada has done.

“Economic efficiency is not the only standard, but economic efficiency is pretty important,” Borenstein stated. “Economic efficiency is the size of the pie. And if you do something inefficient, you are making the pie smaller.”

Grace is an assistant editor for Yahoo Finance.

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