Blog Post

Flexibility and Cost-Effectiveness in Proposed Climate Policies

Apr 9, 2014 | Anthony Paul, Karen L. Palmer

Achieving the goal of an 83 percent reduction in US carbon dioxide (CO2) emissionsfrom 2005 levels by 2050 will require the electricity sector—which accounts for roughly 40 percent of US CO2 emissions—to make an enormous pivot away from fossil fuels toward non-emitting sources. Policy will be required to achieve this goal. In a recent RFF discussion paper with coauthor Matt Woerman, we analyze the economic and social welfare consequences of four CO2 emissions reduction policies, including a carbon tax, a tradable CO2 emissions rate performance standard (TPS), and two versions of a clean energy standard (CES). The analysis examines a way to tailor a CES to improve its efficiency. The Haiku electricity market model is employed in the analysis.

Although a carbon tax is fairly straightforward, the other policies that we explore may require some explanation.  A clean energy standard is similar to a renewable portfolio standard but with a broader scope. A CES imposes a requirement that a minimum amount of electricity sold in the market must be generated using low- or non-CO2 emitting technologies, such as renewables, nuclear, or natural gas combined cycle units.  Each kilowatt hour of electricity produced by these technologies receives some credit under the CES and these credits must add up to the minimum amount required under the policy. Under a technology-based CES, crediting of generation depends on technology alone, with renewables and non-emitting generators receiving full credit toward the standard and generation for other emitting sources (such as natural gas combined cycle plants) getting partial credit. For an emissions rate–based CES, crediting of emitting sources varies depending on their CO2 emissions rate and thus more efficient natural gas combined cycle generators can earn more credits. The last climate policy we examined, a tradable performance standard, imposes a maximum average CO2 emissions rate across all generators and allows generators that have a CO2 emissions rate below the average to sell credits to generators that emit at higher than the average rate.

When all four policies are set to yield identical power sector CO2 emissions, the carbon tax emerges as the most efficient and flexible approach. The tax raises electricity prices and creates an incentive to reduce electricity consumption, resulting in important and cost-effective reductions in emissions. The performance of the TPS makes it first runner-up in efficiency terms. This policy fails to engender efficient reductions in electricity demand, but provides supply-side incentives with the same flexibility as the carbon tax. The two CES policies trail in efficiency terms—they both fail to distinguish among heterogeneous coal boilers—with the emissions rate–based version superior to the technology-based version.

Overall, our scenarios show that at the level of emissions reductions achieved by a technology-based CES policy, a carbon tax is 40 percent more efficient in terms of welfare costs; by comparison, the tradable performance standard and the emissions rate-based CES policy fall in between, with the TPS leading the way. Despite efficiency differences among the policies, they all pass a benefit–cost test when the value of emissions reductions is taken into consideration, and all result in a substantial increase in social welfare.