More on pricing pollution vs. energy efficiency mandates

In my recent Senate testimony, I argued that the best way to address environmental damage caused by energy use is for the government to charge a price for these pollution costs. In previous Senate testimony, I argued that a pollution tax is preferable to a cap-and-trade program, but either will result in substantially lower economic costs than command-and-control regulations that mandate technologies, fuels, or energy efficiency standards. Whether one establishes a price on pollution with a tax or with a cap-and-trade program, the main virtue is the same: a price makes consumers and businesses face the cost of their energy use and creates incentives to reduce pollution as flexibly and cheaply as possible, whether through conservation, developing novel technologies, or using alternative energy sources.

As follow-up to my most recent testimony, I was asked to submit written comments on my view of the American Energy Efficiency Act (S.1063) sponsored by Senator Al Franken (D-MN). Although the bill’s title refers to “energy efficiency,” and the first line states that the goal is “to establish a Federal energy efficiency resource standard for electricity and natural gas suppliers,” the bill does not actually address efficiency. Energy efficiency standards typically set limits on the ratio of energy output (e.g., BTUs) to energy input (e.g., watts). In contrast, the Franken bill establishes a supplier-specific cap on electricity and natural gas delivery rather than addressing efficiency directly.

Caps on energy or energy efficiency are less cost-effective than a price on pollution because they afford less flexibility. For example, in the case of air conditioners, energy-efficiency standards do not give purchasers any incentive to reduce the number or size of air conditioners that might be purchased or how much each of them will be run; only the energy-efficiency of a particular-sized model is regulated. 

The Franken bill mandates that each retail electricity supplier reduce the amount of electricity it produces or supplies relative to the three years before compliance begins, starting with a 1 percent reduction in 2017 and increasing to a 20 percent reduction in 2030. Each natural gas supplier must reduce the amount of natural gas not going to electricity by 0.50 percent in 2017, increasing to a 13 percent reduction in 2030.  (Natural gas going towards electricity is covered by the electricity cap.)

These are quotas on electricity and natural gas that apply individually to each supplier, which means there is no flexibility for different electricity or natural gas levels across suppliers. Across-supplier flexibility would lower costs (while maintaining the same overall cap) because sources could search for the lowest cost actions across the entire regulated sector.

The bill highlights the problem with targeting electricity or natural gas (or any other energy source) rather than targeting pollution directly. The problem with energy use is that we use too much of it because the costs to the environment are not included in the pricing. The optimal response is to charge a price for polluting (whether with a tax or through cap-and-trade), which would raise the price of each energy source in proportion to its pollution cost. Targeting electricity or natural gas (or energy efficiency for appliances or mileage standards for cars or any number of other things) rather than pollution misses the mark. Indeed, in the case of electricity it isn’t certain that a quota would reduce greenhouse gases, the main pollutant of concern. For one, the required reductions in electricity might be achieved by cutting back on clean forms of energy, such as wind and solar power. And by establishing facility-specific quotas rather than a broad cap-and-trade or tax for pollution, total emissions could increase with the emergence of new (albeit regulated) facilities. It is also conceivable that the optimal way to reduce greenhouse gases is to shift our transportation sector towards electric vehicles, which would mean we want more electricity rather than less in order to cost-effectively reduce greenhouse gas emissions. This quota plan is yet another example of how we are pursuing poorly targeted and inefficient regulations instead of the economically sound approach of pricing pollution.