Tag Archives: climate change

The Basic Economics of Carbon Pricing: The Social Cost of Carbon vs. the Abatement Cost of Carbon – Econ 101

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A.  Introduction

Climate change is arguably the most important challenge facing the world today.  The damage being done by a warming world is already clear:  Extreme temperatures have become more common, and extreme weather events have become both more frequent and more severe.  Glaciers as well as the ice that used to cover the Artic Ocean are melting, as are the vast ice sheets covering Greenland and Antarctica.  And the melting glaciers and ice sheets, as well as thermal expansion as ocean water becomes warmer, are together leading the sea level to rise.  If this is not addressed, not only will coastal land be lost but our coastal cities will be inundated.

The problems will grow worse as long as greenhouse gases (mainly carbon dioxide – CO2 – but others as well) continue to be released into the air.  The gases accumulate in the atmosphere, with some, such as CO2, lasting for hundreds of years before being diminished by natural processes.  It is the cumulative total that matters as it is the concentrations of these gases in the atmosphere that lead to the higher temperatures.  And the damage increases more than proportionally with those higher temperatures, where the damage in going from, say, 2 degrees to 3 degrees above the pre-industrial average is far greater than in going from 1 degree to 2 degrees.  Global average surface temperatures are already about 1.2 degrees Celsius greater than what they were on average between 1850 and 1900.

There is, however, a good deal of confusion on the basic economics of what will be needed to address this.  One hears, for example, politicians and others saying that “we cannot afford” to address climate change.  But they have not recognized that the cost of not cutting back on greenhouse gas emissions can be far greater than the cost of reducing those emissions.  Indeed, the cost of reducing greenhouse gas emissions is actually often quite low, even though the cost of not addressing climate change is high.  Those two concepts are different but are sometimes not clearly distinguished.

A diagram such as that at the top of this post can be helpful in keeping the concepts clear, as well as in understanding how they interact.  Many might immediately note the similarity to the standard supply and demand diagrams that economists (but few others) know and love, and there is indeed a similarity.  But there is an important difference:  In the supply and demand diagrams normally used, what is being produced and made available is something good, and hence one wants more of it.  But in the diagrams here, what is being produced (polluting greenhouse gases, and in particular CO2 as the primary greenhouse gas) is something bad.  Hence one wants less of it.  But it costs something to reduce those emissions.

The first section below will discuss this diagram, including the concepts behind it and how to interpret and use it to examine various issues.  This will all be just standard economics, but for something one wants less of rather than more of.  The basic measures – analogous to a demand price and a supply price – are the Social Cost of Carbon (SCC – what it costs society when an extra unit of CO2 is emitted) and what I have labeled here the Abatement Cost of Carbon (ACC- what it costs to reduce the emissions of CO2 by a unit).

The post will then discuss some of the implications that one can work out from this simple diagram.  One does not need to know precisely where those curves will be – just their basic relationship to each other.  And a fair amount can be found simply from the concepts themselves.  The key is to be clear as one thinks things through.  How one in practice determines estimates of specific values for the SCC and the ACC is also important, of course, but that issue is different and will be reviewed in subsequent posts on this blog.  There is an enormous literature on determining those values, a fair amount of controversy, and as practitioners always emphasize, also a good deal of uncertainty.  But there is much that follows from the basic concepts themselves, and this blog post will focus on that.

One point of disclosure:  The diagram above was derived from first principles.  And it is a diagram that I thought would be fairly commonly seen in the literature on climate change.  However, while I looked for references using it, I could not find any.  This does not mean that no one has ever produced something similar.  Someone almost certainly has.  But I have not been able to find an example.  At a minimum, it does not appear to be common, and thus reviewing the basic concepts here may be of interest.

July 25, 2023 – Update:  A reader of this blog flagged to me that there is indeed a text that presents a diagram very similar to what I discuss here.  The text is “Principles of Environmental Economics:  Economics, Ecology, and Public Policy”, by Ahmed M. Hussen (a professor of economics at Kalamazoo College in Michigan, USA).  I would like to thank Mr. Naren Mistry for bringing this reference to my attention.

Furthermore, I created the term “Abatement Cost of Carbon” used here – the cost to reduce the emissions of CO2 by a unit.  I believe it is a good description of the concept, but as will be discussed in the subsequent post on estimating the ACC, others have examined somewhat similar concepts with various names.

B.  The Social Cost of Carbon vs. the Abatement Cost of Carbon

The diagram at the top of this post presents schematically the relationship between the Social Cost of Carbon (SCC) and the Abatement Cost of Carbon (ACC).  These are drawn in relation to the net number of tons of CO2 emissions per year along the horizontal axis of the chart (or x-axis).  And while the diagram is shown in terms of CO2 emissions, CO2 is being taken as a proxy for all greenhouse gas emissions (which are often expressed in CO2 equivalent terms – equivalent in terms of their global warming impact over a period that is usually taken to be 100 years).

While one could measure the CO2 in any physical unit, I have labeled it as tens of billions of tons per year.  World emissions in 2021 were about 37 billion metric tons.  But the physical units one can use are arbitrary.  I also want to make clear that while the horizontal axis depicts CO2 emissions as so many tons (or tens of billions of tons) per year, this is simply a representation of the scale of production of those emissions per year.  The price (whether SCC or ACC) is then of one unit (one ton) of those CO2 emissions in any given year – not a price of one ton being emitted each year for multiple years.  It is the price for just one ton, once.

The Social Cost of Carbon (SCC) is the cost to society of a unit of CO2 being emitted into the atmosphere today, in a scenario where CO2 emissions overall are at the pace per year shown on the horizontal axis.  One can think of the SCC as what society would be willing to pay to avoid a unit of CO2 being released into the air.  Since CO2 will remain in the atmosphere for hundreds of years, the damage due to its incremental global warming effect will equal the damage this year, plus the damage next year, plus the year after that, and so on for hundreds of years.

These future damages will be discounted back to the present year based on some social discount rate.  The subsequent blog post on how the SCC is estimated, referred to above, discusses the question of what the appropriate social discount rate should be.  It will have a significant impact on the specific value of the SCC estimated, and is an issue that has been much debated.  For now we will simply assume that a suitable social discount rate has been used.  But an important and practical implication of discounting is that what matters most in the determination of the SCC estimate will only be the damages over the next century or so.  Beyond that, the discounted values are generally so small (depending on the specific social discount rate used) as not to materially affect the SCC estimate.

The damages caused by an extra unit of CO2 being emitted today will depend on how much CO2 (and other greenhouse gases) are already in the atmosphere.  Importantly, the resulting economic damage (which the SCC measures) per unit of global temperature increase will be highly non-linear.  As noted above, the incremental extra damages will be greater if the CO2 (and other greenhouse gases) have led global average temperatures to be, say 2 degrees higher than what they were in the pre-industrial era, than what the incremental damages were when those temperatures were 1 degree higher.  And those per unit damages will be greater still when coming on top of concentrations that would have led to temperatures 3 degrees higher (than in the pre-industrial period) compared to the incremental impact at 2 degrees higher.

In addition, and also importantly, there are feedback effects resulting from increasing concentrations of CO2 in the air that also lead to more than proportionally higher global temperatures.  An important example is the effect on permafrost.  A higher global temperature leads to permafrost that is on the margin of remaining frozen, instead to melt.  And melted permafrost then leads to additional greenhouse gases being released into the air (in particular the highly potent greenhouse gas methane), which then leads to even higher global temperatures.

For both of these reasons (the resulting economic damages, and the feedback effects) the SCC curve in the diagram above not only slopes upward but also bends upwards.

There is one shortcoming in such a schematic, however, that should be flagged.  Supply and demand diagrams are static and do not handle the time dimension well.  There are similar issues here.  In particular, as emissions accumulate in the atmosphere over time, the damages will be greater.  The SCC curve as shown (over its full length) can be viewed as what it would be for a given starting point for the concentration of CO2 in the air.  At higher atmospheric concentrations of CO2, it will shift upwards over its entire length.  This could in principle be handled by adding a third dimension to the diagram.  That is, one could add a third axis perpendicular to the other two (and going away – i.e. adding depth) for the stock of CO2 that had accumulated in the atmosphere.  The two-dimensional diagram shown here can then be thought of as a slice of that more complete three-dimensional chart – showing a slice for some given level of accumulated CO2.  But such a three-dimensional diagram would be complicated, and the two-dimensional one is adequate for our purposes here.

The Abatement Cost of Carbon (ACC) is what it would cost society to reduce the emissions of CO2 by one unit.  When emissions are high (the right side of the chart), it does not cost much to reduce those emissions by a unit.  There are a lot of relatively easy (low-cost) things that one can do.  But as emissions are reduced, ultimately to zero and then even into net negative levels, it becomes increasingly difficult (and hence increasingly costly) to reduce them further.  Hence the ACC curve goes from the upper left in the diagram to the lower right, and bends upwards as well.

The resulting SCC and ACC curves should therefore be expected to look like those shown.  The SCC curve starts high on the right side of the chart (as damages are great when CO2 emissions are high and assumed to remain so); they fall as one moves to the left to lower rates of emissions (with a resulting lower pace of CO2 being released into the air); and the curve bends upward.  The ACC curve, in contrast, starts low on the right – when a high rate of emissions means much could be done at a low cost to reduce those emissions by a unit – and then rises as one moves to the left to lower rates of emissions and it becomes increasingly more difficult (more costly) to reduce emissions by an additional unit.  It will also bend upwards.

At some point the ACC and SCC curves will cross.  In the diagram above, I have them cross at net emissions of zero.  The reason for that will be discussed below.  But there is no a priori reason why they should necessarily cross at zero net emissions.  Where they will cross is an empirical issue.  Rather, all one knows is that they will cross at some point.  (A contrarian might note that it is possible that the ACC curve might theoretically lie always and everywhere above the SCC curve – at least within the range of CO2 emissions shown on the diagram – and hence will never cross it.  But any reasonable estimate of the SCC and the ACC finds that that is not nearly the case in practice – and not by orders of magnitude.)

C.  Some Implications

With these basics, one can draw several implications of interest:

a)  First, at current levels of CO2 emissions (well to the right in the diagram), the SCC will be high and ACC will be low.  In the diagram at the top of this post, the SCC at point A is far above the ACC at point B.  To say that “we cannot afford” to reduce emissions of CO2 is simply wrong as the cost of not taking action to reduce emissions (the SCC at current emission rates) is well above what it would cost to reduce carbon emissions from their current pace (the ACC at current emission rates).  Indeed, the opposite is closer to the truth:  We cannot afford not taking action to reduce CO2 emissions.  And it will remain worthwhile to do this as long as the SCC is above the ACC.

b)  The SCC curve will intersect the ACC curve at some point.  At the point where they intersect the cost of reducing CO2 emissions by a further unit (the ACC) will match the benefit of doing so (the SCC, i.e. the cost to society from a unit of CO2 being emitted).  Beyond that (i.e. further to the left), the cost of further reducing CO2 emissions exceeds the benefits.  At the point where they intersect, the benefits will match the costs.

In the diagram, I have drawn the curves so that they cross at zero net emissions of CO2.  This is the “net zero” goal that the international community has targeted as the appropriate goal to address climate change.  Assuming the international community is acting fully rationally (a big stretch, I acknowledge), then that net zero goal is the appropriate one if the SCC and ACC curves cross at that point.  I have assumed that in the diagram, and the point where they cross is labeled as point C in the diagram, with ACC* = SCC* there.

c)  In reality, there is of course a good deal of uncertainty on where the SCC and ACC curves lie, and hence where they cross. But they do cross somewhere, and as we learn over time more about how the climate is changing, about the costs that the changing climate is imposing on the world, and what it would cost to cut back on CO2 emissions, we will become better able to determine where that intersection is.  But we do not need to know that with any precision right now.  All we need to know at the current moment is that the point where they cross is at a level of CO2 emissions that are well below where they now are, and that therefore we should be reducing CO2 emissions (i.e. moving to the left in the diagram).

d)  But the fact that the SCC is something positive even at net zero emissions brings out that even at net zero emissions – whenever that is achieved – there will still be damage being done from the CO2 that has accumulated in the atmosphere up to that point.  The planet would be as hot as it had ever been, with all the resulting consequences for the climate.  It would just not be getting even hotter (setting aside the complicated lags in the climate system – an important but separate issue).

e)  There would therefore be benefits from reducing the accumulated CO2 in the air from where it would be at that point, even if net emissions at that point were zero.  There is nothing special about net zero as a target – other than the ease with which it can be explained politically.  If it is the case that the cost of reducing CO2 emissions further at that point (the ACC curve) is below what the cost from damages would be of one more unit of CO2 in the air (the SCC curve), then it would make sense to reduce the net emissions of CO2 further.

It might well become significantly more difficult (more costly) to reduce CO2 emissions further once one has reached the net zero level.  It is easier to stop putting more CO2 into the air than it is to draw CO2 out of the air.  But there are ways to do this.  One can plant more trees, for example, or adopt agricultural practices that fix more carbon in the soil or in the oceans, or make use of more esoteric (and currently much more expensive) technologies that draw CO2 directly out from the air and then store it some manner where it will not end up in the air again.  But the fundamental point to recognize is that there is nothing that special about net zero emissions.  Depending on the cost (the ACC), one might well want to take action to reduce some of the CO2 we have put into the air.

f)  This brings us to the role of technology and how, over time, one should expect the technologies for reducing carbon emissions to continue to improve and thus continue to reduce the cost of abating carbon emissions.  The impact of such technological change in reducing the cost of abatement of emissions would be to shift the ACC curve downward, as shown here:

The appropriate goal would then be to reduce net CO2 emissions even further to the left, into the net negative levels at point D in the diagram rather than point C.  With the technology assumed to be available by the time society has reduced CO2 emissions to point C, the cost to reduce it further could by then be less.  At point C, the SCC cost shown in the diagram would be 3 (in some monetary units – dollars or euros or yen or whatever – per some given physical unit), but the ACC cost to reduce CO2 by one of those physical units would be less at a bit below 2 in this diagram.  Thus it would make sense to reduce CO2 emissions even further (into negative levels), where at D one would be matching the cost to society from it (the SCC) with the cost of reducing it making use of the technology available then (on the ACC’ curve).

D.  Summary and Conclusion

That there is a distinction between the costs that carbon emissions impose on society (the SCC) and what it would cost to reduce those emissions (the ACC) is obvious as soon as one thinks about it.  But many people – and especially politicians – often do not think about it, and have confused the two.

One can look at the issue with the simple tools of basic economics.  The only difference with what is normally done is that what is being produced here (CO2 emissions) are something bad – and hence one wants less of them – rather than something good.  And it costs something to reduce those CO2 emissions, even though there is a benefit when they are reduced.  This is in contrast to standard goods, where it costs something to produce more of them and there is a benefit when one has more of them.

Seen in this way, the SCC can be viewed as similar to but with an opposite sign to a demand price.  A demand price is what one would pay to obtain something good, while the SCC is a measure of the benefit one would obtain (what one would be willing to pay) in order to reduce CO2 emissions by a unit.  And while a standard supply price is how much it would cost to increase production by a unit, the ACC is how much it would cost to reduce emissions by a unit.

This then yields a simple diagram such as that at the top of this post, but where instead of a downward-sloping demand curve and an upward-sloping supply curve (as in a standard supply-demand diagram for a normal good – a good that one wants more of), the analog to the demand curve (the SCC curve) slopes up rather than down and the analog to the supply curve (the ACC) slopes down rather than up (all in going from left to right).

Several implications then follow.  The world is currently emitting high levels of CO2, and should that pace of emissions continue, the costs to society from climate change will be immense.  That is, the SCC is high.  But at these levels of CO2 emissions, there is a lot that can be done, at a low cost, to reduce those emissions by a unit.  That is, the ACC is low.  It is therefore mistaken to assert “we cannot afford” to reduce CO2 emissions.  The cost to society from not reducing them will be far greater.

The pace of CO2 emissions should then be reduced as long as the costs to society from releasing these greenhouse gases into the air (the SCC) exceeds the cost of reducing such emissions (the ACC).  At some point the curves will cross, and at that point it would no longer be worthwhile to reduce further the CO2 going into the air.  The now broadly accepted goal of the international community that net emissions of CO2 should go to zero would be logical if the SCC and ACC curves cross at net zero emissions (and I have drawn the diagram at the top of this post as if this is the case).  But there is uncertainty on precisely where those curves lie.  And it is indeed possible they cross at a net negative pace of emissions – i.e. where CO2 would be removed from the atmosphere by some means.  It is also likely that as technology improves, the position where they cross will move further to the left.

But there is no need to know today precisely where they might cross.  All we need to know right now is that with the social costs from emitting CO2 (the SCC) far in excess of what it would cost to reduce those emissions (the ACC), we should be reducing the CO2 we are putting into the air each year.  Progress on this will take time, but as CO2 emissions are reduced we will learn more about what the true costs are:  for the SCC as well as the ACC.  And with technology also advancing, it may well be the case that society will benefit not simply from reducing net emissions to zero, but then in moving beyond that – and possibly well beyond that – to removing CO2 from the atmosphere.

But that is something that we do not need to address today.  As the common saying goes, if you are digging yourself into a hole, the first thing to do is to stop digging.  That is, stop emitting the greenhouse gases that are warming the planet.  But once we have stopped digging the hole even deeper, there will be the issue of how far out of that hole we should want to go.

This post has covered only the basics.  The practical question remains of how one estimates what the SCC and ACC figures are.  That will come in subsequent posts that I hope to put up soon.

The Basic Economics of Motor Vehicle Fuel Use: Fuel Economy Standards Do Not Save as Much Fuel as One Might Assume

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Fuel economy standards are certainly popular in the US, with recent polling indicating that 78% of the population (including 66% of Republicans) are in favor.  The primary instrument that has been used for this has been the CAFE (Corporate Average Fuel Economy) standards, established by a law passed in 1975 for new cars to be sold starting in 1978.  The original objective was to reduce petroleum use – and hence the import of oil into the US – following the shock of the 1973/74 oil crisis.  More recently the objective has centered on reducing greenhouse gas emissions resulting from the burning of fossil fuels.

Fuel efficiency has certainly improved dramatically since the CAFE standards were established.  And I want to be clear from the start that I am very much in favor of some such standards (although the CAFE system itself leaves much to be desired – it is riddled with provisions favoring special interests that undermine its effectiveness, but such issues merit a separate discussion).  Fuel efficiency standards provide an incentive to improve performance (financial penalties are due when they are not met) and thus serve to guide the direction of technological change.  But whether they in fact lead to less fuel being used overall (and hence fewer greenhouse gases being emitted) is not so clear.  The cost to run your car is effectively cheaper – as the amount and hence the cost of the fuel you will burn will be less – and this makes driving your personal car more attractive than it would be otherwise.  So you drive more.

On average, Americans certainly are now driving much more each year than they were in the early 1970s, as the chart at the top of this post shows.  (The underlying data for the calculations came from estimates produced by the FHA and the EIA, and can be found in the National Transportation Statistics database of the US Department of Transportation.)  Note that the curve for miles per gallon (as well as the other curves in the chart) are for the stock of all cars on the roads in the respective years – not just for new cars sold in that year.

There were certainly several factors behind the long-term trend of more miles being driven each year per person in the population, with the effective cost of fuel being just one.  It will also depend on what has happened to real incomes (which, while stagnant since the 1970s for the bottom 90% of the population, have grown for the top 10%), the cost and availability of public transit alternatives, and other such factors.

But it is striking that the increase in miles driven per person in the population (the line in blue) has basically paralleled the rise in average fuel efficiency (the line in orange) over the last several decades.  Hence the gallons of gasoline used per person (the line in red) has been basically flat.  And from 2008 up to 2019 – just prior to the Covid disruptions – the miles driven per person and the average fuel efficiency had both grown by almost the same proportion, so the gallons of gas used per person were almost exactly the same as they were in 1970.  That is, despite far greater fuel efficiency in the vehicles we drive, we are (as a nation) using the same gallons of gas (per person) as we did in 1970.  The greater fuel efficiency did not lead to less gas being burned – nor to less greenhouse gases being emitted.  (And I will address below the argument that the standards led to less fuel being burned “than would otherwise be the case”.)

The basic economics of this is really rather simple.  Higher fuel standards might result in a higher up-front cost for a vehicle (with the emphasis on “might” – as it really depends on technological developments).  But whether it does or does not affect the up-front costs, what matters in a decision on whether to drive on a particular day is the additional cost (what economists call the marginal cost) of driving that day.  The up-front cost (if any) is a sunk cost that has already been incurred and will not affect the decision on whether or not to drive for some particular trip.

That decision, rather, will be affected by the marginal cost of driving that day, which depends primarily on the cost of the fuel.  With the effective cost of the fuel reduced with a more fuel efficient vehicle, there will be a greater incentive to drive rather than use some alternative, thus offsetting – at least to some degree – what would have been saved in fuel by the higher standards.  If a 10% improvement in fuel efficiency leads to 10% more miles being driven, there will be no overall reduction in fuel use at all.

How much of an increase will there be in miles driven for a given reduction in the effective cost of driving a car?  While there have been efforts to try to estimate this, it is not easy to do.  There are numerous factors one needs to take into account – such as what has happened to real incomes, the distribution of those incomes, the costs of alternatives, the social customs of the time, and more.

But one factor that is key that should be highlighted is the issue of time frame.  In the very short run, if the price of gas should go up or down, you are unlikely to change your driving behavior by much if at all.  Your car will be the same, and you will likely commute to work or school as you have been doing, make the number of shopping trips as you have been doing, and so on.  But as the time frame lengthens, there might be some changes in your driving behavior.  As more fuel efficient cars become available you may well decide it is worthwhile to purchase one (even if the up-front cost is higher).  You may then decide to stop using public transit or carpools to go to work or school, but rather drive alone.  You may decide to make more shopping trips by car, and to drive on holiday trips rather than fly to a destination.  Over an even longer time frame of decades, you might decide to choose to buy a home that requires a longer commute.  While further out from a city (or wherever you are employed), you may be able to buy a larger house in a more pleasant environment than you would be able to buy for the same price closer in.

That is, with a lower marginal cost of driving, one will make decisions that lead to more miles being driven each year.  And that is what one sees in the chart.  How much more is not clear, and it is almost certainly a coincidence that the proportional increases in the number of miles driven after 1970 were similar to the proportional gains in fuel efficiency in the period (and almost exactly the same in the 12 years from 2008 to 2019).  But one should expect at least some offset due to the improved fuel efficiency, and over a period of decades possibly a very large offset.  And that is what we observe.

As was noted above, some will argue that what matters is that the improved fuel efficiency will lead to less fuel being burned “than would otherwise be the case”.  This would, of course, be true by definition if one takes as given that a certain number of miles will be driven each year regardless of fuel efficiency.  But the issue is whether the number of miles being driven each year would have in fact been the same regardless of what happened to fuel efficiency.  Almost certainly not, for the reasons noted above.  It is not known with any certainty how large of an impact the improved fuel efficiency may have had on driving decisions – particularly over a time span of decades where many adjustments (such as where one will live) are possible.  But it is unreasonable to assert there would have been no impact.  And we do know from the data (as shown in the chart) that over time the gallons of gas burned per person were largely unchanged despite the dramatic gains in average fuel efficiency in the cars on the road.

So far we have only been looking at the relative impact the greater fuel efficiency will have on the effective cost of fueling a vehicle, relative to what it otherwise would have been in the period.  But for changes over time – and how those might impact decisions on whether to drive or not – one should also look at how the fuel prices themselves changed:

The top line in the chart (in blue) shows the average price per gallon of gasoline each year, as adjusted for general inflation based on the overall Consumer Price Index and expressed in terms of prices of January 2023.  The figures are annual averages, and are the average retail prices of gasoline as estimated by the Bureau of Labor Statistics from the data it gathers for estimating the Consumer Price Index.

The average price per gallon in 1970 (in terms of the January 2023 overall price level) was $2.53 per gallon.  It rose sharply in 1974 and again in 1979 and 1980 due to the oil embargoes of those periods, but then came down.  Many may not realize that in real terms, the price of gasoline was usually below the (relatively low) level of 1970 from the mid-1980s through to 2003.  It then rose to a peak in 2012 before falling again.  The chart ends in 2021 as the data required for the 2022 calculations of fuel efficiency were not yet available, but the price of gasoline rose sharply in the first half of 2022 due to the Russian invasion of Ukraine, before falling back to earlier levels by the end of the year.

The lower line in the chart (in red) adjusts these prices per gallon for fuel to reflect the gains in average fuel efficiency for the cars on the road in those years, relative to 1970.  Because of the fuel efficiency gains, that red curve will always be below the one in blue.  And it becomes significant over time.  By 2008 it was 40% lower than the price of fuel without an adjustment to reflect the efficiency gains, and was 43% lower than the unadjusted price as of 2021.  This meant that as of 2021, the price effectively being paid for gas was $1.95 per gallon, rather than the $3.42 price per gallon paid at the pump (all expressed in terms of the overall price level of January 2023).

This effective cost of $1.95 per gallon in 2021 was not only 43% below the $3.42 price paid at the pump, but was also 23% below the price paid in 1970 of $2.53 per gallon.  Of greater relevance – as it is the long term factors that matter most – is that the average price per gallon of fuel between 1986 and 2021 (and including the period of higher prices in the decade between 2004 and 2014) was $1.92 per gallon when adjusted for fuel efficiency rather than $3.03 when not adjusted (i.e. 37% less on average over the period).  And this $1.92 per gallon was 24% less than the $2.53 per gallon cost of 1970.

Does this lower effective cost of fuel explain all of the increase in miles driven each year over this period?  Probably not.  But it was a factor, and one that should be recognized.  Higher fuel efficiency standards are a good policy, but one needs to recognize that they will not translate one-for-one directly into less fuel being burned (and greenhouse gases being emitted).  People will drive more, offsetting at least some of the gain.

This also has another implication that does not appear – from what I have seen – to be widely recognized.  And that is that greater fuel efficiency, and hence a greater incentive to drive alone in your car on your commutes and for other trips rather than taking public transit or carpooling, will lead to greater road congestion.  There will simply be more cars driving more miles on the limited roads we have when the marginal cost of driving your car is lower due to the greater fuel efficiency.  This has almost certainly contributed to the greater road congestion we have seen in recent decades.  As shown in the chart at the top of this post, the miles driven per person in 2019 (before the Covid crisis) was 74% higher than in 1970.  Looking forward, as there are more electric battery cars on the roads with their extremely low marginal cost of operation (the cost of the electric power to charge the batteries is well below what the equivalent cost of gas would be), we should expect even more congestion.  This is not to say that a switch to electric cars should in any way be discouraged.  The benefits to the environment will be great if the electric power required comes from renewable sources such as solar or wind.  But we should not ignore that the resulting low cost of driving on any given day will contribute to increased congestion issues in the years ahead.

Most importantly, the response of drivers to improved fuel efficiency needs to be recognized as we design the environmental regulations needed to address a warming planet and the resulting climate change.  Burning fossil fuels is the major contributor to this warming and needs to fall.  Higher fuel economy standards have been viewed as a good instrument to help with this.  But once one takes into account that people can be expected to respond to the lower effective fuel costs by driving more, we need to recognize that this instrument will not be as effective as many assume.  Higher fuel efficiency standards are still good.  I am all in favor of them.  But one should not expect that they will contribute as much as many might believe to what needs to be done to address climate change.  Much more will be necessary.

The Diversity in Prices for Solar Power Generation Contracts

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This will be just a brief post on a point that was central in the March 19 post on this blog on the need for the World Bank to rethink its strategy on climate change.  It was argued there that while the cost, for example, to generate power from renewable sources might on average be higher than from fossil fuels (given the implicit subsidy to fossil fuels by not requiring such plants to pay for the damage they cause), one needs to recognize that there is in fact a range of costs around those averages.  One should not simply focus on whatever the averages are and ignore the ranges.  Costs and hence prices will vary a great deal around the averages, and in the conditions of a particular locale the cost of solar-generated power, for example, will often be less.  Much can be achieved by the World Bank Group by focusing its efforts on ensuring those projects that are viable (meaning profitable) in their particular local conditions will be able to proceed.

To illustrate this, the chart above shows the distribution of the price per megawatt-hour (MWHr), in constant 2021 dollars, that were bid in the power purchase agreement (PPA) contracts awarded for utility-scale solar projects in the United States in the years 2018 to 2021.  The data on solar power generation costs are assembled each year by the Lawrence-Berkeley National Laboratory, with the data here from the 2022 report (released in September 2022).  There were 98 such PPA contracts for solar power generation in those years (excluding contracts that also included a storage component, as their costs will vary widely depending on, among other factors, how much storage capacity would be provided).

Even though the US is a relatively well-integrated market, without the high degree of segmentation one would see in many developing countries, those PPA contract prices nonetheless varied widely.  There were four contracts awarded in the price group of $10 to $14.99 per MWHr and two in the upper end group of $45 to $49.99 per MWHr (and in fact two others that I have excluded here:  one for $59.40 and one for $158.50, where special factors probably played a role).  The modal group was for $20 to $24.99 per MWhr, but only 37 of the 98 contracts (38%) had a price in that bracket.

Several points should be noted.  First, the overall range is wide.  Even excluding the two special cases at the upper end, the PPA prices varied by a factor of four between the lowest and highest groupings.  Second, the prices are in fact all pretty low.  The lowest was $11.64 per MWHr for a contract with an execution date of April 1, 2021, to provide a capacity of 150 MW.  That cost corresponds to a price of 1.164 cents per kilowatt-hour (KWHr) – just over a penny.  This is the amount that a provider chose to bid to cover their full cost of providing that energy, including the up-front capital cost of the solar plant plus whatever operational and maintenance costs they would then have for the life of their contract.  And while 1.164 cents per KWHr is extremely low, even the price at the top of the range included in the chart (for a PPA contract with an execution date of January 15, 2021, for a 90 MW plant) was just $46.86 per MWHr (equivalent to 4.686 cents per KWHr).  By way of comparison, the lifetime cost (in 2018) of a new coal-fired generation plant would have been (on average) almost $80 per MWHr and the average cost of a new gas-fired plant would have been about $45 per MWHr.

(And while some might note that the variation in the PPA prices might reflect, in part, that larger projects (in MW capacity) may have lower PPA prices bid, a simple regression of the MW size vs. the PPA prices finds an R-squared of less than 0.1.  That is, more than 90% of the variation in the PPA prices cannot be explained by the MW size of the projects.)

It should be recognized that these PPA prices will reflect any subsidies received.  But the main such subsidy in the US over this period was the Investment Tax Credit (ITC) for such projects.  The Lawrence-Berkeley report estimated that without that subsidy, the leveled costs for the power would be about 22 to 23% higher (on average for the projects approved between 2018 and 2021).  Even after marking up the prices by such an amount, the prices that were bid to provide such power were still very low – and generally still far below what the costs would have been from traditional, fossil-fuel fired, power plants.

But while such low prices for power from solar generation are interesting and important in themselves, the main point I wish to make here is that there is a wide range in those prices, even in a market as well integrated as that of the US.  People often lose sight of the fact there is such a range when they compare prices of, for example, power generated from renewable sources to the cost from traditional, fossil-fuel fired, plants.  They typically focus on the mean (average) prices rather than the ranges, and hence lose sight of the fact there while the average cost might well be higher in the comparison of one to the other, there will still often be circumstances where the relative cost in a particular locale was the reverse.

Diversity is important in economics.  Indeed, it is central to how markets operate.  It is critical not to ignore it.