A Carbon Tax with Redistribution Would Be a Significant Help to the Poor

Posted on August 6, 2020, 4:57 pm by aneconomicsense

A. Introduction

Economists have long recommended taxing pollution as an effective as well as efficient way to achieve societal aims to counter that pollution. What is commonly called a “carbon tax”, but which in fact would apply to all emissions of greenhouse gases (where carbon dioxide, CO2, is the largest contributor), would do this. “Cap and trade” schemes, where polluters are required to acquire and pay for a limited number of permits, act similarly. The prime example in the US of such a cap and trade scheme was the program to sharply reduce the sulfur dioxide (SO2) pollution from the burning of coal in power plants. That program was launched in 1995 and was a major success. Not only did the benefits exceed the costs by a factor of 14 to 1 (with some estimates even higher – as much as 100 to 1), but the cost of achieving that SO2 reduction was only one-half to one-quarter of what officials expected it would have cost had they followed the traditional regulatory approach.

Cost savings of half or three-quarters are not something to sneer at. Reducing greenhouse gas emissions, which is quite possibly the greatest challenge of our times, will be expensive. The benefits will be far greater, so it is certainly worthwhile to incur those expenses (and it is just silly to argue that “we cannot afford it” – the benefits far exceed the costs). One should, however, still want to minimize those costs.

But while such cost savings are hugely important, one should also not ignore the distributional consequences of any such plan. These are a concern of many, and rightly so. The poor should not be harmed, both because they are poor and because their modest consumption is not the primary cause of the pollution problem we are facing. But this is where there has been a good deal of confusion and misunderstanding. A tax on all greenhouse gas emissions, with the revenue thus generated then distributed back to all on an equal per capita basis, would be significantly beneficial to the poor in purely financial terms. Indeed it would be beneficial to most of the population since it is a minority of the population (mostly those who are far better off financially than most) who account for a disproportionate share of emissions.

A specific carbon tax plan that would work in this way was discussed in an earlier post on this blog. I would refer the reader to that earlier post for the details on that plan. But briefly, under this proposal all emissions of greenhouse gases (not simply from power plants, but from all sources) would pay a tax of $49 per metric ton of CO2 (or per ton of CO2 equivalent for other greenhouse gases, such as methane). A fee of $49 per metric ton would be equivalent to about $44.50 per common ton (2,000 pounds, as commonly used in the US but nowhere else in the world). The revenues thus generated would then be distributed back, in full, to the entire population in equal per capita terms, on a monthly or quarterly basis. There would also be a border-tax adjustment on goods imported, which would create the incentive for other countries to join in such a scheme (as the US would charge the same carbon tax on such goods when the source country hadn’t, but with those revenues then distributed to Americans).

The US Treasury published a study of this scheme in January 2017, and estimated that such a tax would generate $194 billion of revenues in its initial year (which was assumed to be 2019). This would allow for a distribution of $583 to every American (man, woman, and child – not just adults). Furthermore, the authors estimated what the impact would be by family income decile, and concluded that the bottom 7 deciles of families (the bottom 70%, as ranked by income) would enjoy a net benefit, while only the richest 30% would pay a net cost.

That distributional impact will be the focus of this blog post. It has not received sufficient attention in the discussion on how to address climate change. While the Treasury study did provide estimates on what the impacts by income decile would be (although not always in an easy to understand form), views on a carbon tax often appear to assume, incorrectly, that the poor will pay the most as a share of their income, while the rich will be able to get away with avoiding the tax. The impact would in fact be the opposite. Indeed, while the primary aim of the program is, and should be, the reduction of greenhouse gas emissions, its redistributive benefits are such that on that basis alone the program would have much to commend it. It would also be just. As noted above, the poor do not account for a disproportionate share of greenhouse gas emissions – the rich do – yet the poor suffer similarly, if not greater, from the consequences.

This blog post will first review those estimated net cash benefits by family income decile, both in dollar amounts and as a share of income. To give a sense of how important this is in magnitude, it will then examine how these net benefits compare to the most important current cash transfer program in the US – food stamp benefits. Finally, it will briefly review the politics of such a program. Perceptions have, unfortunately, been adverse, and many pundits believe a carbon tax program would never be approved. Perhaps this might change if news sources paid greater attention to the distribution and economic justice benefits.

B. Net Benefits or Costs by Family Income Decile from a Carbon Tax with Redistribution

The chart at the top of this post shows what the average net impact would be in dollars per person, by family cash income decile, if a carbon tax of $49 per metric ton were charged with the revenues then distributed on an equal per capita basis. While prices of energy and other goods whose production or use leads to greenhouse gas emissions would rise, the revenues from the tax thus generated would go back in full to the population. Those groups who account for a less than proportionate share of greenhouse gas emissions (the poor and much of the middle class) would come out ahead, while those with the income and lifestyle that lead to a greater than average share of greenhouse gas emissions (the rich) will end up paying in more.

The figures are derived from estimates made by the staff of the US Treasury – staff that regularly undertake assessments of the incidence across income groups of various tax proposals. The study was published in January 2017, and the estimates are of what the impacts would have been had the tax been in place for 2019. The results were presented in tables following a standard format for such tax incidence studies, with the dollars per person impact of the chart above derived from those tables.

To arrive at these estimates, the Treasury staff first calculated what the impact of such a $49 per metric ton carbon tax would be on the prices of goods. Such a tax would, for example, raise the price of gasoline by $0.44 per gallon based on the CO2 emitted in its production and when it is burned. Using standard input-output tables they could then estimate what the price changes would be on a comprehensive set of goods, and based on historic consumption patterns work out what the impacts would be on households by income decile. The net impact would then follow from distributing back on an equal per capita basis the revenues collected by the tax. For 2019, the Treasury staff estimated $194 billion would be collected (a bit less than 1% of GDP), which would allow for a transfer back of $583 per person.

Those in the poorest 10% of households would receive an estimated $535 net benefit per person from such a scheme. The cost of the goods they consume would go up by $48 per person over the course of a year, but they would receive back $583. They do not account for a major share of greenhouse gas emissions because they cannot afford to consume much. They are poor, and a family earning, say, $20,000 a year consumes far less of everything than a family earning $200,000 a year. In terms of greenhouse gas emissions implicit in the Treasury numbers, the poorest 10% of Americans account only for a bit less than 1.0 metric tons of CO2 emissions per person per year (including the CO2 equivalent in other greenhouse gases). The richest 10% account for close to 36 tons CO2 equivalent per person per year.

As one goes from the lower income deciles to the higher, consumption rises and CO2 emissions from the goods consumed rises. But it is not a linear trend by decile. Rather, higher-income households account for a more than proportionate share of greenhouse gas emissions. As a consequence, the break-even point is not at the 50th percentile of households (as it would be if the trend were linear), but rather something higher. In the Treasury estimates, households up through the 70th percentile (the 7th decile) would on average still come out ahead. Only the top three deciles (the richest 30%) would end up paying more for the carbon tax than what they would receive back. But this is simply because they account for a disproportionately high share of greenhouse gas emissions. It is fully warranted and just that they should pay more for the pollution they cause.

But it is also worth noting that while the richer household would pay more in dollar terms than they receive back, those higher dollar amounts are modest when taken as a share of their high incomes:

In dollar terms the richest 10% would pay in a net $1,166 per person in this scheme, as per the chart at the top of this post. But this would be just 1.0% of their per-person incomes. The 9th decile (families in the 80 to 90th percentile) would pay in a net of 0.7% of their incomes, and the 8th decile would pay in a net of 0.3%. At the other end of the distribution, the poorest 10% (the 1st decile) would receive a net benefit equal to 8.9% of their incomes. This is not minor. The relatively modest (as a share of incomes) net transfers from the higher-income households permit a quite substantial rise (in percentage terms) in the incomes of poorer households.

C. A Comparison to Transfers in the Food Stamps Program

The food stamps program (formally now called SNAP, for Supplemental Nutrition Assistance Program) is the largest cash income transfer program in the US designed specifically to assist the poor. (While the cost of Medicaid is higher, those payments are made directly to health care providers for their medical services to the poor.) How would the net transfers under a carbon tax with redistribution compare to SNAP? Are they in the same ballpark?

I had expected they would not be close. However, it turns out that they are not that far apart. While food stamps would still provide a greater transfer for the very poorest households, the supplement to income that those households would receive by such a carbon tax scheme would be significant. Furthermore, the carbon tax scheme would be of greater benefit than food stamps are, on average, for lower middle-class households (those in the 3rd decile and above).

The Congressional Budget Office (CBO) has estimated how food stamp (SNAP) benefits are distributed by household income decile. While the forecast year is different (2016 for SNAP vs. 2019 for the carbon tax), for the purposes here the comparison is close enough. From the CBO figures one can work out the annual net benefits per person under SNAP for households in the 1st to 4th deciles (with the 5th through the 10th deciles then aggregated by the CBO, as they were all small):

The average annual benefits from SNAP were estimated to be about $1,500 per person for households in the poorest decile and $690 per person in the 2nd decile. These are larger than the estimated net benefits of these two groups under a carbon tax program (of $535 and $464 per person, respectively), but it was surprising, at least to me, that they are as close as they are. The food stamp program is specifically targeted to assist the poor to purchase the food that they need. A carbon tax with redistribution program is aimed at cutting back greenhouse gas emissions, with the funds generated then distributed back to households on an equal per capita basis. They have very different aims, but the redistribution under each is significant.

D. But the Current Politics of Such a Program Are Not Favorable

A carbon tax with redistribution program would therefore not only reduce greenhouse gas emissions at a lower cost than traditional approaches, but would also provide for an equitable redistribution from those who account for a disproportionate share of greenhouse gas emissions (the rich) to those who do not (the poor). But news reporters and political pundits, including those who are personally in favor of such a program, consider it politically impossible. And in what was supposed to be a personal email, but which was part of those obtained by Russian government hackers and then released via WikiLeaks in order to assist the Trump presidential campaign, John Podesta, the senior campaign manager for Hillary Clinton, wrote: “We have done extensive polling on a carbon tax. It all sucks.”

Published polls indicate that the degree of support or not for a carbon tax program depends critically on how the question is worded. If the question is stated as something such as “Would you be in favor of taxing corporations based on their carbon emissions”, polls have found two-thirds or more of Americans in support. But if the question is worded as something such as “Would you be in favor of paying a carbon tax on the goods you purchase”, the support is less (often still more than a majority, depending on the specific poll, but less than two-thirds). But they really amount to the same thing.

There are various reasons for this, starting with that the issue is a complex one, is not well understood, and hence opinions can be easily influenced based on how the issue is framed. This opens the field to well-funded vested interests (such as the fossil fuel companies) being able to influence votes by sophisticated advertising. Opponents were able to outspend proponents by 2 to 1 in Washington State in 2018, when a referendum on a proposed carbon tax was defeated (as it had been also in 2016). Political scientists who have studied the two Washington State referenda believe they would be similarly defeated elsewhere.

There appear to be two main concerns: The first is that “a carbon tax will hurt the poor”. But as examined above, the opposite would be the case. The poor would very much benefit, as their low consumption only accounts for a small share of carbon emissions (they are poor, and do not consume much of anything), but they would receive an equal per capita share of the revenues raised.

In distinct contrast, but often not recognized, a program to reduce greenhouse gas emissions based on traditional regulation would still see an increase in costs (and indeed likely by much more, as noted above), but with no compensation for the poor. The poor would then definitely lose. There may then be calls to add on a layer of special subsidies to compensate the poor, but these rarely work well.

The second concern often heard is that “a carbon tax is just a nudge” and in the end will not get greenhouse gas emissions down. There may also be the view (internally inconsistent, but still held) that the rich are so rich that they will not cut back on their consumption of high carbon-emission goods despite the tax, while at the same time the rich can switch their consumption (by buying an electric car, for example, to replace their gasoline one) while the poor cannot.

But the prices do matter. As noted at the start of this post, the experience with the cap and trade program for SO2 from the burning of coal (where a price is put on the SO2 emissions) found it to be highly effective in bringing SO2 emissions down quickly. Or as was discussed in an earlier post on this blog, charging polluters for their emissions would be key to getting utilities to switch use to clean energy sources. The cost of both solar and wind new generation power capacity has come down sharply over the past decade, to the point where, for new capacity, they are the cheapest sources available. But this is for new generation. When there is no charge for the greenhouse gases emitted, it is still cheaper to keep burning gas and often coal in existing plants, as the up-front capital costs have already been incurred and do not affect the decision of what to use for current generation. But as estimated in that earlier post, if those plants were charged $40 per ton for their CO2 emissions, it would be cheaper for the power utilities to build new solar or wind plants and use these to replace existing fossil fuel plants.

There are many other substitution possibilities as well, but many may not be well known when the focus is on a particular sector. For example, livestock account for about 30% of methane emissions resulting from human activity. This is roughly the same share as methane emissions from the production and distribution of fossil fuels. And methane is a particularly potent greenhouse gas, with 86 times the global warming potential over a 20-year horizon of an equal weight of CO2. Yet a simple modification of the diets of cows will reduce their methane emissions (due to their digestive system – methane comes out as burps and farts) by 33%. One simply needs to add to their feed just 100 grams of lemongrass per day and the digestive chemistry changes to produce far less methane. Burger King will now start to purchase its beef from such sources.

This is a simple and inexpensive change, yet one that is being done only by Burger King and a few others in order to gain favorable publicity. But a tax on such greenhouse gas emissions would induce such an adjustment to the diets of livestock more broadly (as well as research on other dietary changes, that might lead to an even greater reduction in methane emissions). A regulatory focus on emissions from power plants alone would not see this. One might argue that a broader regulatory system would cover emissions from such agricultural practices, and in principle it should. But there has been little discussion of extending the regulation of greenhouse gas emissions to the agricultural sector.

More fundamentally, regulations are set and then kept fixed over time in order to permit those who are regulated to work out and then implement plans to comply. Such systems are not good, by their nature, at handling innovations, as by definition innovations are not foreseen. Yet innovations are precisely what one should want to encourage, and indeed the ex-post assessment of the SO2 emissions trading program found that it was innovations that led to costs being far lower than had been anticipated. A carbon tax program would similarly encourage innovations, while regulatory schemes can not handle them well.

There may well be other concerns, including ones left unstated. Individuals may feel, for example, that while climate change is indeed a major issue and needs to be addressed, and that redistribution under a carbon tax program might well be equitable overall, that they will nonetheless lose. And some will. Those who account for a disproportionately high share of greenhouse gas emissions through the goods they purchase will end up paying more. But costs will also rise under the alternative of a regulatory approach (and indeed rise by a good deal more), which will affect them as well. If they do indeed account for a disproportionately high share of greenhouse gas emissions, they should be especially in favor of an approach that would bring these emissions down at the lowest possible cost. A scheme that puts a price on carbon emissions, such as in a carbon tax scheme, would do this at a lower cost than traditional approaches.

So while many have concerns with a carbon tax with redistribution scheme, much of this is due to a misunderstanding of what the impacts would be, as well as of what the impacts would be of alternatives. One sees this in the range of responses to polling questions on such schemes, where the degree of support depends very much on how the questions are worded or framed. There is a need to explain better how a carbon tax with redistribution program would work, and we have collectively (analysts, media, and politicians) failed to do this.

There are also some simple steps one can take which would likely increase the attractiveness of such a program. For example, perceptions would likely be far better if the initial rebate checks were sent up-front, before the carbon taxes were first to go into effect, rather than later, at the end of whatever period is chosen. Instead of households being asked to finance the higher costs over the period until they received their first rebate checks, one would have the government do this. This would not only make sense financially (government can fund itself more cheaply than households can), but more important, politically. Households would see up-front that they are, indeed, receiving a rebate check before the prices go up to reflect the carbon tax.

And one should not be too pessimistic. While polling responses depend on the precise wording used, as noted above, the polling results still usually show a majority in support. But the issue needs to be explained better. There are problems, clearly, when issues such as the impact on the poor from such a scheme are so fundamentally misunderstood.

E. Conclusion

Charging for greenhouse gases emitted (a carbon tax), with the revenues collected then distributed back to the population on an equal per capita basis, would be both efficient (lower cost) and equitable. Indeed, the transfers from those who account for an especially high share of greenhouse gas emissions (the rich) to those who account for very little of them (the poor), would provide a significant supplement to the incomes of the poor. While the redistributive effect is not the primary aim of the program (reducing greenhouse gases is), that redistributive effect would be both beneficial and significant. It should not be ignored.

The conventional wisdom, however, is that such a scheme could not command a majority in a referendum. The issue is complex, and well-funded vested interests (the fossil fuel companies) have been able to use that complexity to propagate a sufficient level of concern to defeat such referenda. The impact on the poor has in particular been misportrayed.

But climate change really does need to be addressed. One should want to do this at the lowest possible cost while also in an equitable manner. Hopefully, as more learn what carbon tax schemes can achieve, politicians will obtain the support they need to move forward with such a program.

The Increasingly Attractive Economics of Solar Power: Solar Prices Have Plunged

Posted on June 20, 2019, 6:43 pm by aneconomicsense

A. Introduction

The cost of solar photovoltaic power has fallen dramatically over the past decade, and it is now, together with wind, a lower cost source of new power generation than either fossil-fuel (coal or gas) or nuclear power plants. The power generated by a new natural gas-fueled power plant in 2018 would have cost a third more than from a solar or wind plant (in terms of the price they would need to sell the power for in order to break even); coal would have cost 2.4 times as much as solar or wind; and a nuclear plant would have cost 3.5 times as much.

These estimates (shown in the chart above, and discussed in more detail below) were derived from figures estimated by Lazard, the investment bank, and are based on bottom-up estimates of what such facilities would have cost to build and operate, including the fuel costs. But one also finds a similar sharp fall in solar energy prices in the actual market prices that have been charged for the sale of power from such plants under long-term “power purchase agreements” (PPAs). These will also be discussed below.

With the costs where they are now, it would not make economic sense to build new coal or nuclear generation capacity, nor even gas in most cases. In practice, however, the situation is more complex due to regulatory issues and conflicting taxes and subsidies, and also because of variation across regions. Time of day issues may also enter, depending on when (day or night) the increment in new capacity might be needed. The figures above are also averages, particular cases vary, and what is most economic in any specific locale will depend on local conditions. Nevertheless, and as we will examine below, there has been a major shift in new generation capacity towards solar and wind, and away from coal (with old coal plants being retired) and from nuclear (with no new plants being built, but old ones largely remaining).

But natural gas generation remains large. Indeed, while solar and wind generation have grown quickly (from a low base), and together account for the largest increment in new power capacity in recent years, gas accounts for the largest increment in power production (in megawatt-hours) measured from the beginning of this decade. Why? In part this is due to the inherent constraints of solar and wind technologies: Solar panels can only generate power when the sun shines, and wind turbines when the wind is blowing. But more interestingly, one also needs to look at the economics behind the choice as to whether or not to build new generation capacity to replace existing capacity, and then what sources of capacity to use. Critical is what economists call the marginal cost of such production. A power plant lasts for many years once it is built, and the decision on whether to keep an existing plant in operation for another year depends only on the cost of operating and maintaining the plant. The capital cost has already been spent and is no longer relevant to that decision.

Details in the Lazard report can be used to derive such marginal cost estimates by power source, and we will examine these below. While the Lazard figures apply to newly built plants (older plants will generally have higher operational and maintenance costs, both because they are getting old and because technology was less efficient when they were built), the estimates based on new plants can still give us a sense of these costs. But one should recognize they will be biased towards indicating the costs of the older plants are lower than they in fact are. However, even these numbers (biased in underestimating the costs of older plants) imply that it is now more economical to build new wind and possibly solar plants, in suitable locales, than it costs to continue to keep open and operate coal-burning power plants. This will be especially true for the older, less-efficient, coal-burning plants. Thus we should be seeing old coal-burning plants being shut down. And indeed we do. Moreover, while the costs of building new wind and solar plants are not yet below the marginal costs of keeping open existing gas-fueled and nuclear power plants, they are on the cusp of being so.

These costs also do not reflect any special subsidies that solar and wind plants might benefit from. These vary by state. Fossil-fueled and nuclear power plants also enjoy subsidies (often through special tax advantages), but these are long-standing and are implicitly being included in the Lazard estimates of the costs of such traditional plants.

But one special subsidy enjoyed by fossil fuel burning power plants, not reflected in the Lazard cost estimates, is the implicit subsidy granted to such plants from not having to cover the cost of the damage from the pollution they generate. Those costs are instead borne by the general public. And while such plants pollute in many different ways (especially the coal-burning ones), I will focus here on just one of those ways – their emissions of greenhouse gases that are leading to a warming planet and consequent more frequent and more damaging extreme weather events. Solar and wind generation of power do not cause such pollution – the burning of coal and gas do.

To account for such costs and to ensure a level playing field between power sources, a fee would need to be charged to reflect the costs being imposed on the general population from this (and indeed other) such pollution. The revenues generated could be distributed back to the public in equal per capita terms, as discussed in an earlier post on this blog. We will see that a fee of even just $20 per ton of CO2 emitted would suffice to make it economic to build new solar and wind power plants to substitute not just for new gas and coal burning plants, but for existing ones as well. Gas and especially coal burning plants would not be competitive with installing new solar or wind generation if they had to pay for the damage done as a result of their greenhouse gas pollution, even on just marginal operating costs.

Two notes before starting: First, many will note that while solar might be fine for the daytime, it will not be available at night. Similarly, wind generation will be fine when the wind blows, but it may not always blow even in the windiest locales. This is of course true, and should solar and wind capacity grow to dominate power generation, there will have to be ways to store that power to bridge the times from when the generation occurs to when the power is used.

But while storage might one day be an issue, it is mostly not an issue now. In 2018, utility-scale solar only accounted for 1.6% of power generation in the US (and 2.3% if one includes small scale roof-top systems), while wind only accounted for 6.6%. At such low shares, solar and wind power can simply substitute for other, higher cost, sources of power (such as from coal) during the periods the clean sources are available. Note also that the cost figures for solar and wind reflected in the chart at the top of this post (and discussed in detail below) take into account that solar and wind cannot be used 100% of the time. Rather, utilization is assumed to be similar to what their recent actual utilization has been, not only for solar and wind but also for gas, coal and nuclear. Solar and wind are cheaper than other sources of power (over the lifetime of these investments) despite their inherent constraints on possible utilization.

But where the storage question can enter is in cases where new generation capacity is required specifically to serve evening or night-time needs. New gas burning plants might then be needed to serve such time-of-day needs if storage of day-time solar is not an economic option. And once such gas-burning plants are built, the decision on whether they should be run also to serve day-time needs will depend on a comparison of the marginal cost of running these gas plants also during the day, to the full cost of building new solar generation capacity, as was discussed briefly above and will be considered in more detail below.

This may explain, in part, why we see new gas-burning plants still being built nationally. While less than new solar and wind plants combined (in terms of generation capacity), such new gas-burning plants are still being built despite their higher cost.

More broadly, California and Hawaii (both with solar now accounting for over 12% of power used in those states) are two states (and the only two states) which may be approaching the natural limits of solar generation in the absence of major storage. During some sunny days the cost of power is being driven down to close to zero (and indeed to negative levels on a few days). Major storage will be needed in those states (and only those states) to make it possible to extend solar generation much further than where it is now. But this should not be seen so much as a “problem” but rather as an opportunity: What can we do to take advantage of cheap day-time power to make it available at all hours of the day? I hope to address that issue in a future blog post. But in this blog post I will focus on the economics of solar generation (and to a lesser extent from wind), in the absence of significant storage.

Second, on nomenclature: A megawatt-hour is a million watts of electric power being produced or used for one hour. One will see it abbreviated in many different ways, including MWHr, MWhr, MWHR, MWH, MWh, and probably more. I will try to use consistently MWHr. A kilowatt-hour (often kWh) is a thousand watts of power for one hour, and is the typical unit used for homes. A megawatt-hour will thus be one thousand times a kilowatt-hour, so a price of, for example, $20 per MWHr for solar-generated power (which we will see below has in fact been offered in several recent PPA contracts) will be equivalent to 2.0 cents per kWh. This will be the wholesale price of such power. The retail price in the US for households is typically around 10 to 12 cents per kWh.

B. The Levelized Cost of Energy

As seen in the chart at the top of this post, the cost of generating power by way of new utility-scale solar photovoltaic panels has fallen dramatically over the past decade, with a cost now similar to that from new on-shore wind turbines, and well below the cost from building new gas, coal, or nuclear power plants. These costs can be compared in terms of the “levelized cost of energy” (LCOE), which is an estimate of the price that would need to be charged for power from such a plant over its lifetime, sufficient to cover the initial capital cost (at the anticipated utilization rate), plus the cost of operating and maintaining the plant,

Lazard, the investment bank, has published estimates of such LCOEs annually for some time now. The most recent report, issued in November 2018, is version 12.0. Lazard approaches the issue as an investment bank would, examining the cost of producing power by each of the alternative sources, with consistent assumptions on financing (with a debt/equity ratio of 60/40, an assumed cost of debt of 8%, and a cost of equity of 12%) and a time horizon of 20 years. They also include the impact of taxes, and show separately the impact of special federal tax subsidies for clean energy sources. But the figures I will refer to throughout this post (including in the chart above) are always the estimates excluding any impact from special subsidies for clean energy. The aim is to see what the underlying actual costs are, and how they have changed over time.

The Lazard LCOE estimates are calculated and presented in nominal terms. They show the price, in $/MWHr, that would need to be charged over a 20-year time horizon for such a project to break even. For comparability over time, as well as to produce estimates that can be compared directly to the PPA contract prices that I will discuss below, I have converted those prices from nominal to real terms in constant 2017 dollars. Two steps are involved. First, the fixed nominal LCOE prices over 20 years will be falling over time in real terms due to general inflation. They were adjusted to the prices of their respective initial year (i.e. the relevant year from 2009 to 2018) using an inflation rate of 2.25% (which is the rate used for the PPA figures discussed below, the rate the EIA assumed in its 2018 Annual Energy Outlook report, and the rate which appears also to be what Lazard assumed for general cost escalation factors). Second, those prices for the years between 2009 and 2018 were all then converted to constant 2017 prices based on actual inflation between those years and 2017.

The result is the chart shown at the top of this post. The LCOEs in 2018 (in 2017$) were $33 per MWHr for a newly built utility-scale solar photovoltaic system and also for an on-shore wind installation, $44 per MWHr for a new natural gas combined cycle plant, $78 for a new coal-burning plant, and $115 for a new nuclear power plant. The natural gas plant would cost one-third more than a solar or wind plant, coal would cost 2.4 times as much, and a nuclear plant 3.5 times as much. Note also that since the adjustments for inflation are the same for each of the power generation methods, their costs relative to each other (in ratio terms) are the same for the LCOEs expressed in nominal cost terms. And it is their costs relative to each other which most matters.

The solar prices have fallen especially dramatically. The 2018 LCOE was only one-tenth of what it was in 2009. The cost of wind generation has also fallen sharply over the period, to about one-quarter in 2018 of what it was in 2009. The cost from gas combined cycle plants (the most efficient gas technology, and is now widely used) also fell, but only by about 40%, while the cost of coal or nuclear were roughly flat or rising, depending on precisely what time period is used.

There is good reason to believe the cost of solar technology will continue to decline. It is still a relatively new technology, and work in labs around the world are developing solar technologies that are both more efficient and less costly to manufacture and install.

Current solar installations (based on crystalline silicon technology) will typically have conversion efficiencies of 15 to 17%. And panels with efficiencies of up to 22% are now available in the market – a gain already on the order of 30 to 45% over the 15 to 17% efficiency of current systems. But a chart of how solar efficiencies have improved over time (in laboratory settings) shows there is good reason to believe that the efficiencies of commercially available systems will continue to improve in the years to come. While there are theoretical upper limits, labs have developed solar cell technologies with efficiencies as high as 46% (as of January 2019).

Particularly exciting in recent years has been the development of what are called “perovskite” solar technologies. While their current efficiencies (of up to 28%, for a tandem cell) are just modestly better than purely crystalline silicon solar cells, they have achieved this in work spanning only half a decade. Crystalline silicon cells only saw such an improvement in efficiencies in research that spanned more than four decades. And perhaps more importantly, perovskite cells are much simpler to manufacture, and hence much cheaper.

Based on such technologies, one could see solar efficiencies doubling within a few years, from the current 15 to 17% to say 30 to 35%. And with a doubling in efficiency, one will need only half as many solar panels to produce the same megawatts of power, and thus also only half as many frames to hold the panels, half as much wiring to link them together, and half as much land. Coupled with simplified and hence cheaper manufacturing processes (such as is possible for perovskite cells), there is every reason to believe prices will continue to fall.

While there can be no certainty in precisely how this will develop, a simple extrapolation of recent cost trends can give an indication of what might come. Assuming costs continue to change at the same annual rate that they had over the most recent five years (2013 to 2018), one would find for the years up to 2023:

If these trends hold, then the LCOE (in 2017$) of solar power will have fallen to $13 per MWHr by 2023, wind will have fallen to $18, and gas will be at $32 (or 2.5 times the LCOE of solar in that year, and 80% above the LCOE of wind). And coal (at $70) and nuclear (at $153) will be totally uncompetitive.

This is an important transition. With the dramatic declines in the past decade in the costs for solar power plants, and to a lesser extent wind, these clean sources of power are now more cost competitive than traditional, polluting, sources. And this is all without any special subsidies for the clean energy. But before looking at the implications of this for power generation, as a reality check it is good first to examine whether the declining costs of solar power have been reflected in actual market prices for such power. We will see that they have.

C. The Market Prices for Solar Generated Power

Power Purchase Agreements (PPAs) are long-term contracts where a power generator (typically an independent power producer) agrees to supply electric power at some contracted capacity and at some price to a purchaser (typically a power utility or electric grid operator). These are competitively determined (different parties interested in building new power plants will bid for such contracts, with the lowest price winning) and are a direct market measure of the cost of energy from such a source.

The Lawrence Berkeley National Lab, under a contract with the US Department of Energy, produces an annual report that reviews and summarizes PPA contracts for recent utility-scale solar power projects, including the agreed prices for the power. The most recent was published in September 2018, and covers 2018 (partially) and before. While the report covers both solar photovoltaic and concentrating solar thermal projects, the figures of interest to us here (and comparable to the Lazard LCOEs discussed above) are the PPAs for the solar photovoltaic projects.

The PPA prices provided in the report were all calculated by the authors on a levelized basis and in terms of 2017 prices. This was done to put them all on a comparable basis to each other, as the contractual terms of the specific contracts could differ (e.g. some had price escalation clauses and some did not). Averages by year were worked out with the different projects weighted by generation capacity.

The PPA prices are presented by the year the contracts were signed. If one then plots these PPA prices with a one year lag and compare them to the Lazard estimated LCOE prices of that year, one finds a remarkable degree of overlap:

This high degree of overlap is extraordinary. Only the average PPA price for 2010 (reflecting the 2009 average price lagged one year) is off, but would have been close with a one and a half year lag rather than a one year lag. Note also that while the Lawrence Berkeley report has PPA prices going back to 2006, the figures for the first several years are based on extremely small samples (just one project in 2006, one in 2007, and three in 2008, before rising to 16 in 2009 and 30 in 2010). For that reason I have not plotted the 2006 to 2008 PPA prices (which would have been 2007 to 2009 if lagged one year), but they also would have been below the Lazard LCOE curve.

What might be behind this extraordinary overlap when the PPA prices are lagged one year? Two possible explanations present themselves. One is that the power producers when making their PPA bids realize that there will be a lag from when the bids are prepared to when the winning bidder is announced and construction of the project begins. With the costs of solar generation falling so quickly, it is possible that the PPA bids reflect what they know will be a lag between when the bid is prepared and when the project has to be built (with solar panels purchased and other costs incurred). If that lag is one year, one will see overlap such as that found for the two curves.

Another possible explanation for the one-year shift observed between the PPA prices (by date of contract signing) and the Lazard LCOE figures is that the Lazard estimates labeled for some year (2018 for example) might in fact represent data on the cost of the technologies as of the prior year (2017 in this example). One cannot be sure from what they report. Or the remarkable degree of overlap might be a result of some combination of these two possible explanations, or something else.

But for whatever reason, the two estimates move almost exactly in parallel over time, and hence show an almost identical rate of decline for both the cost of generating power from solar photovoltaic sources and in the market PPA prices for such power. And it is that rapid rate of decline which is important.

It is also worth noting that the “bump up” in the average PPA price curve in 2017 (shown in the chart as 2018 with the one year lag) reflects in part that a significant number of the projects in the 2017 sample of PPAs included, as part of the contract, a power storage component to store a portion of the solar-generated power for use in the evening or night. But these additional costs for storage were remarkably modest, and were even less in several projects in the partial-year 2018 sample. Specifically, Nevada Energy (as the offtaker) announced in June 2018 that it had contracted for three major solar projects that would include storage of power of up to one-quarter of generation capacity for four hours, with overall PPA prices (levelized, in 2017 prices) for both the generation and the storage of just $22.8, $23.5, and $26.4 per MWHr (i.e. 2.28 cents, 2.35 cents, and 2.64 cents per kWh, respectively).

The PPA prices reported can also be used to examine how the prices vary by region. One should expect solar power to be cheaper in southern latitudes than in northern ones, and in dry, sunny, desert areas than in regions with more extensive cloud cover. And this has led to the criticism by skeptics that solar power can only be competitive in places such as the US Southwest.

But this is less of an issue than one might assume. Dividing up the PPA contracts by region (with no one-year lag in this chart), one finds:

Prices found in the PPAs are indeed lower in the Southwest, California, and Texas. But the PPA prices for projects in the Southeast, the Midwest, and the Northwest fell at a similar pace as those in the more advantageous regions (and indeed, at a more rapid pace up to 2014). And note that the prices in those less advantageous regions are similar to what they were in the more advantageous regions just a year or two before. Finally, the absolute differences in prices have become relatively modest in the last few years.

The observed market prices for power generated by solar photovoltaic systems therefore appear to be consistent with the bottom-up LCOE estimates of Lazard – indeed remarkably so. Both show a sharp fall in solar energy prices/costs over the last decade, and sharp falls both for the US as a whole and by region. The next question is whether we see this reflected in investment in additions to new power generation capacity, and in the power generated by that capacity.

D. Additions to Power Generation Capacity, and in Power Generation

The cost of power from a new solar or wind plant is now below the cost from gas (while the cost of new coal or nuclear generation capacity is totally uncompetitive). But the LCOEs indicate that the cost advantage relative to gas is relatively recent in the case of solar (starting from 2016), and while a bit longer for wind, the significant gap in favor of wind only opened up in 2014. One needs also to recognize that these are average or mid-point estimates of costs, and that in specific cases the relative costs will vary depending on local conditions. Thus while solar or wind power is now cheaper on average across the US, in some particular locale a gas plant might be less expensive (especially if the costs resulting from its pollution are not charged). Finally, and as discussed above, there may be time-of-day issues that the new capacity may be needed for, with this affecting the choices made.

Thus while one should expect a shift towards solar and wind over the last several years, and away from traditional fuels, the shift will not be absolute and immediate. What do we see?

First, in terms of the gross additions to power sector generating capacity:

The chart shows the gross additions to power capacity, in megawatts, with both historical figures (up through 2018) and as reflected in plans filed with the US Department of Energy (for 2019 and 2020, with the plans as filed as of end-2018). The data for this (and the other charts in this section) come from the most recent release of the Electric Power Annual of the Energy Information Agency (EIA) (which was for 2017, and was released on October 22, 2018), plus from the Electric Power Monthly of February, 2019, also from the Energy Information Agency (where the February issue each year provides complete data for the prior calendar year, i.e. for 2018 in this case).

The planned additions to capacity (2019 and 2020 in the chart) provide an indication of what might happen over the next few years, but must be interpreted cautiously. While probably pretty good for the next few years, biases will start to enter as one goes further into the future. Power producers are required to file their plans for new capacity (as well as for retirements of existing capacity) with the Department of Energy, for transparency and to help ensure capacity (locally as well as nationally) remains adequate. But these reported plans should be approached cautiously. There is a bias as projects that require a relatively long lead time (such as gas plants, as well as coal and especially nuclear) will be filed years ahead, while the more flexible, shorter construction periods, required for solar and wind plants means that these plans will only be filed with the Department of Energy close to when that capacity will be built. But for the next few years, the plans should provide an indication of how the market is developing.

As seen in the chart, solar and wind taken together accounted for the largest single share of gross additions to capacity, at least through 2017. While there was then a bump up in new gas generation capacity in 2018, this is expected to fall back to earlier levels in 2019 and 2020. And these three sources (solar, wind, and gas) accounted for almost all (93%) of the gross additions to new capacity over 2012 to 2018, with this expected to continue.

New coal-burning plants, in contrast, were already low and falling in 2012 and 2013, and there have been no new ones since then. Nor are any planned. This is as one would expect based on the LCOE estimates discussed above – new coal plants are simply not cost competitive. And the additions to nuclear and other capacity have also been low. “Other” capacity is a miscellaneous category that includes hydro, petroleum-fueled plants such as diesel, as well as other renewables such as from the burning of waste or biomass. The one bump up, in 2016, is due to a nuclear power plant coming on-line that year. It was unit #2 of the Watts Bar nuclear power plant built by the Tennessee Valley Authority (TVA), and had been under construction for decades. Indeed the most recent nuclear plant completed in the US before this one was unit #1 at the same TVA plant, which came on-line 20 years before in 1996. Even aside from any nuclear safety concerns, nuclear plants are simply not economically competitive with other sources of power.

The above are gross additions to power generating capacity, reflecting what new plants are being built. But old, economically or technologically obsolete, plants are also being retired, so what matters to the overall shift in power generation capacity is what has happened to net generation capacity:

What stands out here is the retirement of coal-burning plants. And while the retirements might appear to diminish in the plans going forward, this may largely be due to retirement plans only being announced shortly before they happen. It is also possible that political pressure from the Trump administration to keep coal-burning plants open, despite their higher costs (and their much higher pollution), might be a factor. We will see what happens.

The cumulative impact of these net additions to capacity (relative to 2010 as the base year) yields:

Solar plus wind accounts for the largest addition to capacity, followed by gas. Indeed, each of these accounts for more than 100% of the growth in overall capacity, as there has been a net reduction in the nuclear plus other category, and especially in coal.

But what does this mean in terms of the change in the mix of electric power generation capacity in the US? Actually, less than one might have thought, as one can see in a chart of the shares:

The share of coal has come down, but remains high, and similarly for nuclear (plus miscellaneous other) capacity. Gas remains the highest and has risen as a share, while solar and wind, while rising at a rapid pace relative to where it was to start, remains the smallest shares (of the categories used here).

The reason for these relatively modest changes in shares is that while solar and wind plus gas account for more than 100% of the net additions to capacity, that net addition has been pretty small. Between 2010 and 2018, the net addition to US electric power generation capacity was just 58.8 thousand megawatts, or an increase over eight years of just 5.7% over what capacity was in 2010 (1,039.1 thousand megawatts). A big share of something small will still be small.

So even though solar and wind are now the lowest cost sources of new power generation, the very modest increase in the total power capacity needed has meant that not that much has been built. And much of what has been built has been in replacement of nuclear and especially coal capacity. As we will discuss below, the economic issue then is not whether solar and wind are the cheapest source of new capacity (which they are), but whether new solar and wind are more economic than what it costs to continue to operate existing coal and nuclear plants. That is a different question, and we will see that while new solar and wind are now starting to be a lower cost option than continuing to operate older coal (but not nuclear) plants, this development (a critically important development) has only been recent.

Why did the US require such a small increase in power generation capacity in recent years? As seen in the chart below, it is not because GDP has not grown, but rather because energy efficiency (real GDP per MWHr of power) improved tremendously, at least until 2017:

From 2010 to 2017, real GDP rose by 15.7% (2.1% a year on average), but GDP per MWHr of power generated rose by 18.3%. That meant that power generation (note that generation is the relevant issue here, not capacity) could fall by 2.2% despite the higher level of GDP. Improving energy efficiency was a key priority during the Obama years, and it appears to have worked well. It is better for efficiency to rise than to have to produce more power, even if that power comes from a clean source such as solar or wind.

This reversed direction in 2018. It is not clear why, but might be an early indication that the policies of the Trump administration are harming efficiency in our economy. However, this is still just one year of data, and one will need to wait to see whether this was an aberration or a start of a new, and worrisome, trend.

Which brings us to generation. While the investment decision is whether or not to add capacity, and if so then of what form (e.g. solar or gas or whatever), what is ultimately needed is the power generated. This depends on the capacity available and then on the decision of how much of that capacity to use to generate the power needed at any given moment. One needs to keep in mind that power in general is not stored (other than still very limited storage of solar and wind power), but rather has to be generated at the moment needed. And since power demand goes up and down over the course of the day (higher during the daylight hours and lower at night), as well as over the course of the year (generally higher during the summer, due to air conditioning, and lower in other seasons), one needs total generation capacity sufficient to meet whatever the peak load might be. This means that during all other times there will be excess, unutilized, capacity. Indeed, since one will want to have a safety margin, one will want to have total power generation capacity of even more than whatever the anticipated peak load might be in any locale.

There will always, then, be excess capacity, just sometimes more and sometimes less. And hence decisions will be necessary as to what of the available capacity to use at any given moment. While complex, the ultimate driver of this will be (or at least should be, in a rational system) the short-run costs of producing power from the possible alternative sources available in the region where the power is needed. These costs will be examined in the next section below. But for here, we will look at how generation has changed over the last several years.

In terms of the change in power generation by source relative to the levels in 2010, one finds:

Gas now accounts for the largest increment in generation over this period, with solar and wind also growing (steadily) but by significantly less. Coal powered generation, in contrast, fell substantially, while nuclear and other sources were basically flat. And as noted above, due to increased efficiency in the use of power (until 2017), total power use was flat to falling a bit, even as GDP grew substantially. This reversed in 2018 when efficiency fell, and gas generated power rose to provide for the resulting increased power demands. Solar and wind continued on the same path as before, and coal generation still fell at a similar pace as before. But it remains to be seen whether 2018 marked a change in the previous trend in efficiency gains, or was an aberration.

Why did power generation from gas rise by more than from solar and wind over the period, despite the larger increase in solar plus wind capacity than in gas generation capacity? In part this reflects the cost factors which we will discuss in the next section below. But in part one needs also to recognize factors inherent in the technologies. Solar generation can only happen during the day (and also when there is no cloud cover), while wind generation depends on when the wind blows. Without major power storage, this will limit how much solar and wind can be used.

The extent to which some source of power is in fact used over some period (say a year), as a share of what would be generated if the power plant operated at 100% of capacity for 24 hours a day, 365 days a year, is defined as the “capacity factor”. In 2018, the capacity factor realized for solar photovoltaic systems was 26.1% while for wind it was 37.4%. But for no power source is it 100%. For natural gas combined cycle plants (the primary source of gas generation), the capacity factor was 57.6% in 2018 (up from 51.3% in 2017, due to the jump in power demand in 2018). This is well below the theoretical maximum of 100% as in general one will be operating at less than peak capacity (plus plants need to be shut down periodically for maintenance and other servicing).

Thus increments in “capacity”, as measured, will therefore not tell the whole story. How much such capacity is used also matters. And the capacity factors for solar and wind will in general be less than what they will be for the other primary sources of power generation, such as gas, coal, and nuclear (and excluding the special case of plants designed solely to operate for short periods of peak load times, or plants used as back-ups or for cases of emergencies). But how much less depends only partly on the natural constraints on the clean technologies. It also depends on marginal operating costs, as we will discuss below.

Finally, while gas plus solar and wind have grown in terms of power generation since 2010, and coal has declined (and nuclear and other sources largely unchanged), coal-fired generation remains important. In terms of the percentage shares of overall power generation:

While coal has fallen as a share, from about 45% of US power generation in 2010 to 27% in 2018, it remains high. Only gas is significantly higher (at 35% in 2010). Nuclear and other sources (such as hydro) accounts for 29%, with nuclear alone accounting for two-thirds of this and other sources the remaining one-third. Solar and wind have grown steadily, and at a rapid rate relative to where they were in 2010, but in 2018 still accounted only for about 8% of US power generation.

Thus while coal has come down, there is still very substantial room for further substitution out of coal, by either solar and wind or by natural gas. The cost factors that will enter into this decision on substituting out of coal will be discussed next.

E. The Cost Factors That Enter in the Decisions on What Plants to Build, What Plants to Keep in Operation, and What Plants to Use

The Lazard analysis of costs presents estimates not only for the LCOE of newly built power generation plants, but also figures that can be used to arrive at the costs of operating a plant to produce power on any given day, and of operating a plant plus keeping it maintained for a year. One needs to know these different costs in order to address different questions. The LCOE is used to decide whether to build a new plant and keep it in operation for a period (20 years is used); the operating cost is used to decide which particular power plant to run at any given time to generate the power then needed (from among all the plants up and available to run that day); while the operating cost plus the cost of regular annual maintenance is used in the decision of whether to keep a particular plant open for another year.

The Lazard figures are not ideal for this, as they give cost figures for a newly built plant, using the technology and efficiencies available today. The cost to maintain and operate an older plant will be higher than this, both because older technologies were less efficient but also simply because they are older and hence more liable to break down (and hence cost more to keep running) than a new plant. But the estimates for a new plant do give us a sense of what the floor for such costs might be – the true costs for currently existing plants of various ages will be somewhat higher.

Lazard also recognized that there will be a range of such costs for a particular type of plant, depending on the specifics of the particular location and other such factors. Their report therefore provides both what it labels low end and high end estimates, and with a mid-point estimate then based usually on the average between the two. The figures shown in the chart at the top of this post are the mid-point estimates, but in the tables below we will show the low and high end cost estimates as well. These figures are helpful in providing a sense of the range in the costs one should expect, although how Lazard defined the range they used is not fully clear. They are not of the absolutely lowest possible cost plant nor absolutely highest possible cost plant. Rather, the low end figures appear to be averages of the costs of some share of the lowest cost plants (possibly the lowest one third), and similarly for the high end figures.

The cost figures below are from the 2018 Lazard cost estimates (the most recent year available). The operating and maintenance costs are by their nature current expenditures, and hence their costs will be in current, i.e. 2018, prices. The LCOE estimates of Lazard are different. As was noted above, these are the levelized prices that would need to be charged for the power generated to cover the costs of building and then operating and maintaining the plant over its assumed (20 year) lifetime. They therefore need to be adjusted to reflect current prices. For the chart at the top of this post, they were put in terms of 2017 prices (to make them consistent with the PPA prices presented in the Berkeley report discussed above). But for the purposes here, we will put them in 2018 prices to ensure consistency with the prices for the operating and maintenance costs. The difference is small (just 2.2%).

The cost estimates derived from the Lazard figures are then:

(all costs in 2018 prices)

A. Levelized Cost of Energy from a New Power Plant: $/MWHr

	Solar	Wind	Gas	Coal	Nuclear
low end	$31.23	$22.65	$32.02	$46.85	$87.46
mid-point	$33.58	$33.19	$44.90	$79.26	$117.52
high end	$35.92	$43.73	$57.78	$111.66	$147.58

B. Cost to Maintain and Operate a Plant Each year, including for Fuel: $/MWHr

	Solar	Wind	Gas	Coal	Nuclear
low end	$4.00	$9.24	$24.38	$23.19	$23.87
mid-point	$4.66	$10.64	$26.51	$31.30	$25.11
high end	$5.33	$12.04	$28.64	$39.41	$26.35

C. Short-term Variable Cost to Operate a Plant, including for Fuel: $/MWHr

	Solar	Wind	Gas	Coal	Nuclear
low end	$0.00	$0.00	$23.16	$14.69	$9.63
mid-point	$0.00	$0.00	$25.23	$18.54	$9.63
high end	$0.00	$0.00	$27.31	$22.40	$9.63

A number of points follow from these cost estimates:

a) First, and as was discussed above, the LCOE estimates indicate that for the question of what new type of power plant to build, it will in general be cheapest to obtain new power from a solar or wind plant. The mid-point LCOE estimates for solar and wind are well below the costs of power from gas plants, and especially below the costs from coal or nuclear plants.

But also as noted before, local conditions vary and there will in fact be a range of costs for different types of plants. The Lazard estimates indicate that a gas plant with costs at the low end of a reasonable range (estimated to be about $32 per MWHr) would be competitive with solar or wind plants at the mid-point of their cost range (about $33 to $34 per MWHr), and below the costs of a solar plant at the high end of its cost range ($36) and especially a wind plant at its high end of its costs ($44). However, there are not likely to be many such cases: Gas plants with a cost at their mid-point estimate would not be competitive, and even less so for gas plants with a cost near their high end estimate.

Furthermore, even the lowest cost coal and nuclear plants would be far from competitive with solar or wind plants when considering the building of new generation capacity. This is consistent with what we saw in Section D above, of no new coal or nuclear plants being built in recent years (with the exception of one nuclear plant whose construction started decades ago and was only finished in 2016).

b) More interesting is the question of whether it is economic to build new solar or wind plants to substitute for existing gas, coal, or nuclear plants. The figures in panel B of the table on the cost to operate and maintain a plant for another year (all in terms of $/MWHr) can give us a sense of whether this is worthwhile. Keeping in mind that these are going to be low estimates (as they are the costs for newly built plants, using the technologies available today, not for existing ones which were built possibly many years ago), the figures suggest that it would make economic sense to build new solar and wind plants (at their LCOE costs) and decommission all but the most efficient coal burning plants.

However, the figures also suggest that this will not be the case for most of the existing gas or nuclear plants. For such plants, with their capital costs already incurred, the cost to maintain and operate them for a further year is in the range of $24 to $29 (per MWHr) for gas plants and $24 to $26 for nuclear plants. Even recognizing that these costs estimates will be low (as they are based on what the costs would be for a new plant, not existing ones), only the more efficient solar and wind plants would have an LCOE which is less. But they are close, and are on the cusp of the point where it would be economic to build new solar and wind plants and decommission existing gas and nuclear plants, just as this is already the case for most coal plants.

c) Panel C then provides figures to address the question of which power plants to operate, for those which are available for use on any given day. With no short-term variable cost to generate power from solar or wind sources (they burn no fuel), it will always make sense to use those sources first when they are available. The short-term cost to operate a nuclear power plant is also fairly low ($9.63 per MWHr in the Lazard estimates, with no significant variation in their estimates). Unlike other plants, it is difficult to turn nuclear plants on and off, so such plants will generally be operated as baseload plants kept always on (other than for maintenance periods).

But it is interesting that, provided a coal burning plant was kept active and not decommissioned, the Lazard figures suggest that the next cheapest source of power (if one ignores the pollution costs) will be from burning coal. The figures indicate coal plants are expensive to maintain (the difference between the figures in panel B and in panel C) but then cheap to run if they have been kept operational. This would explain why we have seen many coal burning plants decommissioned in recent years (new solar and wind capacity is cheaper than the cost of keeping a coal burning plant maintained and operating), but that if the coal burning plant has been kept operational, that it will then typically be cheaper to run rather than a gas plant.

d) Finally, existing gas plants will cost between $23 and $27 per MWHr to run, mostly for the cost of the gas itself. Maintenance costs are low. These figures are somewhat less than the cost of building new solar or wind capacity, although not by much.

But there is another consideration as well. Suppose one needs to add to night-time capacity, so solar power will not be of use (assuming storage is not an economic option). Assume also that wind is not an option for some reason (perhaps the particular locale). The LCOE figures indicate that a new gas plant would then be the next best alternative. But once this gas plant is built, it will be available also for use during the day. The question then is whether it would be cheaper to run that gas plant during the day also, or to build solar capacity to provide the day-time power.

And the answer is that at these costs, which exclude the costs from the pollution generated, it would be cheaper to run the gas plant. The LCOE costs for new solar power ranges from $31 to $36 per MWHr (panel A above), while the variable cost of operating a gas plant built to supply nighttime capacity ranges between $23 and $27 (panel C). While the difference is not huge, it is still significant.

This may explain in part why new gas generation capacity is not only being built in the US, but also is then being used more than other sources for additional generation, even though new solar and wind capacity would be cheaper. And part of the reason for this is that the costs imposed on others from the pollution generated by burning fossil fuels are not being borne by the power plant operators. This will be examined in the next section below.

F. The Impact of Including the Cost of Greenhouse Gas Emissions

Burning fossil fuels generates pollution. Coal is especially polluting, in many different ways. But I will focus here on just one area of damage caused by the burning of fossil fuels, which is that from their generation of greenhouse gases. These gases are warming the earth’s atmosphere, with this then leading to an increased frequency of extreme weather events, from floods and droughts to severe storms, and hurricanes of greater intensity. While one cannot attribute any particular storm to the impact of a warmer planet, the increased frequency of such storms in recent decades is clearly a consequence of a warmer planet. It is the same as the relationship of smoking to lung cancer. While one cannot with certainty attribute a particular case of lung cancer to smoking (there are cases of lung cancer among people who do not smoke), it is well established that there is an increased likelihood and frequency of lung cancer among smokers.

When the costs from the damage created from greenhouse gases are not borne by the party responsible for the emissions, that party will ignore those costs. In the case of power production, they do not take into account such costs in deciding whether to use clean sources (solar or wind) to generate the power needed, or to burn coal or gas. But the costs are still there and are being imposed on others. Hence economists have recommended that those responsible for such decisions face a price which reflects such costs. A specific proposal, discussed in an earlier post on this blog, is to charge a tax of $40 per ton of CO2 emitted. All the revenue collected by that tax would then be returned in equal per capita terms to the American population. Applied to all sources of greenhouse gas emissions (not just power), the tax would lead to an annual rebate of almost $500 per person, or $2,000 for a family of four. And since it is the rich who account most (in per person terms) for greenhouse gas emissions, it is estimated that such a tax and redistribution would lead to those in the lowest seven deciles of the population (the lowest 70%) receiving more on average than what they would pay (directly or indirectly), while only the richest 30% would end up paying more on a net basis.

Such a tax on greenhouse gas emissions would have an important effect on the decision of what sources of power to use when power is needed. As noted in the section above, at current costs it is cheaper to use gas-fired generation, and even more so coal-fired generation, if those plants have been built and are available for operation, than it would cost to build new solar or wind plants to provide such power. The costs are getting close to each other, but are not there yet. If gas and coal burning plants do not need to worry about the costs imposed on others from the burning of their fuels, such plants may be kept in operation for some time.

A tax on the greenhouse gases emitted would change this calculus, even with all other costs as they are today. One can calculate from figures presented in the Lazard report what the impact would be. For the analysis here, I have looked at the impact of charging $20 per ton of CO2 emitted, $40 per ton of CO2, or $60 per ton of CO2. Analyses of the social cost of CO2 emissions come up with a price of around $40 per ton, and my aim here was to examine a generous span around this cost.

Also entering is how much CO2 is emitted per MWHr of power produced. Figures in the Lazard report (and elsewhere) put this at 0.51 tons of CO2 per MWHr for gas burning plants, and 0.92 tons of CO2 per MWHr for coal burning plants. As has been commonly stated, the direct emissions of CO2 from gas burning plants is on the order of half of that from coal burning plants.

[Side note: This does not take into account that a certain portion of natural gas leaks out directly into the air at some point in the process from when it is pulled from the ground, then transported via pipelines, and then fed into the final use (e.g. at a power plant). While perhaps small as a percentage of all the gas consumed (the EPA estimates a leak rate of 1.4%, although others estimate it to be more), natural gas (which is primarily methane) is itself a highly potent greenhouse gas with an impact on atmospheric warming that is 34 times as great as the same weight of CO2 over a 100 year time horizon, and 86 times as great over a 20 year horizon. If one takes such leakage into account (of even just 1.4%), and adds this warming impact to that of the CO2 that is produced by the gas that has not leaked out but is burned, natural gas turns out to have a similar if not greater atmospheric warming impact as that resulting from the burning of coal. However, for the calculations below, I will leave out the impact from leakage. Including this would lead to even stronger results.]

One then has:

D. Cost of Greenhouse Gas Emissions: $/MWhr

	Solar	Wind	Gas	Coal	Nuclear
Tons of CO2 Emitted per MWHr	0.000	0.000	0.510	0.920	0.000
Cost at $20/ton CO2	$0.00	$0.00	$10.20	$18.40	$0.00
Cost at $40/ton CO2	$0.00	$0.00	$20.40	$36.80	$0.00
Cost at $60/ton CO2	$0.00	$0.00	$30.60	$55.20	$0.00

E. Levelized Cost of Energy for a New Power Plant, including Cost of Greenhouse Gas Emissions (mid-point figures): $/MWHr

	Solar	Wind	Gas	Coal	Nuclear
Cost at $20/ton CO2	$33.58	$33.19	$55.10	$97.66	$117.52
Cost at $40/ton CO2	$33.58	$33.19	$65.30	$116.06	$117.52
Cost at $60/ton CO2	$33.58	$33.19	$75.50	$134.46	$117.52

F. Short-term Variable Cost to Operate a Plant, including Fuel and Cost of Greenhouse Gas Emissions (mid-point figures): $/MWHr

	Solar	Wind	Gas	Coal	Nuclear
Cost at $20/ton CO2	$0.00	$0.00	$35.43	$36.94	$9.63
Cost at $40/ton CO2	$0.00	$0.00	$45.63	$55.34	$9.63
Cost at $60/ton CO2	$0.00	$0.00	$55.83	$73.74	$9.63

Panel D shows what would be paid, per MWHr, if greenhouse gas emissions were charged for at a rate of $20 per ton of CO2, of $40 per ton, or of $60 per ton. The impact would be significant, ranging from $10 to $31 per MWHr for gas and $18 to $55 for coal.

If these costs are then included in the Levelized Cost of Energy figures (using the mid-point estimates for the LCOE), one gets the costs shown in Panel E. The costs of new power generation capacity from solar or wind sources (as well as nuclear) are unchanged as they have no CO2 emissions. But the full costs of new gas or coal fired generation capacity will now mean that such sources are even less competitive than before, as their costs now also reflect, in part, the damage done as a result of their greenhouse gas emissions.

But perhaps most interesting is the impact on the choice of whether to keep burning gas or coal in plants that have already been built and remain available for operation. This is provided in Panel F, which shows the short-term variable cost (per MWHr) of power generated by the different sources. These short-term costs were primarily the cost of the fuel used, but now also include the cost to compensate for the damage from the resulting greenhouse gas emissions.

If gas as well as coal had to pay for the damages caused by their greenhouse gas emissions, then even at a cost of just $20 per ton of CO2 emitted they would not be competitive with building new solar or wind plants (whose LCOEs, in Panel E, are less). At a cost of $40 or $60 per ton of CO2 emitted, they would be far from competitive, with costs that are 40% to 120% higher. There would be a strong incentive then to build new solar and wind plants to serve what they can (including just the day time markets), while existing gas plants (primarily) would in the near term be kept in reserve for service at night or at other times when solar and wind generation is not possible.

G. Summary and Conclusion

The cost of new clean sources of power generation capacity, wind and especially solar, has plummeted over the last decade, and it is now cheaper to build new solar or wind capacity than to build new gas, coal, and especially nuclear capacity. One sees this not only in estimates based on assessments of the underlying costs, but also in the actual market prices for new generation capacity (the PPA prices in such contracts). Both have plummeted, and indeed at an identical pace.

While it was only relatively recently that the solar and wind generation costs have fallen below the cost of generation from gas, one does see these relative costs reflected in the new power generation capacity built in recent years. Solar plus wind (together) account for the largest single source of new capacity, with gas also high. And there have been no new coal plants since 2013 (nor nuclear, with the exception of one plant coming online which had been under construction for decades).

But while solar plus wind plants accounted for the largest share of new generation capacity in recent years, the impact on the overall mix was low. And that is because not that much new generation capacity has been needed. Up until to at least 2017, efficiency in energy use was improving to such an extent that no net new capacity was needed despite robust GDP growth. A large share of something small will still be something small.

However, the costs of building new solar or wind generation capacity have now fallen to the point where it is cheaper to build new solar or wind capacity than it costs to maintain and keep in operation many of the existing coal burning power plants. This is particularly the case for the older coal plants, with their older technologies and higher maintenance costs. Thus one should see many of these older plants being decommissioned, and one does.

But it is still cheaper, when one ignores the cost of the damage done by the resulting pollution, to maintain and operate existing gas burning plants, than it would cost to build new solar or wind plants to generate the power they are able to provide. And since some of the new gas burning plants being built may be needed to add to night-time generation capacity, this means that such plants will also be used to generate power by burning gas during the day, instead of installing solar capacity.

This cost advantage only holds, however, because gas-burning plants do not have to pay for the costs resulting from the damage their pollution causes. While they pollute in many different ways, one is from the greenhouse gases they emit. But if one charged them just $20 for every ton of CO2 released into the atmosphere when the gas is burned, the result would be different. It would then be more cost competitive to build new solar or wind capacity to provide power whenever they can, and to save the gas burning plants for those times when such clean power is not possible.

There is therefore a strong case for charging such a fee. However, many of those who had previously supported such an approach to address global warming have backed away in recent months, arguing that it would be politically impossible. That assessment of the politics might be correct, but it really makes no sense. First, it would be politically important that whatever revenues are generated are returned in full to the population, and on an equal per person basis. While individual situations will of course vary (and those who lose out on a net basis, or perceive that they will, will complain the loudest), assessments based on current consumption patterns indicate that those in the lowest seven deciles of income (the lowest 70%) will on average come out ahead, while only those in the richest 30% will pay more. It is the rich who, per person, account for the largest share of greenhouse gas emissions, creating costs that others are bearing. And a redistribution from the richest 30% to the poorest 70% would be a positive redistribution.

But second, the alternative to reducing greenhouse gas emissions would need to be some approach based on top-down directives (central planning in essence), or a centrally directed system of subsidies that aims to offset the subsidies implicit in not requiring those burning fossil fuels to pay for the damages they cause, by subsidizing other sources of power even more. Such approaches are not only complex and costly, but rarely work well in practice. And they end up costing more than a fee-based system would. The political argument being made in their favor ultimately rests on the assumption that by hiding the higher costs they can be made politically more acceptable. But relying on deception is unlikely to be sustainable for long.

The sharp fall in costs for clean energy of the last decade has created an opportunity to switch our power supply to clean sources at little to no cost. This would have been impossible just a few years ago. It would be unfortunate in the extreme if we were to let this opportunity pass.

What a Real Tax Reform Could Look Like – III: A Carbon Tax to Address Climate Change

Posted on January 3, 2018, 10:30 pm by aneconomicsense

Source: James Hansen, Global Temperatures, update of December 18, 2017

A. Introduction

The final element of a comprehensive tax reform would be a tax to address climate change. Previous posts have looked at what a true reform of corporate and individual income taxes could look like, plus what could be done to ensure Social Security benefits can continue to be paid in accord with current formulae, and indeed enhanced. This post will look at a tax on greenhouse gas emissions (commonly called a carbon tax, as carbon dioxide is the primary contributor) to address global warming.

There is no doubt the planet is warming – the chart above shows the most recent estimates. And this is primarily due to our economies pouring into the air carbon dioxide and certain other gases (such as methane) that lead to heat being retained by the atmosphere. These greenhouse gases have warmed the planet, leading to an increased frequency of extreme weather events such as the series of remarkably intense hurricanes that hit the US this August and September. The cost, already being incurred, has been staggering. Early estimates of the cost of just Hurricanes Harvey (which hit Texas) and Irma (which hit Florida) reach $290 billion. Hurricane Maria (which hit Puerto Rico) may have cost Puerto Rico as much as $95 billion according to an early estimate (and this excludes the cost to other Caribbean nations it hit).

As I am writing this (January 3, 2018), record-breaking cold has swept over much of the eastern half of the US. And it is forecast to get worse over the next few days. Trump has, not surprisingly, tweeted that this cold shows that global warming is not true. But this illustrates well his ignorance. First, there is more to the world than the eastern US. There is also today unseasonably warm weather in the western US (especially Alaska, relative to what is normal there), as well as in Europe, Russia, and especially Siberia. Overall, the average global surface temperature today is 0.5 degrees Celsius above the 1979 to 2000 average for this time of year, and 0.9 degrees Celsius above that average in the Northern Hemisphere. But second, that blast of cold hitting the eastern US should not be taken as a surprising outcome of global warming. Warming leads to greater volatility in atmospheric currents, including in the jet streams that allow (or block) cold air to come down from the Arctic.

One cannot, of course, attribute with certainty any particular severe weather event (whether hurricanes, extreme hot or cold temperatures, drought or floods, and more) to climate change. We had severe weather events before global warming became significant. But the same is true of lung cancer and smoking: One cannot attribute any individual’s death from lung cancer to his or her smoking. People died of lung cancer before smoking became common. The issue, rather, is that smoking increases the likelihood of getting lung cancer. Similarly, global warming increases the likelihood and hence frequency of severe weather events.

And that is precisely what we have seen. Severe weather events have increased in number in recent years as the planet has warmed and as climate change models have predicted. A database maintained by the National Oceanic and Atmospheric Administration (NOAA, the home of the National Weather Service) has kept track since 1980 of the number of weather and climate disasters in the US which each cost $1 billion or more (in 2017 prices). Over that close to 37 year period the 7 worst years (in terms of the number of such disasters) have all come in the last 10 years (including 2017, which as of end September already had tied the worst full year so far, and will exceed it once fourth quarter data is included).

Global warming, arising from man-made emissions of carbon dioxide (CO2), methane (natural gas), and certain other gases (together, greenhouse gases or GHGs, for the greenhouse effect they cause), is thus imposing a huge cost already on society, and one which will get worse as the planet warms further. It is thus a mark of confusion to say, as Trump and many Republican politicians have, that we cannot “afford” to address the causes of the warming planet. We are already bearing the costs, and those costs will get far worse if nothing is done. The question is whether steps will be taken to reduce those costs by addressing the underlying causes.

The issue is that the costs such GHG emissions cause are not being borne by those who emit those gases. The emitters of GHGs are in effect being subsidized, and encouraged to burn fossil fuels rather than make use of a cleaner alternative. And when a producer is not bearing the full cost of what he is producing, it will be badly done. The key is to charge a tax or fee on such production equal to the cost being imposed on others, so that the producer faces the full cost of what he is making. The producer will then have a reason to make suitable choices on how the product can be made at the least cost to all. And consumers, facing the full costs of what they are buying, can then make suitable choices on whether to buy one product or another.

A suitable tax on greenhouse gas emissions would bring prices in line with the total costs being incurred. A comprehensive tax reform should include this. And it would be straightforward to implement. There is indeed a well worked out plan being promoted by a group of traditional Republican conservatives, the Climate Leadership Council, with the active involvement and endorsements of several Treasury Secretaries in past Republican administrations (Hank Paulson, James Baker, and George Schultz); as well as of individuals such as Michael Bloomberg and liberal and conservative economists such as Larry Summers, Martin Feldstein, and Gregory Mankiw; companies such as ExxonMobil, General Motors, and Shell; and environmental organizations such as The Nature Conservancy and Conservation International.

It is a good plan, and I would suggest basically just copying it. The proposal will be explained below. A one-page summary of the Climate Leadership Council’s specific proposal is available here, while a more complete description is available here. A very similar proposal has also been assessed by the US Treasury, with a brief summary of the Treasury analysis available on the Climate Leadership Council website here, while the complete Treasury analysis is available here on the Treasury website (assuming the Trump administration has not taken it down). The Treasury assessment is excellent, as it reviews precisely how one could implement such a tax, including the practicalities, and arrives at specific quantitative estimates of the impact on different income groups. The analysis below will basically follow the variant of the plan as assessed by the Treasury.

This post will first provide a description of that plan, how it could be implemented, and what the impact on prices might be. Importantly, clean alternatives exist for many of the processes which emit GHGs, particularly from the burning of fossil fuels, which thus can be substituted for processes emitting those gases. This would limit the price impact and smooth the way to sharp reductions in GHG emissions. Furthermore, a key feature of this plan is that the revenues that would be collected by the carbon tax would all be rebated to the American population. The final section will discuss this and the distributional implications. The plan would be revenue neutral – the aim is to change prices so that they fully reflect the costs being incurred, not to raise revenues. And the rebates would be distributionally positive, with the bottom seven deciles of the population (the bottom 70%) coming out ahead after the rebates. Only the top three deciles (top 30%) would see a net loss, as a direct consequence of their disproportionate share in consumption of goods that cause the GHG emissions in the first place.

B. A Carbon Tax to Address Climate Change

In brief, under this proposal a tax would be charged for each unit of GHG pollution emitted. The Climate Leadership Council would set the tax to start at $40 per ton of CO2, with the taxes on other GHGs set in proportion based on their global warming impact per ton relative to that of CO2. This is often called simply a carbon tax, although it is in fact a tax on CO2 (carbon dioxide) emissions and on other GHGs in proportion to their global warming impact. The tax would then rise in real terms over time. The start date would presumably have been 2018, although this was not explicit (the proposal came out in early 2017). The Treasury variant examined a price of $49 per ton of CO2-equivalent starting in 2019 (with some phasing in of the goods to which it would apply until 2021), and then increasing at a rate of 2% a year in real terms from 2019.

Importantly, all revenues collected would be returned directly to the American population. The impact on the federal budget thus would be revenue neutral. There would also be border adjustments for imports and exports (discussed below). The Treasury estimates that at $49 per ton, the carbon tax would lead to a rebate in the first year (2019) of $583 per person, or $2,332 for a family of four. Scaling this in proportion, a $40 per ton carbon tax would lead to a rebate of $476 per person, or $1,904 for a family of four. And the tax would be highly progressive. The Treasury estimated that there would on average be net income gains for the bottom 70% of the population. That is, their rebates would be greater than the higher amounts they would need to spend on goods and services to reflect the cost of the carbon tax.

In more detail, under this plan a price (whether $40 or $49 to start) would be charged which reflects the cost to society of the GHGs being emitted as part of the production process for the good or service being produced. This is called the “social cost of carbon”, and while the concept is clear, it is difficult in practice to estimate precisely. Its value will depend on factors which are difficult to know at this point in time, including the full cost to our economies (starting now and extending many decades into the future) as a consequence of climate change, the cost of technologies to limit GHG emissions (again starting now, and then for decades into the future), and the appropriate values for parameters such as the proper discount rate to use to put the costs and benefits over this range of time all into the prices of today. A fundamental difficulty of GHG emissions is that their impact is not just in the near term, but can extend for centuries. They remain in the atmosphere for a very long time.

Thus while starting at a reasonable cost of carbon (whether $40 or $49) is important, probably more important is how this price should be adjusted over time to reflect actual experience. Some predictability in the path is also valuable, so firms can make their investment decisions accordingly. Thus the Climate Leadership Council plan would have the price rise in real terms over time at some unspecified pace, while the Treasury assessment assumed concretely a rise of 2% a year in real terms. Such a 2% real increase is reasonable.

One should, however, also recognize the inherent uncertainty, as the proper price on carbon is difficult to know before we have any experience with such a plan. Thus one should allow for reassessment and adjustment, perhaps every five years or so, with the pace of price adjustment increased or decreased depending on the observed response. The pace would be raised if we find that GHG emissions are not falling at the pace needed, or reduced if we find GHGs are falling at a more rapid pace than anticipated and needed. Past experience with market mechanisms to reduce pollution (in particular the use of trading schemes to reduce sulfur dioxide and nitrogen oxides pollution) worked surprisingly well, with costs well below what had been anticipated and what would have been incurred through traditional regulatory regimes. The same would be likely, in my view, if we would start to price GHG emissions.

Pricing GHG emissions is also relatively straightforward administratively for the bulk of GHG sources. Fully 76% of GHG emissions in the US come from the burning of fossil fuels. This rises to 83% if one adds in the emission of GHGs in the production of the fossil fuels themselves (at the mine or well-head) plus from the non-energy use of fossil fuels. The carbon tax thus could be applied at the level of the limited number of power plants that still burn coal; at the level of petroleum refineries where substantially all crude oil must be processed; and at the level of gas pipelines as substantially all natural gas is transported via pipelines. A limited number of industrial plants then account for a significant share of the remainder. These include from the use of coking coals in the production of iron and steel; from the production of petrochemicals such as plastics; and GHGs resulting from the production of cement, glass, limestone, and similar products. For these, it would be straightforward to apply a carbon tax at the factory or plant level. There would remain GHG emissions from a range of resources, including in particular in agriculture (accounting for about 8% of GHG emissions in the US), and the Treasury analysis assumes the carbon tax would not apply to those sources. But they are a small share of the total, and an issue one could address in the future.

A key part of the plan is that there would also be a border tax adjustment, where exports would receive a rebate for the carbon taxes paid on their production, while imports would be charged a carbon tax based on the GHGs emitted in their production. The rebate for exports means that US production would not be disadvantaged by being located here, and there would be no incentive from this source to move such plants abroad. This addresses the Trump criticism (and confusion) that such carbon taxes will make US industry uncompetitive. And imports would be charged a carbon tax based on their GHG emissions to the extent such imports do not already reflect such charges (which would likely be the case, as they too would likely be given rebates in their home countries on carbon taxes paid, just as US exports would be).

A feature of this border tax adjustment is that revenues for the US would be generated (and rebated to the US population) in the case where other countries are not themselves charging a carbon tax (or the equivalent, such as in a cap and trade system), but also (given the US trade structure) even when they are. In the first case, where other countries are not at first themselves charging such a tax, imposing the carbon tax on such imports will generate revenues which would be distributed to the US population. This would provide a strong incentive for those other countries to join the US and start to charge a similar carbon tax. And such a border adjustment for the carbon tax would be compliant with WTO rules on trade, as the tax would simply be ensuring that imported goods are being taxed the same as their domestic equivalents are (just as is true for a value-added tax). This is not discrimination against imports, but rather equal treatment.

In the second case, where trading partners are themselves all charging a similar carbon tax (let’s assume), the US would still come out ahead in carbon tax revenues due to our trade structure. US imports of goods are about 50% higher than its exports of goods, and it is primarily in the production of goods that GHGs are emitted. Partially offsetting this in the overall trade balance, US exports of services are about 50% higher than its imports of services. But services are a smaller share of trade, plus services are not as intensive as goods in the GHGs emitted. Overall, the US has a current account deficit (more imports of goods and services than exports), matched by capital inflows being invested in the US. With such a trade structure, the carbon taxes charged on imports will substantially exceed whatever is rebated on exports. The US population would come out ahead. Put another way, producers of goods being sold in the US are currently being provided a subsidy by not charging them for the cost we are incurring due to the greenhouse gases being emitted in their production. Given the US trade structure, a substantial share of this subsidy is going to foreign producers. A tax on such GHG emissions is simply the removal of this subsidy.

C. Price Impacts, and the Viability of Clean Alternatives

Applying the carbon tax will lead producers to raise their prices if they do not otherwise adjust their processes. For transportation fuels, for example, the Treasury analysis estimated that at $49 per ton of CO2 (and its equivalent for other GHGs), the tax would equal 44 cents per gallon for gasoline, or 50 cents per gallon for diesel fuel. While significant, such increases are not huge. There have been far greater fluctuations in such fuel prices in recent years in response to the price of crude oil rising or falling, and consumers and the economy have been able to accommodate such changes.

More broadly, and expressed in terms of percentage increases, the Treasury analysts estimated that if the cost increases from the carbon tax were all fully passed along, the price of gasoline would rise by 11.8%, home heating oil by 12.4%, and air transportation by 7.5%. The price of natural gas would go up by 27.0% and the price of electricity by 16.9%, but note these are the prices of just the energy alone. The delivered price to our homes also includes distribution and other charges. For natural gas, for example, the energy component of my bill (in Washington, DC) was just 44% of my total bill over the last 12 months, so a 27% increase in the wholesale cost of natural gas would mean a 15% increase in my overall bill for gas. There would be no reason for distribution and other such charges to go up by any significant amount, as their costs depend on the volume delivered and not on the wholesale cost of the gas being delivered (and similarly for electricity). Overall, the Treasury analysis forecasts that prices in general would go up by 2.6% if the new carbon tax (at $49 per ton of CO2) were fully passed forward.

But the higher costs would provide incentives both to producers to change how they make things, and to consumers to take into account the total costs in their decisions on what to buy. One would see this most importantly (given its share as a source of GHG emissions) in how electricity is produced. Generating electricity by the burning of fossil fuels is now heavily subsidized, in effect, as nothing is charged for the cost of the damage done (hurricanes and other severe weather events, and more) by the resulting GHG emissions. But even with such subsidies going to those who burn fossil fuels, solar and wind produced power is now competitive (even without the subsidies going to solar and wind – see below) for newly built power plants, and indeed has been for some years. See the careful analysis of the relative costs that is undertaken annually by Lazard (see here for their November 2017 report). Indeed, Lazard found in its 2017 analysis that at current costs, utility-scale solar and wind generation is now often cheaper than just the operating costs of coal or nuclear plants, thus encouraging such substitution even when the capital costs of coal and nuclear plants are treated as a sunk cost.

Furthermore, solar and wind technology is still developing, with costs falling rapidly, while at this point the further reduction in costs in traditional power generation is slow. Lazard estimates the levelized cost of energy production at a new installation (in terms of dollars of overall costs, including capital costs, per megawatt hour of electricity generated, and excluding explicit subsidies on renewables) fell by 72% between 2009 and 2017 for utility-scale solar installations and by 47% for wind generation (to prices of $50 and $45 per megawatt hour, for solar and wind respectively; this is equivalent to 5 cents and 4.5 cents per kilowatt hour). In contrast, the cost for power generated by coal fell by just 8% over this period (to $102 per megawatt hour) and by 28% for natural gas (to $60). And the full levelized cost for nuclear power generation actually rose by 20% over the period (to $148).

There is, of course, wide variability in the cost of solar and wind across the country, depending on local conditions. Existing coal and nuclear plants are also of various ages and efficiencies, and hence also of varying costs. Thus overall averages tell only part of the story. The cost competitiveness (on average) of new installations does not mean that all new installations will be solar or wind, much less that all generation would or could shift immediately. But the now competitive costs have led to a bit over 50% of all new generation capacity built in the US over the last 10 years (2007 to 2016) to come from installations of solar, wind, or other renewables (with most of the solar coming only in the second half of that period).

No transition will be instantaneous, but should a significant carbon tax be imposed (of $40 or $49, for example), one should see an acceleration in the pace of such substitution of renewables for fossil fuels. And with such substitution, the impact on higher power prices will be limited in time, and should soon decline.

The other major user of fossil fuels is transportation, and here one sees a similar dynamic. Electric battery powered cars are now either competitive in cost or close to it (depending on how one values other attributes, such as better performance and inherently easier maintenance), and a carbon tax will accelerate the transition to such vehicles. And battery-powered vehicles are not just limited to cars. Tesla has announced plans to produce heavy trucks powered by batteries, with a range of up to 500 miles on a charge. Costs would be more than competitive with traditional fueled heavy trucks, and a substantial number of pre-orders have indeed already come in from owners of large trucking fleets. There is an interest at least in trying this. And with battery-powered heavy trucks possible, the same is true for full-size buses.

Again, starting to charge for the costs borne by society from the CO2 and other GHGs emitted in transportation would accelerate the shift to less polluting vehicles. It won’t happen overnight. But that shift will limit the extent and duration of higher costs stemming from charging a carbon tax.

And while such a tax alone will not lead to zero GHG emissions with current technologies available, it would be a giant step in that direction. It would also provide a strong incentive to develop the technologies that would carry this further and at a lower cost.

D. Distributional Implications

Finally and importantly, the funds collected by the carbon tax would be fully rebated to all Americans, with the same amount rebated per person. The Treasury analysis estimated that at $49 per ton of CO2 in 2019, the carbon tax would collect funds sufficient to provide a rebate of $583 per person (for the year), or $2,332 for a family of four. The rebate could be provided annually or quarterly, or even monthly, and through the IRS or Social Security.

The rebates would also be distributionally positive. The poor would indeed benefit on a net basis. Being poor, they do not consume that much, and thus do not account for a high share of GHG emissions. The rich, in contrast, not only consume more (they are rich, and can afford more), but the products they buy are also more polluting in greenhouse gases (big gas-guzzling cars rather than small fuel-efficient ones; jet travel for vacations but not public transit; large homes kept heated and air-conditioned rather than smaller homes and apartments; etc.). Thus the rich will receive back less than what is paid in carbon taxes on the goods they consume, while the poor will receive back more. Furthermore, because the poor are poor, a given dollar amount rebated to them will be a higher percentage of their (low) incomes, than the same dollar amount would be (in percentage terms) for the rich.

The impacts are significant. The Treasury analysis (based on data they use for their tax simulation models) concluded that the impacts by family income decile would be:

Net Impact on Income from $49 per ton Carbon Tax, with $583 per Person Rebate, by Family Decile

Decile	% of Income
0 to 10	+8.9%
10 to 20	+4.7%
20 to 30	+3.1%
30 to 40	+2.0%
40 to 50	+1.2%
50 to 60	+0.6%
60 to 70	+0.1%
70 to 80	-0.3%
80 to 90	-0.7%
90 to 100	-1.0%

Families are ranked here by income decile, so the first decile (0 to 10%) is made up of the 10% of families (in number) who have the lowest incomes, the second decile (10 to 20%) is made up of the 10% of families with the next lowest incomes, and so on, up to the richest 10% of families (90 to 100%).

The results indicate that on a net basis (i.e. after taking account of the higher prices that would be paid on goods purchased, reflecting the carbon tax at $49 per ton), the lowest income decile families would see an increase in their real incomes of 8.9% following the $583 per person rebate. This is quite substantial. And the analysis found there would be a similar, positive, gain for all families up through the 7th decile, although at diminishing shares of their income. The top 3 deciles would end up paying more on a net basis, due to their greater purchases of goods where greenhouse gases are emitted (both in total amount and in the mix of their goods). But the net cost reaches just 1% of incomes for the richest decile. It is only a small share in part because their incomes are of course the highest. This tax is not unaffordable.

E. Conclusion

To conclude, imposing a carbon tax is administratively practical, would bring prices and costs in line with the costs being borne by society when greenhouse gases are emitted, and even with current technologies would lead to a significant shift away from processes that are warming our planet. It is a fundamental confusion to assert, as Trump and others have done, that “we cannot afford it”. That is nonsense: We are paying the costs already (in an increased frequency of severe weather events, in droughts in some areas and floods in others, and other such impacts), and they will get far worse if nothing is done. Furthermore, such a carbon tax would not reduce our competitiveness when applied equally to imported items (and rebated for exports). Indeed, with our current trade structure, the US would come out ahead financially by starting to charge for GHG emissions.

Such a tax also would be distributionally highly progressive, as the poor would come well ahead on a net basis with the revenues collected being rebated back to the population. Indeed, it is estimated that the bottom 70% of the population would come out ahead on a net basis. And while the rich would end up paying more, reflecting their greater consumption and the GHG intensity of the goods they buy, this would come just to 1% of the incomes of the richest 10% of the population.

Such a tax on GHG emissions would be the final component of what a comprehensive tax reform really should have looked like. As discussed in the preceding posts on this blog, there should have been a reform to simplify corporate and individual income taxes (with all sources of income taxed similarly), plus action taken on Social Security taxes to ensure the system will be sustained for the foreseeable future. None of this was done. Nor was any action taken to address climate change, where the subsidy we are implicitly providing fossil fuels and other sources of greenhouse gas emissions (by not charging for the damage being done as a result of those emissions) could have been addressed by a tax on such emissions.

This is not surprising, unfortunately. There are important vested interests in the fossil fuel industries (coal, oil, and gas) that benefit from not being charged for the damage their fuels are causing. As a rationalization of this, Trump and much of the Republican Party continue to deny that climate change even exists. But the result will be that the damage being done, already large, will grow over time. Plus, once the doubters do finally recognize it, the actions that will then need to be taken will be more costly and disruptive than if action were taken now.

As discussed above, there is no practical or special administrative difficulty to addressing the climate change problem now. It would be straightforward to implement a tax on GHG emissions. And the sooner this is done, the better.

An Economic Sense

It's the Economy, Stupid!

Tag Archives: climate change

A Carbon Tax with Redistribution Would Be a Significant Help to the Poor

The Increasingly Attractive Economics of Solar Power: Solar Prices Have Plunged

What a Real Tax Reform Could Look Like – III: A Carbon Tax to Address Climate Change

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