Could Clean Energy Tax Credits Be More Effective than a Carbon Price?

While most economists believe that putting a price on carbon is the most efficient way to reduce emissions from electricity generation, the attention of U.S. state and federal lawmakers has instead focused on clean electricity standards or clean energy tax credits. Which approach will lead to the least emissions during a clean energy transition? Which will raise electricity prices the most? Which will contribute more to public budget deficits? Which is most efficient? A new study answers these questions and casts doubt on assertions that carbon pricing is necessarily the most efficient policy for deeply decarbonizing the grid.

“Policymakers have many factors to consider when deciding which policy approach to endorse, and all approaches have tradeoffs,” says study co-author Ryan Kellogg, a professor at the University of Chicago Harris School of Public Policy. “Our evaluation found that a clean electricity standard and clean energy tax credits have many advantages, and that they might even be more efficient than a carbon price in practice.”

Kellogg and his co-author Severin Borenstein, professor of the Graduate School at the Haas School of Business and faculty director of the Energy Institute at Haas, evaluated the three approaches most often considered for driving electricity sector greenhouse gas emissions to nearly zero: 1) carbon pricing, either through a tax that mandates generators pay for the carbon they produce or through cap-and-trade where firms trade permits to stay within a set carbon budget; 2) clean electricity standards that specify a minimum share of all generation that must come from zero-emissions sources; and 3) clean generation subsidies, either through a production or investment tax credit. For each policy, they consider a gradual increase in policy stringency that transitions the U.S. grid to 90 percent zero-emissions energy supply.

Borenstein and Kellogg first examine how the policies may lead to different greenhouse gas emissions during the transition. A virtue of pricing carbon is that doing so especially penalizes fossil fuels like coal that are the “dirtiest.” Clean electricity standards, on the other hand, just distinguish between “clean” and “dirty” fuels, so that as clean electricity supply increases, fossil-fueled generators exit the market in order of highest to lowest operating cost, not accounting for emissions intensity. Borenstein and Kellogg point out that the importance of this distinction comes down to the alignment between the emissions intensity and the operating cost of fossil fuel sources. They show that unless natural gas prices are high, this alignment is actually quite close, so that clean electricity standards may reduce emissions almost as effectively as a carbon price. In fact, using pre-pandemic 2019 fuel prices, a carbon price eliminates just 2.2 percent more emissions than the clean electricity standard during a clean energy transition.

The authors then consider the impact on electricity prices and government revenue from the different policies. Carbon pricing leads to the highest electricity prices for consumers and generates government revenue during the transition. Prices under a clean electricity standard are lower and raise no government revenue. Under clean electricity tax credits prices are lower still and require government spending.

Economists typically view the high prices under carbon pricing to be efficient, since these prices reflect the full social cost of electricity and therefore give consumers the right incentives to conserve. Under this logic, the low prices under the alternative policies then lead to over-consumption of electricity. Borenstein and Kellogg, however, point out that this logic is unlikely to hold in a decarbonized grid. First, utilities mark up the retail price of electricity substantially above the wholesale price to cover the fixed costs associated with electricity transmission and distribution, as well as utility programs such as subsidies for energy efficiency and rooftop solar. In many parts of the United States these utility markups can be more than twice the cost of producing the electricity itself.

If the grid is decarbonized using a carbon price, the combination of these markups with carbon pricing then implies that consumers will be paying electricity prices that substantially exceed the cost of generation, including the cost of greenhouse gases and other pollutants. This over-pricing of electricity is especially problematic if the pathway to decarbonizing other sectors of the economy—especially transportation and building space heating—is electrification. Clean electricity tax credits that result in lower wholesale electricity prices may then be better at efficiently aligning retail prices with social costs.

“We found that the standard economic logic of carbon pricing doesn’t fit the electricity sector very well, due to the other pricing distortions in the industry that have necessitated other regulations,” says Borenstein.  “Carbon pricing is still a powerful tool, but this shows it is important to think through the full context in which we are doing greenhouse gas regulation.”

This article originally appeared at Energy Policy Institute at the University of Chicago.