How The U.S Prices Carbon
Understanding the Complexities of Pricing Carbon and its Implications for Energy Prices in the US
Despite not having a federal carbon tax, the United States has numerous state and federal programs that incentivize companies to reduce their carbon emissions.
In theory, a carbon price should reflect the social cost of carbon, which is the damage that GHG emissions cause to the environment. Underlying this, is an assumption that the prices of carbon-intensive goods like energy reflect their marginal private cost, which should happen in a competitive market. However, in the US, the retail prices of electricity and natural gas are often set by regulatory processes, not a competitive market.
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The primary source of GHG emissions in the US is fossil fuel combustion, which also includes the production and distribution of natural gas and electricity. These sectors require significant infrastructure costs related to the energy transition and are often operated as regulated monopolies, with regulatory agencies authorizing retail energy prices that exceed the marginal private costs of production and distribution to enable recovery of capital investments and operating expenses.
The increasing capital investment costs in the USA's regulated retail electricity and natural gas prices have been a growing concern for both consumers and policymakers. The reasons for this escalation are multifaceted and include the need to upgrade aging transmission and distribution systems, climate change mitigation efforts, and climate change adaptation. With the increase in investment costs, the regulatory regime has been recovering non-incremental costs in volumetric rates, leading to upward pressure on retail electricity and natural gas prices. As a result, retail prices have exceed marginal costs by a considerable margin.
California is a key jurisdiction to examine when analyzing the impact of climate change mitigation and adaptation investments in the power sector. The state has been at the forefront of investing in these areas, and it has shown in the retail electricity rates. According to a study by Borenstein et al. (2021), California households are paying retail electricity prices that are two to three times the SMC, which is the standard marginal cost. This gap is expected to widen as the state prepares to invest billions in wildfire-related grid hardening, new transmission projects, distribution system upgrades, and public purpose programs. These investments are essential for ensuring that California's power system can withstand the effects of climate change, but they also come at a cost to consumers.
While pricing carbon at the textbook-prescribed level would result in retail energy prices that are too high, the current and future trends in regulated residential electricity and natural gas prices have implications for carbon pricing policies going forward. Policymakers must take into account the current regulatory regime, the increasing capital investment costs, and the need for carbon pricing policies that balance the goal of reducing GHG emissions with maintaining affordable energy prices for consumers. The challenge is to design a carbon pricing policy that strikes a balance between achieving the social cost of carbon and ensuring that retail energy prices remain affordable for consumers.