Internalizing the carbon externality : greenhouse gas mitigation’s financial impact on electric utilities and their customers

Social, political, and economic trends suggest that the United States may soon join other United Nations Framework Convention on Climate Change (UNFCCC) countries in drafting substantive, national climate change policy. After providing a brief overview of past and present climate action taken both nationally and internationally, this paper explores different economic solutions to address the externalities of fossil fuel emissions. Alternatives include command-and-control regulation, a carbon tax, and a cap-and-trade program. Several factors, including domestic political anti-tax sentiment, suggest that a cap-and-trade framework is the most promising market-based alternative to reduce carbon emissions within the United States’s electricity sector. Case studies focus on the power generation components of four Texas utilities: Austin Energy, CPS Energy of San Antonio, NRG Energy, and Luminant and assess cap-and-trade’s ramifications on electricity prices. Utilities would seek to pass through to customers in the form of higher electricity prices up to 100 percent of expenses incurred from mitigating greenhouse gas (GHG) emissions. Three primary factors will determine how a given carbon dioxide cap-and-trade allowance price will affect the electricity price charged by utilities: the carbon intensity of the generation fuel mix, whether the wholesale electricity market is regulated or competitive, and whether greenhouse gas allowances are auctioned or grandfathered to covered entities. Consumer elasticity would determine resulting demand for the higher priced energy. Relatively inelastic electricity consumption could cause electricity sector customers to incur financial losses approximately eight times larger than producers by the year 2020 under a mature cap-and-trade framework. Furthermore, evidence suggests market-based GHG reduction tools such as a cap-and-trade schema alone are not sufficient to decarbonize the electricity generation sector. Without complementary regulatory policies that mandate transition to clean energy sources, cap-and-trade will only succeed in redistributing the opportunity cost associated with the carbon externality.