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PRICING POLLUTION IN A COMPETITIVE MARKET

It is now broadly accepted that external costs in electricity production will play an increasing role in shaping future energy policy. Drawing on two major 1995 studies, mechanisms devised to account for external costs in competitive markets are reviewed. Three broad categories of costs are identified and approaches to quantifying costs in monetary terms discussed. Although only a few markets have specifically included external costs in electricity prices, mechanisms such as taxes and integrated resource planning are effectively applying external costs in a number of other markets. The author argues that such implicit use of external costs is probably the best solution in today's political climate where green issues are subordinate to economics.

External costs are set to play an increasing role in shaping future energy policy. Cleaning up the business of power supply has been declared a fundamental aim of governments around the world. They are now recognising the monumental costs to society of pollution -- costs the electricity industry is a major contributor to. The task facing energy policy makers is how best to go about the job of reducing pollution in electricity generation when in most countries external costs are not reflected in the market price of the end product. If they were, the price of fossil fuel technology and nuclear would rise, making wind energy one of the cheapest technologies around.

In the west, strict regulation of fuel mix as the best way of reducing pollution has largely been abandoned -- history has taught us that regulated markets lead to inefficient and monopolistic industries, inflexible and highly resistant to necessary change. Uncovering all external costs in such a structure has proved to be impossible; they have remained an invisible burden on national economies or been passed through to consumers in taxes. With the regulation option discarded, governments have been left grappling with a plethora of ideas for getting external costs included as an integral element of the competitive electricity markets of the future -- without interfering with beneficial free market forces. Not all governments are following this route, but there is a clear trend in that direction.

At one end of the spectrum is Denmark, determined to bring about a 20% cut in carbon dioxide emissions. It has an efficient distribution system and plenty of renewables -- all promoted by carefully designed energy taxes which, in effect, apply external costs to conventional generation. Britain, seemingly at the other end of the spectrum, has an unambitious target for carbon dioxide reductions, with consideration of external costs presently sidelined. Ironically, despite deregulation of the UK market, renewables are still at the mercy of government legislation requiring utilities to purchase a fixed amount of renewables generation. A market mechanism for sending the right signal on pricing -- and thus opening the door to renewables -- awaits.

Deregulation of the power market, it would seem, can either aid or hamper the quest for proper recognition of external costs. It all depends on the details. Crucial to the process is the willingness of governments to mandate that all energy options compete on an equal footing. This will spur utilities to take the full costs of electricity generation into account. Such levelling of markets will also require that the hidden subsidies to conventional technologies are forced into the open -- one of the potential benefits of privatisation, "unbundling," or deregulation. What is needed are fair and workable procedures to achieve, to use the jargon, "internalisation" of external costs.

Three cost categories

Before looking more closely at the procedures available, a brief analysis of the make-up of external costs will help explain why there is such controversy about how to quantify them. External costs, or at least some elements, are difficult to quantify, but they are nonetheless real. If the enormous costs of cleaning up after the Chernobyl nuclear disaster had been taken into account when the plant was constructed, it clearly would never have been built. Although there is general agreement as to the broad definition of external costs -- costs attributable to an activity that are not borne by the party involved in that activity -- there are widespread variations in defining the boundaries. Arguments for the external costs attributable to oil fired generation range from supertanker spillages, to a substantial proportion of western defence budgets. In other words, external costs for energy are infernally complicated. For simplification they can, however, be divided into three broad categories:

¥ hidden costs borne by governments

¥ costs of the damage caused to health and the envi-

ronment by emissions other than CO2

¥ the costs of global warming attributable to CO2

emissions

The first category includes the cost of regulatory bodies and pollution inspectorates (generally minimal) and the cost of energy industry subsidies and research and development programmes. These are not so minimal. In the ground-breaking analysis of external costs published by the European Commission in 1988, The Social Costs of Energy Consumption, by Olav Hohmeyer, it was calculated that support to the German coal industry added DEM 0.002/kWh to the price of electricity. Hohmeyer also assigned a cost of DEM 0.0235/kWh for nuclear R&D, compared to around DEM 0.004 DM/kWh for wind.

The second category, costs due to emissions which cause damage to the environment or create health problems, make up 10-20% of the external cost of power generation, depending on the fuel used. They include a wide variety of external effects, including damage from acid rain and damage to health from oxides of sulphide and nitrogen from thermal power stations. In a new study of external costs recently released by the European Commission, ExterneE, the cost of damage to health was estimated by calculating the loss of earnings and cost of hospitalisation of people susceptible to respiratory diseases.

Other costs included in the damage and health category are power industry accidents, whether they occur in coal mines, on offshore oil or gas rigs, or in nuclear plant. The probability of a nuclear accident in Western Europe might be extremely low, but should a catastrophic failure occur the costs would be undeniably huge. Multiplication of a number close to zero (the probability of a nuclear accident) by a number close to infinity (the cost of such an accident), does not necessarily give a meaningful result. Fortunately, public opposition and the high costs of nuclear power plant means they are a dying breed and eventually the need for such statistical juggling will become obsolete.

The third category is by far the largest: external costs due to greenhouse gas emissions which cause global warming, with all its associated effects. This category accounts for some 40-80% of the hidden costs of the world's consumption of electricity. It is also the most contentious area of the external costs debate. The range of estimates for the possible economic implications of global warming is huge in the studies conducted to date. Costs associated with climate changes, flooding, changes in agricultural patterns and other effects all need to be taken into account.

in dollars and cents

Clearly, discussion of the make-up of external costs could continue ad infinitum. But they are no less real for that. What is important is that governments and regulators should not allow the uncertainty surrounding external costs to inhibit acknowledgement of their existence when energy options are being considered. To aid decision makers, studies over the past eight years have identified and quantified the pollution caused by the electricity business. Importantly, they have also tackled the job of putting a dollars and cents evaluation on that pollution through the so-called "monetarisation" of external costs.

Hohmeyer, ExternE, and other studies have looked at overall damage potentials on health and the environment, assigning a cost penalty to each generating technology, depending on the fuel used. This approach enables the difference in external costs between, say, coal and wind, to be easily compared. Another approach to monetarisation, from a slightly different angle, calculates costs per pollutant, remembering that different fuels generate different quantities of pollutant. Typically these penalties, as proposed by some states in America today, are around $10/tonne for CO2 and up to $25,000/tonne for SO2 (fig 1). Since the quantities of each pollutant emitted per kilowatt hour are well known for the differing fuels, these costs per tonne enable calculation of the external cost of each unit of electricity. Coal fired generation produces the most pollutants, about one kilogram of CO2 per kWh, plus SO2 and other pollutants, thus attracting the highest penalties (fig 2).

Significantly, the external cost assigned to coal on both sides of the Atlantic -- and using both approaches to monetarisation -- adds about one US cent to each kWh. That being the case, it would seem that the various exercises in monetarisation are to be relied upon.

Market mechanisms

Once the job of assigning precise monetary values to the cost of pollution has been achieved, the next step for governments is to use this knowledge for defining energy policies which can reconcile economic development with a sustainable future. To achieve more use of clean electricity generating technologies, governments could choose to regulate the precise fuel mix, allocating percentage quotas to each technology. But that leaves them responsible for correctly second-guessing all conceivable factors which might and might not influence future markets, from war in the Middle East to an invasion from Mars; an impossible task and not one which history has revealed them to be particularly adept at. For this and other reasons, the current vogue is to deregulate.

In free markets, however, short term interests prevail, with external costs ignored, as in Britain today. To ensure a market also takes account of long term economics, governments can introduce taxes as market mechanisms. This is the route chosen by several American states, Denmark and the proposed European Union carbon tax, among others.

Assigning cost penalties to polluting technologies brings market forces into play -- the price of dirty technology is pushed up and wind becomes relatively cheaper. Several American states have already taken the step of assigning external costs to the principal pollutants, as the US Energy Information Administration reveals in its recent study, Electricity Generation and Environmental Externalities: Case Studies.

The European Union's proposals for a carbon tax are still frustratingly stymied in inter-government disagreement on the basics of whether external costs should be reflected in electricity prices. The EU's approach would alter the balance between coal, gas, nuclear and wind (figure 3), with the proposed tax levels clearly reflecting the mid range of estimates for damage (table 2). They are also consistent with other tax proposals (figs 1-2). If applied, wind would undercut coal and nuclear, but not gas. The proposed EU levy includes an "energy" element as well as a "carbon" component, which is why nuclear is penalised. The tax was intended to be "fiscally neutral," with tax revenue supposedly used for measures such as energy saving. Relief from the tax was proposed for energy-intensive industries, but some countries, particularly the UK and France, remain concerned that higher energy taxes would reduce the competitiveness of their industries in global markets.

Nevertheless, several European countries have gone ahead and introduced carbon taxes, including Denmark, the Netherlands, Sweden, Finland and Norway. As one of the first, Denmark has implemented a wide range of measures aimed at encouraging its energy industries to become more efficient and to reduce harmful emissions. The taxes are applied to fuels and to electricity, but also focus on consumption, with space heating, for example, attracting the highest tax rates. However -- and this is crucial -- the tax revenue will be used to encourage measures such as recycling and energy efficiency. In addition, firms will be allowed rebates if they initiate such schemes. The aim is a 20% reduction in carbon dioxide emissions by 2005 -- one of the highest targets in the world, albeit from a country with an electricity industry emitting more pollution per head of population than almost anywhere in the world.

An alternative approach to the problem of reflecting external costs -- and one which possibly causes less economic disturbance -- is to assign the renewable energies "environmental credits." This is the basis of the one-and-half cent "production tax credit" currently available to wind power in the United States. The approach has the merit of simplicity and has only a marginal effect on energy costs, but it is not a true integration of external costs into market prices. The taxpayer forks out, not the electricity consumer.

Applying common sense

A third approach -- and one favoured by many American states, as the US report makes clear -- is to use "integrated resource planning" (IRP) to assess future generating plant needs. The beauty of IRP is that, in complying with government mandates to consider all energy supply options, the regulatory body simply accepts the argument for external costs and assumes they are to be applied, without actually imposing any. The net result is to make some renewables (like wind) a competitive option. It also helps to ensure that power plants are built in the right place and that the electricity network operates efficiently. Denmark shows this can be done, Britain is showing the need for it. IRP, it seems, achieves the best of both worlds -- a competitive market operating under guidelines aimed at long term economic (environmental) responsibility.

Warning bells have been sounding, though. Recent studies in California and elsewhere indicate that the net result of this approach is simply to shift the utility plant mixes in favour of gas, which is currently cheap and which has lower external costs than coal. Renewables profit, but their additional market share so far remains relatively small. It is important to remember, however, that gas is unlikely to remain so cheap indefinitely. What's more, given time, government and popular pressure will accelerate the introduction of renewable energy technologies.

The popular desire of consumers for more clean electricity is graphically illustrated in the trend towards "green pricing" in the US, Australia and Europe. Given the choice, electricity consumers will pay more for green electricity. In the Pacific Northwest of the US, a modest 4% increase in rates is making a utility 20% "green" and the initial reaction of the consumers is 75% in favour. But while "green pricing" is a clear signal to governments to get renewables into the market, it cannot be regarded as a substitute for a fair energy policy. Neither will green pricing, though highly democratic, necessarily deliver the most efficient system overall. A little bit of IRP needs to be built into the process.

It would thus seem that the American solution of IRP with a tacit admission of external costs is the best solution. Efficiency and the renewables are encouraged, discussions are public, and consumers -- if they wish -- can vote through their pockets for more renewables. Whether the consumers should be the ultimate arbiters of the value of external costs, or whether they should mandate governments to take action on their behalf, is a point in serious need of government attention. It is high time consumers were listened to on this crucial issue.

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