True Energy Costs

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Market prices of energy often diverge from the true cost to society of consuming that energy. Two of the most common reasons for that divergence are external costs and subsidies, both of which make consumers think that energy is less expensive to society than it really is, and hence lead to more consumption of energy than would be economically optimal.


According to J. M. Griffin and H. B. Steele (1986), external costs exist when "the private calculation of costs differs from society's valuation of costs." Pollution represents an external cost because damages associated with it are borne by society as a whole, not just by the users of a particular fuel. Pollution causes external costs to the extent that the damages inflicted by the pollutant are not incorporated into the price of the fuel associated with the damages. External costs can be caused by air pollution, water pollution, toxic wastes, or any other damage to the environment not included in market prices for goods.

Some pollutants' external costs have been "internalized" because the resulting damage has already been incorporated into the price of energy by a tax on the energy source, or because an emissions-trading regime has been established to promote cost-effective control of that pollutant. The pollutants may still cause environmental damage, but these damages have been made internal to the economic calculations of consumers and firms by the taxes or emissions-trading schemes. They are thus no longer external costs.

For example, sulfur emissions from utility power plants in the United States are subject to an emissions cap and an allowance-trading system established under the Clean Air Act. An effective cap on annual sulfur dioxide emissions took effect in 2000, so no more than 8.95 million tons of SO2 can be emitted annually. Utilities that want to build another coal plant must purchase sulfur emission allowances from others who do not need them. This system provides a market incentive for utilities to reduce their sulfur emissions as long as the cost of such reductions is less than the price of purchasing the allowances.


Subsidies represent an often hidden financial benefit that is given to particular energy sources by government institutions in the form of tax credits, research and development (R&D) funding, limits on liability for certain kinds of accidents, military spending to protect Middle East oil supply lines, below-market leasing fees for use of public lands, and other forms of direct and indirect government support for energy industries. Subsidies affect choices between different energy sources (which garner different levels of subsidy) and between energy-efficiency and energy supply choices (because some energy-efficiency options that would be cost-effective from society's point of view may not be adopted when energy prices are kept artificially low by the subsidies).

Subsidies can be created to reward important political constituencies, or they can promote the adoption of particular technologies. For example, an energy technology that has desirable social characteristics and low external costs might be a recipient of tax subsidies in the early stages of its development, so that it can gain a foothold against more established energy forms. This kind of support can be especially important for mass-produced technologies that have high costs when few units are being manufactured, but could achieve significant economies of scale in large volume production if the technology were widely adopted. The subsidy can provide the initial impetus that allows the technology to achieve lower costs and widespread acceptance. This rationale was the one used to justify the early subsidies of wind generation, which eventually led to the creation of an economically viable and internationally competitive U.S. wind industry.

Subsidies can also apply to the creation of new technology, through funding of research and development (R&D). The rationale for government subsidies for R&D (particularly long-term R&D) is well established in the economics literature. Companies will not fund the societally optimal level of basic R&D in new technologies, because many of the benefits of such research will flow to their competitors and to other parts of the economy (Mansfield 1982, pp. 454–455). Innovations are often easy to imitate, so which the innovators spend money on R&D, the followers can copy those innovations and avoid the risk and expense of such spending. R&D therefore has characteristics of a "public good."

Subsidies for relatively new energy technologies or fuels tend to be small in the aggregate and they tend not to have a measurable effect on the overall price of energy. When subsidies apply to widely used energy sources, however, they may create significant economic distortions, and the divergence from long-term economic efficiency may be substantial. Such distorting subsidies can sometimes exist for years because they are defended by powerful political constituencies.


A comprehensive analysis of external costs and subsidies must treat each and every stage and phase in the process, which makes any such calculation inherently difficult. Uncertainties abound in these calculations, especially for external costs. As a result, estimates of total external costs and subsidies for different energy sectors vary widely.

External costs for fossil fuels are generally largest at the point of end use (combustion), though exploration (oil and gas drilling, mining), processing (refineries), and transportation (pipeline ruptures, tanker spills) can each contribute significant external costs in particular cases. For nuclear power, the accident risks associated with the conversion stage and the long-term issues surrounding disposal of spent fuel are the external costs that typically garner the most attention. There are also external costs from other stages of the nuclear fuel cycle, including the various effects of exploration, harvesting, and processing, as well as the risk of nuclear weapons proliferation from the spread of fissionable materials and related knowledge.

For nonfuel renewables such as hydroelectricity and wind power, external costs are most significant at the point of conversion (e.g., salmon migration blocked by dams, birds killed by wind turbine blades, noise and visual pollution from wind turbines). Construction of dams, particularly large ones, can also cause significant externalities by flooding large land areas, displacing people and wildlife, releasing methane from anaerobic decay of plant matter, and affecting local evapotranspiration rates. In contrast, generation of electricity using solar photovoltaics has few external costs, with the exception of small amounts of pollutant emissions from the manufacture and installation of the modules.

Most analyses of external costs have focused on electricity because of regulatory activities in that sector. One analysis of energy-related externalities in all sectors was conducted by Hohmeyer for Germany (Hohmeyer, 1988), but such comprehensive estimates are rare. For those analyses that have been done, estimates of external costs range from near zero (for photovoltaics and energy efficiency), to amounts that are significant relative to the market price of energy for some fossil fuels and nuclear power. The uncertainties in these calculations are typically quite large.

The most common subsidies for fossil fuels have been R&D and production incentives that have affected exploration and harvesting. R&D funding has also been important for fossil-fired, end-use technologies, such as furnaces that use a particular fossil fuel. For nuclear power, significant subsidies exist for processing/refining of fuel, R&D (which affects most stages), limitation of accident liability from operation of the plants, and management of long-lived wastes from the fuel cycle.

A U.S. federal tax subsidy exists for wind generation and certain kinds of biomass-fired power plants built before December 31, 2001. Qualifying wind and biomass generators are paid 1.7 cents per kilo-watt-hour generated over their first ten years of operation (the amount paid per kilowatt-hour increases over time at the rate of inflation). In the early days of wind generation there were subsidies in the United States for wind capacity installed, but these subsidies were phased out in the mid-1980s. R&D subsidies have been important for the development of new and more reliable renewable energy technologies. For energy-efficiency technologies, R&D funding and consumer rebates from electric and gas utilities have been the most important kinds of subsidies, but there has also been subsidization of installation of energy-efficiency measures in low-income housing. As the electric utility industry moves toward deregulation, states are increasingly relying on so-called "systems benefit charges" to fund subsidies for energy efficiency and renewable energy sources.

Unfortunately, the most recent estimates of energy subsidies in the United States date from the early 1990s and earlier, and such subsidies change constantly as the tax laws are modified and governmental priorities change. It is clear that total subsidies to the energy industries are in the billions to a few tens of billions of dollars each year, but the total is not known with precision.


External costs and subsidies for both energy efficiency and supply technologies must be included in any consistent comparison of the true energy costs of such technologies. Pollutant emissions from supply technologies are both direct (from the combustion of fossil fuels) and indirect (from the construction of supply equipment and the extraction, processing, and transportation of the fuel). Emissions from efficiency technologies are generally only of the indirect type. Increasing the efficiency of energy use almost always reduces emissions and other externalities.


While exact estimates of the magnitude of external costs and subsidies are highly dependent on particular situations, a hypothetical example can help explain how these two factors affect consumers' decisions for purchasing energy. In round numbers, if subsidies are about $20 billion for energy supply technologies, and total direct annual energy expenditures for the United States are about $550 billion, the combined cost of delivering that energy is $570 billion per year. This total represents an increase of about four percent over direct expenditures for energy.

Including external costs associated with energy supplies would increase the cost still further. Typical estimates for external costs for conventional energy supplies are in the range of 5 to 25 percent of the delivered price of fuel (for the sake of this example, we assume that these percentages are calculated relative to the price of fuel plus subsidies). If we choose ten percent for externalities in our example, we can calculate the "true energy price" that the consumer would see if subsidies and externalities were corrected in the market price. If the average price of fuel (without any taxes) is P, then the price of fuel correcting for subsidies is P × 1.04, and the price of fuel correcting for both subsidies and externalities is P × 1.04 × 1.10. So in this example, the price of fuel would be about fourteen percent higher if subsidies and externalities were correctly included in the price.

If the particular energy source in question is already taxed (say at a five percent rate), then part of the external cost is already internalized. The true cost of fuel would remain the same (P × 1.04 × 1.10) but the size of the additional tax needed to correct for the externality would be smaller (about five percent instead of ten percent).


New subsidies often outlive the public policy purpose that they were intended to address. The betterdesigned subsidies contain "sunset" provisions that require explicit action to reauthorize them after a certain time. Subsidy and externality policies are often interrelated. It may be politically difficult to tax an energy source with high external costs, but much easier to subsidize a competing energy source with low external costs. Such "second best" solutions are often implemented when political considerations block the preferred option.

Another important consideration is that "getting prices right" is not the end of the story. Many market imperfections and transaction costs affecting energy use will still remain after external costs are incorporated and subsidies that do not serve a legitimate public policy purpose are removed. These imperfections, such as imperfect information, asymmetric information, information costs, misplaced incentives, and bounded rationality, may be addressed by a variety of nonenergy-price policies, including efficiency standards, incentive programs, and information programs.

Jonathon G. Koomey

See also: Economic Externalities; Market Imperfections; Subsidies and Energy Costs.


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