Carbon Pricing 201: Pricing Carbon in the Electricity Sector

Carbon pricing is a policy tool that aims to reduce the amount of carbon dioxide released into the atmosphere by either imposing a fee or a cap on the tons of carbon dioxide emitted. When applied to the electricity sector, carbon pricing discourages the use of carbon-intensive generators, like coal-fired power plants, in favor of lower- or zero-emitting generators, like efficient combined-cycle natural gas plants or renewables. This explainer details how carbon pricing can reduce emissions in the power sector and its impacts on generation dispatch, investment, and electricity prices.

Electricity generation accounts for about 27 percent of total greenhouse gas emissions in the United States. Within this sector, about 65 percent of carbon emissions comes from the use of coal, and 33 percent comes from the use of natural gas (see EIA table 11.6). In 2018, about 36 percent of electricity was generated using zero-carbon resources like nuclear and renewables.

Over the past few decades, emissions from the power sector have fallen significantly, primarily due to market forces. Falling costs for natural gas have led to the retirement of coal plants, and the number of zero-carbon renewables on the grid has grown due to a combination of falling technology costs and state and federal policies that support clean energy investments. These market forces have reduced carbon emissions in the power sector by nearly 33 percent since 2005 (as shown in Figure 2); however, without additional policies, market forces are likely insufficient for achieving deep decarbonization (80 percent or greater reductions) or a net-zero power sector.

Options for pricing carbon in the electricity sector include a carbon tax and cap and trade. A carbon tax directly prices emissions created from the use of fossil fuels for electricity generation. The tax is usually applied at the point of generation so that producers have an incentive to use less carbon-intensive fuels. A cap-and-trade program, by contrast, places a cap on the total amount of emissions from the electricity sector. Polluters must hold and surrender to the government one allowance for every ton of carbon dioxide emitted. Permits can be traded among polluters, and thus the price for carbon is determined through a market rather than administratively.

These policies are described in more detail in RFF’s carbon pricing explainer series.

Carbon pricing in the electricity sector reduces emissions through the following three primary channels:

1. Fuel switching from carbon-intensive to low- or zero-carbon fuels in the short-run through changes in economic dispatch and in the long-run through capacity investment in cleaner resources
2. Improvements in the efficiencies of existing carbon-emitting plants
3. Reductions in overall electricity consumption

Fuel switching refers to both short-term changes in which power plants are run to meet electricity demand (known as dispatch) and long-term changes in capital investment from carbon-intensive to low-or zero-carbon resources.

Changes in Dispatch

At any given moment, electricity generation must match electricity demand, and central grid operators must decide which power plants to run, or dispatch, in order to meet this demand. Regulations in the United States require that grid operators have enough generating capacity built to meet peak demand plus a reserve margin in order to prevent possible blackouts. Thus, unless demand surges past peak demand, grid operators have multiple power plants at their disposal to choose from, and they base their decision on which power plants to dispatch on their relative costs of operation. (Learn more about how US electricity systems work in US Electricity Markets 101).

When carbon pricing is introduced to the electricity sector, it changes the relative costs of operating generators depending on how much carbon they emit. A carbon price makes carbon-emitting plants ( those that run on coal, natural gas, or oil) more expensive to operate but does not impact the cost of operating non-carbon emitting plants, like renewables and nuclear. As a result, the cost of operating non- and low-emitting plants decreases relative to higher-emitting plants under a carbon price. This is true across and within fuel types; for example, a carbon price would increase the operational cost for a coal plant more than for a single-cycle natural gas plant, and it would also increase the operational cost more for a single-cycle natural gas plant relative to a more efficient combined-cycle plant.

Stringency of the Policy

The impact of a carbon price on dispatch of generation depends on multiple factors, including the stringency of the carbon price chosen, the carbon intensity of the power plants, and the existing fuel mix of the generating fleet.

The more stringent the carbon price, the more it will influence generation dispatch. For example, a carbon price of $50 per ton would increase the cost of operating the average coal and natural gas plant by about $50 per megawatt-hour (MWh) and $20 per MWh, respectively. For context, in New York State, day-ahead energy clearing prices hover around $10 to $30 per MWh, indicating that plants that clear the market bid below these prices. A $50- and $20-per-MWh cost increase for coal and natural gas plants is therefore substantial in comparison to typical market clearing prices and would likely raise clearing prices (to the extent that these resources are still dispatched) and result in some of these resources not being dispatched.

By contrast, a carbon price of $7 per ton would increase the cost of operating an average coal plant by an estimated $7/MWh and about $3/MWh for an average natural gas plant, which would likely have lesser impacts on the changes in dispatch since the impacts of the carbon fee on electricity costs are relatively low. Notably, however, these estimates represent a rough average because there is some heterogeneity in the emissions rate of different power plants of a common technology, due to factors like utilization rates and other conditions that affect fuel use per MWh produced.

Existing Fuel Mix

The impacts of a carbon price on economic dispatch also depend on the existing fuel mix. A more diverse fuel mix will likely experience greater changes in the short term. For example, if a carbon tax on electricity generation were introduced in Wyoming, where coal produced about 86 percent of the state’s electricity in 2018 and accounts for 75 percent of the existing generating capacity, it would be unlikely to substantially change dispatch of resources in the short run due to limited fuel-switching opportunities. Consequently, the immediate short-term impacts of a carbon price would likely be a reduction in electricity consumption due to increases in retail rates or an increase in imports from neighboring states that have a cleaner energy mix.

In New York, by contrast, where coal only makes up about 4 percent of the total operating capacity while natural gas plants, renewables, and nuclear make up nearly 86 percent of generating capacity, the introduction of carbon pricing could have more significant impacts on dispatch in the short-term since more resources are available as substitutes. Coal, which generated less than 1 percent of the state’s electricity in 2018, would likely be dispatched less than it already is. Given a high carbon price, some of the natural gas fleet would likely be dispatched less frequently as well.

Investment in Low-Carbon Resources

Once carbon pricing is in place and unlikely to be retracted, it provides incentives for changes in investment that lower the carbon-intensity of electricity production over time, thus leading to larger emissions reductions.

Over time, carbon pricing provides generation companies with an incentive to invest in cleaner resources and to retire more carbon-intensive resources. As the resource mix becomes cleaner, dirtier resources are much less likely to be dispatched and thus suffer financial losses. Meanwhile, clean resources do not have to pay a carbon fee and benefit from higher energy prices in wholesale energy markets, thus enabling more investment in clean technologies.

These changes in retirement and investment include 1) retirement of coal plants in exchange for lower-carbon natural gas plants, 2) a transition away from investment in fossil fueled generators to zero-carbon resources, like investment in new renewable technologies (likely with backup energy storage), and 3) keeping existing nuclear plants online that may otherwise retire.

The price of natural gas, costs of renewable technologies, and the stringency of a carbon price influence how investments are affected by a carbon price. RFF analysis of a proposed carbon tax in the electricity sector found that, due to falling technology costs, investment in renewables is more responsive to a carbon tax now than it used to be. The analysis found that, as a result, the cost of achieving emissions reductions in the power sector is lower than it was a few years ago.

Figure 3 shows projections of how a $28-per-metric-ton carbon tax (in 2013$) would affect US electricity generation by source in 2035 versus business-as-usual (assuming policies in place as of August of 2019).

As shown in the plot above, the carbon tax leads to a shift in generation resources due to changes in dispatch and in investments and retirements over the long-term. Generation from nuclear, wind, and solar increases by 123 percent, 54 percent, and 83 percent, respectively, compared to the business-as-usual case. By contrast, coal- and natural gas-fueled generation falls by 89 percent and 16 percent, respectively, compared to the business-as-usual case. It also leads to slight drop in electricity generated.

Carbon pricing can also create incentives for existing carbon-emitting generators to reduce their carbon intensity. This can be done through investments in control technologies, such as efficiency improvements, like improving a plant’s heat rate, or carbon capture and storage.

Generators will only invest in reducing their carbon intensity if the benefits from avoiding or reducing carbon fees outweigh the costs of upgrading the plant. Heat rate improvements that enable a power plant to operate more efficiently also reduce operational costs as an added benefit; therefore, these improvements may be worth the investment for coal plants. Carbon capture technology, on the other hand, is currently more expensive relative to other clean energy generation options and would likely only be economical under a very high carbon price. Adoption of carbon capture technology may therefore be a more plausible response to a carbon price in the future, once technology costs have fallen.

One drawback of improving the heat rate of power plants is the potential for an emissions rebound effect. The rebound effect refers to the notion that as the efficiency of a power plant improves, it becomes cheaper to operate on the margin and thus could be dispatched more, which could lead to higher emissions. An example of the rebound effect was seen in analysis of the proposed Affordable Clean Energy (ACE) Rule that requires existing coal plants to improve their heat rates in order to reduce carbon emissions. This analysis suggested that, after accounting for rebound, carbon reductions from implementing the ACE rule were projected to be lower than anticipated.

Carbon pricing raises wholesale electricity prices, which leads to higher retail electricity prices. In the short term, consumers can respond to higher retail prices by reducing electricity consumption through energy conservation efforts (such as turning off lights when not in use or using appliances less frequently). Notably, the extent to which these changes occur depends on the consumer and the price elasticity of demand for electricity (the amount that demand changes as a result of a change in price). One study found that short-run price elasticity for electricity is very small, suggesting that energy conservation responses are likely small.

The long-term electricity price elasticity may be larger because consumers make different investments to adapt to higher electricity prices. Over the long-term, if a carbon price is introduced with some long-term certainty (unlikely to be impacted by factors like changing political administrations), then consumers will be more likely to invest in energy-efficient technologies that will help them avoid costly electric bills. These investments could include upgrading to more energy-efficient appliances and weatherizing homes in order to reduce energy consumption and save money. (To learn more about energy efficiency, see “Energy Efficiency 101”). When consumers use less energy over the long term, carbon emissions from the electricity sector fall if the generation that is avoided would have come from carbon emitting resources.

As mentioned above, carbon pricing increases wholesale electricity prices, which then causes an increase in retail prices for consumers.

In areas that use markets to determine which generators are dispatched, a carbon price causes wholesale electricity prices to rise for two reasons. First, it increases the cost of operating some generators, which increases wholesale energy prices if these generators determine the market-clearing price. Second, it rearranges the dispatch order of generators, putting some cleaner resources (such as some higher-cost nuclear plants, for example) that may have been relatively more expensive without a carbon price earlier in the dispatch, which can also affect which generator determines the market-clearing price.

In rate-regulated jurisdictions, where utilities earn a regulated rate of return on capital investments, the expenditures that result from a carbon price (both clean energy investments and carbon price payments) lead utilities to increase electricity rates. As shown in Figure 4, RFF modeling projects that a $28-per-metric-ton carbon tax would increase national average electricity prices by about 0.7 cents per kilowatt-hour (kWh) in 2035 relative to rates in 2035 under existing policies. Since the average household uses about 900 kWh of electricity per month, such an increase would raise electricity bills for the average US household by about $6 per month, assuming that demand stays constant. However, a decrease in demand, as described above, would reduce the price impact of the carbon fee for the average household.

While electricity prices would rise under a carbon pricing policy, the carbon price also generates revenue (except for cap-and-trade programs in which allowances are given away for free) that could be used to mitigate price impacts and in particular any negative impacts for lower income households and vulnerable communities. For example, some programs return revenues from carbon pricing in the form of per customer dividends to residential consumers, which tend to benefit low income households the most. To learn more about carbon pricing revenues and options for mitigating the impacts of a carbon price on low-income households, see “Carbon Pricing 102: Revenue Use Options” and “Carbon Pricing 104: Economic Effects across Income Groups”.