Full Social Cost Pricing

Excerpts from : Environmentally Responsible Energy Pricing EPA Interim Draft Report on Efficient Energy Pricing, Project on Economics Research for Long-Term Environmental Risks and Pollution Prevention, Cooperative Agreement with Duke University CA-814388-02.

Prices act as the marketplace signal to allocate goods and services among producers/sellers and consumers. To achieve the efficient allocation, market prices should reflect the full cost of supplying a good. The adverse marketplace implications of pollution arise because pollution damages, and the true costs of the production of a commodity such as energy, are often not reflected in market prices. In the case of energy consumption, market prices reflect the private costs of consumption, but not the environmental consequence.

Air pollution, the subject of this research effort, is shown in Full Social Cost Energy- to be a substantial cost of energy consumption." Excluding pollution costs from energy prices creates inadequate incentives for optimal resource allocation. It has been shown by economists since the time of Pigou that incorporating an appropriate tax in the price of a commodity priced below its full social cost can create a signal, leading buyers and sellers to optimal resource allocation. One of the purposes of this research effort has been to calculate the appropriate tax rates on energy resources, incorporating the full social costs of energy production and consumption in the market price signal.<


Ideally society wants to promote efficient utilization of all resources. The nation&#146;s energy resources are among those for which we would like to establish efficient utilization. This concern is particularly great since energy consumption has been linked to a number of important environmental costs principally relating to air pollution. Because energy users do not pay for these costs, they are labelled as "externalities" by economists. In any market context, it is desirable for economic actors to bear the full consequences of their actions so that their behavior will incorporate the social effects as well as the private benefits. In the case of energy usage, the consumers are not paying these costs since they are permitted to use an environmental resource without paying any explicit fee.

The economic objective is two-fold. First, we want all energy producers to be supplying the appropriate amount of each form of energy given these social costs, and we want consumers to be consuming the amount of each energy source that reflects a balancing of the benefits to them of the energy and the social costs of their actions

There is some level of energy production that represents the amount of energy that should be produced after recognizing the market value of the energy and all of the costs associated with energy production. This energy output level can be achieved in two ways. First, one could establish an environmental quality standard that ensures that the production or usage of energy resulted in the level of pollution that balances the benefits and costs of pollution reduction appropriately. (Or), one could charge a user fee for energy usage to promote the efficient outcome.&#146; &#133;a user fee or a standards approach. The emphasis of the U.S. Environmental Protection Agency and other regulatory agencies has been on the promulgation of regulatory standards. Standards are also attractive to firms in that they involve lower compliance costs than do pollution fees, if these fees are imposed on all pollution, not just pollution above some regulatory standard. Under a standards regime, a firm must pay for the cost of meeting the standard, but once the standard has been met the firm does not pay for any of the pollution that it generates. Thus, in effect, the firm receives a free right to pollute up to the efficient level of pollution, and it is not charged for this pollution.

The focus of this report will be on establishing user fees that will lead energy users to incorporate the environmental costs of energy in their energy choices. The approach will be to determine what the price of energy should be to internalize all the costs and subsidies involved in the energy resource area. This calculation will indicate the appropriate user fee level that will give both consumers and producers the correctprice incentives. 


A consumption tax would fall on fuel consumers at the point of purchase of the fuel or in some cases for purchase of the energy produced from the fuel. The tax could be administered centrally or on a state or local basis. Fuel taxes are already collected on most consumer purchases of gasoline, diesel fuel, aircraft fuel, and heating oils. While the final buyers of most supplies of coal and substantial quantities of natural gas and heating oils are electric utilities, taxes on those fuels could be passed through to electricity customers. New collections would have to be introduced on sales of wood fuel in most cases.  Because taxes would be collected at the point of sale/supply, incorporating differing tax rates for different regions would be possible, but coordinating differentiated tax rates across the different fuels and local jurisdictions may be unwieldy. Updating tax rates because of new or improved scientific or emissions data may be difficult to coordinate as well. Because the tax would fall on all fuels in relation to the emissions from that fuel, consumption levels of each fuel would adjust optimally.<

Coal Output Tax 

Like the gasoline tax, coal output tax addresses a restricted set of sources of conventional pollutants. In that sense, a coal output tax will result in a less than optimal resource allocation. This tax does, however, address the largest single polluting fuel source. Consumption of coal for fuel accounts for the greatest portion of acid precipitation and health effects of sulfur oxides. Substantial amounts of the precursors to ozone are also products of coal consumption. As with the production tax discussed above, taxes could be collected from a limited number of suppliers providing for ease of implementation. These suppliers are somewhat removed from local fuel consumption, making local administration of the tax and adjustment of the tax rates unworkable.  Much like the case for the gasoline tax, updating the tax rates would be relatively simple because of the more narrow focus of this approach. Also as is the case with the motor fuels tax there will be marketplace incentives to reduce coal consumption which may not yield an optimal resource allocation.<


A tax on electricity would be one step removed from a more direct tax on fuel consumption. In this case, electricity generators would tax consumers for their electricity use, electricity which could be generated from a number of different combinations of coal, heating oils, and natural gas. An electricity tax shares many of the same advantages and disadvantages of the motor fuels and coal output taxes discussed above. This tax focuses on a restricted set of the fuels that create conventional air pollutants, but significant environmental and health end points are addressed. Electric utilities are primarily responsible for the emissions of pollutants which lead to acid precipitation, and the large quantities of coal and heating oils consumed by electric utilities account for a substantial portion of the health and environmental effects of sulfur oxides.

Administering an electricity tax at the local level provides a substantial opportunity to readily adjust tax rates for the health and environmental effects specific to that region's facilities. Supervisory and administrative boards overseeing public utilities already exist in most areas. Some broader coordination would probability be required to insure that the adverse impacts occurring downstream from the facilities, as is the clearly the case with acid precipitation which may occur far from the generating facilities, are properly incorporated in local tax rates.

Taxing electricity would create incentives for utility customers to consume fuels directly. Large customers like factories and businesses may wish to bum fuel on-site while homeowners may rely more heavily on furnaces for heat. These incentives may lead to undesirable emissions being shifted from electricity-generating facilities to homes and businesses

In 1986, 46 percent of electric utility generation was due to coal and 12 percent from fuel oil. The remaining amount was for nuclear, hydro, and natural gas.