Economics -energy market exam

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Economics 473 Spring 2020 Problem Set Four – Answer Notes

1. (10 points) The graph below depicts the marginal benefit (MB) of carbon emissions and the social cost of carbon (SCC) curve. Use this graph to answer the questions below.

a) Explain in words why the socially optimal level of Carbon emissions is not zero. In the graph above, at a level of zero emissions, the marginal benefit (MB) from emissions is much higher than the marginal cost (or, social cost of carbon, SCC) of emissions. From an economic point of view, some modest positive level of emissions has economic benefits that dramatically exceed the economic damages associated with the emissions. My own view is that the real-world empirical situation regarding zero emissions is similar to what is depicted in the graph above. b) Suppose that the government sets a tax on Carbon emissions (e.g., a carbon tax). Show the optimal level for the tax on emissions on the graph. Explain in words how the tax is determined. Whatever the per unit tax on carbon emissions is, polluters would (collectively) choose their amount of emissions at the quantity where the tax rate intersects the MB curve. So, if you want to achieve the optimal emissions level E* (and optimal emissions reductions), set the tax rate at the dollar amount equal to the dollar amount where MB and SCC intersect. In order to implement this in practice, you would have to know – or have estimates of – the MB and SCC curves. c) Suppose instead that the government establishes a cap and trade program for Carbon emissions. Show the optimal level for the emissions cap on the graph. Compare the outcome this cap and trade program with the outcome for the emissions tax from part (b). The cap should be set equal to E*. The outcome in terms of emissions and emissions abatement would be the same as with the tax in part (b). The cost of abatement would also be the same. The cost of acquiring permits in the cap and trade program may differ from the tax payments under emissions taxation, depending on how permits are issued under cap and trade.

$

Emissions

SCC

MB

E* E’

p’

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d) Now suppose that the government sets a cap that is too lenient; that is, the cap allows more emissions than the optimal cap you identified in part (c). Show the equilibrium trading price for emissions permits with this ‘too lenient’ cap, and compare this equilibrium trading price with the optimal emissions tax from part (b).

Let’s say the cap is set at E’ > E*. The equilibrium trading price is determined by the MB at the capped emissions quantity of E’. This is illustrated by price p’ on the graph.

e) The social cost of carbon is based on the net present value of current and future damages from an additional ton of carbon emissions now. Suppose that a higher social discount rate is used to calculate these damages. Explain how this change in the social discount rate would affect the position of the SCC curve, and the optimal current level of emissions and emissions abatement. Since much of the damage from CO2 emissions are in the future, a higher social discount rate would lower the NPV of damages from current CO2 emissions and reduce (shift down) the SCC curve. This shift would increase optimal emissions and reduce optimal emissions abatement. 2. (5 points) Explain in words the meaning of the term, ‘levelized cost of energy’. LCOE is often used to compare the costs of different technologies for generating electricity. Explain pros and cons of using LCOE for such comparisons. LCOE is equal to the constant price per unit energy that would equate NPV of revenues to NPV of costs. Alternatively, a measure of the real average total cost of generation over the lifetime of a generation plant. PRO – LCOE provides a way to compare average costs of different methods for generating electricity. CON – LCOE is focused on cost rather than benefits or value. Value of different technologies may differ due to: (1) timing of generation – e.g., wind turbines tend to generate electricity at night when electricity is not valuable, (2) dispatchable vs. non-dispatchable generators. 3. (10 points) A variety of government policies promote greater energy efficiency. Examples include programs for more energy efficient lighting and the federal CAFÉ program for autos and light trucks. Consider the following claim – “Government policies promoting energy efficiency are bound to fail because of the rebound effect. These policies have the unintended consequence of lowering the effective price of energy services and thereby encouraging greater energy use.” Discuss this claim and explain whether or not you agree with it. It’s true that EE policies have this unintended consequence. You can make an argument on either side of this. The argument turns on how large the rebound effect is. If this effect is large for a particular EE program, then the claim is basically correct – an example would be the Mexico Cash for Coolers program for air conditioners. If the effect is small – which is likely true for most programs, then the claim is wrong.