The New US Climate Law Will Reduce Carbon Emissions and Make Electricity Less Expensive, Economists Say

U.S. consumers are expected to save money on their electricity bills under the nation’s first comprehensive climate law—perhaps more than $200 billion over the next decade, economists project. Even utilities are talking about eased prices at the same time they are detailing new clean energy investments.

The potential price drop flies in the face of an argument made by climate action foes for years—that a move to cleaner power will mean higher energy prices for U.S. homes and businesses. Instead, the Inflation Reduction Act signed this week by President Joe Biden will direct government support to companies that invest in and generate carbon-free power, lowering their costs in a way that will enable them to pass those savings to their customers, analysts say.

Certainly, Democrats were weighing the politics when they chose such a consumer-friendly, incentives-based climate strategy. But the new climate law also reflects some of the latest thinking among economists. Recent research shows that higher prices, imposed through a tool like carbon taxing, may not be the best way to drive fossil fuel emissions out of U.S. electricity.

In fact, more than half of U.S. residential consumers already are paying too much for electricity, if the carbon costs of the current electricity grid were taken into account, according to a study by University of California researchers. The study used $50 per ton as the societal cost of carbon emissions.

“We found that the standard economic logic of carbon pricing doesn’t fit the electricity sector very well, due to the other pricing distortions in the industry,” said Severin Borenstein, faculty director of the energy institute at the University of California, Berkeley’s Haas School of Business. “Carbon pricing is still a powerful tool, but this shows it is important to think through the full context in which we are doing greenhouse gas regulation.”

Plummeting Clean Energy Costs

The Inflation Reduction Act includes an unprecedented $370 billion in federal spending to tackle climate change, much of it through tax credits for developers and producers of clean electricity. It’s an approach that would not have been effective in the early days of global attention to climate change, analysts believe, because solar and wind energy were still too expensive.

“When solar was astronomically expensive, you could have given it a 30 percent tax credit and wouldn’t have made a whit of difference,” said James Stock, vice president for climate and sustainability at Harvard University, who served on the White House Council of Economic Advisers under President Barack Obama.

Economists’ early ideas for addressing carbon emissions focused on carbon pricing—through a tax, fee or cap-and-trade system, a form of carbon pricing which enables polluting industries to remain above permitted levels for carbon emissions by trading credits with non-polluters. Since more than half of U.S. power was then generated by coal, a carbon tax would have made electricity more expensive, and in theory, would have driven homes and businesses to adopt efficiency measures and use less. “There really was not any choice,” said Stock. “If you wanted to reduce emissions, all you could do was reduce demand for the services of energy, because you didn’t have a better way to produce energy.”

But thanks to a mix of government policies, technological innovation and international competition, clean energy costs have plummeted over the past decade—some 80 percent for utility-scale solar, for example. The fracking boom also made natural gas available at prices cheaper than coal. As a result, coal’s share of U.S. electricity has fallen to 22 percent. 

Clean energy now has enough of a head start that the incentives in the Inflation Reduction Act are expected to accelerate decarbonization. Environmental analysts at  Energy Innovation, Rhodium Group and Princeton University’s REPEAT Project all have concluded that the law will help bring U.S. greenhouse gas emissions about 40 percent below 2005 levels by 2030.

At the same time, retail costs of electricity are expected to fall about 5 to 7 percent over the next decade, saving consumers from $209 billion to $279 billion, according to researchers at the think tank Resources for the Future. On a per-household basis, RFF projects savings of about $170 to $220 per year over the next decade. 

“Retail prices will fall, even in the relatively near term, because there are projects already in the pipeline that will be eligible for these credits,” said Kevin Rennert, director of RFF’s federal climate policy initiative.

For example, the midwestern power company Ameren, which has a corporate goal of achieving net zero emissions by 2035, told investors last week that bill’s tax credits for wind, solar, energy storage, nuclear, carbon capture and storage, and hydrogen “align very well” with the significant investments the company already has proposed in Missouri. “The benefits of these tax incentives will ultimately lower the cost of the clean energy transition for our customers in Missouri and Illinois over time,” said Martin Lyons, Ameren’s president and CEO. 

Duke Energy, which operates one of the largest U.S. nuclear power fleets, expects to benefit from the new nuclear production tax credit in the Inflation Reduction Act. The provision is designed to keep nuclear power plants open, despite their recent cost struggles. Nuclear plants account for 19 percent of U.S. electricity, and almost half of carbon-free electricity now on the grid.

“The clean energy tax credits will lower our cost of service, which in turn reduces the cost to customers of our energy transition,” said Lynn Good, Duke’s CEO, at the company’s earnings call last week.

Duke, which has a goal of reaching net zero emissions by 2050, this week announced two new lithium-ion battery projects to increase efficiency and improve electricity reliability in Florida; such projects could be eligible for new investment tax credit the law makes available for standalone energy storage, which experts say could lower the capital equipment costs some 30 percent.

Federal policy that holds down electricity prices and encourages more deployment of clean energy also will play an important role in protecting consumers from volatility in natural gas prices, which have been high this year due to a mix of factors, including instability in the global markets amid the Russia-Ukraine war. Because 38 percent of U.S. power is currently fueled by natural gas, sustained high prices can cause electricity prices to rise. But even in a scenario with high natural gas prices through 2030, the RFF models show that U.S. electricity rates will fall under the Inflation Reduction Act.

“Having more clean electricity on the grid certainly insulates you against price shocks,” said Rennert.

The Price Distortion Is Highest in the Greenest State

Lower electricity rates surely could make the transition to clean energy more acceptable to electricity consumers and more palatable to voters. But it also makes sense from a climate economics perspective, according to some recent economic research.

Much of the past analysis of the potential impact of carbon taxes assumed that electricity was priced “efficiently,” in the language of economists—in a way that made sense. Carbon pricing advocates argued that the primary problem with electricity prices was that the societal costs of carbon pollution were not factored in. A carbon tax could fix that, and ensure electricity was “priced right,” as society drives to cleaner energy sources, they said.

But in a study published earlier this year, Borenstein and his colleague James Bushnell, of the University of California, Davis, found that current U.S. electricity prices were anything but efficient. Customers were paying electricity rates substantially higher than the costs of generating or buying the electricity. There are a number of complex reasons for the mark-up, including that companies are trying to recover a variety of fixed costs, such as transmission and distribution. On average, Borenstein and Bushnell found the overcharge on residential bills is 8 cents per kilowatt-hour (kwh). That means the mark-up is a significant portion of what U.S. households are paying for electricity, which is currently about 14 cents per kwh.

Borenstein and Bushnell then analyzed residential electricity rates in light of the carbon-intensity of the electricity supply on the grid today, using a “social cost of carbon” measure of $50 per ton. (This is close to the figure the Biden administration has adopted when weighing the costs and benefits of its environmental decision-making.) The researchers found that about 53 percent of U.S. residential electricity customers were paying rates that were “too high,” in light of the carbon-intensity of the electricity they were purchasing.

This “distortion,” as the researchers called it, was the most severe in regions of the country that had done the most to clean up their electricity. In California, for example, which gets more than half of its electricity from renewables and nuclear energy, residential customers are paying rates from 8 cents to 32 cents per kwh more than the cost of carbon pollution on their grid.

The finding has major climate policy implications. Not only would it be senseless to slap a carbon price on these customers, it would be counterproductive for reducing greenhouse gas pollution. Any pathway to net zero carbon emissions would require more electricity use, as consumers would need to switch to electric vehicles and electric heating and cooking to drive down use of oil and gas.

The finding that so many U.S. customers are paying inflated electricity rates “is an incredibly important insight,” Stock said. “What it says is, ‘Gosh, electricity prices should be lower.’ With lower prices, you can say, ‘Maybe heat pumps will be better and maybe EVs will be better, and maybe we really can do this electrify-everything deal.'”

In separate research, Borenstein and Ryan Kellogg, professor at the University of Chicago’s Harris School of Public Policy, found that government incentives—essentially, an approach like that adopted by Congress and the Biden administration—make a great deal of economic sense, given the current U.S. landscape of electricity prices. They found that clean technology incentives can spur emissions reductions in the sector (through retirement of coal plants, for example) just as quickly as a carbon tax would. And of the three big policy options they looked at (including a national clean electricity standard, originally part of the Biden plan, which they found also would be effective in cutting emissions), Kellogg and Borenstein found that electricity prices would be lowest under an incentives approach.

Under an incentives-driven climate policy, government spending is higher than it would be under carbon pricing or a clean electricity standard, the analysis showed. But the researchers said that spending needs to be considered in the context of the realities climate policymakers are facing, including the premium residents currently are paying on their electricity bills.

“That spending is offsetting, in some sense, the electricity ‘tax,’ the per-kilowatt-hour electricity tax that we’re all paying, that’s going to be really inefficient in a world where the grid is green,” Kellogg said.

In the climate law that Congress struggled with for more than a year, lawmakers did take steps to put a check on government spending, which some of them—particularly Democratic Sen. Joe Manchin of West Virginia—feared could stoke further inflation, at a time when it already was at a four-decade high.  The Inflation Reduction Act more than offsets its $370 billion in climate policy spending with an expected $764 billion in government savings and new revenue, including establishment of a 15 percent minimum tax for corporations.

The formula enabled Congress to overcome a 25-year stalemate over climate policy. “There is actually this happy coincidence for electricity grid decarbonization in the U.S. that subsidies are both economically efficient and attractive from a political perspective as well,” Kellogg said.

To be sure, few climate economists or advocates think that the Inflation Reduction Act is a magic bullet. Even optimistic projections show the U.S. will fall short of Biden’s goal of a 50 percent cut by 2030 under the legislation. Stock’s own research shows that complementary climate policies would work better in decarbonizing than any one policy on its own. He anticipates that regulation, a clean electricity standard or some other form of carbon pricing eventually will be needed to drive down emissions in areas of the country where renewable resources have not gained enough of a foothold against old coal plants.

“A carbon tax would really do the trick,” Stock said. “But I don’t even like to suggest it, because I’ll just sound like a stupid economist.”

He feels his profession has gotten a bad rap in discussions about how Congress arrived at the Inflation Reduction Act. “People think they’ve gone with tax credits and investment because it’s politically saleable, and we’ve moved beyond the economists and all that stuff,” he said. “My point is there’s a really, really strong economic reason to go that route. We need to make electricity less expensive.”