07/07/2010 04:20 pm ET Updated May 25, 2011

Pricing the Cost of Carbon Dioxide Emissions

At climate talks in Copenhagen last year, the Obama administration pledged that the United States would cut its carbon dioxide emissions to 17 percent below 2005 levels by 2020. This target can be substantially achieved by a transition from coal-based electricity to natural gas. The United States is already moving from coal-based electricity production to a system based on natural gas. Policymakers should encourage this transition.

There are three important unresolved questions in the current debate on the reduction of carbon dioxide emissions. First, what is the range of prices on carbon dioxide emissions that will be necessary to achieve the desired reductions? Second, should electrical generators and transport fuels be regulated jointly or should they be regulated separately? Third, should the restrictions be in the form of a quantity restriction such as cap and trade or should the restrictions be in the form of a price restriction such as a carbon tax?

We recently calculated the price of carbon dioxide emissions that would result in the transition from coal to gas in electrical generation. The results of these calculations enable us to comment on these questions. Based upon our research, we believe that for the purposes of carbon emissions policy, it is may prudent to decouple the regulation of electricity generation and transportation fuels. It would also be our recommendation that in regulating electricity generation, Congress adopt a price restriction such as a carbon tax rather than quantity restriction such as a cap and trade. Our work suggests an initial 20 percent reduction in carbon dioxide emissions could come from the transition from coal to gas in electrical generation. This approach carries several benefits. First, the electricity generation infrastructure in the United States is already converting to natural gas as the coal-powered infrastructure ages, so Congress would be working with existing market forces. Second, there is spare natural gas capacity within the system so the transition from coal to gas would not be constrained by the delays in having new gas generation capacity come online. Third, a carbon tax would not introduce the volatility to the market for electricity that might result from the dynamics in the market for carbon dioxide emission permits.

Using the cost of displacing coal with gas may seem like a simplistic approach to a very complicated question, but the coal generation of electricity is the 900-pound gorilla in the room. The United States produces approximately 4 billion megawatt hours (MWh) of electricity a year, of which about 2 billion MWh are produced by coal-fired generators. Coal produces about 33 percent of U.S. carbon dioxide emissions or about 2 billion metric tons. Coal-fired generators produce as much carbon dioxide as the total amount produced by transport fuels in the United States.

Replacing coal generators with those that run on natural gas is the most economical way to achieve a target of reducing carbon dioxide emissions by 20 percent. Unless or until there is a technological breakthrough in carbon sequestration, the carbon intensity of coal means that "clean coal" cannot be an important factor in reducing carbon dioxide. Replacing existing coal generation capacity with modern coal generation plants can only reduce total carbon dioxide by 5 percent. However, through the development of nontraditional sources of natural gas, the United States is in the fortunate position of having enough new natural gas production coming online to make it possible to shift electricity generation from coal to natural gas. It is still doubtful whether natural gas supplies will be adequate to maintain this shift in the long run; therefore, development of nuclear and renewable electricity generation will need to continue at a rapid pace. Natural gas, however, can be the transition technology to carbon-neutral electrical generation.

An important element in our calculation of carbon dioxide emission prices is the distribution of coal generators in the United States by efficiency. As the cost of carbon dioxide emissions increases, the less efficient generators shut down first. The efficiency of coal generators in the United States is very concentrated. This concentration restricts the range over which carbon dioxide prices are effective in managing the displacement of coal with gas. At current prices for fuels, a carbon price of approximately $30/metric ton (MT) will shut down 10 percent of coal generator capacity. An additional increase of $15 -- resulting in a carbon dioxide price of $45/MT -- will shut down 90 percent of coal generator capacity. This somewhat narrow band of viable prices for carbon dioxide emissions has two very important implications.

First, the narrow range for the price of carbon dioxide means that coal generator capacity is very sensitive to the price of carbon dioxide emissions. This means that small variations in the price of carbon dioxide emissions can lead to large variations in the amount of electricity supplied by coal generators. There is the possibility that the market in carbon dioxide permits will create volatility in the market for electricity. In 2000 and 2001 the effect of a few generators being shut down led to high volatility in the price of electricity in California. This suggests that there should be a careful study of the dynamics of introducing a market for carbon dioxide permits on the market for electricity. The market for carbon dioxide permits in Europe has been volatile, so a carbon tax may the preferable alternative to regulate the transition from coal to gas. A carbon tax at the mine would avoid our exporting our carbon to other nations.

Second, the carbon prices implied by the transition from coal to gas will have very little impact on transportation fuels. Consumption of transportation fuels that produce two billion metric tons (MT) of carbon dioxide would only be reduced by about 5 percent or less by carbon dioxide prices that are compatible with the orderly transition from coal to gas. As a minimal reference point, for carbon dioxide at $45 per ton, the cost of the carbon dioxide emitted upon burning a gallon of gas is 40 cents per gallon. Thus, it possible to decouple the pricing of the allocations for transportation fuel from the pricing of the allocations for the production of electricity.

A transition from coal to gas in electrical generation would enable the United States to reduce carbon dioxide and meet the initial 20 percent goal. This buys time. Subsequent carbon emission reductions could come from research and development on sources of electricity such as wind, solar and nuclear that are carbon free. Research and development can lead to a more efficient vehicle fleet as well. New regulations require the efficiency of the vehicle fleet to improve by 30 percent. In 15 to 20 years, a more efficient vehicle fleet might reduce carbon dioxide emissions after the gains from transitioning electricity generation from coal to gas are exhausted.