American-style climate policy

October 06, 2023 Environment

By adopting the Inflation Reduction Act, the United States has chosen to massively subsidize decarbonization rather than penalizing carbon-based energy sources. A welcome cure for fossil fuel addiction, but one with a few undesirable side-effects.


The Inflation Reduction Act

August 16, 2022 marked the end of intense negotiations that culminated in a very close vote in Senate (51 votes for, 50 against). On that day, President Joe Biden signed the executive order implementing the first major climate policy at federal level: the Inflation Reduction Act (IRA). In order to secure the support of the  Democratic Senator Joe Manchin, who made his fortune in coal, the plan to charge for CO2 emissions was abandoned. Only a tax on methane emissions from fossil fuel extraction remains. In its final form, the IRA commits on $392 billion in tax exemptions, loans, or grants, for investments in decarbonized technologies: wind and solar renewables, energy storage, nuclear, electric cars, energy efficiency, and carbon capture and sequestration.

This choice contrasts with that of the European Union, which has made emissions trading the cornerstone of its climate policy. Each ton of CO2 emitted into the atmosphere through the combustion of fossil fuels currently costs European industrial and electricity companies around 85 euros. This system is set to be extended to other sectors and reinforced by a carbon pricing mechanism at the border. Rather than increasing the cost of fossil fuels through carbon pricing, the United States reduces the cost of equipment that produces or uses decarbonized electricity. A political compromise that tipped the balance in the Senate in favor of adoption, but not without negative effects.


Low cost energy

A recent study estimated the impact of the IRA on electricity prices. In the graph reproduced below, the authors compare dollar prices per megawatt-hour of electricity on the US wholesale market under the IRA (blue curve), without the IRA (grey curve) and under a "European-style" climate policy based on a CO2 price (yellow curve). The three data sets are rearranged in descending order according to the percentage of the year's 8760 hours.

Clearly, the IRA has achieved one of its objectives: to reduce energy cost inflation. But at the cost of seriously disrupting the electricity market. We can see that the blue curve touches and then falls below the horizontal axis around 55% of the hours, meaning that the price per megawatt-hour (MWh) will be zero, or even negative, almost half the time. For almost 4,000 hours a year, wind and solar farm operators will either collect nothing, or will have to pay to get rid of the overproduction of electricity. We can also see that the blue curve is the one with the greatest amplitude. In other words, price volatility rises considerably, increasing the risks of investing in power generation. All this would not happen with CO2 pricing (yellow curve). Prices would have been stable and positive (around $50 per MWh). Despite the drastic drop in wholesale prices, the IRA will result in a modest reduction in retail prices of around 2.2% in 2030 and 4.5% in 2050 for consumers.

Lower energy costs are not good news for the climate. It does not encourage sobriety. It induces what economists call the "rebound effect": since it costs less to heat or travel, we might as well raise the temperature in our homes and drive more often. On the other hand, by promoting heat pumps and electric cars, the IRA reduces demand for fossil fuels. This contraction in demand should translate into lower gas and fuel prices, at least in the short term until supply adjusts. Finally, by not pricing CO2 emissions and subsidizing electrification, the IRA will have the effect of encouraging people to burn more gas and oil. This undesirable collateral effect could have been avoided with a carbon price.


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How do you cure an addiction to fossil fuels while keeping them affordable? The IRA makes it possible to avoid a tax on greenhouse gas emissions, which is perceived as punitive, by rewarding clean technologies with subsidies. These rewarding environmental policies are more readily accepted by public opinion, and therefore by elected officials like Senator Joe Manchin. However, they have several drawbacks. First, they keep the price of energy at a level that does not reflect its environmental cost, which fosters its consumption. Second, they are more expensive. For an order of magnitude, electricity production in the USA amounted to 4,547 TWh in 2022. So, the 392 billion dollars of the IRA compared to this production gives 86 dollars per MWh. Of course, it will be objected that the IRA, and therefore its cost, is not annual, and that its benefits will extend over one or more decades. But this intertemporal effect is difficult to estimate. Furthermore, the cost of administering and monitoring subsidies is generally not included in the calculation. The great advantage of the IRA is that it is painless. By refusing to finance it through a carbon price, the US administration avoids making polluters pay, thus sparing Senator Joe Manchin.


Published in La Tribune

Photo credits: Brandon Mowinkel on Unsplash