Borenstein, Severin and Bushnell, James “Do Two Electricity Pricing Wrongs Make a Right? Cost Recovery, Externalities, and Efficiency” (Revised July 2021) (Revised version forthcoming in American Economic Journal: Economic Policy) | WP-294R | Blog

Economists favor pricing pollution in part so that consumers face the full social marginal cost (SMC) of goods and services. But even without valuing externalities, retail electricity prices typically exceed private marginal cost, due to a utility’s need to cover average costs. Furthermore, due to costly storage, the marginal cost of electricity can fluctuate widely hour-to-hour, while retail prices do not. We show that residential electricity rates exceed average SMC in most of the US, but there is large variation, both geographically and temporally. This finding has important implications for pass-through of pollution costs, as well as for policies to promote dynamic pricing, alternative energy and reduced electricity consumption.