Borenstein, Severin and Bushnell, James “Headwinds and Tailwinds: Implications of Inefficient Retail Energy Pricing for Energy Substitution” (Revised July 2021) (Revised version published in Environmental and Energy Policy and the Economy, 3, February 2022) | WP-319R | Online Appendix | Blog

Electrification of transportation and buildings to reduce greenhouse gas (GHG) emissions requires massive switching from natural gas and refined petroleum products. All three end-use energy sources are mispriced due in part to the unpriced pollution they emit. Natural gas and electricity utilities also face the classic natural monopoly challenge of recovering fixed costs while maintaining efficient pricing. We study the magnitude of these distortions for electricity, natural gas, and gasoline purchased by residential customers across the continental US. We find that the net distortion in pricing electricity is much greater than for natural gas or gasoline. Residential customers in much of the country face electricity prices that are well above social marginal cost (private marginal cost plus unpriced externalities), while in some areas with large shares of coal-fired generation, prices are below SMC. Combining our estimates of marginal price and SMC for each of the fuels with a large survey of California households’ energy use, we calculate the distribution of annual fuel costs for space heating, water heating, and electric vehicles under actual pricing versus setting price at SMC. We find that moving prices for all three fuels to equal their SMC would significantly increase the incentive for Californians to switch to electricity for these energy services.