Click here for part one.

Last time, we talked about externalities, and how they apply to environmental policy. The short version: activities which pollute have an adverse effect, and thus a cost, to society. Those costs are not incorporated into the cost of the polluting activity, i.e. electricity that pollutes costs the same as electricity that doesn't. A price which incorporated externalities would allow the market to decide whether or not the polluting activity was a better choice. How to incorporate the cost of these externalities on electricity pricing? It is perhaps an unimaginative answer to say the government must impose them, but can you think of a better way?

Once we come to the conclusion that the externality costs of pollution should be incorporated into electricity costs, we must now answer a difficult question, that is, the monetary cost of the externality. When a kWh of electricity produced from coal is concerned, how much worse off is society? Two cents? Ten cents? Am I asking alot of questions? Sorry. Here come some answers.

Put yourself in the place of a power producer. You are considering expanding your business and making more power. You will sell your electricity on the open market, which currently has a value of $0.10 cents. You have the option of building a coal power plant or a solar power plant. The coal plant will pollute, but costs less. You build a coal plant.

Now, perhaps you are in an area where the utility is considering a feed-in tariff. The feed-in tariff will guarantee you a higher price for electricity than you would get for your coal power. (Feed-in tariffs are why Germany is a world leader is solar, despite a rather poor climate for sunshine.) In the classical feed-in tariff situation, the tariff is set by the utility. Under this situation, there are two possible outcomes. Either the tariff is too low, and you decide to build a coal plant, or the tariff is too high, and you build the solar plant, but the system is inefficient (there is a price at which you would have still built the solar farm, which is the outcome I wanted, but I would have had money left over to pay someone else to also build a solar farm.)

Enter the California Public Utilities Commission and their reverse auction proposal. The commission will set the feed-in tariff at the lowest price that a utility is willing to sell solar power. In other words, they will let the market decide what the actual value of the externality price is!

There are two exciting results from this proposal. The first, obviously, is that more solar power will be built in California, which will reduce pollution and spur the growth of the alternative power market. The second is that we will have an answer from a free market that tell us exactly what the externality price of pollution is.

How does this result potentially apply to cap and trade? Stay tuned to part 3.