AT SOME POINT in the latter part of the twentieth century, Americans commenced to "overconsume" or waste electricity. Such consumption patterns have begun to push at the global limits of land and energy resources that include not only indigenous fossil fuel reserves but also the capacity of the environment to benignly accept the damaging by-products of fossil fuel combustion. We are burdening society and future generations with the costs of consuming too much electricity. This is not due entirely to any inherent American cultural tendencies to waste resources. It is a partial result of an archaic but easily applied, understood, and, therefore, commonly used pricing methodology that severely understates the true cost of electricity consumption.
Electricity is generally priced at average costs which are substantially lower than the marginal costs of electricity production. Although marginal costs are referenced in setting prices in a small number of states, even these costs exclude the external costs imposed on society. Some of these costs take the form of air pollution, water pollution (acid rain) and the depletion of the ozone layer in our atmosphere. Additionally, indirect costs include heightened uncertainty in fossil fuel supplies and costs from increased reliance on unstable foreign suppliers and the associated worsening trade balances that increase American debt to other countries. Costs associated with the recent war in the Persian Gulf and its aftermath are surely related.
Following Baumol and Oates (1988), an externality can be formally defined as a condition where an individual's utility function or a firm's production function includes real (nonmonetary) variables whose values are chosen by others who pay no particular attention to their effects on the other individual's utility or the firm's production function. For example, the water quality needed by a brewery may be affected by the actions of many farmers who use fertilizers that concentrate nitrates in the groundwater supply. This public "bad" affects the production of the brewer by requiring the buying of water treatment systems or the purchasing of offsite pure water supplies. It also reduces land values by the discounted stream of added costs to maintain adequate water quality at the location.
Rational consumers and firms make decisions that maximize their own satisfaction or profit and not those of society. For example, average-cost price signals lead them to use more "cheap" electricity to light their homes and offices with incandescent bulbs rather than invest in compact fluorescent light bulbs that provide the same lumens with 75% to 85% less electricity.(1) Improper pricing in the electricity "market" has created an excess demand for electricity and an excess supply (widespread lack of use) of energy efficiency(2) equipment. Thus, we have a disequilibrium in another market.
Public policymakers traditionally have relied on "command-and-control" methods rather than economic incentives to address these market failures. For example, the National Energy Conservation Act of 1978 required utilities to perform energy audits of their customers' houses upon request and offer to arrange for installation and financing of the recommended energy efficiency measures. The mandated energy efficiency programs offered by utilities have not created a cost-effective level of energy savings, according to the U.S. Department of Energy, and utility and state-sponsored research projects. Electric utilities were required by law to sponsor energy efficiency program investments that, if successful, reduced their revenues. Additionally, many of the utilities did not have an opportunity to earn a rate of return on these investments to compensate them for their time value of money.
Therefore, the mandated energy efficiency initiatives were deemed to be not cost-effective to the customer or utilities. Hahn and Stavins (1992) have noted that command-and-control approaches that use conventional regulations have failed in comparison to market-based approaches, since they do not meet environmental objectives in the least costly manner. …