We all know that solar photovoltaic (PV) technology is too expensive. Although technological advancements and economies of scale in manufacturing have lowered the cost of PV dramatically over the past decade, PV-generated electricity today is more expensive than power produced from conventional generators fueled with coal or natural gas. Many commentators suggest that the Holy Grail for solar is Grid Parity; once achieved, the world will be saved and fortunes will be made. Grid Parity is defined as the point when PV-generated electricity becomes competitive with the retail rate of grid power.
While I’m all for lowering the cost of renewables, playing the Grid Parity game is tantamount to giving in to distorted market outcomes and diminishes the real economic value that renewables bring to society. We should never lose sight of the fact that economic theory provides a robust justification for why it makes sense to pay more for clean, renewable forms of energy like solar. The economic concepts of externalities and market failure serve to explain why the goal of Grid Parity is a fallacy.
Let me explain…
Any Econ 101 course will highlight the role that the market forces of supply and demand play in producing efficient outcomes and thus leading to an optimal allocation of society’s scarce resources. Economic theory, and real world experience, suggests that market forces are the best way to allocate a society’s scarce resources to the highest valued uses, and thus has served as the core concept behind our capitalist system.
However, economic theory also acknowledges that in certain cases market forces do not deliver the best outcomes for society, referred to as “market failure.” Most economic text books list three specific cases leading to market failure: 1) excessive market power (monopolies), 2) public goods, and 3) externalities.
Here we will focus on the externality problem. An externality is a negative cost or positive benefit from the production or consumption of a good or service to an individual or group of individuals that were not involved with the original market exchange. When these costs are not reflected in the price of the good or service under consideration, the market fails to deliver the best outcome for society.
When negative externalities are not captured in the price of a good or service, we tend to pay too little for the product or service and consume too much. For example, I pay say 12¢/kWh for electricity from the local utility. The price that I pay does not include all of the external costs of producing the electricity, such as the real costs associated with smog, acid rain, mercury contamination, thermal pollution, and of course climate change. The costs associated with these impacts show up in different sectors of the economy including increased healthcare expenditures and reduced recreation opportunities among others.
The famous economist Arthur C. Pigou (1877 – 1959) is best known for his proposed remedy to address the externality problem. He argued that market failures associated with negative externalities should be corrected by imposing a tax on a market exchange equal to the external costs associated with the production and/or consumption of the good or service under consideration—a so called Pigovian Tax. Once the market price reflects both the private and external costs, the market will once again deliver the best outcome for society.
The theory described above has been embraced to varying degrees over time. In the early 1990s, many state utility commissions required utilities to include environmental adders as they compared the price of various resources under the integrated resource planning framework. For example, the levelized cost of power from a coal plant would be adjusted to reflect the significant externality costs, thus other less polluting resource options would become relatively more cost competitive. However, these efforts were generally abandoned as the push to deregulate the electric power sector picked up steam in the mid-1990s.
Admittedly, things get a bit tricky when one attempts to estimate the externalities associated with power production. However, economists have developed a set of sophisticated analytical techniques to estimate society’s willingness to pay to avoid negative environmental and health impacts. As is stands now energy markets implicitly assign a zero value to these impacts, which they certainly are not, thus leading to distorted market outcomes.
So let’s continue to work to lower the cost of solar; but let’s not play the Grid Parity game. We should not forget that the use of fossil and nuclear fuels to produce electricity come with significant external costs that are not reflected in the prices we pay for electricity. While renewable forms of power production do have impacts, I would argue that they pale in comparison to those associated with conventional forms of power production. Renewable energy advocates should embrace externality theory to demand policies and regulations to correct market failures associated with the significant health and environmental impacts that results from power production using conventional fuels.
Steven E. Letendre, PhD, is a professor of economics and environmental studies at Green Mountain College in Poultney, VT. He holds a masters degree in economics from Binghamton University and a doctorate in energy policy from the University of Delaware. Steven has published over forty technical papers on energy, including feature articles in Public Utilities Fortnightly, The Electricity Journal, Energy Policy, Solar Today and Renewable Energy. He currently serves as the Board Treasurer for Renewable Energy Vermont, the State’s renewable energy industry association.