The Role of Output Reallocation and Investment in Coordinating Externality Markets
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2019
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We empirically measure the inefficiency of uncoordinated externality markets in the context of CO2 regulation of electricity generation. Using data from a large regional U.S. wholesale electricity market that spans multiple states, we estimate a dynamic structural model of production and investment, and simulate the model under two scenarios to measure the inefficiency. In the first scenario, plants face CO2 prices that differ across states. In the second scenario, plants face a single CO2 price. Holding investment in new plant capacity fixed, generation costs in the first scenario can be as high as $7.8 billion, or about 50% of the cost of complying with the regulation, relative to the second scenario. However, we find that the inefficiency with uncoordinated CO2 markets is eliminated once we allow for optimal investment.