This working paper was published as WP2015-09 in the Colorado School of Mines Division of Economics and Business Working Paper Series while CEnREP Affiliate Harrison Fell was on faculty there.  When referencing this manuscript, please cite it as part of Colorado School of Mines’ Division of Economics and Business Working Paper Series (full information is contained on the cover page for the linked manuscript below).

ABSTRACT: In order to comply with the Environmental Protection Agency’s (EPA) recently released regulations governing greenhouse gas emissions from power plants, states are given the option to implement rate-based emissions intensity standards for the power sector. One well-known consequence of rate-based emissions standards is that in addition to encouraging substitution towards less emissions-intensive sources, they also subsidize output, and thus are considered by economists to be inferior to a first-best solution. However, the exiting literature has not considered energy efficiency decisions within the framework of intensity standards. This omission is particularly problematic in the context of the power sector, where energy efficiency has been considered an important channel of cost-minimizing emissions reductions. To encourage end-use efficiency measures under an intensity standard EPA allows states to credit electricity savings as a means of complying with the rule by treating them as a form of zero-emissions output. In this paper we investigate the role of energy efficiency choices in rate-based emissions intensity standards. We show that when demand for energy services is perfectly inelastic, crediting efficiency measures can recover the first-best allocation. This approach extends the output subsidy in a traditional intensity standard to energy efficiency, thereby eliminating the distortion that favors electricity generation over energy efficiency. However, when demand for energy services exhibits some elasticity, crediting energy efficiency can no longer recover first-best. While crediting energy efficiency removes the relative distortion between energy generation and energy efficiency, it distorts the equilibrium level of both energy generation and energy efficiency via an energy services subsidy. Simulations calibrated to the electricity sector in Texas examine the above issues numerically, as well as explore the implications of alternative energy efficiency crediting schemes.