Tuesday, September 8, 2009

Part IV: Elasticity of Demand and the Price for CO2

In this section, the carbon price is evaluated using the elasticity of demand of electricity*. The elasticity of demand for electricity has been estimated to be ~0.2 in the short run, and ~0.7 in the long run. In subsequent calculations, the short-run value of 0.2 is assumed for calculations, providing a conservative estimate of the reduction in the emissions. In the short-run (2009-2012), it is unlikely that there will be significant deployment of any new technology for electricity generation, and therefore, the entire reduction in emissions has to occur through a reduction in consumption. The WM targets are a 3% reduction in the emissions, and therefore, we have:

DQ/Q (for electricity) = 0.03
Elasticity =0.2

--> DP/P (for electricity) =0.03/.2=0.15

Therefore, electricity is 15% more expensive due to WM. Since this 15% increase in electricity price is entirely due to the carbon price, the price of carbon may be estimated as:

DP/P=0.15 ==> DP = 0.15*P = 0.15*0.1 ($/KWhr)= $0.015 /KWhr

1KWhr = 1.35 pounds of CO2 = $0.015
1 Ton = 2204 pounds of CO2 = 2204*0.015/1.35 = $24.5/Tonne of CO2.

This value is clearly higher than the floor price used in earlier calculations ($10), indicating that the "fundamental value" of a CO2 permit is ~$25 in the period up to 2012. The estimates for periods beyond 2012 are fraught with uncertainty, because of the following reasons:
(1). Higher (and uncertain) elasticity of demand
(2). Possible role for deployment of new technologies (though 10 years seems relatively small from a utility context. However, other possibilities, such as plug-in hybrids could indeed be deployed faster, resulting in faster changes in demand).

Since the actual CO2 price is $25 per tonne, the price increase per household is now 24.5/10*73.5 ~ $180 per household per year.

*Elasticity of demand refers to the % change in demand of a good due to a specific % change in price. For details, see here.

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