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Energy Policy with Externalities and Internalities

  • Hunt Allcott
  • Sendhil Mullainathan
  • Dmitry Taubinsky

We analyze optimal policy when consumers of energy-using durables undervalue energy costs relative to their private optima. First, there is an Internality Dividend from Externality Taxes: aside from reducing externalities, they also offset distortions from underinvestment in energy efficiency. Discrete choice simulations of the auto market suggest that the Internality Dividend could more than double the social welfare gains from a carbon tax at marginal damages. Second, we develop the Internality Targeting Principle: the optimal combination of multiple instruments depends on the average internality of the consumers marginal to each instrument. Because consumers who undervalue energy costs are mechanically less responsive to energy taxes, the optimal policy will tend to involve an energy tax below marginal damages coupled with a larger subsidy for energy efficient products. Third, although the exact optimal policy depends on joint distributions of unobservables which would be difficult to estimate, we develop formulas to closely approximate optimal policy and welfare effects based on reduced form "sufficient statistics" that can be estimated using field experiments or quasi-experimental variation in product prices and energy costs.

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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 17977.

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Date of creation: Apr 2012
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Publication status: published as Allcott, Hunt, Sendhil Mullainathan, and Dmitry Taubinsky (Forthcoming). “Energy Policy with Externalities and Internalities.” Journal of Public Economics.
Handle: RePEc:nbr:nberwo:17977
Note: EEE PE
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