''Second-best'' adjustments to externality estimates in electricity planning with competition

Some public utility commissions use monetary place-holders to reflect externality values in the financial evaluation of utility investments. This approach can be justified as a ''second-best'' policy tool if existing environmental regulation can be taken as given. This paper addresses two possible unintended consequences of this policy: the effect on the price-marginal cost gap and the potential substitution towards unregulated generation. We compute a ''second-best adder'' to correct for externalities in electricity planning in three regional case studies using a normative model of economic efficiency. Such adders are found to differ from externality estimates by 10-20 percent or more.