Electricity generation causes external costs because of the emission of air pollutants. Pricing an electric utility＇s service at the sum of the utility＇s marginal generation cost and marginal emission cost, however, is inefficient due to ＇＇bypass＇＇ by large industrial customers and the need to maintain the utility＇s financial viability. This paper derives the optimal tax on emission and efficient prices for retail service to two customer classes, one of which has the option to self-generate. These rules are used to evaluate the pricing proposals made in a recent rate case in California. These proposals are shown to be inefficient, in that they encourage over-consumption by residential customers who do not have access to alternative sources of electricity supply.