Power Sector Emission Caps: Environmental and Economic Design Goals

1. Power Sector Emission Caps: Environmental and Economic Design Goals California Public Utilities Commission April 19, 2007 Richard Cowart Website: http://www.raponline.org

2. The Regulatory Assistance Project RAP is a non-profit organization providing technical and educational assistance to government officials on energy and environmental issues. RAP is funded by US DOE & EPA, several foundations, and international agencies. We have worked in 40+ states and 16 nations. Richard Cowart was Chair of the Vermont PSB, Chair of NARUC’s Energy & Environment Committee, and of the National Council on Electricity Policy. Recent assignments include technical assistance to RGGI, the New York ISO, the California PUC, the Oregon Carbon Allocation Task Force, and to China’s national energy and environmental agencies.

3. State and regional power sector carbon caps California & Oregon RGGI - 8 to 10 states Together, their carbon profiles exceed most nations.

4. How to evaluate the options? Cap-and-trade design criteria • Coverage and environmental integrity • Costs to power consumers • Societal costs – promoting low-cost solutions, especially energy efficiency • Administrative simplicity • Legal limitations and challenges • Coordination with other states and possible federal system

5. Acid Rain cap-and-trade– What’s different now? • US Acid Rain program – universally recognized success. NOx and CAIR build on this model. • GHG situation is different: • The best low cost solutions are not at individual smokestacks • Nor in the fuel supply -- we don’t have low-carbon coal • Power markets, utility structures have changed • Ask: what did the Acid Rain program do for energy efficiency?

6. Does the system have environmental integrity? Will it ensure reductions in the real world? Does it cover all relevant emissions? AB 32 -- All emissions associated with serving California electric load Is the system vulnerable to “leakage” – substitution of emissions outside the cap? California and Oregon load-side caps are intended to bring power imports into the capped system Improves coverage, reduces leakage, but requires rules to properly assign emissions to power imports Coverage &Environmental Integrity

7. (2) Consumer Power Costs How much does it cost power customers for a given level of attainment? • Wrong assumption: Power generators lose money under cap and trade • Design really matters here • Options to consider: • Generator-side cap with free allocation • Generators must buy allowances • Load-side cap – LSEs get a carbon budget, manage portfolio within a cap

8. Most generators make money with free historic allocation

9. Windfalls to generators ? • US Congressional Budget Office:“Producers would have to receive only a modest portion of the allowances to offset their costs from a cap on carbon emissions, because they would be expected to pass a large share of those costs on to consumers.” • RGGI study (by RFF): With free allocation in a source-based cap, consumers pay much more than the cost of adding clean resources to the mix • UK Parliament: EUTS is creating windfall gains for generators in the UK; • Similar results in Germany, Netherlands: • “Under all scenarios considered, power prices turn out to increase significantly due to CO2 emissions trading.” (--Sijm, Neuhof, and Chen May 2006)

10. Citigroup Analysis of the Impact of the EU Carbon Market on European Utilities (up to 2007)

11. Lowering consumer power costs: two options • Require generators to purchase allowances • RGGI “consumer allocation” • Prices rise, but some portion can be returned to ratepayers • Load-side cap: • Likely to be the lowest-cost solution, since generators face neither an auction cost nor an opportunity cost for carbon • This should be modeled for California

12. (3) Societal CostsDoes the cap system promote investment in low-cost GHG reduction options? • The main purpose of cap and trade is to reveal and capture low-cost reductions • Some improvements (e.g., heat rate) can be made at power plants, but • Low-carbon generation costs more, while • End-use efficiency is the lowest-cost way to reduce power sector GHGs. • SO: lowest social cost will come from a system that promotes customer efficiency

13. What does it cost to avoid a ton of electric CO2 ?* *Generation cost data (except nuclear) from EPRI (“Generation Technologies in a Carbon-constrained World,” 2005, assuming gas at $6MMbtu); EE data from Efficiency Vermont. For the point made here the precise numbers are not critical.

14. What happens if we double efficiency spending in RGGI? Extensive modeling* for RGGI found: • Carbon credit prices drop 25% • Need for new fossil capacity drops 33% • Customer bills drop 5% to 12% • And – even greater EE investments (quite attainable) would yield greater savings *IPM model runs by ICF Consulting using EE portfolios developed by ACEEE

15. Lesson from experience:EE programs are more powerful than rate increases • Economic theory: just raise the price of power • DSM reality: Programs are needed to surmount market barriers to efficiency • $ spent through smart programs will deliver at least 5x the efficiency savings of $ spent through higher prices • Key conclusion: Build efficiency support into program architecture. • BUT: Generators don’t deliver efficiency, some other avenue is needed

16. RGGI answer: The Consumer Allocation • Allocate up to100% of initial credits to consumer representatives (eg, distribution utilities, Efficiency Utility) • RGGI MOU - state minimum commitment is 25% • Most states will be higher – Vermont law is 100%; NY & MA draft rules now at 100%; CT, NJ may follow • Generators need to purchase allowances, recycling the windfall revenue BACK to consumers • PUCs supervise use of the $$ for benefit of consumers • Best result: focus these $ on investments that lower carbon (EE &RE) • Results: lower cost per ton avoided, lighter macro-economic impact >> quicker progress in reducing GHG emissions

17. (4) Administrative simplicity • Goal: Simple rules, easily measured compliance • Difficult criterion to meet for US states or regions – leakage requires regional measurements and attributions • Rules for flexibility devices, auctions and offsets can be complex • Different sectors CAN be treated differently • Power sector can differ from transportation, fuel oil, steel & cement

18. (5) Legal IssuesDoes it satisfy the requirements of AB32, the commerce clause, and other mandates? • AB32 requires meaningful accounting for imports (hard to envision this without actually capping/trading those tons) • But CA cannot directly regulate or tax out-of-state sources • And the commerce clause of the US constitution forbids even facially-different treatment of out-of-state sources • Load-based system satisfies these standards • Hybrid systems (smokestack cap for CA plants, something else for imports) raise thorny legal questions • Many seemingly good ideas are not legally possible • Auctions raise legal issues too – Agency authority, Treasury receipts, political appropriations process

19. (6) Coordination with other systems and possible national system • Trading with RGGI, European system? • “A ton is a ton” even if systems are different • But integrity is key – leakage, price caps can undermine value of CA credits • Should California’s system be designed to anticipate federal preemption? • Yes – and we know what that will be • No – we don’t know what it will be, and it may permit alternative approaches anyway

20. Conclusion: The three main issues • Environmental integrity – does the system cover the whole sector & ensure real reductions? (= minimal leakage) • Power price effects – how much do consumers pay to improve the sector’s carbon footprint? • Societal cost – how well does the cap system encourage delivery of low-cost, low-carbon resources ?

21. Concluding notes • The art of cap and trade design is evolving – RGGI, EUTS, Oregon, California are taking new approaches and learning from implementing older ones • RGGI consumer allocation is a major innovation, not previously expected • Too early to impose a single model on all states or all power markets • CPUC approach to cap-and-trade for power and natural gas builds on CA market conditions, and experience with energy efficiency and portfolio management .

22. For more information… “Another Option for Power Sector Carbon Cap and Trade Systems – Allocating to Load” (May 2004) “Why Carbon Allocation Matters – Issues for Energy Regulators” (March 2005) “Addressing Leakage in a Cap-and-Trade System: Treating Imports as Sources” (November 2006) “Why A Load-Based Cap?” (March 2007, with Julie Fitch) Richard Cowart, Regulatory Assistance Project Posted at www.raponline.org Email questions to RAPCowart@aol.com