Carbon trading under the Clean Power Plan

The following article appeared in the July 2016 issue of EM, the Magazine for Environmental Managers.

By Ashley Lawson, Senior Solutions Fellow, Policy and Resilience, Center for Climate and Energy Solutions (C2ES)

The Clean Power Plan gives states the option to include carbon trading provisions in their state implementation plans. This carbon trading can come in many “flavors” – mass-based, rate-based, intrastate, interstate, or even economy-wide. Regulators are still examining this complex landscape of options to understand the compliance approach that minimizes consumer costs while delivering the required emission reductions. This paper summarizes the economic benefits of carbon trading, examines key differences between rate-based and mass-based compliance, and argues that the electricity sector will be best positioned for a carbon-constrained future if it embraces carbon pricing in the near-term.

Leading economists say that the most efficient, cost-effective way to reduce climate-altering emissions is to put a price on carbon through a cap-and-trade program, a carbon tax, or some other method. A price on carbon means we’re accurately reflecting the real costs of carbon emissions – the climate change impacts like more extreme heat waves, more intense downpours, sea level rise, and ocean acidification that we’re already experiencing. Give companies a clear economic incentive to cut their emissions, and they’ll find the cheapest way to do it.

The Clean Power Plan recognizes the benefits of carbon pricing and provides multiple pathways for states to use it in their implementation plans, but the carbon trading options have received most of the attention. Although a Supreme Court stay of the plan means that immediate compliance deadlines will not be enforced, many states, utilities, regulators, and others continue to examine the potential for carbon trading. C2ES is facilitating these conversations so that states can be prepared to design smart implementation plans under the Clean Power Plan – or whatever power sector carbon regulation is ultimately enforced.

Carbon pricing under the Clean Power Plan

The Clean Power Plan’s approach to carbon pricing is consistent with the role that environmental markets play in other Clean Air Act regulations. The most notable example is the sulfur dioxide (SO2) cap-and-trade program established in Title IV of the Clean Air Act. This program created a market for the right to emit SO2, the main cause of acid rain. We don't hear much about acid rain today because power plants significantly cut SO2 emissions through a cap-and-trade program created by a bipartisan Congress. Emissions were reduced about twice as fast as predicted -- and at a fraction of the expected cost.1

A pollutant like CO2 is well suited to a market-based regulation because the environmental harm (namely, climate change) depends upon the total global concentration and not its specific location of origin. The environmental benefit from preventing the emission of one ton of CO2 is identical, regardless of where the prevention (abatement) occurs. However, the economic cost varies considerably from one source to another. When the costs of abatement vary by a large degree – as is the case for the U.S. power sector – then there can be large economic benefits to trading. A source that has low cost abatement potential can “overcomply,” allowing another source to “undercomply.” The second source would pay the first source for the extra reductions it achieves, up to the point where the second source could achieve the same reductions at the same price.

The U.S. Environmental Protection Agency (EPA) has constructed a useful, simplified illustration2 (see figure) to demonstrate the economic benefits of trading. In this example, there are three sources that initially emit 10 tons of pollutant each, for a total of 30 tons of emissions. A cap is then set at 15 tons overall – a 50 percent cut. Under a traditional command-and-control regulation, each source would need to reduce its emissions to 5 tons. The cost of compliance would equal each source’s abatement cost times the number of tons it reduces. For a command-and-control regulation in this example, this would be $1500, or ($100/ton * 5 tons) + ($80/ton * 5 tons) + ($120/ton * 5 tons).

When trading is allowed, the source with the lowest abatement cost can reduce more and trade those reductions to the source with higher abatement cost. As shown in the figure, Plant B can reduce its emissions by 7 tons while Plant C has to reduce its emissions by 3 tons to bring the whole sector into compliance. The overall cost of compliance when trading is allowed becomes $1420, or ($100/ton * 5 tons) + ($80/ton * 7 tons) + ($120/ton * 3 tons). In this simplified example, trading lowers the overall compliance costs by 5 percent.

In the Clean Power Plan, unlike this example, tradable credits can be given to non-emitting electricity generators and demand-side energy efficiency projects, in recognition of the reductions they provide to the electricity system overall. These sources often have costs much lower than heat-rate improvements or other on-site reduction options, so they are expected to play a major role in Clean Power Plan compliance where trading is allowed.

Economic incentives

Pricing carbon

By limiting the amount of CO2 that can be emitted, in either absolute terms (mass-based trading) or intensity terms (rate-based trading), the Clean Power Plan allows the market to form a price on carbon. This price incentivizes a sector-wide switch to lower-emitting sources in two distinct ways.

First, the electricity from high-emitting fuels becomes more expensive and, therefore, less profitable. The exact mechanism by which this economic incentive changes the amount of electricity generated from high-emitting fuels depends upon the structure of the electricity market. But in both competitive and regulated markets, the end result is that existing high-emitting generating units are run less.

Second, a price on carbon makes low-emitting fuels more profitable. Non-emitting sources (renewable, hydro, and nuclear) will see an increased profit margin when a carbon price is introduced. Non-emitting sources are already cheaper than fossil fuel-fired sources to operate because their fuel costs are lower, so the carbon price doesn’t affect how much the existing non-emitting sources generate. It does, however, encourage more of these generators to be built, so that the generation from these sources increases over time. The same incentive applies, though to a lesser degree, to efficient natural gas-fired units.

The Clean Power Plan also allows states to implement a carbon tax on power plants if they so choose. A tax puts a price on carbon, so the same electricity market changes occur as described above. However, since emitters could theoretically pay the tax to be in compliance with their state Clean Power Plan rules, yet still exceed the limits set in the Clean Power Plan, EPA requires a back-up plan that would ensure the emissions limits are met. States overall appear to be leaning toward carbon trading programs to price carbon rather than use a carbon tax for Clean Power Plan compliance.

Experience on the ground shows that the economic incentives from carbon pricing work. Carbon trading has been put in place in jurisdictions around the world, and through more than 10 years of experience, we have numerous examples of its success. In the U.S., 10 states that are home to a quarter of the population currently have a price on carbon. Emissions from sources covered by California’s cap-and-trade program were 3 percent lower in 2014 than they were in 2012, the year before the program started.3 The nine Northeast and Mid-Atlantic states in the Regional Greenhouse Gas Initiative (RGGI), another cap-and-trade program, have cut carbon emissions from power plants 40 percent since 2005. These reductions are more than what would be expected through other market and policy drivers (e.g. low natural gas prices, renewable portfolio standards) alone.4

Rate vs. mass

As states examine compliance options under the Clean Power Plan, a central question is whether to implement a rate-based standard or a mass-based standard. In our assessment,5 both approaches incentivize energy efficiency and new non-emitting electricity generation through the creation of a carbon price that increases the cost of generation from high-emitting sources and improves the economics of new non-emitting sources. The details regarding emissions reductions and loss of electricity market share for existing high-emitting sources will vary depending on the existing electricity portfolio.

Models find only small differences in the environmental outcome of the two approaches, supporting the idea that they provide the same incentives. For example, the Center for Strategic & International Studies and Rhodium Group found that a scenario of rate-based compliance reduced cumulative 2020-2030 power sector emissions by 4,415 million tons (Mt) from a reference case, while a mass-based compliance scenario saw 4,285 Mt of cumulative reductions.6

Auction revenue can further reduce emissions, costs

The Clean Power Plan allows states with a mass-based plan to determine the method used to distribute (allocate) allowances to the generating units that need them for compliance. The method of allocation does not change the environmental outcome, because the number of allowances in circulation is determined by the Clean Power Plan, and every ton of emissions must be covered by an allowance to show compliance. One option is to give all or a portion for free to generating units or other entities in the power sector such as distribution utilities. This approach minimizes costs to consumers because generating units only have to pay to cover emissions in excess of their allocation. Another approach is auctioning: The state sells allowances, and generating units will buy the amount they need to cover their emissions.

Auctioning allowances instead of giving them away gives cash-strapped states revenue they can use in a wide variety of ways to help achieve the goal of reducing emissions. A state could use auction revenue to directly subsidize innovative technologies like battery storage, microgrids, or carbon capture and storage. It could return the revenue to customers to reduce inequities, for example through bill rebates for low-income consumers who spend a larger share of their budgets on necessities like electricity. The revenue could even offset state taxes. Research into the pros and cons of each choice is widely available, and the choice is ultimately a political one. State legislatures would likely want to weigh in on the appropriate use of auction revenue. In some cases, the regulatory agency tasked with implementing the Clean Power Plan may also need legislative authority to conduct allowance auctions at all.

The 10 states with carbon cap-and-trade programs today all use auctions as the primary means of allocating allowances, but they have made different choices about how to spend the revenue. In California, state case law dictates that all revenues be invested in projects that reduce greenhouse emissions, and a state law specifies that a quarter of state revenue must be directed to disadvantaged communities. For example, more than $20 million will go to install solar panels in disadvantaged neighborhoods for free, saving each household as much as $1,000 a year in energy costs.7 The states in RGGI spend the large majority of their $1 billion in auction revenue on energy efficiency programs8 – upgrading appliances, lighting, insulation, and heating and air conditioning units. Connecticut uses a portion of its auction revenue to fund its Green Bank, an effort that leverages public funds to encourage private investment in clean technologies in the state.

Benefits of broad interstate trading

The economic benefits of trading are greatest when emitters have very different costs for reducing emissions. In carbon markets, bigger is generally better. A national trading market would be expected to have greater economic benefit than multiple regional trading markets, and a regional trading market would be better than single state markets. Moreover, a uniform national trading program would remove some of the concerns that stakeholders have about individual state programs, namely leakage. Leakage is when a source of emissions moves from a regulated jurisdiction to an unregulated jurisdiction to avoid paying the cost of emissions, resulting in lowered environmental benefits of the program. If all states are in a single market with a uniform carbon price, the risk of leakage between states is very small.

The Clean Power Plan does not require a single nationwide market, though it does offer a streamlined path, via trading-ready state plans, for states to collaboratively develop one. The use of common definitions, measurement and verification processes, and compatible tracking systems allows companies in trading-ready states to trade credits or allowances across borders.

In EPA’s analysis of a mass-based approach,9 it found that carbon allowance prices would range from $0/ton to $26/ton (all in nominal 2011 dollars) in the year 2030. This model scenario shows there are likely large economic benefits to be realized if states all implement trading-ready plans under the Clean Power Plan and allow their affected units to buy (or sell) tradable units.

Costs in the EPA projections varied within geographic regions, showing the potential value of nationwide trading. For example, seven states in the model had allowance prices of $0/ton, and they were in the Northeast and Northwest. Eight states in the model had allowance prices of $20/ton or greater, and they were in the West and Midwest. A linked market of trading-ready state plans in each of these regions would allow the full economic benefit of trading to be realized. A state with a low allowance price in the model is likely to have units that could cheaply overcomply. A state with a high price, in contrast, is likely to have units that would prefer to buy allowances or credits on the market.

The economic benefits for the buyer are clear – it can comply with the rule at a lower cost by purchasing an allowance or credit on the market instead of undertaking expensive reductions. But the seller also benefits because the “extra” reduction that it generates is paid for by the buyer. Like any market, the actual price will be influenced by a number of non-fundamental factors, but in theory, the seller’s extra reductions would be fully compensated for by the carbon price. Society overall benefits because the buyer’s more expensive reductions would not be required. This keeps the overall costs of compliance down, just as in the simplified example discussed above.

States have the option of implementing a “trading-ready” plan that would give their affected units the flexibility of participating in a market. States also have the option of implementing rate- or mass-based approaches. Under the Clean Power Plan, trading between these two types of plans is not allowed. Based on our conversations with stakeholders across the country, it appears likely that most states prefer a trading-ready plan, but they are split on their preference between rate and mass. Given this, it appears unlikely that states will implement plans that would result in a single national trading program.

A likely scenario for Clean Power Plan implementation, based on the final rule as it is today, is a patchwork of state plans – at the very least, one set of mass-based trading-ready plans and one set of rate-based trading-ready plans. This scenario is sub-optimal in the sense that overall costs to U.S. consumers would likely be higher than under a scenario of a single trading-ready approach implemented in all states. But the Clean Power Plan encourages states to do what they do best – innovate – and more examples of state success on the ground can inform a potential national approach to pricing carbon in the future.

Consideration of other policies

The Clean Power Plan is just one regulation in a large universe of policies and rules aimed at reducing greenhouse gas emissions. It is useful to consider not just how carbon trading under the Clean Power Plan can lower compliance costs, but also how it relates to other (existing and future) policies.

At the local level, cities and counties across the country are taking action to reduce greenhouse gas emissions. City efforts to promote energy efficiency in residential and commercial buildings and to boost renewable energy purchases have direct implications for future trajectories of electricity sector emissions. The trading mechanisms included in the Clean Power Plan could become a tool for advancing these city efforts while simultaneously bringing utilities into compliance.

Taking the long-term view, policies to mitigate climate change will be necessary moving forward. The United States has committed to reduce national greenhouse gas emissions 26 – 28 percent below 2005 levels by 2025 under the international Paris Agreement agreed to at the COP21 meeting in December 2015. The strong support that U.S. cities, states, businesses, and others give to this agreement indicate strong political pressure to achieve this goal. Worryingly, several independent modelling studies have estimated the Clean Power Plan and other existing policies will not be sufficient to achieve the target.

Setting a price on carbon can create business opportunities out of the necessity to reduce emissions further, and help address this gap. Companies that can find low-cost ways to reduce emissions can sell these reductions to others. Successful implementation of carbon pricing programs under the Clean Power Plan would also position the power sector to benefit from future policies that will be needed to meet the country’s long-term climate goals. Assuming these future policies would utilize carbon pricing (to take advantage of the reduced costs described above), this would extend the number of potential buyers for power sector reductions. Moreover, the non-emitting electricity technologies that a carbon price promotes can provide energy to other sectors like transportation and industry that do not currently widely use electricity as an energy source.

Promoting carbon pricing in the near term is a wise long-term strategy for electricity companies. Successful implementation of carbon pricing under the Clean Power Plan can demonstrate the advantages of these policies and build support for a national program. This will create competitive advantages for those electricity companies that adapt their business practices now for a carbon-constrained future.

Conclusion

Carbon trading under the Clean Power Plan can deliver the required reductions in power sector carbon emissions at the least cost while simultaneously incentivizing new clean energy deployment. EPA has included carbon pricing as an option for implementation plans, but it is up to states to decide to what extent pricing will be used to achieve the Clean Power Plan goals. Successful experience with trading programs under the Clean Power Plan will benefit the electricity sector if and when future carbon pricing policies are put in place. C2ES believes that these policies are inevitable given the strong pressure from local governments and businesses to act on climate change. When thinking about long-term climate policy goals, a greater reliance upon carbon-free electricity is likely. The faster the sector can decarbonize, the greater will be its position to support other policies that would enhance carbon-free electrification of the economy. Carbon pricing is the best tool to achieve this aim.