A new coalition wants Congress to crack down on greenhouse gas emissions. Sound like no big deal? Before you start yawning, take note: this coalition isn’t made up of the usual suspects in the environmental movement. This coalition is made up of businesses.

American Businesses for Clean Energy (ABCE) launched four months ago with a simple goal: to demonstrate the vast amount of business support that exists for climate change legislation. Already, about 2500 businesses in 41 states have signed onto the initiative.

The lesson is that being pro-planet can also be pro-profit. We can’t have sustainable businesses in an unsustainable world. Even better, we can ensure that slashing greenhouse gas emissions reduces energy costs rather than increasing them. All we need is the creativity and political will to undertake real reform.

With the business community starting to holler, the chances for such reform just got better.

The United States’ energy and environmental policy sucks. That’s the bad news. The good news is we can fix it with a smart approach to clean energy:

• “Output standards” for emissions, so that regulators look at how much pollution is released per unit of energy generated, rather than the current rule of basing it on how much fuel is used. This change would encourage efficiency rather than penalizing it.
• A “clean energy standard offer” for federal electricity purchases, so the government gives preferential treatment to clean, efficient energy options.
• A “regulatory modernization committee” to transform our energy system from a Hummer into a hybrid.

Check out more of my ideas for promoting energy efficiency through CHP and waste energy recovery.

Question: are there any examples of a completely free market inducing investment in mature, capital-intensive industries? I’m not sure there are. More problematically, I’m not sure that economists and policy makers appreciate this reality. The result is that we continue to create markets — from electricity to CO2 — that by design are incapable of rewarding or encouraging capital investment. In electricity markets, this has created a situation in which the wholesale prices are insufficient to encourage new investment and — if left unchecked — could lead to serious power supply shortfalls. In CO2 markets, this has the potential to create a situation wherein the one thing we most want from CO2 policy — namely, capital investments to reduce CO2 — is not achieved.

First, let me define my terms. By “free market”, I’m referring to the market of Econ 101 textbooks: no barriers to entry, no barriers to exit, no one entity can independently affect price, etc. By “mature”, I refer to industries wherein the next investment is unlikely to produce a product with a significantly lower cost structure than the industry average. Finally, by “capital-intensive”, I refer to any industry where the majority of the annual cost goes to capital recovery.

Economists have spent a lot of time figuring out how to structure markets to get as close as possible to that free market ideal. Much of the most interesting work in that vein has been in the design of auctions, especially in the electric sector. A host of models have emerged that seek to drive costs down the marginal cost of the highest-cost supplier necessary to meet supply needs. For the most part, these auctions have been successful. Yes, there are some high-profile screw-ups (see: Enron), but they are the exceptions that prove the rule — the absence of front-page stories on 99.99% of the world’s auctions is a testament to their effectiveness.

But here’s the rub: no one invests capital to cover their operating costs. We invest capital to earn profits in excess of our operating costs. And there are no profits if you’re only covering your marginal production cost. Robert Solow won a Nobel prize for noticing that the presence of profits (and its result: economic growth) is de facto proof of the absence of free markets. Solow’s conclusion was that the persistence of economic growth must therefore result from technological innovation. So long as opportunities exist for technological advance that allow one to produce widgets at a discount to the market clearing price, companies will make those investments, capture profits and reinvest in further growth.

But what happens when those opportunities don’t exist anymore? When’s the last time someone built a new integrated steel mill in response to a free-market price signal? Oil refinery? Cement plant? Might the deindustrialization of the United States result in part from an economic model that drove prices for manufactured goods down to their marginal cost once those industries reached maturity?

Moreover, as we look for places where we have invested in large capital projects in mature industries, a consistent feature emerges of heavy subsidization and distortion of free market principles. China has invested in basic infrastructure by government mandate. Regulated utilities build power plants on the back of rate-payer guarantees and monopoly franchises. Wind turbines have been built in response to technology-specific tax incentives and RPS mandates.

This becomes problematic when we look at what we are currently expecting markets to do. We have designed electric capacity markets to clear at the marginal cost of capacity services, but expect them to bring new investment forward. Greenhouse gas cap & trade markets will fail utterly if they fail to incentivize investments in CO2 reduction…but they too are being set up within the framework of auctions and marginal clearing prices. Market purists fall back on just-so stories when confronted with these failures, noting that the lack of investment in response to these markets suggests nothing more than that the investment wasn’t needed. Maybe they’re right. But if they’re wrong, we’re in dangerous waters — and since the economic theory upon which these markets are based is supposed to drive price down to the margin, why should we expect it to induce new investment?

This isn’t to suggest that we all turn socialist, but simply that we acknowledge the limitations of the tool. Markets structured to drive costs down to the margin are great at rationalizing production and forcing discipline on business managers. But asking them to also encourage new investment may be like trying to catch a deer with a fishing pole. In cases where new investment is needed — as is most obviously the case with any effective GHG regulation — we may need more tools.

Read more of Sean’s thoughts on markets and capital investment.

1. Use less downstream energy. Turn down the thermostat, ride your bike to work, move to a smaller home, etc.

2. Switch upstream fuels. Favor coal in the name of national security. Favor nuclear in the name of CO2. Favor wind in the name of green jobs. Etc.

3. Use less upstream energy. Insulate your home, build CHP plants, recycle your plastic and aluminum waste, etc.

All three have a critical role to play, but note that only the third creates social benefits and can be guaranteed to increase our overall standard of living. In the famous Amory Lovins-ism, no one gives a damn about how much coal, oil or gas they use — they care about how hot their shower is and how cold their beer.

Ergo, we ought to make maximal use of anything that fits into that third bucket as a matter of public policy. Which raises the question: how big is that third bucket? Or, framed another way: how much energy does the U.S. currently waste? Any increase in our efficiency of energy conversion (from upstream fuel to downstream energy) is implicitly a reduction in our energy waste. Tell me how much we waste and you will tell me the maximum size of that third bucket.

How Much do we Consume?

As it turns out, there’s very little good data on how much energy we waste. DOE estimates that we use about 100 quadrillion btus (“quads”) of primary energy per year. But they too often present that data in charts like this one that seem to assume a perfectly efficient economy. As that great philosopher Homer Simpson said, “In this house, we obey the laws of thermodynamics!” And I’m pretty sure thermo says that you can’t get 100 percent of the energy you put in out in a useful form. DOE charts to the contrary notwithstanding…

Nonetheless, this does bound our analysis. If we put 100 quads of primary energy in, we must get 100 quads out somewhere. At the very least, it implies that there can’t be more than 100 quads of wasted energy presently available in the system.

Solid Waste

EPA estimates that the average American produces 1,130 lbs of trash per year.  At 4,500 btu/lb and just over 307 million people, that’s 1.6 quads of energy in our trash.  Add in 6.5 million metric tons of solid waste in our sewage per year at 10,000 btu/dry ton and that’s another 0.1 quads.  So in total, all our solid waste is about 1.7 quads of total energy waste, or 1.7 percent of all our primary energy use.

Industrial Waste

Lawrence Berkeley National Lab has estimated that the US could produce 96 GW of electric power from energy that is currently wasted by the US industrial sector.  (This waste includes a host of different materials, from paper sludge to waste heat.)  RED‘s internal analysis suggests that this may be conservative, but let’s use the LBNL data.  Assuming 25 percent fuel-to-power generation efficiency (and assuming further that this represents 100 percent of all energy wasted by the US industrial sector, and not simply the economically recoverable/LBNL-identifiable fraction) that works out to an additional 11.4 quads.

Power Generation Waste

In 2008, we generated 3,806,611 GWh from fossil-fired thermal power plants. Those plants, on average, operate at 33 percent fuel efficiency, meaning that for every 1 unit of electric power generated, 2 units of waste heat were thrown away in cooling towers, rivers and streams. That’s 2 x 3,806,611 GWh of wasted heat, or 26.4 quads up in smoke.

Transportation Waste

The total US transportation sector uses some 28.6 quads of fuel per year. For rather obvious reasons, there’s not a lot of good data on how much of that goes out the tailpipe vs. a more productive use. But conservatively, let’s assume that we get 30 percent of the useful energy out of that fuel (this is considerably higher than a passenger car over normal driving cycles, but probably low for rail, shipping and long-haul trucking on an efficiency per ton-mile basis.) Clearly, this is the least accurate of the numbers, but even at 30 percent, that implies an additional waste of 0.7 x 28.6 or 20 quads of waste, going into tail pipe exhaust, hot brakes, burnt tires, etc.

Total Identifiable Waste

Add those all up and we’ve got 100 quads of primary energy and 60 quads of waste energy. For all the reasons noted above, the waste energy is probably much higher, but even at this level, it is a massive opportunity. Recovering just half of this total would reduce every issue associated with fossil fuel use by one third with no detriment to our standard of living. Getting this waste out of the system ought to be a priority of our national energy and environmental policy.

Note: This first appeared on Grist.

Now consider that you are a legislator trying to reduce CO2 emissions as quickly and as cheaply as possible. Should you bother putting a price on pollution to discourage its release? Noting the extreme rarity of “perfect markets” and the recent spate of financial scandals, should you not instead conclude that using markets as a policy tool is a waste of time?

The two questions are logically equivalent. Like training, markets do not guarantee perfection. But just as you can’t win unless you train, you cannot identify the lowest cost solutions to any given challenge without markets.

This point is too often lost in our public debate, which is framed as an argument between two equally illogical positions. One side argues for small-government policies on the tenuous basis that anything done by government can be better done by market forces in the guise of profit-seeking companies. The other side argues for big government on the grounds that only an enlightened regulator can ensure the public welfare. The one point of agreement between these extremes is that economic theory stipulates the existence of perfect markets (their dispute is over whether or not the purported theory is correct.) But that’s not what the theory says. It is like arguing whether the best way to run faster is to do nothing but push-ups or consume nothing but steroids.

The problem comes from a confusion of terms. Profit-seeking behavior, markets and efficient capital allocation are not synonymous, and the presence of one does not guarantee the presence of the others.

A “market”, after all is nothing more than a collective allocation their resources. Economists refer to markets as being efficient only when they meet a specific set of conditions, at which point the benefits that accrue from Adam Smith’s invisible hand are realized through the independent actions of profit-seeking actors. But most markets are inefficient – often woefully so. Effective regulatory processes can make markets more efficient – but regulatory processes that seek to bypass market forces will serve only to increase the inefficiency of the markets that remain.

What Economic Theory Actually Says About Markets

Basic economic theory says that price is a function only of supply and demand, and therefore is a perfect reflection of all of the information affecting both sides of that equation: production costs, consumer preferences, future availability of raw materials, competing options, possible changes in regulation, and so on. To the extent that this price-omnipotence is obtained, markets for the good/service in question are completely free to optimally allocate their scarce resources: money flows to its best use, labor is perfectly matched to the talents and demands of the community and natural resources are precisely consumed in careful consideration of both their present and future values.

Assuming perfection makes for easy choices. Adonis didn’t have to worry about changes to his diet, exercise routine, fashion sense or hairstyle since knew that any change to his perfect form would, by definition, render him imperfect. Many regulators and journalists fall into this same Adonis-trap when discussing markets. Any policy change intended to encourage different behaviors is dismissed as a step towards imperfection – and any unsuccessful business/technology is not worthy of regulatory support since “if it’s such a good idea, our perfect markets would have already done it.”

But here’s the rub: economic theory does not claim that markets are perfect. It simply explains how capital would be allocated if they were. As proof, look no further than the Nobel committee:

• Robert Solow won the Nobel in 1987 in part for making the observation that economic theory implies that prices will always be driven down to the marginal cost of production. If this occurred, corporate profits, the reinvestment of those profits and ultimately economic growth would be mathematically impossible. Solow’s insight was that this persistent “impossibility” exists in part due to technological progress. But note the implication: the presence of economic growth implies the absence of perfect markets.
• Daniel Kahneman and Vernon Smith shared the 2002 Nobel for their work in behavioral economics. They showed (among other things) that prices depend significantly on context rather than fundamentals of supply and demand, and thus the “signal” that price sends to the market is often incompatible with that required for efficient capital allocation.* Again, note the implication: perfect markets may incompatible with the way the human brain works.

*(An example: would you go 10 minutes out of your way to save $20 on a $100 piece of furniture? Would you also go 10 minutes out of your way to save $20 on a $20,000 car? If you answered yes to the first but no to the second, you have demonstrated economic irrationality by “charging” for your time based on variables other than supply, demand and your marginal cost. Shame on you!)

So why does the perfect market theory persist? Two reasons:

1. It’s a useful approximation tool. Knowing how to calculate the area of a circle is helpful, even if there are very few naturally-occurring perfect circles. Similarly, there are many markets (commodities being an obvious example) where actual behavior can be very nearly approximated and understood with perfect market theory.
2. It’s a useful policy tool. If we understand the conditions that allow a perfect market to exist, we are better able to craft policies that will reap its rewards.

For policy purposes, this latter point is critically important. Recall Solow’s insight that perfect markets are incompatible with profits. That is understood at a gut-level by every business owner who has seen competition drive down their margins – which is why businesses seek to make their markets as imperfect as possible. In turn, we have created regulatory agencies (like the SEC) to counter-balance. That is a healthy tension, and a good model for well-informed policy: don’t simplify markets as pure good or pure bad, but rather seek to create conditions that facilitate efficient markets.

So what are the conditions under which “perfect” markets exist?

1. There are no barriers to entry and exit.
2. No single entity can independently act to control price.
3. Markets consist of many buyers and many sellers.
4. There is perfect information; all prices up and down the value chain are fully known to all buyers and sellers.
5. All sellers seek to maximize their profits.
6. The good/service traded in the market is perfectly homogeneous, such that there is no differentiation (other than price) between competing suppliers.

It’s pretty easy to identify imperfect markets with from this list. Want to find a barrier to entry? Try to start a new car company tomorrow. Barrier to exit? Try to sell your house. Imperfect information? Look no further than Bernie Madoff. But it’s also easy to use this list to guide good policy that will steer markets towards perfection.

Policy Consequences for CO2 regulation

So let’s return to the question posed at the start. If you are a legislator seeking to craft policies to reduce CO2 emissions, how should you approach the problem?

1. Avoid polemicists. Do not assume that price alone is sufficient to drive market behavior, but do not discount the tremendous power of markets to provide least-cost solutions to complex problems.
2. Maximize market participation. Exempting sectors from participation in CO2 markets permanently or temporarily (e.g., through a phase-in) increases the likelihood that individual actors will be able to control price to their advantage.
3. Craft rules to ensure price consistency. The cost of a ton of emissions release ought to be identical to the revenue received for a ton of emissions reduction. The cost a ton of CO2 imposes on our climate is independent of the location or corporate structure of the source; its price shouldn’t either.
4. Maintain robust market oversight. The lesson to take from the California power crisis is not that markets don’t work, but that markets can fail when large players can independently affect the supply/price of a given commodity. Trade watchdogs will be no less critical for emerging CO2 markets.

What all agree on is that uncertainty is unacceptable.  And so, not surprisingly, we get policies like Waxman-Markey that are neither a pure cap nor a pure tax nor a pure subsidy, but a bit of certainty scattered hither and thither. Sausage making at it’s finest.

But do we really have that much uncertainty?  At least in the electric sector (which is, after all, responsible for over 42% of US CO2 emissions), we have a fairly high degree of certainty on two ponits: in the short term, we’ll shift from coal to gas.  And in the long-term, power prices will fall.

Which is probably sufficiently heretical to demand explanation.

Near Term

So why can we be certain of a near term shift to gas?  That’s fairly easy: because we don’t have any other choice.

The current US power mix is supplied by coal (49%), natural gas (22%) and nuclear (19%).  Everything else is piddly.  6% hydro, 2% petroleum and 3% from all other renewables combined.  Given the 24+ month timeline required to design, finance, build and commission any new power plant, the only near term response to GHG pricing is to shift the resource allocation amongst those generators that are already built.  And while nuclear is a low-carbon power source, it can’t generate any harder than it already is.  As noted here (see Fig 4), the nuclear fleet is currently running at a 90% capacity factor, and on historically trends, appears to have pretty well maxed out.  Which means that short of building new nuclear plants – hardly a quick, near term solution – there’s no way to swap coal-fired electricity for nuclear.

The gas fleet, on the other hand, hardly runs at all.  In 2006, the fleet had a 20% capacity factor.  Roughly speaking, this means that any given plant was shut down for four days out of every five.  Gas fleet capacity factor bounces a bit from year to year, but generally stays in the 20 – 30% range.  Thus, if we immediately put a price on carbon that immediately applies to all generators (color me politically naive if you wish), the immediate impact would be to shut some coal plants off and run some gas plants a bit harder.  It’s not a long-term solution, and its cost depends solely on the price spread between coal and natural gas.  But as noted here, it does have the potential to quickly and massively lower the CO2 signature of the US electric sector.

Long Term

Now to the heretical part.

Let’s extend our gaze sufficiently far into the future that new capital has been deployed, facilitating the retirement of the old dirty stuff.  What’s it likely to look like?

I’m not foolish enough to make technology-specific predictions.  But I will go out on one very small limb: power plants deployed in response to GHG controls will be less GHG-intensive than the ones we build today.  Wind, nuke, solar, CHP, biomass, geothermal… and probably lots of other things we haven’t thought of (not to mention lots of end-use conservation).

Here’s the unifying feature of all those technologies: they cost less to operate on the margin than the stuff we use today.  That’s not to say they’re all cheaper.  After all, many of the technologies we will deploy in response to GHG regulation are technologies that today are held back due to high capital costs (solar, nuclear, etc.)  But once a power plant is installed, the decision to run it one more hour isn’t based on capital cost recovery, but on the marginal cost of production.  If it costs me $2.50 to make one more widget and I can sell it for $2.51, I’ll make that widget regardless of how much the widget factory cost me.  That, in a nutshell is why our nuclear fleet today runs all the time and the gas fleet doesn’t.  Inclusive of capital recovery, the gas plants have lower all-in costs… but on the margin, the nuke plants make more sense to run.

This point is key, and too often overlooked.  We assume that new, low-CO2 technologies are held back by economics – but forget that those economics include both capital and variable costs.  And in the long-run, it is only the variable cost that matters.  Shifting to low-CO2 power is therefore a shift to low variable cost power.  Which in turn is a shift to low cost power.

I should emphasize that it may take a while to get to this point, as initial prices from high-cost construction have to be amortized.  A comparison with nuclear in the 1970s is instructive, when huge cost overruns put upward pressure on prices until the political will was broken and owners went bankrupt… but the plants kept running, and today form the low-cost base for much of our grid.  This will happen again with new low-CO2 sources, for the simple reason that CO2 sources (e.g., fossil fuel) cost money.  Cut the source, save the money.

I should also note that there is one exception to the low cost/low CO2 paradigm: Coal with CCS.  It’s low CO2 (if it works) but high cost.  Which is why it will never matter.  It won’t be built unless subsidized, and if it is built, it won’t run.  I’m certain.

Note: This first appeared on Grist.

I’ve always found the above to be one of the wiser quotes about deregulation. (Kahn, for those who don’t know him, was at the helm of the Civil Aviation Board when airlines were deregulated, and has since written some of the more insightful pieces on deregulatory processes in multiple industries.)

What does this have to do with commodities and Senator Feinstein? Recently, she announced a proposed amendment to the Senate climate bill, one that would commence federal oversight of CO2 markets “to prevent Enron-like fraud, manipulation and excessive speculation in the new federal, state and regional carbon markets that will be established by [a cap and trade] system.”

That sounds perfectly noble,  part and parcel of the broader political backlash against commodity market speculators. Recall a few years back, when speculators were being blamed for driving the price of oil and gas to artificial highs. Economists argued that such trading had no effect, but was a part of a healthy market that allowed informed people to make bets and hedge risks. Populists argued that energy is too important a commodity to be exposed to such volatility, especially for folks living paycheck to paycheck. Both points are valid, and with the political turnover in DC, the general mood is shifting from one favoring laissez-faire, let-‘em-speculate approaches to one favoring market regulations and speculator constrainment. (See here for the NYT‘s recent take.)

Speculation pros and cons

Discussions of regulation, populism, and economic theory inevitably take a political turn, so let’s state a few obvious, apolitical truths:

1. Unless you’re an energy producer, high energy prices stink.
2. No matter who you are, volatile energy prices stink.
3. Not withstanding points (1) and (2), high and/or volatile energy prices encourage greater energy efficiency.

To argue that energy price volatility and/or perpetually high energy costs are categorically good or bad is false, and unnecessarily polemical, even if it does make for a good political soundbite. As we now start to contemplate the creation of entirely new markets for entirely new commodities (namely, CO2 emissions rights), it’s not at all surprising to hear the battle joined on familiar sides. Nor is it surprising to hear the e-word word (Enron!) thrown around, which calls for a brief digression.

What Enron did and didn’t do

Enron undoubtedly engaged in a host of amoral transactions, not to mention lots of illegal transactions. But not everything   that was amoral was also illegal. This latter point is particularly true with respect to California electricity markets, and it’s worth reviewing some history—especially when Enron-as-metaphor comes to have a meaning so distinct from Enron-in-reality.

When the California Power Exchange, or CalPX, was first created in 1998, it was essentially the first time that electricity could be bought and sold external to a regulated transaction. After a cautious year learning the rules, the gloves came off once electric generators, buyers, and speculators came to appreciate the magnitude of potential market swings (and how much money could be made therein). Enron’s Star Wars-inspired ploys were the most famous example, making them the poster child for rapacious speculation. So far, so fair.

The awkward wrinkle to this story is that some of those transactions weren’t technically illegal. If you’re an avocado farmer and you can get $2 an avocado at Kroger and $2.50 at Safeway, no one calls you amoral for selling to Safeway. And if that then causes Kroger to raise their avocado prices to draw you back into their supply chain, no one is likely to take out their ire on the greedy avocado broker.

But watch what happens if you replace the word “avocado” with electricity. If your power plant will earn more money tomorrow (given the hot weather forecast) than it will today, and you therefore curtail production today to horde your fuel, are you breaking the law? If you then notice that the price today starts to rise when you curtail, such that you can independently affect price, are you amoral for using that knowledge to your economic advantage?

To be clear, I don’t in any way mean to suggest that Enron wasn’t amoral, nor that society’s access to electricity is no more important than society’s access to avocados. However, when the regulatory rules are set up such that the electricity broker’s regulatory constraints are broadly similar to those of an avocado broker, a fair portion of the blame for whatever next ensues is rightly laid at the foot of the regulator. Every time we simplify the California power crisis to “Enron-type manipulation,” we give the regulator an undeserved free pass.

Why Kahn matters

In a regulated enterprise, the role of the regulator is essentially to set price. That’s how consumers get protected. In an unregulated enterprise, the role of the regulator is to make sure that the market sets the price, but that no individual actor (or collection of actors, acting in concert) can affect that price. That’s why he says that the regulatory function shifts from price setting to anti-trust enforcement. The fact that Enron was allowed to exist in California is all the evidence that you need that antitrust enforcement was absent.

Which brings us back to Senator Feinstein’s efforts to regulate emerging CO2 markets. Should we be leery of amoral market speculators? Yes. Should we guard against market dominance that can affect the price and supply of CO2 credits? Yes. But should we define success by a stable, not-too-high price for CO2 emissions credits? Absolutely not. A healthy market is incompatible with price controls. What’s more, a regulator focused on price controls is often blind to precisely those antitrust-busting games that smart, amoral speculators like to play.

For now, I’m cautiously encouraged by Feinstein’s efforts. Encouraged, that is, to the extent that her invocation of Enron meant that we need to adopt greater regulatory discipline to ensure we don’t repeat our prior regulatory mistakes. But cautious, also, because too often, that invocation turns a blind eye to the culpability of regulatory agencies whenever we have a regulatory failure.

Note: This first appeared on Grist.

Broadly speaking, there are only three things we can do to lower CO2 emissions:  switch fuels, use energy more efficiently, or use less energy (conserve).

Our CO2 conversations too often focus on one of those three in isolation: Coal bad. Recycled waste heat good. Conservation isn’t an energy policy. Each assertion is both narrowly true and broadly incorrect, to the extent that each simplifies three prongs into one.

To understand why, try to answer a simple question: if we shifted our power generation fleet to preferentially dispatch natural gas plants instead of coal plants, how much would CO2 emissions fall?

That would seem to be an easy bit of math: just measure the CO2/MWh of each plant, multiply the difference by the MWh switch, and we have our answer, right? Turns out it’s a tad complicated, for the simple reason that the fuel switching strategy is also an efficiency strategy. Does a newly dispatched gas plant look like one of the old, 30% efficient, natural gas-fired Rankine “steamers,” or does a newly dispatched gas plant look like one of the new, 50% efficient combined cycle gas turbines? What about the coal plant that gets turned off?

Better still, let’s ask an easy question: how has the CO2 signature of our nation’s coal and gas-fired power fleet changed with time?

DOE/EIA keeps voluminous records of fossil fuel consumption and power generation by fuel type. On the following charts, I’ve divided total fleet fuel use by total fleet MWh and then multiplied by a consistent 0.06 tons of CO2/mcf of natural gas / 2.7 tons CO2/ton of coal to yield the following:

Interesting. From 1960-1990, there was no statistically significant change in gas fleet CO2 emissions, which held steady at 0.63-0.65 tons/MWh. Then all of a sudden in the 1990s, the fleet transformed itself, reducing its CO2-intensivity by 25% in just 10 years. What happened?

In a word: competition. The introduction of competitive access in the 1992 Energy Policy Act (and subsequent FERC rulings) brought forth a flood of natural gas plants, many of which were nearly twice as fuel efficient as the old junk that the grid had previously relied on. Prior to that point, costs were simply something that you passed along to customers. After that point—for much of the grid—cost control was a route to greater profits. Not surprisingly, generator owners suddenly got religion on cost-control. And when your number one cost is fuel, that means they got religion on fuel control. That’s good.

Now let’s look at what happened to the coal fleet during the same period:

From 1960-1970, the coal fleet holds steady at 1.17 tons/MWh, but then starts an inexorable upward trend. While the gas fleet became more efficient with time (after 1990, at least), the coal fleet is steadily less efficient. Way less in fact—to the point that the CO2 emissions associated with a MWh of coal-derived electricity are 18% higher today than they were in 1960.

What happened here? Two things:

1. Unintended consequences. 1970 saw the passage of the Clean Air Act,  a deeply flawed bill. It was good in terms of what it did for regulated pollutants, but lousy in terms of what it did for unregulated ones (e.g., CO2). By effectively mandating pollution control approaches that impose parasitic loads on coal plants, the CAA is directly responsible for lowering coal plant energy efficiency, so that we now burn way more coal per MWh than we did before passage. We therefore emit way more CO2 per unit of useful electricity. That’s not to ignore the beneficial elements of the CAA, from sulfur to particulate control, but simply to point out that an environmental regulation that encourages energy inefficiency leaves much to be desired.

2. Dispatch considerations. As noted here, the last 30 years have seen virtually no construction of new baseload power plants in the US, but have seen a steady increase in the annual load factor of currently existing baseload plants. In other words, plants that used to spend most of their life turned off now spend most of their life turned on. In the coal fleet, that means that the least efficient stuff runs more now than it used to. So in addition to the unintended consequences of the Clean Air Act, we also have the simple fact of steadily growing electricity demand that causes us to pull our power from ever-more-undesireable sources.

Why didn’t the competitive forces unleashed by the 1992 EPACT also drive up the efficiency of our coal fleet, like they did for gas? Again, it’s an easy answer: competition. Coal plants are lousy investments. No one builds them who has to put their own money at risk.

One last thing

Here’s the tragedy: If we had run the gas fleet at a constant fuel efficiency from 1960-present, we would have emitted an additional 1.3 billion tons of CO2 into the atmosphere. That’s 1.3 billion tons not in the atmosphere today thanks to energy efficiency.

On the other hand … if we had run the coal fleet at a constant fuel efficiency from 1960-today, we would have emitted nearly 9 billion fewer tons of CO2 into the atmosphere over the last fifty years.

1,300,000,000 steps forward, 9,000,000,000 steps back.

Note: This first appeared on Grist.

The result is a policy conversation that hinges on the assumption that it is hard to change. How much must we spend to accelerate new technology? How many decades should we allow for a phase-in of new regulations?

As it turns out, the industry can change—and indeed, has changed—at a much faster pace than you might think. Contrary to conventional wisdom, it turns out to be quick and fairly painless to replace meaningful fractions of our power fleet in very short time frames.

Why should that be surprising?

The electric sector is arguably among the most regulated part of the U.S. economy. From municipal light boards to state utility commissions to the Federal Energy Regulatory Commission (FERC), there are layers upon layers of regulatory bodies designed primarily to ensure electricity reliability and cost recovery for what have historically been monopoly franchises. What those bodies were most certainly not created to provide is a rapid rate of change.

By and large, those bodies have delivered on their promise. They’ve kept the lights on, kept electric utility profits low enough to protect consumers but high enough to attract capital, and maintained a fairly sleepy industry with very little default risk, virtually none of the “creative destruction” that idles assets in competitive industries, and virtually no significant technological innovation. (The power plant serving your town today not only looks like the power plant that served your town 50 years ago, but most likely is the same power plant.)

While these regulations have maintained predictability within the regulated industry, they have not prevented innovation and change external to the industry. Like flood levees, these regulations have kept the external weather at bay—but they haven’t changed the weather. From new generation technologies to smart grids to emerging concerns about the environment, volatility outside of the regulated enterprise has been persistent, invisible to customers of regulated utilities only to the degree that the regulatory levees hold.

Every once in a while, the levees are breached, exposing regulated markets to the volatility those of us who live in normal markets have come to take for granted. Perhaps unsurprisingly, those historic events have brought about the most dynamic periods in the industry. GHG regulation is, without question, a massive external change to the regulated enterprise. As such, rather than presuming a static, lumbering industry response, we ought to be looking at what happened the last time external changes breached the regulatory levee.

Specifically, let’s look at two recent events: the advent of wholesale market competition in the late 1990s and the creation of capacity markets in New England in the early 2000s.

1992 EPACT and FERC 888

In 1991, the U.S. had 581 GW of combined coal, natural gas, and nuclear capacity (307 GW coal, 174 GW natural gas, 100 GW nuclear). New additions were essentially zero, as the combination of Three Mile Island, the Clean Air Act, and a high fleet reserve margin gave little incentive for new construction. Meanwhile, a broader political push for deregulation was afoot. Into this environment came the 1992 federal Energy Policy Act (EPACT), which—among other things—provided full market access for any electric generator. (Previously, such access had been limited to regulated utilities and the narrow suite of technologies allowed under the 1978 Public Utility Regulatory Policy Act, or PURPA.)

After EPACT became law, there was essentially no discernible impact on new generator deployment; by 1995, we still had 100 GW of nuclear, had 311 GW of coal, and were up to 196 GW of natural gas.[1] It became apparent that while generators were now allowed to sell into deregulated power markets, access to the transmission grid—which was still largely controlled by regulated monopoly utilities—was being constrained for non-utility generators. FERC responded with Order 888, mandating non-discriminatory access to the transmission system for all power plants in 1996. That ruling was contested in the courts, but became final in 1998.

Within just 10 years after the final implementation of Order 888, nearly 200 GW of new generation capacity was added to the U.S. power grid, or 20% of the entire fleet. Nearly all was natural gas. This is a remarkable statistic: having taken nearly a century to build the first 800 GW[2] of total U.S. generation, it took us just one decade to build an additional 200 GW. Moreover, our generation fleet, which had to that point been dominated by coal, was now dominated by gas.

This is a massive rate of change in any industry, but especially in one that is supposedly resistant to quick change. Today, we take it for granted that much of our power grid is gas-marginal, but it was not self-evident that this would happen in 1995 (or, for that matter, in 1991). Arguably, we didn’t even have the lens to contemplate this type of change prior to deregulation.

Note, after all, that the big, capital intensive plants that had historically been built by regulated utilities (coal and nuclear) weren’t built prior to EPACT/888 and weren’t built after. In that narrow sense, our belief that the industry was incapable of quick change was correct; what we failed to recognize was the scope of innovation that would occur once new players entered the industry. Those 200 GW of new gas plants were built largely by unregulated companies with fundamentally different appetites for risk than the companies that had heretofore dominated the space. And while many of those new entrants subsequently ran into financial constraints, it bears noting that in many parts of the country, the lights are on today precisely because of this unpredicted, largely unregulated construction of new natural gas facilities.

Building out 20% of the generation fleet in 10 years was a remarkable and unprecedented rate of change. But just as the deployment of new natural gas assets was starting to level off, ISO-New England would make that rate of change look downright glacial.

ISO-NE Forward Capacity Markets

In the early 2000’s, ISO-New England began to consider markets for capacity services (e.g., MW, as distinct from MWh), the better to encourage long term investments in the New England grid. The Forward Capacity Market (FCM) that was ultimately developed had several noteworthy features:

1. It had a low cost-of-entry, to facilitate participation from smaller resources.
2. It explicitly recognized the value of “negawatts,” allowing load-sited resources and conservation to participate on the same terms as remote power plants.[3]

ISO-NE has now completed two years under their FCM, and two corresponding forward capacity auctions (FCAs). As of their most recent auction, they had brought forth a total of 2,936 MW of demand-side resources. To put that total in perspective, the peak demand on the New England grid ranges from 19,000-24,000 MW in a typical year, with the all time peak demand recorded on August 2, 2006 of 28,130 MW.[4]

In other words, in just 2 years, the FCM program has brought forth more than 10% of the all time peak capacity demand on the New England grid, without building a single central power plant. Put another way, that’s equivalent to bringing on line more than two Seabrook Nuclear plants (a 1200 MW facility in New Hampshire) in just 24 months.[5]

Note the similarity with the natural gas fleet deployment in the wake of EPACT/888. In both cases, minor market reforms allowed non-traditional entities to participate in power markets, and in both cases, the rate at which those entities engaged vastly exceeded any historical precedent.

What it means for GHG policy

Successful greenhouse gas policy will require, first and foremost, a massive reallocation of capital in the electric sector. Electricity generation accounts for over 40% of U.S. CO2 emissions, thanks to an antiquated, inefficient, fossil-fuel dominated fleet. The discussion of possible CO2 policies tends to be framed around a handful of technologies (coal, nuclear, renewables, carbon sequestration, etc.), most of which have historically been dominated by regulated monopolies. Noting the slow pace of change in that sector, this conversation inevitably turns to near-term winners and losers, with the presumption that there will be no short-term change in the fleet—just a differential dispatch order as we migrate to lower-carbon sources.

But as the two examples above show, this assumption doesn’t wash. Like New England’s FCM, GHG pricing is nothing more than the monetization of an externality that was previously subsidized by the system. Like EPACT/888, it contemplates revenue streams and market participation by a host of companies and individuals who are not currently a part of the traditional power industry. Both factors suggest that the pace of fleet overhaul will be vastly quicker and cheaper than we anticipate. Will we replace 20% of the fleet in 10 years, like we did after 888? Will we move 2.5 times as fast, as we did in New England after FCM? Might it be possible to move faster still?

The one thing that is certain is that it will be decidedly faster and cheaper than we think.

Conclusions

In addition to speed, there are two broad lessons that can be taken from the examples above.

First, note that in neither case did the reform require a drain on government coffers. Governments did not have to throw money at natural gas generators, nor at demand-side resources. They simply needed to modify regulations to allow market participation by non-traditional actors.

We ought to bear this in mind as we move towards a national GHG policy. Regulators and commentators, schooled in the merits of cost-benefit analysis, have a chronic temptation to assume that any GHG reduction will cost money, and fiscal prudence demands that those costs be minimized per unit of CO2 reduction. That’s a healthy approach, but one that paradoxically tends to overlook the lowest cost forms of CO2 reduction—namely, those which cost nothing more than the political capital necessary to remove existing regulatory barriers. In a market as heavily regulated as the electric sector, one can safely presume that massive volumes of private capital stand ready to invest as soon as those barriers are removed, even before providing any explicit fiscal incentive.

Second, note that neither of the reforms that led to these investments were preconditioned on the removal of the entire regulatory edifice. A common skepticism with respect to the potential for barrier removal derives from the sheer scale of regulatory barriers. We have 100 years of regulated power monopolies in this country, with regulations at the state and federal level (not to mention jurisprudence in courts and utility commissions) designed to sustain that model. The sheer magnitude of those barriers compels one to question the hubris of anyone who thinks that reform is easy.

However, if we stand back to look at the data above, we discover the obvious: you don’t need to tear down an entire dam to restore the flow of a river. You need only remove enough bricks to let the water pressure behind do the rest of the work for you. Modest regulatory reform, targeted only at the critical barriers, is sufficient to unleash massive energy sector reform.

Both lessons are cause for great optimism. Fundamentally changing the GHG signature of our economy will undoubtedly be easier, cheaper and faster than we think … once we start.

——-

[1] Data here and throughout on generator fleet capacity taken from U.S. DOE/EIA.

[2] I’ve omitted hydro and oil capacity from this discussion, which account for the remaining ~200 GW up to the 1998 800 GW base (and were largely unchanged during the period in question).

[3] In fact, load-sited resources participate on more favorable terms than central plants, as the FCM explicitly recognizes the savings in line losses and reserve margins innate to locally-sited capacity investments.

[4] Source: ISO-NE website and personal correspondence.

[5] For comparison, 14 years elapsed between the issuance of Seabrook’s permit in 1976 and full power production in 1990, and was directly responsible for the bankruptcy of Public Service of New Hampshire.

Note: This first appeared on Grist.

1. 50% of U.S. power generation (in MWh) comes from coal, while only 20% comes from natural gas.
2. 32% of total U.S. power generation capacity (in MW) is coal-fired, while 42% is gas-fired.

When it runs, the natural gas fleet emits just 50% of the CO2 of the coal fleet, which raises a rather interesting question: what would we have to do to make it run harder? And how big a difference would that make in our national CO2 footprint?

MW vs. MWh

So why, if we have more natural gas generation capacity, do we get more of our power from coal?

Simple: we have a lot of gas-fired generation (449 GW, as of 2007), it doesn’t run very often. The coal fleet is comparatively smaller (336 GW), but runs a lot more frequently. It is as if our vehicle fleet were dominated by Priuses, but they stayed parked while we drove our Escalades to work.

We have a huge resource that is already built that could massively lower CO2 emissions. Taking a page from the NRA, what if the problem isn’t that we need to build more low-carbon generation, but that we just need to make better use of what we have?

Environmental potential

To understand the opportunity, let’s look at a bit of simple math.

In 2006, the gas fleet generated 816,441,000 MWh, or 20% of what it could have produced if it had run 24/7/365.

The coal fleet, by contrast, generated 1,990,551,000 MWh, or 68% of what it could have generated if it had run 24/7/365.

If we never built another gas-fired power plant, but simply increased the annual capacity factor of the gas fleet up to the coal fleet’s 68% capacity factor, it would generate an additional 1,845,485,000 MWh, effectively displacing 93% of our coal fleet without the construction of a single new power plant.

Looking at the comparative CO2-signatures of those two fleets, that would reduce total power sector CO2 emissions by 37%. Since the power sector is responsible for 42% of U.S. CO2 emissions, that implies a 16% reduction in total U.S. CO2 emissions, just from changing generator dispatch order.

That’s a massive opportunity. What would it take to get there?

Economic considerations

There is an obvious limitation to the Prius/Escalade analogy: it’s cheaper to drive a Prius per mile, but it’s more expensive to generate a MWh of power from a gas plant than a coal plant. That, after all, is why the gas fleet doesn’t run as often.

But historic dispatch choices were made in a world in which the costs of CO2 pollution were not monetized. So the real question becomes: how big a CO2 price would be required to change dispatch order?

Intriguingly, while the environmental potential is huge, the economic cost to realize that potential turns out to be quite small.

The great economic disadvantage of gas-fired generation relative to coal is that gas is more expensive per unit of energy. The great economic advantage of gas-fired generation relative to coal is that it is more fuel efficient: while the U.S. coal fleet has an average generation efficiency of about 27%, the gas fleet has an average efficiency of about 38%.

The gas fleet also tends to have much lower non-fuel operating costs (less $ for fuel handling, fewer moving parts, etc.). Taking these factors into consideration—and assuming $2.50/MMBtu coal vs. $6/MMBtu natural gas—the variable costs (e.g., exclusive of capital recovery) of a coal plant are about $18/MWh lower than a gas plant (1.8 cents/kWh). Obviously, that is very sensitive to fuel price assumptions, but this range is hardly unreasonable for current markets.

But remember, the gas fleet has a much lower CO2 signature than the coal fleet. On a fleet average basis, every MWh shifted from coal to gas reduces CO2 emissions by 0.56 tons. So if we look at a $18/MWh cost differential to achieve 0.56 tons/MWh of CO2 reduction, that implies a (18/.56) = $32/ton CO2 price would be sufficient to tip the scales. That’s not insignificant—but not implausible either. And—here’s the key point—massively less than what any reasonable person might think it would take to shutter most of the coal industry.

Finally, note that this doesn’t require a carbon price of $32/ton to happen; it simply requires a net change in the relative costs of coal and gas-fired generation equal to $32/ton. You could get there by giving the gas guys nothing and hitting the coal plants with a $32 fine, but you could also get there by giving the gas guys $10 and hitting the coal guys with a $22 fine. A functioning cap-and-trade with bilateral rights will allow some sort of transaction between those two parties and—without speculating on those specific rules—one can assert with confidence that a $32 delta between coal and gas does not need anyone to buy or sell carbon credits at a $32/ton price.

Practical constraints

To be sure, we’re never going to shut down 93% of the coal fleet just by running gas harder. There are parts of the grid (like West Virginia) so devoid of gas assets that there’s no way to maintain voltage stability if you rely on far-away gas. And of course, there is the supply and demand issue (booming gas demand + slumping coal demand is almost certainly incompatible with $6 gas and $2.50 coal).

On the other hand, the gas fleet is hardly capped out at 68% capacity factor. Moreover, if we started the switch, we’d start by running the most efficient gas plants harder and the least efficient coal plants less so the first 20% is much cheaper, per ton of CO2 reduction, than the last 20%.

Of course this isn’t a panacea. You can’t get to the end game only with gas any more than you can get to the end game only with solar. It’ll take a lot of steps. But what’s fascinating about this analysis is that the gas fleet is uniquely able to quickly and—at least initially—quite cheaply make a huge dent in our CO2 emissions. It’s a tool we ought to use, and we ought to examine our proposed CO2 regulations carefully to make sure it gets put to use. Free allowances to coal plants don’t get you there …

Note: This first appeared on Grist.