How much does carbon pricing cost us on our electric bills?

The surprising answer? Not much.

In 2006, there was a total of 4,058,285,000 MWh of power generated in the US. 49% came from coal, 20% from natural gas, 19% from nuclear, 7% from hydro and the remaining 4% from a mixture of renewables, petroleum, and various waste gases.

Looking just at the fossil fuel uses (to estimate the CO2 release per sector), during the same year the electric power sector burned 1,053,783 thousand tons of coal, 131,005 thousand barrels of petroleum, and 7,404,432 thousand Mcf of natural gas. Taking some middle-of-the-road estimates for CO2 content by fuel type (2.14 lbs/lb of coal, 0.13 lbs/scf of natural gas and 922 lbs/barrel of oil), that works out to a total fossil (e.g., non-renewable) CO2 release from the electric sector of 2,784,805 thousand tons.

(Wonk note: For any given year, there are lots of estimates available from the EPA and elsewhere of sector-specific CO2 emissions. I’ve chosen not to use those here only to avoid any questions of data integrity, since not all data sets treat non-CO2 GHGs in the same way, cross-border trades with Canada & Mexico, transmission and distribution losses, etc. I don’t suggest that my math here is precise, but rather that if we draw all data from the same EIA dataset, we at least have the benefit of internal consistency.)

OK, now for some multiplication and division. Dividing CO2 emissions by power generation, we get an average CO2-intensity for the whole U.S. power grid of about 0.68 tons/MWh. In other words, for every $1/ton of price on carbon, there is a total increase in energy costs of $0.68/MWh. So if we assume that carbon prices will work out to something like $20/ton (note that Waxman-Markey has a $28/ton cap as currently formulated), that means an increase in total electricity costs of $13.60/MWh, or 1.4 cents/kWh.

Let’s put that in perspective: that’s the difference in retail electric rates between Maine (13.9 cents/kWh) and Massachusetts (15.3). Or, if you prefer, a tad less than the difference between the prices in Kentucky (5.6) and Tennessee (7.1). To argue that this increase in retail electric rates is economically unpalatable is to argue that the Tennessee and Massachusetts economies are doomed to suffer a mass exodus across their northern borders unless they can get their rates down.

Alternatively, given the current average U.S. power prices of 9.75 cents/kWh, that $20/ton carbon price works out to a 14% rate increase. Nothing to sneeze at, to be sure, but compared to the massive rate increases that utilities like AEP are asking for even in a pre-carbon world, you’ll hardly notice.

That’s not to make light of the impact on people’s wallets from power price increases, but rather to acknowledge that the impacts we are talking about pale in comparison to the economic impacts caused by much more mundane issues (like which side of the Tennessee/Kentucky border you live on).

So why all the fuss? Not because 1.4 cents/kWh is going to kill our economy. Rather, it’s a big deal from the perspective of a power plant owner. A $20/ton carbon price imposes something like a ~40% reduction in the profits of a modern coal-fired power plant unless they can pass it along to their customers. And let’s be very clear: it is not the concern for their customers’ wallets that has driven the coal industry to demand a free right to pollute (no matter how much their PR departments claim otherwise).

That’s why the fuss. Not because of economic disruption, but because of wealth transfers from the politically-powerful coal industry to the (comparatively weaker, and much less well-organized) renewable, gas, and nuclear lobbies. The politics may be distasteful, but that doesn’t make it any less real.

That said, when politics stands in the way of good policy, it behooves us all to demand better. It behooves us all to do the math.

Note: This first appeared on Grist.

It’s an article of faith that cap-and-trade will raise our energy costs, but it’s not necessarily true.

The ubiquity of this faith makes clear that the Smart People who write, talk, and vote about CO2 policy don’t really understand the issues. A quick discussion, and then some math to clarify.

There are two core problems with the theory that carbon pricing schemes will raise energy costs:

• We habitually confuse sector-specific wealth transfers with economy-wide pain; the two are not necessarily the same.
• Rather than admit our failure to imagine how the world would adapt to carbon pricing, we tend to assume stasis, thereby overstating the costs of compliance.

Discussion on both points follows.

Taxes vs. wealth transfers

First, a statement of the obvious: no one likes to lose money, and we’re all hypocrites, me included. Speeding tickets I have to pay are a drag on the economy and a diversion of police resources from more socially urgent activities; speeding tickets you pay are but a small drag on your income, offset by massive intangible social gains.

This love of money and hypocrisy is no less true for businesses. My reasoned argument against speeding tickets for Sean (or as I call them,  “fun taxes”) is different only in degree from the coal company that argues CO2 regulation will be a tragedy for low-income rate payers.

So let’s agree to be more honest. If taxpayer X suddenly has a new $1,000 cost, it’s only a drag on the economy to the extent that the money disappears into non-productive activities. If the Fun Police give me a $200 ticket and then set my money on fire, it’s a clear economic drag. On the other hand, if those proceeds go to fund public safety measures that we all benefit from, then my personal economic pain is partially/wholly offset at a macro level. This is no less true with carbon regulation. If a coal company suddenly has a billion dollars worth of annual penalties it has to pay, but that billion dollars is used to bring an equivalent volume of clean energy forward, the wealth transfer isn’t necessarily a drag on the economy.

(I’m obviously over-simplifying a complicated story, but directionally, if the effect of a carbon regulatory regime is to replace high capital cost / low variable cost coal with an equivalent MWh production of high capital cost / zero variable cost renewables, then you could well end up with bankrupt coal companies but cheaper power and a stronger economy in the long run.)

This suggests that as we assess carbon policy, we shouldn’t be asking whether the price is high enough to impose meaningful penalties, but whether the result of the payment is a socially-benefical wealth transfer – as opposed to a socially-detrimental Money Fire. The basic problem with the vast majority of carbon regulatory models is that they fail to ask this question, even as they fall in love with the proceeds that CO2 auctions will send back to political bodies for redistribution. Political bodies historically have a certain preference for Money Fires.

Statics vs. dynamics

While it’s analytically easy to show possible scenarios wherein a CO2 regulatory model yields an economically-neutral wealth transfer, it’s impossible to guarantee that outcome, for the simple reason that none of us have a crystal ball. I can articulate plenty of scenarios wherein dirty MWh are displaced by clean ones, with the economic pain necessary to shut down the former is sufficient to incentivize construction of the latter. But I can’t guarantee that those possibilities will materialize. (As a friend at NREL once told me, “the great thing about writing laws is that you see behavior change immediately. The lousy thing about writing laws is that you don’t have any good way to predict how behaviors will change.”) Humans are too clever, and our behavior too dynamic, to allow accurate predictions.

That’s fine, except that when it comes to carbon regulation, we end up falling into one of two traps—either assuming omniscience (e.g., “This bill will change behavior as follows”) or stasis (e.g., “Assuming no change in behavior in response to this bill, economic impacts are as follows”). A classic example of this is in the “scoring” process that the Congressional Budget Office uses, wherein tax breaks are calculated based on their cost to the treasury. CBO analysis assumes that the only impact of the bill will be to reduce tax receipts—with no offset for increased demand for product and corresponding growth in personal and corporate income tax receipts. (Or, for that matter, any monetization of the social benefit sought by the tax break.)

The result is that all our predictions are wrong. Moreover, at least in my experience, the assumption of a static world is much more common, meaning our predictions are generally skewed in an unfavorable direction. Speeding tickets do make me drive slower. Likewise, putting a price on CO2 emissions will cause power plants and industrials to look for lower-carbon ways to stay in business. And yet we frame our analyses as if the only impact of a $20/ton CO2 price is a $20/ton increase in the price of power. It’s one thing to acknowledge our inability to predict the future, but something else entirely to presume that the human instinct not to lose money will suddenly go away once a carbon bill is passed.

Stay tuned!

Here’s the point: When you factor in both of these issues and run some pretty simple math, it becomes apparent that good carbon policy has the potential to be a massive wealth transfer that is damned near economically-invisible. Which in turn means that the hand-wringing and political horsetrading going on in DC right now as we debate CO2 policy is, while perhaps politically necessary, ultimately irrelevant. That’s a cause for some optimism.

Math coming in part II of this post.

Note: This first appeared on Grist.

E&E Daily reports ($ub. req’d) today on efforts in the House to try and determine how to minimize the economic pain of CO2 pricing.

They note:

Government studies conclude that for a new U.S. climate law to work, it must stem the demand for carbon-based energy by increasing prices — not exactly the most politically popular thing to do during an economic crisis that is being compared to the Great Depression.

All the logical failing of our CO2 policy discussion is nested in this paragraph.

For climate law to work, it must put a price on CO2 emissions. But there is no logical reason why that must imply an increase in energy costs, for the simple reason that energy is not CO2.

A price on CO2 emissions, done right, will facilitate a wealth transfer away from CO2-intensive forms of energy, but to assume that this must lead to higher energy costs is to assume that low costs and high carbon go hand in hand. And no matter how many hearings we hold and policies we develop that implicitly or explicitly make this linkage, it ain’t there. Coal is freakin’ expensive. Efficiency is cheap. Even solar PV is cheap if you ignore the capital costs (just like coal!).

The idea that charging for CO2 will increase energy costs makes as much sense as assuming that charging for mercury will increase tuna costs.

This persistent idea is both inane and dangerous. Inane because it’s wrong. Dangerous because it leads to one of two places:

1. Do nothing. For the last decade, we’ve spent so much time talking about the bogeyman under our bed that we’ve actually come to believe it. And so we stay in bed, per legislative mandate.
2. Do something economically dangerous. As I’ve noted before, this framing biases us towards economically disastrous CO2 policies, effectively giving us what we fear.

In other words, we have the power to make that economic bogeyman real. It is entirely within our power to pass economically disastrous CO2 policies that will drive up the cost of energy. But that is a policy failure, and in no way innate to good climate policy.

We need to send a clear message to D.C.: Grow up. Get over your bogeyman fears. We can’t afford to wait for you any longer.

Note: This first appeared on Grist.

Here are some thoughts on the American Recovery and Reinvestment Act recently unveiled by House leaders — specifically, the appropriation of Section 451 (aka “Subtitle E”) from the 2007 Energy Bill.

For obvious reasons, we’ve been following this bill very closely, which not only provides $10 per MWh to waste heat recovery and high-efficiency cogeneration projects, but it also provides a nice suite of carrots to induce the states to reform their paleolithic electricity regulatory laws. Often these laws have long been perhaps the biggest barrier to reducing the carbon footprint of U.S. electricity generation and distribution.

For less obvious reasons, it’s hard to get programs like this through the Congress. This is the result of some peculiarities of the way the federal government makes decisions to spend money:

1. Tax bills require one vote to enact (OK, technically three, since they have to be approved by both houses and then signed by the President, but it is a single vote on a single decision throughout). All other fiscal bills require two votes: the first authorizes the funding, and the second appropriates the money through the budget process. Since no vote is certain, this makes it much easier for regulators to get things done by tinkering with tax policy than through any other measure. In no small part, this is why the tax code is so full of complexity, loopholes, and social-engineering run amok. But I digress.
2. Any appropriation process must be “scored.” This is the process by which the Congressional Budget Office estimates the cost of the legislation to the Treasury for the purpose of figuring out whether we can afford it. That’s quite reasonable, but the nature of the process is such that it tends to ignore most of the upside because it does not readily differentiate between good and bad investments. (It is as if you made a decision to buy a stock based on the price per share without any consideration of whether it was likely to rise or sink in the future.) This becomes especially problematic when the economy sours, as the stimulative effects of investments are not readily quantified or evaluated precisely at the time when they are most needed.

Frustrating as this may be, the good news is that the limitations are well-understood by those inside the Beltway. Setting aside what the scoring rules say, here is what Section 451 will actually do for the U.S. economy … with lessons broadly applicable to investments in all flavors of enhanced resource efficiency.

Section 451 will stimulate private-sector lending.

In the current liquidity-constrained environment, manufacturers and clean-energy developers are finding it difficult, in some cases impossible, to secure debt against their investments, driven in no small part by lenders’ concerns about borrowers’ long-term solvency. This grant effectively provides $166 million per year of revenue from a triple-A credit offtaker (the federal government). Banks like that, which means that the individual investing in that power plant immediately can borrow more money from his bank than he otherwise would, even in the current environment. Based on current debt markets, this program will pull something on the order of $200-450 million of debt into the economy. Or, if you prefer, $0.40-0.90 of private sector stimulus for every $1.00 of federal stimulus. (Note that this cash will support hard assets generating clean energy, which are much healthier places for the U.S. to be investing its cash than dodgy financial instruments!)

Section 451 will install additional (and cleaner) U.S. electricity generation.

We are facing a train-wreck in the U.S. power system, caused by the fact that while electricity consumption has grown inexorably at 1-2 percent per year, we haven’t invested in the baseload generation needed to keep up. Outside of the Luddite community, setting aside the environmental consequences of certain types of generation, this is a really bad situation, which can lead to blackouts and economic crises if not addressed. Along came the economic crisis, which effectively accelerated the unraveling process by limiting people’s ability to obtain the capital necessary to build new generation.

By paying an incentive for power generation that is at a minimum twice as fuel efficient as the U.S. grid, Section 451 not only provides an added inducement for new generation, but also provides an inducement for clean generation. From an economic perspective, it only gets spent if the generation gets built, which creates some rather interesting economics:

• $500 million, spread over three years and paid out in $10 per MWh units, will bring onstream an additional 16.7 million MWh per year of clean generation. This implies an additional construction of 2,000-3,000 new MW of generation capacity.
• On average, these projects cost about $2,500 per kW to install. This means that our $500-million federal investment will bring about $6.25 billion of private sector investment in the U.S. economy. That’s a hell of a leverage ratio!
• One of the requirements of Section 451 is that these projects be economically viable, so we do not simply throw federal money after boondoggles. This is accomplished by requiring that any eligible project demonstrate a simple payback of no more than five years in order to qualify. In turn, it means that this $6.25 billion worth of private sector capital is generating at least $1.25 billion in annual cash for U.S. energy consumers.
• Here’s the neat part: Those $1.25 billion in annual cash flows are ultimately taxable. Clearly, not every beneficiary will be a taxpayer. Equally clearly, there will be tax offsets in the early years from depreciation and interest payments. But these investments are long-lasting, typically operating for 20 years or more, which means that the federal government will get its money back many, many times over from its initial $500 million investment.

Section 451 will create targeted green and gray jobs.

This bill provides highly targeted funding directly to those organizations who are investing in clean energy resources. Not only does it facilitate the installation of green power sources, but it also (a) provides employment to the manufacturers and installers of those technologies, and (b) provides additional income to those organizations who install these technologies from the innate savings (the five-year payback) and from the grant itself.

Unlike tax credits which on average only provide about 70 percent of the federal payment to the asset owner (with the balance going to the transaction fees common to tax equity markets), this revenue-driven grant provides 100 percent of the federal investment directly to those who are investing in clean technology.

The short summary: Section 451 is really good.

The takeaway lesson: so is any investment in U.S. energy efficiency, despite what the fiscal scoring process may say!

The bill still needs to be passed and signed into law, of course. But we’re close to something really good: This bill represents the beginnings of an economic policy that stimulates by reforming our energy sector.

Note: This first appeared on Grist.

With apologies to Little Milton.

Good news: With the incoming Obama administration, we are finally going to get some sort of a greenhouse gas (GHG) bill.

Bad news: We are still having an inane, economically uninformed conversation about GHG policy.

Many of the ideas that pass for Serious GHG Policy are silly, not because they aren’t serious but because they are based on economic theories that are as widely believed as they are at odds with the way all of us (economists included) actually behave.

The crux of the problem lies in the fact that policymakers, economists, and, yeah, some bloggers completely misunderstand the link between costs and prices.

There are a host of GHG models based on upstream carbon pricing, wherein GHG emissions are priced not at the point of GHG release (i.e., where the fire is), but at the point of fuel purchase. This was innate to Lieberman-Warner and is still found in many current cap & somethin’ and carbon tax proposals. The theory is that if you put a cost somewhere in the upstream end of the system, it will cascade downstream to affect point-of-use decisions. The idea is nonsense, worthy of Wolfgang Pauli’s famous put-down: it’s so bad it’s “not even wrong.”

The crazy thing is that outside of idle economic theorizing, no one really believes the idea. When gasoline prices go up, do you expect trucking companies profits to stay the same? When health insurance costs rise, does your boss give you a raise so that your take home pay will be unaffected? When your local phone company outsources directory assistance to some dude in Bangladesh, do their rates fall to reflect their lower cost structure?

Of course not. Yet we assume that if we put a price on carbon at the point of fuel purchase, it will diffuse perfectly through the system, affecting everyone downstream who burns fuel and release GHGs. It won’t. And to the degree that it doesn’t, an upstream GHG price is an economically flawed GHG price, disproportionately shifting the burden of GHG abatement away from those actually releasing GHGs into the atmosphere — and, therefore, failing to provide an effective incentive to reduce GHG emissions.

Obvious as it may be, it bears noting that companies set prices based on a wide number of variables, only one of which is cost:

1. Some customers are more profitable than others, reflecting the reality that it is easier to pass costs along to some customers than others. For example, fuel providers commonly make more profit on small businesses than large businesses, because the small guys have a harder time changing suppliers. Should those fuel providers have to pay carbon taxes on their fuel, they may well decide to “stick it to the little guys,” leaving the biggest users agnostic on GHG emissions.
2. While economics tends to assume that all prices are variable (e.g., $X per widget), many pricing schemes have much more complicated structures, with set-up fees, membership fees, and use fees all combining to (intentionally) hide the full cost of service and make the decision to incrementally use a product appear relatively cheap. (Think of your gym, or your ATM.) In the energy sector, many gas and electric rates have a fixed monthly fee for the contract plus a low variable cost for use. If the cost of upstream GHG emissions is borne in the fixed cost, it will have no more effect on the decision to reduce fossil fuel use than your gym’s initiation fee does on your decision to work out tomorrow.
3. In many cases, much or all of the impact of a change in cost is not borne at all by a company’s customers, but by their owners. When oil prices fall, refinery profits tend to rise, as falling costs boost their profitability. Conversely, when fuel costs rise, airline profits tend to fall, for the opposite reason. It is quite reasonable to assume that a world with upstream GHG pricing will lead to lower profits for fossil fuel producers and distributors (many in the environmental community would very much like to see this). But if it does, that necessarily means that fossil fuel users are not seeing the full price signal. Corporate profits would fall, but day-to-day emission-causing behavior would not change.

None of this is complicated. But it is far too frequently glossed over with grossly simplistic economic theory utterly at odds with the reality of price-setting. And to the extent we base GHG policy on these flawed theories, there is a very real danger that we will craft a GHG policy that won’t work. The stakes are too high to get this wrong.

Note: This first appeared on Grist.

A great frustration for those who (a) really care about reducing CO2, and (b) believe in the power of well-structured market mechanisms is that the current discussion around carbon policy has bastardized the language of environmental economics. There are tremendous economic and environmental benefits to be gained by a true cap-and-trade CO2 system. Unfortunately, all the plans that are currently being bandied about as cap-and-trade structures are really carbon taxes.

To understand why, we need to review a couple basic environmental economic concepts. There are essentially three ways that government can induce environmentally responsible behavior: mandates, taxes, and tradeable permits.

Mandates

The best example of a mandate is the Clean Air Act, and since we first started crafting environmental regulation, this has been the dominant approach. Thou shalt unlead thy gasoline. Thou shalt install a baghouse. Thou shalt comply with Best Available Control Technologies. In all cases, these are top-down, proscriptive approaches that mandate technologies and/or pollution limits. Their great advantage is that their environmental impacts can be known with some degree of certainty. (e.g., if you mandate a phase-out of leaded gasoline in five years, you can be certain that there will be no more lead emissions from tailpipes five years hence.) The disadvantage of these approaches are two-fold:

1. They are economically ignorant. If the mandate does not direct the lowest-cost pollution control solution, the lowest-cost pollution control solution will not be deployed.
2. They are strictly pass-fail, and encourage a nation of D students, environmentally speaking. If a mandate compels my factory to achieve no more than 10 ppm NOx emissions as a prerequisite of operation, I’ll make sure I can achieve 9.9 ppm NOx; but since there’s no incentive to make deeper cuts, I won’t reduce any further. This adds to the economic problem with mandates, since it does not differentiate between the individual who can make deep cuts cheaply and the one who faces huge costs for shallow cuts — and in so doing, fails to maximize pollution reduction.

Pollution taxes

A better tool is a tax. Such models simply price the externality, so that one can still pollute, but only at a price. Relative to mandates, their great disadvantage is that they do not lead to certain reductions. I can mandate the elimination of leaded gasoline and know that leaded gasoline will go away, but if I instead place an added tax on leaded gasoline, I cannot be certain that the tax will be sufficiently high to eliminate its use.

On the other hand, pollution taxes do solve the two problems with mandates. By placing a fixed and known price on pollution, markets are encouraged to use the lowest-cost means of pollution control to minimize their net pollution payment. Moreover, since the tax is paid per unit of pollution emitted, deeper pollution reductions afford greater economic savings. On balance, this gives pollution taxes (in my opinion, at least) a net benefit against mandates. But they still have a couple glaring weaknesses:

1. Most obviously, they include the word “tax,” which is often a political non-starter.
2. They are sticks without carrots. Like income taxes, they constitute a great source of government revenue and, on the margin, do compel markets to factor the price of pollution into their math, but they don’t provide any more direct incentive to invest in pollution reducing technology than an income tax provides an incentive to quit your job.
3. As noted above, they do not guarantee pollution reductions.
4. Finally, they are politically uncertain. Governments are always tempted to fiddle with tax policy, but are unable to fiddle with existing contracts. A factory that installs a scrubber to comply with sulfur pollution regulations will cry foul (and have ample legal protection) if the regulator comes back and tries to rescind their permit five years hence. On the other hand, if sulfur emissions are taxed at$20/ton and government decides to lower or raise the tax five years hence, the same factory cannot readily complain that they invested in their scrubber in anticipation of a permanent tax regime. As a result, it is considerably harder to deploy capital in response to a pollution tax than in other, contractual approaches.

Tradeable permits

In theory, tradeable permits are the ne plus ultra of pollution regulation, correcting all the failures of the above mechanisms. The model is that the government sets an allowed level of overall pollution (thereby ensuring that future pollution levels are known) and then allows pollution sources and sinks to trade among themselves for the rights to emit their pollution levels within that cap. Government’s role is to set the cap and ensure that sufficient measurement and verification is in place between pollution buyers and sellers, but not to stipulate technologies nor price.

These models ensure that markets are always pursuing the lowest-cost pollution-reduction measures, while still ensuring that pollution is reduced to environmentally acceptable levels. The political consequences of a tax are avoided and sticks are perfectly balanced with carrots (since every buyer is matched to a seller at the same price per unit of pollution).

Applying to modern GHG policy

This didactic review is necessary because if you only read the headlines, you might be tempted to conclude that current GHG policy is actually based on the idea of tradeable permits. After all, we talked about carbon taxes and decided we’d do cap-and-trade instead. Since the phrase “cap-and-trade” includes the words “cap” and “trade,” it must include both, right?

Sadly, no.

Every GHG policy out there today — from RGGI to Kyoto — is really a tax masquerading as a cap-and-trade. Notice why:

1. A pollution tax requires polluters to pay money to a regulatory body, who then distributes the proceeds as they see fit. A tradeable permit approach is based on bilateral trading of pollution credits without any government intermediary. Every existing GHG policy has a government intermediary and is therefore structured as a tax rather than a tradeable permit.
2. A tradeable permit model provides an incentive to reduce pollution that is exactly the same as the cost it stipulates for those who choose to pollute. If you want to release 50 units of pollution and I want to reduce pollution by 50 units and I agree to sell you my reduction for $200, you’ve paid $4/unit and I have been paid $4/unit. By contrast, a pollution tax places a cost on pollution, but the only benefit that accrues to those who are reducing pollution is the avoidance of a tax. Which, as noted above, is the same benefit that accrues to those who don’t have any income. All of our current GHG policies are structured more like taxes than tradeable permits since regulatory agencies use the proceeds of their GHG auctions to provide a variety of social goods, not all of which lead to GHG reductions; ergo, less than 100 percent of the proceeds go to GHG reduction, and the value of reduction is less than the cost of pollution.

If the issue were merely semantic, this wouldn’t be worth making a big deal about, but the problems with carbon taxes are real, and they don’t go away simply because we choose to relabel a tax as a tradeable permit. As we go into the next political season and get serious about GHG policy, let’s hope that we don’t lose sight of these realities.

Note: This first appeared on Grist.

If you put a price on GHG emissions, will it raise the cost of energy?

That question goes to the core of carbon policy. Unfortunately, many people inside and outside the environmental community consistently get it wrong, with potentially disastrous results.

Consider: if the answer is yes, then we don’t need any incentives for GHG reduction. The costs of carbon-intensive energy will rise, giving we energy users the incentive they need to lower consumption.

But if the answer is no, we will find ourselves with a tax on dirty energy but no incentive to reduce its use. That is, we will end up with a greenhouse-gas policy that fails to do the one thing it’s supposed to do above all else: lower our greenhouse-gas emissions.

The answer, more often than not, is no.

Ironically, this fact is understood by people individually even as they misunderstand it globally. When you get hit with sudden medical bills, does your salary increase? If you lose your job, do your costs suddenly fall to maintain a constant bank balance?

Of course not. Our individual costs vary independently of our individual revenues, and whatever’s left — our individual profit — bounces accordingly. And it’s not at all clear that it levels out in the long run. Some people with low incomes are fantastically thrifty, and die with money in the bank. Some people with enormous incomes fall in love with fancy cars and drugs and die in debt.

And what’s true for individuals is no less true for businesses. If Ford Motor Company negotiates a new deal with the UAW that leads to a 20 percent rise in labor costs, they don’t suddenly get to charge more for their cars — they either reduce their profits or figure out a way to conserve those costs somewhere else. If they don’t, they’re going to find that folks who wanted to buy a Ford like the price on the Toyota better.

Is cost a factor in pricing decisions? Of course — but it’s only one among many, and it’s easily trumped by other considerations. Prices of alternatives (like the aforementioned Toyota) must be considered. Your customer’s willingness to pay matters (which is why Ford makes more money on leather seats than on gas caps). The quality of your marketing factors in.

This is no less true for big companies than it is for small ones. Try offering your $10/hour babysitter $12/hour if you disagree. I’m guessing you won’t get a $2/hour rebate at the end of the night!

As another example, try buying your next airline ticket at the airport on the day of your trip instead of a month in advance. The airline’s cost is identical, but I’ll bet they charge you a lot more — not based on the costs you’re imposing on them, but because of your apparent willingness to pay. The flip side of this is that they really can’t raise prices on the person who buys the ticket a month before on Expedia. Thus, the airline earns much higher margins on some customers than others.

So why does this matter for GHG policy?

The exact same disconnect between prices and costs exists in the energy industry. If energy companies can pass along costs by raising prices without compromising their bottom line, they will. But if in raising those prices they find that their revenue starts falling faster than margins can keep up, they will accept lower per-unit margins to protect revenues. This doesn’t make them nefarious — it just makes them human.

And watch what else they’ll do: Just like the airlines, they will find it much easier to pass along price increases to customers who have no other options. Big industrials that can invest in efficiency or other fuel supply options will probably end up seeing little movement in their costs of energy — they are the Expedia customer in this example. On the other hand, small residential consumers with little free cash and less technical savvy will probably see price increases. Which means that those sectors of the economy that have the most capability to lower their energy consumption will have the least incentive to do so. Again, this isn’t suggestive of any nefarious behavior — it’s just how pricing works.

All of this is precisely why we need carrots as well as sticks in an effective GHG policy. Without them, there is simply no guarantee that the resulting policy will impose any economic incentive to lower GHG emissions.

Note: This first appeared on Grist.

The disarray of the clean energy community is partially to blame:

1. Enviros banded together in 2001 to stop the Democratic-led Senate Energy Panel from introducing a bill that would mandate clean energy, including recycled energy. We worked to cut a deal with Billy Tauzin, then Republican head of the House Commerce Committee, who had insisted that an RPS would be ‘Dead on Arrival’ at the House until we showed him that Louisiana, although short on good solar or wind prospects, had lots of waste heat that could be recycled and lots of CHP opportunities. The collective group of environmentalists, stupidly seeing energy recycling and CHP as the enemy, persuaded Senator Jeffords to threaten to pull his support for the Senate energy bill if it included all forms of clean energy. No bill. Aaargh!
2. We worked to build a coalition to get the best possible bill through the House last year, given our good luck at having a real friend of and believer in clean energy in the general counsel position to the Subcommittee on Energy and ended up with fights within USCHA, with EPA, and with the Renewable advocates. We are collectively the Edison Electric Dream Team for an opposition. Engine and turbine manufacturers feared using the term ‘recycled energy’ because they only were interested in legislation that helped create a market for their machines. EPA feared they would lose a line item on their budget if we strayed away from CHP. The climate change leader of one of the major environmental organizations told the others he could not wait for the ‘bastards to get out of the process’ referring to those of us seeking to broaden the clean energy definition to include CHP and industrial waste recycling. In the end, we lacked the cohesion and the economic arguments to gain enough Republican defections. We ended up with no clean energy standard provision (Called RPS) and no tax package.
3. The ethanol community takes serious criticism for net fossil fuel reduction, but ignores the fact that good CHP could raise the net fossil gain from 16,000 Btu per gallon to 51,000 Btu’s per gallon.

Do we unite and promote all clean energy, or do we keep fighting over who shares the few scraps not covered by monopoly protected generation?

We, who produce or promote clean energy, with any method, need each other.

• Renewables: Solar and wind are easy to understand as clean and have broad public sex appeal. Seven windy states and sunny southwestern states are supportive, but the rust belt states see added costs and wealth transfer to windy states. Geothermal has friends in good resource states, but offers little in the way of electric power in a majority of the states. As long as clean energy only includes renewables, clean energy legislation is vulnerable to some powerful arguments including cost for everyone and load factor for wind and solar. Yeah, there are technical dreams but we need votes now.
• CHP is less sexy, not as obviously clean, since it often starts burning fossil fuel, but has very wide applicability and is competitive against today’s average retail prices. It avoids half of the CO2, eases wire congestion, and helps balance load with wind. It seldom receives much over half of the value it creates and thus has not boomed. But the CHP community, with a concerted effort, could round up a vast amount of support from the industrial states, from educational and medical institutions and from beleaguered manufacturing facilities that are being squeezed by high energy costs, and who, nearly to a person, fear renewables impact on their electric prices. These folks vote.
• Recycling industrial waste energy is the sleeper. It faces the most severe resource limitations – perhaps a maximum of 65,000 megawatts with current technology – but has no incremental carbon, no incremental wires, and pencils at the lowest current cost per kWh. Bundle recycled energy with CHP and other renewables in a national clean energy portfolio standard and we can at least neutralize the chamber of commerce and manufacturing associations, and get some of them to weigh in with support. There is nothing to object to about extracting energy from industrial waste streams, but the public is unaware of the benefits and there is no clear manufacturing community that benefits from deployment, as is the case with all other clean energy. The climate does not have time to wait for us to educate everyone about this form of clean energy.

So I suggest we assemble the clean energy leaders from all three sectors and seek agreement on a goal of total clean energy, form a council, and then make a united attack on every regulation that prevents clean energy or promotes more forced warming of our climate. Perhaps the Climate Institute could provide adult supervision. Recycled Energy and CHP could swing their weight on the economics of clean energy, Renewables could swing their weight on the sex appeal of clean energy and the long term promise of a carbon free world, and we attack the load factor argument with the robustness of a grid with multiple local generators. We all concentrate on removing the regulatory barriers and extracting more of the value we create. Grants, tax credits or subsidies have to be renewed again and again, but once barriers are gone, they stay gone. We work together to make sure the emerging carbon emission rules allocate allowances based on delivered electricity and thermal output. We make job one the mitigation of climate change and stop blocking good ideas because they might help nuclear, which does help reduce carbon. We ask for an output based allowance standard for all six criteria pollutants and for CO2 to replace the present system of individual operating permits and NSPS. Let every plant invest in efficiency without losing its operating permit, but give everyone an allowance of each pollutant for every MWh they deliver that is equal to the average pollution for all MWh in the country, and then schedule reduced allowances. Let the dirty plants purchase the allowances they need from the clean energy folks. As we start receiving more of the value we create, we will lose our reliance on annually renewing subsidies and all of the clean energy industries will boom.

This alliance could deliver a huge message and transform the climate change debate. We enlist all of the grass-roots environmental organizations to gain support by explaining the benefits of deploying all possible clean energy. We enlist manufacturing support by explaining how the regulations prevent them from capturing value from their waste streams, or from benefiting from local CHP. We enlist help from all who manufacture any component used in clean energy production. We work together with a clear understanding that the enemy is anyone who produces dirty energy.

Consider the alternative. If the clean energy community cannot get together and compromise, how can we ever expect intelligent national clean energy legislation?

Spots vs. strips

This is the fourth post in five-part series on the details required to get carbon policy right. See also parts one, two, and three. Or download pdf of full series.

We now get into an issue that will seem a bit arcane, because no one’s talking about it, at least not explicitly. But it’s a real choice, and in many conversations about carbon policy we are implicitly getting it wrong.

Should we price carbon in spots, or strips? Or, to take it out of financial jargon, should we:

1. set up markets such that people who are selling or buying emissions credits have to go to the market with each incremental ton to determine what the price will be (a “spot” market), or
2. set up markets such that buyers and sellers can enter into long-term contracts for the emissions they will produce/reduce (a “strip” market)?

Before talking about carbon, we need to take a brief foray into electricity deregulation, specifically back to the early 1990s, when academics were developing rules for how a deregulated market would work, based on broader theories of how markets work. As a reminder, the central test of a good carbon policy is whether or not it encourages investment in carbon-reducing technologies. Replace the word “carbon” with “electricity” and you’ve got a good test for whether the attempt at electric deregulation worked. It didn’t.

In those states which elected to deregulate their wholesale power markets, the driving theory was that if you provide a spot price for power, and allow any buyer or seller to trade at that spot price, you will liberate the power of markets.

While there are many complicated details to these transactions, that is basically still the way all these markets work, whether at PJM, ISO-New England, NYISO, or any number of foreign markets. There is a fair amount of regular trading volume on these markets today, and so it may sound odd to hear someone say they don’t work. But they don’t, for the simple reason that it’s really hard to get comfortable spending billions of dollars of capital based on a gamble about where future prices are going to go.*

A thought experiment may be helpful. Imagine that you have a billion dollars — about enough to build a modestly sized coal plant (or, if you prefer, around 400 MW worth of wind turbines). You have the good fortune to be planning your project in a deregulated state, so you don’t need to get a bunch of permission slips from the local utility to build your plant. You just need to get permits, connect to the transmission system, and build. Now, for the sake of argument, we will stipulate that the average price on those power markets for the last year has been sufficiently high that — if your plant was operating last year, and selling into those markets — you would have earned $200 million/year in net revenue. That sounds pretty good, right? Five year payback, or an 18 percent return on your investment over the next 15 years. Would you build the plant?

This pretty quickly raises an obvious question: what’s the price on the market going to be next year? The answer: You have no idea. Sure, you can predict. You can hire consultants to make forward price forecasts. But when all is said and done, if you build this plant, you are placing a bet with risks you cannot control. What if the economy slumps, demand for power falls, and the spot price collapses? You lose. What if spot prices go up? You win. Which is more likely? You don’t know.

This is not to say that no one will build the plant. Some people have a higher tolerance for risk and will build anyway, in the belief that they have some underlying knowledge of where power markets are going. Some of them will be right. Some of them will be terribly wrong (witness Calpine’s stunning $16 billion bankruptcy which, at core, was the result of a bad bet on the way that gas and electric prices were going to move on those spot markets).

But here’s the rub: we didn’t have to design the market that way. Indeed, there is no real market that works that way. (And by “real,” I mean a market that traces its origins back to one dude who had something another dude wanted and negotiated a price, as opposed to ones whose rules were crafted by academics and regulators.) If you live in New England and buy fuel oil to heat your house, you have a whole choice of payment options. You can pay each month based on the price of oil. You can prepay and lock in your price for the year. You can pay a little more on delivery in exchange for a predictable fixed contract. And so on. Ditto for any number of other volatile commodities that we all buy on a regular basis.

And, ironically, the old, regulated utilities never build plants on spot prices. When they build a plant, they hold a rate case and then lock in their price. (They will also then buy long-term “strips” on their fuel contracts to ensure that they don’t get pinched between future fuel and electric price volatility.)

Note that this is not to say that strips are always better than spots — simply that if you want people to invest capital, you need to provide the option to sell on a long-term strip, short-term spot, and any crazy hybrid of the two. And those options naturally emerge whenever governments simply allow buyers and sellers to meet up, negotiate deals, and get out of the way. Risk-averse buyers will naturally gravitate towards risk-tolerant sellers and vice versa, ultimately creating a mélange of spots, strips, futures, swaps, hedges, derivatives, and all those exotic-sounding increments that are the hallmark of a functioning market. (For those not familiar with the terms, don’t worry — they can all be thought of as different ways to bundle risks, with higher risk “flavors” offering potentially greater — but more volatile — returns and lower risk options offering stabler — but generally lower — returns.)

Relevance to carbon markets

You can probably see where this is going. How are we going to price carbon?

As a tax? Notwithstanding my prior post, this approach isn’t even as good as spot, since it is a price set from a regulator on high, stipulating a fixed price with no market correction to capture the vagaries of supply and demand.

As an auction, with periodic re-auctions to reset the price, as Gar Lipow suggested? That gives us something like a spot but has all the problems that we’ve seen in the last decade in the electric sector.

As a government-established trading floor, modeled on the electricity sector? That simply repeats the problems we’ve already faced in the electric sector.

Here’s the salient point. As of today, the only way you can buy or sell carbon (in the U.S.) in voluntary markets is on a spot basis. And the majority of the trading structures that are being considered in Congress are implicitly spot markets. And spot markets will have little impact on the decision-making process of those who want to invest money in projects to reduce greenhouse-gas emissions.

To the extent that there is a simple solution, it is this: trust markets. Let buyers and sellers meet up and trade in whatever fashion they like, and you’ll get what you need. (With suitable government oversight, of course.) And if regulators cannot trust markets, then at least take advantage of the government’s balance sheet to build in long-term contracts from the get-go. But don’t assume that a spot price alone is sufficient.

*Point of candor: In the clearing prices for power (PJM, ISO-NE, etc.) that were set up as purely spot markets, one can now find other parties — primarily financial traders — who will buy and sell long-dated contracts, finally giving some semblance of “strips” to these markets. However, those transactions remain external to the regulated market, and it bears noting that it has taken about a decade for these players to arrive.

Note: This first appeared on Grist.

This is the third post in a series about details we are still getting wrong in the climate policy discussion. See also part one and part two. Or download pdf of full series.

There is no shortage of economic analysis and policy discourse that shows that carbon tax and cap-and-trade methodologies can deliver economically equivalent outcomes. The general consensus — at least today — seems to be that since they’re equivalent, it really comes down to politics, and it’s politically difficult to do anything with the word “tax” in it, so we’ll do cap-and-trade. I like the conclusion, but the rationale is pure bunkum.

To understand why, we need only go back to my simple test of any climate policy proposal: the degree to which it encourages investment in capital that lowers atmospheric greenhouse gas concentrations.

Cap-and-trade and carbon taxes do not pass the test equally.

A carbon tax provides no direct revenue to carbon reducers

Suppose you’re me. You’ve got investors who want you to invest in projects that reduce GHG emissions. They also want to invest their money as rapidly as possible, and to earn as much money as possible from those investments. All of that makes them very keen to figure out how different carbon policies affect their investment thesis.

You now find yourself in a board meeting, trying to explain to them how you will realize financial value from a carbon tax, given your expertise identifying and building projects that reduce GHG emissions. Let’s walk through your conversation:

Q: Will your projects get paid for their beneficial GHG impacts?

A: No. The tax gets charged to emitters. Since my projects don’t emit carbon, I don’t have to pay the tax. But I don’t get any of the revenue.

Q: That still gives you a cost advantage relative to your competition, right?

A: Not precisely. In the long run, the tax could increase the cost of electricity as produced by more carbon-intensive suppliers.

Q: “Long run”? “Could”?

A: Yes. Utility costs don’t immediately translate into higher rates. First they have to go through rate cases, and there is a time lag between when their cost structure goes up, when they file for a new rate case, and when that rate case gets approved.

Q: But you can at least assume it will have a demonstrable impact on the competing price of power, right?

A: Not really. I don’t know how the rate case will apportion rates across different rate classes, so I don’t know whether my customers will be affected in a predictable way by the carbon tax. It is possible that they will simply impose those costs on other rate payers.

There is also a move afoot in the environmental community that would prohibit utilities passing the costs of greenhouse-gas abatement along to their rate payers; in that case, the impact of the tax would be to lower the profit margins of regulated utilities, but it would not have any impact on the competing price of electricity.

Q: But surely you can structure power contracts with your hosts such that they give you some upside from the resulting carbon tax, should it come, right?

A: Maybe, but that’s a hard commercial sell. Would you pay me money today on a gamble about the direction that Congress will take on tax treatment for carried interests to private equity funds? Probably not — and for the same reasons, it’s unlikely that my customers would give me upside on a tax bet.

Q: So what value should we place on carbon reductions for your projects, given this carbon tax?

A: Zero.

This (Socratically) is the crux of the problem with carbon taxes. It is a stick upon the emitter, without any direct carrot for the reducer. And the financial value to the reducer is therefore only realized depending upon the manner in which the emitter’s prices change — but this is far from precise. (Witness all the manufacturers whose profits get squeezed when fuel costs rise because they have no direct way to pass those costs along to consumers.) By contrast, a system that allows emitters and reducers to trade allows for direct financial benefits to those who do the right thing — and a benefit that can be negotiated, built into contracts, and used to affect investment decisions.

Tax policy is a blunt tool

So suppose we could fix all the above. Maybe we do a balancing tax and use tax increases on one side to offset tax reductions on the other side. Does that solve the problem?

Directionally, it’s an improvement. But it is still a poor substitute for a market-based trading system, for the simple reason that tax policy is an indirect tool.

Tax incentives are a great vehicle, if you are a taxpayer. Individuals pay income tax, and mortgage interest tax deductions are a nice perk. But people who invest in energy projects are not taxpayers, at least not in the near term. Why? Because of depreciation and debt. If I spend a lot of capital on a project, I get depreciation shields to lower my taxable income in the early years of project operation. I will also almost certainly debt-finance some portion of the project, and my interest payments will also provide a tax shield. For most energy-related investments (e.g., all investments that either emit or avoid the emission of CO2), you can count on not having any taxable income for the first 7 to 10 years of the project’s operating life. And if you’re not paying a tax, a reduction in your taxes isn’t worth much.

So what do you do? You sell off your tax liabilities to someone with a “tax appetite,” in the jargon of the trade (read: someone with lots of profits that they’d prefer not to pay tax on — typically, banks). They will pay you if you assign them your rights to those tax losses, based on some discounted cash flow stream, giving you an immediate cash flow — but essentially giving away some portion of the gain to the tax equity buyer (after all, they’re not going to buy all those losses from you without getting some benefit).

Don’t get me wrong — this transaction is not a bad thing. Indeed, this is how most wind projects get financed. But the end result is that of all the dollars the government allocates from the treasury for The Good Thing, less than 100 percent of those dollars flow to the person who does The Good Thing. Which means that less than 100 percent of the investments that could theoretically be incentivized by this tax policy actually get incentivized, while the balance essentially goes to bank fees.

So how do you fix this? Two potential ways: One, make the federal payment a revenue payment rather than a tax offset. This is what Section 451 of the recently passed energy bill does, and it’s huge. The net cost to the feds is the same, but for every dollar paid by the treasury, there is a dollar going to incentivize projects. Two, allow bilateral trades between those who cause the pain and those who provide the gain.

Both of those put the incentives in the right place and create real incentives for those considering investments in carbon-reducing technologies. And neither are amenable to a tax-driven approach.

Note: This first appeared on Grist.