Recycled Energy Development (RED) has released a new video that proposes policies to encourage the more efficient generation of heat and power, which accounts for two-thirds of our greenhouse-gas emissions. The video, entitled “Barriers,” explains the practical consequences of today’s environmental and energy regulations that discourage clean energy production. According to RED chairman Tom Casten, “We could dramatically improve cost and fuel efficiency while producing clean, carbon-free power.”

Two policy proposals are advanced. A Clean Energy Standard Offer Program (CESOP) would provide clean power at a discount, while output-based pollution credits would keep the government from selecting technology winners and allow clean-energy producers to benefit directly from polluter payments.

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.

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.

Carbon prices v. use of carbon proceeds

Let’s review the electric sector math. In 2006, the sector was responsible for some 2,784,805,000 tons of fossil fuel-derived CO2 emissions. If we had a carbon policy in place at that time charging $20/ton of emissions,  electricity generators would have had to pay some $56 billion in pollution fees. Which is a big number. But, as noted previously, that works out to about 1.4 cents/kWh. A small number.

But that math was sloppy, as it violated my own insistence that we not confuse taxes and wealth transfers. After all, $56 billion only works out to a 1.4 cent rate increase to the degree that (a) it all gets passed along to consumers and (b) the government uses that $56 billion for a great big Money Fire. After all, even if you have a deeply cynical view of government and presume that only 25% of all the money government spends goes to a useful purpose, you’d still have to conclude that the total “cost” to the rate payer from that policy is just 75% x 1.4 cents, or 1 cent/kWh.

Conversely, even if you have a really charitable view of government, you probably still don’t believe that every dollar government spends accrues to the benefit of tax payer. (Salaries for certain members of Congress come to mind. Or, on a larger scale, tax breaks for domestic oil production, certain pentagon line items, etc.) The point here isn’t to be political, but simply to note that if every dollar paid to pollute goes back to DC for redistribution, both sides of the aisle would probably agree that the electricity consumer realizes less than a dollar worth of offsetting benefit.

There are many ideas about how to fix this. Cap & dividend and/or payroll tax reductions are probably the most widely noted, but those both have their flaws as well—most notably in the way that they sever cause from effect. (What after all, is the logic for providing the same $ to individuals with wildly different carbon footprints if the fundamental purpose of that $ is to provide an economic signal to reduce carbon emissions?)

Same math, with output-based standards

My personal preference, as regular readers know, is output-based standards, in which an allowance is only provided up to some level of emissions per MWh (set to something < the current 0.68 ton/MWh average, so as to create an implicit cap) and anyone who emits above that level is required to procure credits from anyone below. No federal intermediary, and no dilution of impact. If you emit a ton, you have to pay a $/ton rate that is identical the revenue realized by those who are acting to lower the CO2 intensivity of the grid. Many more details in the hyperlink above, but here’s the point on the math:

If coal plants have to buy credits from nuclear plants (or any other high/low carbon combo you’d like), the net increase in cost to the coal plant is exactly matched by a net reduction in cost to the nuke. Societally, no change in overall power prices, unless two conditions are met:

• The allowance level is set below the current average (as it must be, to drive the overall emission down), and
• markets are totally static (e.g., there is no shift in generation patterns as a result of the new economic paradigm).

The first item is a necessity of good policy, and always true, but the second is an impossibility given human behavior. As a result, it is almost certainly true that a properly designed output-based system with full economic participation leads to no net change in energy costs. (It might even lower them.)

That said—and as I noted before—no one can accurately model a dynamic world. So let’s just look at the math in a static world, and assume we set an output-based allowance at 0.6 tons/MWh. We’ll again assume a $20/ton pollution price, but applied only to pollution above the allowance level (and paid to those below the allowance level, pro rata to their benefit).

First, the coal industry pays less. They emitted some 2.2 billion tons of CO2 in 2006, but—since they get an allowance for the first 0.6 tons—only have to pay for 1.06 billion tons worth of pollution. So instead of seeing a $23/MWh increase in their operating cost, they see a $11/MWh increase in their operating cost. In total, that’s a $21 billion payment they have to make. Not to the government though: to zero/low carbon sources, pro rata with their carbon benefit. In other words, that’s a $21 billion stimulus package to the clean energy sector, exactly offsetting the increase in power prices that would otherwise have to be passed onto rate payers and/or divvied up in DC.

For a zero carbon source, that works out to a net reduction in their operating costs of $12/MWh. And at an aggregate level (since we are assuming a static world), the overall impact to all US rate payers is an increase in power prices by just $1.72/MWh, or 0.2 cents/kWh.

The point here is not to suggest that output-based standards are a panacea to all the world’s woes (although it’s hard to argue for any non-political reason that they aren’t miles better than everything else on offer). Rather, it’s to point out that if we insist on carbon policy that transfers wealth from the dirty to the clean, we can create massive economic incentives to lower carbon without economic pain. Why shouldn’t we set that as a goal?

Note: This first appeared on Grist.

We are rapidly approaching national greenhouse gas legislation, either through a congressionally-led cap-and-trade bill or an EPA-led amendment to the Clean Air Act. However passed, these regulations will then immediately face a practical problem: how do you enforce a law that is in conflict with itself?

This problem arises because of the Clean Air Act’s core failing: It compels businesses to increase their CO2 emissions. The moment we compel businesses to reduce those same emissions is the moment we expose this flaw and invite waves of litigation that will not only delay the implementation of CO2 policy, but also invite compromise and negotiation that will likely be forced to sacrifice some of the Act’s environmental intent. How on earth did we get here? And what are we to do about it?

The clean air act mandates greenhouse gas pollution

Broadly characterized, the Clean Air Act does three things:

1. It sets limits on the concentration of regulated pollutants at regulated point sources;
2. It steadily tightens those limits over time, and;
3. It requires any new pollution sources to meet the most current (stringent) pollution standards.

By any measure, the act has done a commendable job of reducing non-CO2 air pollution. But it has unwittingly increased CO2 pollution as well.

The first reason is the political tension in the act’s structure, which led to the concept of “grandfathering.” In essence, grandfathering says that if you get an air permit, you can always operate under that permit, regardless of future environmental rules. Many of us have direct experience with this concept in practice: when cars were forced to no longer burn leaded gasoline, we didn’t have to scrap our old Dodge Darts and buy new cars; we simply had to come into compliance once we bought a new car. Similarly, a coal plant permitted to release 200 parts-per-million of nitrogen oxide pollution can emit at those levels in perpetuity, even though new plants must comply with standards that are 10-times more stringent.

Seen from the perspective of the polluter, this makes a lot of sense. It would be hard to contemplate buying a car if you might be forced to buy a new one a year later because of tightening environmental regulations. However, for power plants and industrial facilities that generate pollution as a byproduct of selling a product (power, steel, etc.) grandfathering serves to give a decided economic advantage to the dirtiest and oldest sources, since they compete in a market that is set by the costs of pollution controls which they do not have to bear.

The perverse result is that rules designed to clean the air provide direct economic incentives to the dirtiest sources. Recognizing this potential, the Act has a built in trap-door in the form of “New Source Review.” NSR says, in essence, that your permit is revoked the moment you do a “major modification.” This line is not nearly as sharp as one might hope, but it has generally been interpreted to mean that while regular maintenance won’t jeopardize your permit, plant upgrades will.

That sounds reasonable, except for this awkward fact: the cheapest and most environmentally beneficial way to increase plant capacity is to increase fuel efficiency. Generate more power with the same amount of fuel combustion and associated pollution and the world is a better place, right? Wrong. Because that upgrade would constitute a major modification, revoking your air permit and taking away the economic advantage that your old, dirty plant has. The result is that our electric and industrial sector has, since the passage of the Clean Air Act, been incentivized to keep old, dirty facilities running rather than build new, clean ones. In the transportation sector, this largely hasn’t mattered: Dodge Darts weren’t built to last. But for the rest of the economy, we are intentionally driving 12-mpg, 1960s-vintage power plants, furnaces, and boilers, spewing needlessly high levels of CO2 into the atmosphere.

There are laws in process that would fix some parts of these problems and cause some of the dirtiest of the grandfathered coal facilities to be shut down. But even if the problems innate to grandfathering were fixed, the Act would still mandate increased CO2 emissions. This reason is mathematical.

Suppose you want your kids to eat healthier. Which is the more effective approach? (a) Tell them they can only have one scoop of ice cream with dinner, or; (b) Tell them their meal cannot exceed 10 percent ice cream?

Option A clearly limits their ice cream consumption. Option B most likely leads to fat kids, who quickly figure out that if they can scarf down a few more bites of spaghetti, they’ll get a pro rata increase in their ice cream allowance. The Clean Air Act takes the fat kid approach.

The overwhelming majority of the exhaust gas in a stack is CO2 and combustion air. Both of these are a direct function of the volume of fuel burned. The Clean Air Act sets pollution limits not based on total pollution release, but based on the concentration of pollutants in the stack exhaust. The perverse result is that if you increase the efficiency of your combustion process — e.g., you burn less fuel — you will very likely violate your air permit, even if your actual air pollution is unchanged. Thus, like the kid who tempers his desire to eat less pasta with the pain of less ice cream, our power plants and industrials are forced to temper their desire to save money on fuel purchases with the pain of losing their operating permit. The result is massive, needlessly inefficient combustion of fossil fuels, raising the cost and pollution of US goods and services.

To date, this has been an egregious environmental failure, but it is about to become a legal issue as well. Stealing from Peter to pay Paul may be short-sighted, but only presents a legal problem at the point when both Peter and Paul have equal rights under the law. The moment CO2 becomes a regulated pollutant is the moment when Peter files his first lawsuit.

The easy fix

The solution is surprisingly simple. We ought not compromise our environmental principles — we simply need to fix the math. But EPA needs to make the fix now, before CO2 regulation is passed, when the changes can be made administratively, and on the the agency’s terms. If we instead wait until the inevitable litigation starts, those changes will be directed by the courts, the Congress, and any number of self-interested parties — not all of which will have the long-term health of the environment in mind.

Fixing the math requires only that we shift existing pollution standards to an output-basis. (Note that this need not initially address CO2 — but it must address currently-regulated pollutants to avoid conflict.) Replace parts-per-million permits with parts-per-kilowatt-hour permits (or parts-per-Btu, in the case of many industrial processes. As is often the case, the states have led the way in this effort (See here [PPT] for an overview of Connecticut’s efforts, to pick just one example.) Moreover, the EPA already has a deep internal understanding of the issue and how to best implement.

This simple change would immediately convert energy efficiency from a permit-killer to a pollution control device on its own merits. Perhaps more significantly, it immediately would allow businesses to profitably meet their environmental requirements (after all, burning less fuel saves money). A world facing economic and environmental challenges inevitably asks which of those goals must be sacrificed in the name of the other. Output-based standards is that rare policy tool that succeeds on both fronts. But the moment for reform is now, before litigation forces us down a path that is only indirectly shaped by the broader public interest.

Note: This first appeared on Grist.

Kevin Drum over at Mother Jones blogged on my recent Grist post, joining my mom in the list of people who publicly praise my math skills. Thanks!

Much more interestingly, he raises this question:

Are we willing to charge [a price for CO2 emissions] openly, with the carbon charges going to the public, [or] inside a complex giveaway to a favored corporation?

(The question is in response to my estimate here that the recently passed Illinois Clean Coal Portfolio Standards Act represents an implicit $300-$500-per-ton payment in the name of CO2 reduction.)

It’s a great question because the truth is that under current federal and state policy, we do pay people for their actions to reduce CO2. But we do so in a horribly inconsistent way, providing not only inconsistency between technologies and “favored corporations,” but also wild disparities in price.

For instance, suppose you’re getting $0.03 per kWh from your state renewable portfolio standard. Those kWh displace — on average — 1,300 lb per MWh of U.S. power, and you are therefore being paid $46 per ton of CO2 you reduce. CO2 reduction is not the only justification for RPS policies, but would we ever have an RPS if we didn’t care about CO2? I doubt it.

The good news there is that people are, today, being paid in the U.S. for reducing CO2. But is there any rhyme or reason to their price? And is it at all consistent with what others are getting for the same environmental service?

More math below the fold.

1. Wind, geothermal, and closed-loop biomass are eligible for a $0.021 per kWh production tax credit. That works out to $32 per ton of CO2 reduction.
2. Open-loop biomass, landfill gas, municipal solid waste, and qualifying hydro are eligible for $0.01 per kWh production tax credits. That works out to $15 per ton of CO2 reduction.
3. The investment tax credit for solar PV at 30 percent of project capital costs works out to $253 per ton of CO2 reduction. (I assume $8,000 per kW, a 20 percent capacity factor, and a 12 percent annual cost of capital.)
4. The investment tax credit for fuel cells is also 30 percent. If we assume a typical fuel cell is $6,000 per kW, natural gas-fueled, and 45 percent efficient with a 60 percent annual capacity factor, that’s a $262-per-ton credit for CO2 reduction.
5. Nuclear plant loan guarantees have a massive impact on the ability of those plants to finance themselves. If I make the conservative assumption that this federal backstop to 80 percent of the capital costs of the plant lowers the borrowing costs of those plants by 10 percent (e.g., money they can borrow at 12 percent interest would have cost them 22 percent without the loan guarantee), that program alone is paying them $165 per ton of CO2 reduction. (This value may well be infinite, because it’s not clear to me that anyone would loan money at any price to a nuclear plant developer without those loan guarantees.)
6. The ethanol blender’s credit at $0.51 per gallon yields a net well-to-wheels CO2 advantage relative to gasoline of about 20 percent. At that level, this works out to a $52-per-ton payment for their CO2 reduction.

One can quibble with an assumption here or there, but here’s the larger point: The absence of a coherent policy on CO2 emissions has not stopped well-meaning legislators from crafting incentives that encourage actions to lower CO2 emissions. But those actions are wildly incoherent, providing radically different incentives to different technologies for no obvious reason.

This suggests the following:

First, it is a certainty that we are not making rational investments in response to the climate challenges we face. OK, that’s no great insight, but it does bear keeping in mind as we think about future CO2 policies. When two otherwise environmentally-identical technologies are subject to ten-fold differences in their public subsides, markets will allocate capital in ways that have nothing to do with fundamental value (economic, environmental, or otherwise).

This raises the question: What might a world look like that did provide a consistent policy signal on CO2? One, we would deploy a host of technologies that are cheaper and more diverse than those we currently deploy in the name of CO2 reduction. Two, we would deploy a host of technologies that cannot possibly be contemplated by those who’s knowledge of possibilities is limited to those possibilities we are currently deploying. In other words, all of us.

Taken in combination, this means that a consistent and coherent plan to reduce CO2 emissions will be cheaper and engender a more diverse suite of technologies, companies, and solutions than we can possibly contemplate based on current experience. All we have to do is start.

Note: Here and throughout, I have insisted, erroneously, on using 2,000 lb tons rather than the metric 1,000 kg tonnes in which CO2 prices are commonly denoted. Adjust the math if you like, but it doesn’t affect my larger point about the massive variability in CO2 pricing.

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.

Two troubling things I heard last week:

1. The on-going question about what our next president will sacrifice in the name of the economy. If the financial crisis has taught us nothing else, it is that federal coffers are not infinite, and something will inevitably give.
2. At a panel on GHG policy in Washington, congressional staffers for Sen. Byron Dorgan (D-N.D.) and Rep. Jay Inslee (D-Wash.) conceded that the RGGI auction — and specifically, the $40 million raised for the northeastern states — will create some need for the feds to “give,” once the feds pass auctions of their own.

These are closely related and direct results of an environmental policy that continues to remain hostile to economic responsibility.

We must get over the idea that minimizing the cost per ton of GHG reduction somehow cheapens our environmental credentials. Financial resources are finite, and any decision not to minimize the cost per ton reduced is algebraically equivalent to a decision not to maximize the total tons of GHG reduction.

The responsible end of the environmental spectrum knows this, but the policy environment still doesn’t. Both RGGI and Lieberman-Warner have been set up to focus resources only on the most expensive means of GHG reduction, and while their exclusion of more cost-effective sources from participation wasn’t intentional, it wasn’t responsible either.

(Note: RGGI only allows participation by generators 25 MW and over, with any other CO2 source or sink participating only through offset auctions with the rules of offset engagement left up to the individual states. Lieberman-Warner died, thankfully, but its central precept that GHG reduction will be economically painful remains the dominant policy framework in Washington.)

As a result, we find ourselves in a situation where well-intentioned, but fiscally responsible politicians are going to be under pressure to put off the passage of GHG policy, based on the bogus idea that it will deepen our financial malaise.

But the bigger impact is that we lower our expectations, and write regulations that become self-fulfilling prophesies. This vicious cycle is often overlooked, but needs to be better understood. Let’s start with a simple analogy, and then see how this relates to GHG policy.

Dumb analogy

You are the King of Broccoli-land, a nation where everyone eats nothing but broccoli. For years, none of your subjects knew any better, and could not contemplate a world where any other foodstuff was available. However, in recent years, your soils have become depleted in various nutrients from your monoculture plantations. You send your Learned Scientists abroad to study possible solutions, and they come back with fabulous stories of trips to exotic lands far away — – in particular, Ice Cream Land, a world where no one eats anything but Ice Cream. In this land, they have cattle for milk, chickens for eggs, cocoa, sugar, and vanilla bean plantations. As their land becomes depleted, they rotate in crops of pistachios, strawberries, and chocolate chip cookie dough. Better still, it tastes awesome.

So you decree that your nation will commence a 20-year shift away from Broccoli toward Ice Cream. You will impose a tax on broccoli growth to dissuade broccoli harvest. You will use the proceeds of this tax to provide job re-training to broccoli farmers, to fund Ice Cream research and deployment programs, and to buy fertilizer to replace diminished soils. Just to be (personally) safe you will distribute massive amounts of government wealth to the Broccoli Land Broccoli Company, Ltd., to ease their transition into your low-broccoli future.

Dumb reality

If only the above example had nothing to do with the current situation. Our broccoli king assumed that de-broccolification would be painful, and that all likely solutions to the broccoli problem were known by the Learned Scientists. Having concluded thus, the policy was written to ensure that it would be painful, and that money would flow only to those ideas favored by the Learned Scientists. Years later, history will agree with the King. It really was expensive to shift an economy from broccoli to ice cream — not because it really was expensive, nor because ice cream is the only solution to the broccoli problem, but because if the regulations are set up to demand expensive ice cream, that’s what they will get. Reality was constrained so severely that the public comes to conclude that there were no alternatives. We know better right?

Not really. Because this is exactly what we are doing in our GHG debate. We assume it will be painful, so we take money and throw it at adaptation, R&D, and other public goods. We assume we must buy off the existing polluters, confusing GDP reductions with wealth transfers. And we are writing policies that get what we expect.

The proof? First, because politicians are already talking about making sacrifices due to the financial crisis, and GHG policy is on the list of potential things to be delayed.

But the RGGI issue is more problematic. The RGGI auction took in $40 million for the states, and the feds now see this as $40 million that they can’t take, lest they lose the state’s support for federal policy. But here’s the rub: if the state is collecting money that it counts as revenue, it’s not a cap-and-trade! It’s a tax by another name. And taxes on carbon provide no more incentive for carbon reduction than taxes on income provide incentives for poverty. (Or, if you prefer, than broccoli taxes and ice cream R&D credits provide incentives for boulangerie construction.)

So where does this leave us?

One, with a policy debate that is increasingly tempting to put off until we put this fiscal crisis behind us. Two, with a set of policy ideas that ensure that GHG reduction will be expensive.

Both of these outcomes are environmentally dangerous. And the environmental community deserves some of the blame, which I will address in my next post.

Note: This first appeared on Grist.

This is the fifth and final post in a series on the details required to get carbon policy right. See also parts one, two, three, and four. Or download pdf of full series.

So far, I’ve done a lot of complaining — which, in and of itself, is just, well … whiny. Here, then, is a solution.

First, a very brief review:

1. A test of good carbon policy is whether it encourages the private sector to invest capital in projects that will reduce GHG emissions.
2. “Additionality” confuses carbon policy, by preferentially shifting investment toward less economic GHG-reduction technologies.
3. Carbon taxes provide sticks without carrots, and thereby provide no direct incentive to those who might otherwise use carbon pricing to invest in projects that lower GHG emissions.
4. Long-term carbon pricing is necessary to encourage private sector investment. Spots alone will not.
5. Although not covered in this series, it bears repeating that auctions trump allocation.

Unfortunately, virtually all of the GHG-reduction strategies currently in existence (e.g., Kyoto, RGGI) or being contemplated (e.g., Lieberman-Warner, California AB 32) fail one or more of the prior tests. Moreover, all those actual/proposed bills are really complicated, with many moving parts that are rife for gaming — or, more charitably, significant legislative error. Here, then, is a better approach: output-based GHG regulation.
Output-based standards: The simple version

The concept of output-based standards comes from the world of criteria pollutant regulation. In conventional environmental rules, pollutants are regulated on a so-called “input basis” — which is to say, the more fuel you consume, the more pollution you’re allowed to produce.

As illustration, consider a typical parts-per-million (ppm) standard. Let’s say that you are a regulated source (boiler, power plant, etc.) with a permit that allows you to produce no more than 15 ppm NOx. You build your plant, put the appropriate pollution controls on, and check in at 14 ppm. Now watch what happens if you try to increase the efficiency of that plant. The denominator of your permit (the “millions”) is a function of only two variables: fuel combustion and air stoichiometry (the amount of air consumed per unit of fuel). For most technologies, air stoichiometry is just about fixed, so your only real variable is fuel combustion — which means that the more fuel you consume, the more total pollution you are allowed to produce, given a constant ppm.

Now, let’s assume that you suddenly find a way to dramatically increase the efficiency of your process, thereby cutting your fuel use in half. Since stoichiometry is fixed, you also cut your air flow in half. Let’s also assume that you cut your NOx emissions, but “only” by 40 percent. That’s good, right? Lower fuel costs, less fuel combustion, lower NOx — you would think so. But since the denominator (the millions) has fallen faster than the numerator (the “parts”) you suddenly find yourself in violation of your permit. 14 ppm NOx in the efficient device has suddenly become 14 x 0.5 / 0.4 = 17.5 ppm NOx, and you can no longer run your plant. The result? You simply keep running your inefficient device, over-emitting NOx, over-burning fuel, and over-paying for energy.

This is a really dumb policy outcome. It’s also ubiquitous. What would be vastly better is to go to an output-based standard, where your pollution is a function of the useful output of your project (e.g., lbs/MWh). Drive up your efficiency, and it’s easier to comply with your permit. Drive down your emissions, and it’s also easier to comply with your permit.

Remarkably, virtually all jurisdictions still use input-based standards, although a few (like Texas) have shifted to an output basis. Now let’s look at carbon.

Output-based GHG standards

As typically framed, carbon emissions are regulated on an absolute basis (tons per year, or some variant thereof). This would seem to be a step in the right direction, but it’s not. Our goal is to reduce global GHG emissions, not local emissions. And regulation that sets local caps has a really hard time setting an appropriate value for anything beyond battery-limits emissions. Witness the ongoing debate on biofuels — if I replace my fuel oil boiler with a biomass boiler, do I get credit for eliminating 100 percent of my carbon emissions, or should I first have to pay for the CO2 associated with fertilizer production, soil carbon depletion, and non-sustainable harvesting?

This is a legitimately difficult question. And it’s hard on the positive side as well. Suppose I replace my boiler with an on-site cogen plant that generates all my heat and power. I no longer buy power from the grid, and I’m making power more efficiently than the power I used to buy, but locally, my emissions increase, and so I have to try to figure out how much credit I should get (in terms of CO2 displacement) for the power I’m no longer buying. Again, hard issues.

Under current carbon rules, these dilemmas are addressed through some sort of offset rule (raising additionality issues, as Gar Lipow has pointed out) or on rather abstract theories that, since carbon prices will eventually affect those other fuels, you’ll eventually realize some incentive. Which is sort of like promising to buy someone a birthday present once they turn 80.

All of these problems go away if we shift to an output-based standard.

Nationally, our greenhouse gases come from three sources: electricity generation (about 40 percent of U.S. GHG emissions), transportation (27 percent), and thermal energy generation (33 percent). (The latter category includes not only residential and commercial space heating, but also a wealth of industrial operations — drying, calcining, melting, etc.) Let’s take electricity first.

In 2006, the U.S. produced 2,393 million metric tons of CO2 emissions in the process of generating electricity, and we generated just over 4,000,000 thousand MWh of electricity. By division, that works out to about 0.6 metric tons per MWh. That means that anyone who builds a power plant with CO2 emissions exceeding 0.6 metric tons per MWh is making our life harder, and anyone who’s beating it is making our life easier.

Under an output-based approach, we simply set a standard for all power plants at 0.6 MT/MWh and mandate that anyone who’s over that number has to pay for any excess pollution, while anyone who is under gets paid for their good deeds. Who do they pay? Each other. Measurement is easy, since both parties have fuel bills and electric meters — so, from a regulatory perspective, we simply require that they submit audited records of both at the end of the year, along with evidence that they bought or sold to get to 0.6 as appropriate.

To make sure that this structure caps CO2 emissions (e.g., to ensure that it doesn’t increase as total MWh production increases), we simply reset the cap every year based on actual CO2 emissions. If total CO2 emissions have increased by 2 percent, we reset the cap in the following year to 0.6 x (1 – 0.02) = 0.588. (A variant of this structure is that you can recalculate the MT/MWh factor every year based on actual data. As the payment streams incentivize low-carbon generation — and discourage high-carbon generation — this continual re-averaging would have the effect of steadily lowering the allowable level of pollution — a cute trick that requires no regulatory approval to tighten emissions standards.)

Now watch what happens. The structure has immediately created both carrots and sticks. If you install a solar panel (0 MT/MWh), you have 0.6 MT/MWh to sell. (And if you can drive up the efficiency of your solar panel, you get more tons to sell.) If you build a coal (1 MT/MWh) plant, you’ve got to buy 0.4 MT/MWh. Additionality? No need — just good guys and bad guys, selling or buying GHG emissions. Spots vs. strips? Solved — after all, the coal plant wants a long-term fixed price just as much as the solar plant does — they simply have to agree on a price. Goal- vs. path-based regulation? Done. The price is on carbon, not a technology. If a sexy new yet-to-be-dreamt-of technology comes along, it gets the same access to carbon pricing as everyone else.

The same mechanism can be applied to thermal energy generation, although the math is a bit trickier. (And indeed, to accurately capture the value of cogeneration, you have to factor in the value of thermal energy.)

The benefits are that the government need only set up the rules and then provide the appropriate oversight. It can then get out of the way and let market forces figure out how to optimally price and deploy technology. In doing so, it will naturally drive capital towards the most cost-effective carbon reduction approaches.

The tricky bits

That said, there are a couple of complexities:

1. The model doesn’t deal with transportation very well. In theory, you could calculate tons/mile, or some equivalent metric. In practice, though, that would be really hard to monitor. Unless someone has a better idea, this probably means that you’d still have to impose some type of carbon tax on transportation fuel for economy-wide coverage. (Note, however, that the tax could be set to equal the carbon-content of a given fuel multiplied by last year’s average carbon price in thermal and electric markets on a $/ton basis, providing a linkage between the two markets.)
2. For similar reasons, residential fuel use is hard. Again, it may be that a sector-specific tax is ideal.
3. Biomass would require some additional paper trail to quantify which fraction of the carbon associated with the biomass is truly renewable and which part is not.

I’ve got no way to fix these complexities — but compared to the massive complexities that work into tax and/or cap-and-trade models, this is comparatively quite simple. It also has the benefit of being fiscally neutral. With the exception of the wrinkles for transportation and residential (which could be eliminated), the buyers and sellers balance exactly, so there is no net economic cost — simply a wealth transfer from polluters to cleaners. This means that we get big reductions in GHG emissions with no economic pain (and, better still, we see no net increase in energy costs, since every increase in the cost of a dirty MWh is offset exactly by a reduction in the cost of a clean MWh.)

Eager to hear comments. But if I were king, I’d roll this out tomorrow.

Note: This first appeared on Grist.

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.