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by Karen Palmer, Dallas Burtraw, and Danny Kahn
Emissions cap-and-trade programs impose costs on electricity suppliers required to participate in such programs. The free allocation of tradable emissions allowances to electricity suppliers is one way to offset the costs of the programs to these firms. However, in the case of a cap-and-trade program aimed at reducing CO2 emissions, giving away 100 percent of the emissions allowances will vastly overcompensate the electricity sector as a whole.
Moreover, such an approach leaves nothing to help achieve economic or energy efficiency goals or to help compensate consumers or other affected parties who may be adversely affected by the program. RFF researchers Dallas Burtraw, Danny Kahn, and Karen Palmer have been studying simple allocation rules that could compensate firms and at the same time avoid overcompensation in order to maximize the value of the allowances available to allocate to consumers or others. Their findings are presented in a new discussion paper, Simple Rules for Targeting CO2 Allowance Allocations to Compensate Firms (DP 06-28).
This research focuses on the proposed regional CO2 cap-and-trade program for electricity generators in the nine northeastern states originally participating in the Regional Greenhouse Gas Initiative (RGGI). |
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The analysis of compensation within the RGGI context is based on the results of a detailed national electricity market simulation model developed at RFF.
The policy that is analyzed is not intended to match the RGGI agreement precisely but instead includes a CO2 emissions target that is set at 20 percent below 2008 baseline emissions by 2025, with a linear phase-in between 2008 and 2025. As such, the policy is about twice as stringent as the caps in the RGGI agreement signed in December 2005. Nonetheless, the authors believe their results are relevant for the RGGI agreement.
The key to balancing compensation and efficiency is finding ways to limit the potential overcompensation of electricity generating firms doing business in RGGI. Tailoring compensation rules helps in this regard, but the outcome also depends on whether regulators are willing and able to distinguish firms according to the economic impacts of the cap-and-trade policy. If a regulator can identify winners under the trading system - such as firms that operate a large portfolio of nonemitting generation - then he or she can exclude these firms from receiving free allowances and dedicate a larger fraction of the allowances to other purposes.
One possible approach to identify the impact on firms would be to replicate the process used during stranded cost-recovery proceedings in the late 1990s. Regulators might introduce a default policy allocating a portion of the emissions allowances to firms for free and invite firms that seek to increase their free allocation to participate in a jointly convened simulation modeling effort. Firms that choose to participate would have to recognize that their default allocation would be put at risk. Such a strategy could lead firms to reveal the true extent of their losses under a cap and trade regulation. If such a regulatory strategy were fully effective and regulators had accurate information about winning and losing firms, the regulator could limit free allocation to roughly one-third of the emissions allowances, and this would be sufficient to maintain the market value of firms in the industry. The remaining two-thirds of the allowances could be allocated to compensate consumers or auctioned to generate revenue for efficiency investments.
Realistically, it may be impossible for the regulator to determine the level of each firm's gains and losses under a CO2 cap-and-trade program. In such cases, the regulator would be constrained to use coarser rules to determine a firm's free allocation. For instance, if the regulator differentiated facilities by fuel into three categories - coal, oil, and gas - and used this fuel distinction together with an adjustment for share of non-emitting generators as a basis for free allocation, it would be necessary to give away roughly three-fourths of the emissions allowances for free to maintain 100 percent of the market value for the most adversely affected firm. In this case most firms would be better off, some dramatically so. The remaining one-fourth of emissions allowances would be available for auction.
The examples presented assume that policy is announced and implemented right away and that firms should be compensated for 100 percent of their losses under the cap-and-trade program. The time between announcement and implementation of a policy delays the cost of compliance and gives firms an opportunity to depreciate existing capital and to adjust their investment strategies. Perhaps investors should assume responsibility for risks stemming from changes in policy or market conditions, especially because in many cases they are poised to capitalize on these changes. One might argue, for instance, that firms deserve less than full compensation for disadvantageous investments made after global warming emerged onto the policy agenda. The allocation rules calculated in this research can be adjusted linearly to achieve whatever fraction of 100 percent allocation is desired for the industry. |
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