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Compensation Rules for Climate Policy in the Electricity Sector

Dallas Burtraw and Karen Palmer

As the debate over a national climate policy in the United States heats up, much attention has focused on the use of an emissions cap-and-trade approach as the preferred way to regulate emissions of carbon dioxide (CO2) and other greenhouse gases. A cap-and-trade approach limits the number of emission allowances for CO2 issued each year and then requires regulated entities that emit CO2 to surrender one allowance for each ton of emissions. Some policymakers support an emissions tax or fee instead. However, the fee approach is less popular than cap and trade because, from an environmental perspective, it creates more uncertainty about how much emissions reductions will be achieved, and, from a political perspective, it involves a new tax. The cap-and-trade approach has also been successfully used to reduce emissions of other pollutants including SO2 and NOx and, thus, the vast majority of the federal legislative proposals that seek to limit CO2 emissions directly adopt a cap and trade approach.

The total value of the emissions allowances created by such a federal program is on the order of tens of billions of dollars annually arising from the value placed on emissions by a cap-and-trade system. Some estimates put this value at as high as $130-$370 billion by 2015, an amount equivalent to $1,600 to $4,900 per family of four in the United States. How this valuable asset is distributed within the economy has important implications for who wins and who loses as a result of the policy.

In their paper, "Compensation Rules for Climate Policy in the Electricy Sector", RFF Senior Fellows Dallas Burtraw and Karen Palmer look at the impact of climate policy on producers and consumers within the electricity sector and how free distribution of emissions allowances can help compensate those who will bear a disproporionate share of the costs.

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Dallas Burtraw and Karen L. Palmer
07-41 | July 2007 | Abstract

Policies to cap emissions of CO2 in the U.S. economy could pose significant costs on the electricity sector, which contributes roughly 40 percent of total U.S. CO2 emissions. Whether electricity producers or electricity consumers bear the cost of this regulation depends on whether generators are subject to cost-of-service regulation, and thus sell electricity at regulated prices, or sell power at market-determined prices. In general, consumers in areas with competitive electricity markets are more likely to bear the cost of the regulation regardless of how the allowances are initially allocated, while the effects of a cap-and-trade policy on consumers in regulated regions will depend importantly on whether electricity generators pay for allowances or get them for free.

Using a detailed simulation model of the electricity sector, Burtraw and Palmer examine one recent, relatively modest proposal from the National Commission on Energy Policy that would create a pool of tradable emissions allowances within the electricity sector with a net present value that sums to $141 billion (1999$). They consider the situation in which all generating facilities are required to pay for the emissions allowances necessary to cover emissions associated with their generation, either through direct purchase or through the purchase of allowances bundled into the price of fossil fuel. In this situation, the limit on CO2 emissions would cause a cumulative loss in market value of $50 billion at affected generation facilities; however, another group of facilities would gain $41 billion in value, and harm measured at the industry level would be just $9 billion, or 6 percent of total allowance value.

This approach ignores the fact that generation facilities belong to firms, however, and firms own a portfolio of generating facilities, with different firms owning different portfolios representing varying fuel mixes and levels of CO2 emissions. Typically, firms that own more non-emitting generators located in competitive regions are more likely to benefit from the cap-and-trade program than firms that rely more on coal to produce electricity. Focusing on the firm level shows that firms that are negatively affected would suffer a loss summing to $14 billion, while other firms gain $5 billion in value. Consumers would incur a loss approximately eight times as great as that of industry.

The initial free distribution of a portion of the valuable emissions allowances represents a significant potential source of compensation for parties adversely affected by the policy, but compensation can easily fail to reach those who bear the burden of costs. Free allocation also has substantial efficiency costs, raising the social cost of a policy that already promises to be more expensive than prior air pollution regulations.

Butraw and Palmer find, however, that regulators can use simple approaches or rules that make use of publicly available information to compensate producers through initial distribution of allowance in a way that maximizes the share of allowances available for another purpose. Such information includes the fuel and technology mix of the firm's generating fleet or the average corporate-wide CO2 emissions rate.

If regions or states are apportioned emissions allowances, they find that state regulators, using these simple rules, can achieve a particular compensation target for typically half of the allowance value that such rules would require if implemented at the federal level. For instance, at the regional level, full compensation based on emissions rates requires 32 percent of the allowances be given away in competitive regions and yields industry a net gain of $14.7 in value. At the federal level, full compensation could be achieved using 65 percent of emissions allowances in competitive regions (31 percent of national allowances), leaving a net gain in the industry of $36.7 billion.

While their analyses assume that the compensation goal is to fully compensate the worst-off firm, Burtraw and Palmer note that less than 100 percent compensation may be desirable, especially since compensating firms has dramatic cost. Under the most optimistic scenario, they find that compensating the last $2.6 billion in harm at the federal level has an opportunity cost of about $25.4 billion in allowance value, the difference accruing as excess compensation to firms that bear no cost or a substantially lower cost from the policy than their share of the allowances under the simple-rule approach to targeting free distribution of allowances. These opportunity costs may suggest practical limits on the amount of compensation for electricity generators that should be incorporated in climate policy.



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