Discussion Paper

Compensation Rules for Climate Policy in the Electricity Sector


Policies to cap emissions of carbon dioxide (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 producers or consumers bear the cost of this regulation depends on whether generators are subject to cost-of-service regulation or sell power at market-determined prices. Using a detailed simulation model of the electricity sector, we examine one recent, relatively modest proposal that would create a pool of tradable emissions allowances with a net present value that sums to $141 billion (1999$). The limit on CO2 emissions would cause a cumulative loss in market value of $50 billion at affected 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. Firms own a portfolio of facilities, and firms that are negatively affected would suffer a loss summing to $14 billion. Other firms would gain $5 billion in value, while consumers would incur a loss approximately 8 times as great as that of industry.The initial distribution of a portion of the valuable emissions allowances represents a significant potential source of compensation, but it is easy for the compensation to 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.We look for approaches to target the initial distribution of emissions allowances to compensate producers to maximize the share of allowances available for another purpose. We find that if regions/states are apportioned emissions allowances, they can achieve a compensation target using simple rules based on public information for typically half of the allowance value that such rules would require if implemented at the federal level. Under the most optimistic scenario, we 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 undeserving firms.