Thursday, March 26, 2009

Applying Cap & Trade to Coal Plants Uses The Wrong Tool

I believe action needs to be taken to reduce GHGs. When designed well and used appropriately, a cap and trade regulatory approach has a lot of value and can effectively, efficiently and economically reduce GHGs. But it is also true that a poorly designed and inappropriately applied cap and trade program can be inefficient, uneconomic and ineffective.

It is this “flip side of the coin” concern that leads me to lament President Obama’s decision to address GHGs through an economy-wide cap and trade program using 100%-auction in his budget. First, I do not believe a cap and trade program is a suitable regulatory tool for dealing with GHGs from the transportation sector. Another concern is that implementing such a program where the government collects the credit auction money distorts market principles that underpin the cap and trade concept. And, finally a cap and trade program is unlikely to reduce emissions from installed coal plants. I will discuss the first two laments in future weeks; for today I will discuss my last concern.

Like any tool, cap and trade is a regulatory approach that works well in some settings and not so well in others. It works well where there are a manageable number of sources that can directly control, limit, replace or trade their emissions in response to increased cap-induced costs. This is why it worked for acid rain precursor emissions like sulfur dioxide from coal burning electric generating facilities. In the GHGs setting, I think cap and trade can work for manufacturing and industrial sectors that emit GHGs as an unfortunate by-product of their production. The participants in these sectors can and will make relatively quick economic analysis of whether reducing emissions through their industrial creativity or purchase GHG credits are in their best interests. The cap and trade approach may even work in the electricity sector when applied to future resource selections.

But as I reflect on a cap and trade approach and watched it’s use in the RGGI states or Europe, it becomes abundantly clear that such a program is a complicated tool crafted by humans with all our good intentions and frailties and inevitable political balances. As a result, I conclude that a cap and trade program is unlikely to reduce GHGs from the nation’s fleet of installed coal plants. This is an important shortcoming, since these sources emit somewhere north of a quarter of the country’s GHGs.

Although there are relatively few coal plants in the country (about 600 or so), unlike SO2, their GHG emissions are integral to their operations. Their GHGs cannot yet be scrubbed or economically captured. Just as important to my analysis, these installed coal plants produce electricity very cheaply and it is very unlikely that the cap will impose GHGs costs so high that newer or cleaner (in the case of natural gas) but more expensive alternatives would be an economic replacement…an alternative to new coal plants, possibly; but not as a replacement of the installed coal plants which produce electricity at under 5cents per kilowatt-hour versus over 10 cents for new. In short, for a cap and trade program to affect the GHGs from these installed coal plants, the imposed very, very high costs; costs so high that closing down is cheaper than buying credits from elsewhere. I doubt the political balancing process will impose such a high cost…it hasn’t yet in the other places that are pushing forward on cap and trade programs.

Thus, what is likely to occur is that the cap and trade program will impose higher costs on the generator that will be passed on to consumers…which of course may affect overall demand but not the emissions from the facility. The result: higher energy costs but minimal reductions in GHGs.

To make matters worse, the cap and trade program may actually encourage the generators to extend the coal plants lives since there would be little incentive to shut them down because the GHG costs will have been internalized or passed through to consumers. Thus, and to repeat for emphasis, the most likely result of a GHG cap and trade program will be higher electricity costs with little GHGs reductions….at least from the electricity generating sector. This should not be an acceptable outcome.

Since the cap and trade is an unsuitable tool for reducing GHGs from installed coal plants, there is a need to think of an alternative. The idea I have is that the installed coal plants should have their own program and certainly be exempted from any cap and trade program as a result. In my program, when a coal plant turns 50 years old it would be decommissioned, and between now and then the owner/operator of the exempted coal plant will work with their utility commissions to begin collecting money and putting it in escrow on the utility’s books for the sole purpose of replacing the energy from that facility (sort of like a pension fund) when it is decommissioned.

The result of this cap and trade alternative would be an orderly and economic phase out of the installed coal plants and replacement with inevitably cleaner facilities a significant environmental improvement…even if they are replaced with new coal plants. Ratepayers would be no worse off than if they were included in the cap and trade program and are likely to be much better off because the escrow collection would be equal to or less than the associated carbon costs a cap. Plus, that money will become down payments for the replacement facilities, reducing their costs and lowering the rate impacts instead of being “redistributed” through government programs. Knowing the end-of-life timing for their electricity generating facilities will prevent very expensive life extending improvements. The result: manageable electricity costs and significant GHGs reductions from the electricity sector…something that probably will not happen under a cap and trade.

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