Economic & Administrative Considerations for the Initial Distribution of Emissions Allowances. Dallas Burtraw Resources for the Future

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1 Economic & Administrative Considerations for the Initial Distribution of Emissions Allowances Dallas Burtraw Resources for the Future

2 Initial Distribution of New Asset Value Rate approach implicitly assigns ERC credits (MWhs) to production Mass approach explicitly leaves the assignment of allowances (tons) up to the state

3 Process can triumph over politics Initial distribution emissions allowances can seem like a cat fight waiting to happen. But, The value is created by introducing scarcity (limiting use) on a resource that was previously available for free, as part of the global commons Recognize this decision assigns substantial value Decisions of this nature should be in the public domain Getting to Yes The policy process can do better by starting with an identification of interests rather than positions.

4 Getting to Yes starts with identifying interests Progress begins by identifying criteria that would guide the assignment of value, like: transparency, perceived fairness, procedural fairness, efficiency, in some cases minimizing the change in electricity prices, keeping value in the sector, keeping value in the state, marshaling resources for energy development in the state, compensation and others

5 A Primary Consideration for State Economies Where does the state want to go? How will they achieve a transformation of their energy industries?

6 Initial Distribution of Emissions Allowances 1. Backward looking allocation to incumbents (grandfathering) (SO 2, some NO x, EU ETS Phase 1 & 2) 2. Forward looking allocation (updating), or auction (some NO x, EU ETS Phase 3, RGGI, California, Quebec) 6

7 The First Order Dimension of the Decision about Allocation Is not free versus payment. It is about the incentives provided by the allocation.

8 Allocation represents substantial value Forward looking allocation (updating, some uses of auction revenue) provide substantial incentives for new investments

9 Allocation represents substantial value A backward looking approach based on previous activities rewards past behavior and provides weaker incentives for investments

10 Second Order Dimension of the Allocation Decision Initial distribution of allowances: Free or payment? If free, three options: Grandfathering to emitters Updating to generators (output based allocation - OBA) Consumers (to local distribution companies - LDCs) Free implies compensation. To whom? Significant interaction with regulatory structure

11 Effect of grandfathering, in particular, interacts with state regulatory structure Grandfathered allowances are given to historic emitters and allocation is fixed for all time. In competitive power markets, producers bid the opportunity cost of allowances, so allowance costs are passed on to consumers (P ). Windfall profit goes to shareholders at the expense of consumers. In regulated power markets, allowance value accrues to the ratebase New producers receive no allocation 11

12 Effect of updating output based allocation is to provide incentives for operation and investment Allowances are given to eligible generators based on electricity production on an updating basis Creates incentive for production Allocation may be targeted to technology categories Production incentive mitigates allowance cost passthrough to consumers Compensation is shared with consumers 12

13 Allocation to Consumers Ongoing electricity bill rebates Allowance value is allocated via LDCs as electricity bill rebates Reduced bills provide relief to consumers, encourage consumption. Compensation is shared with producers Lump-sum rebates Consumers receive allowance value in a manner that is divorced from consumption, such as an annual rebate Allocation mitigates net consumers costs without encouraging consumption 13

14 Allocation to State State auctions allowances and uses revenues to fund: Demand-side energy efficiency programs in lieu of a system benefits charge Investment in renewables Reduction of pre-existing state taxes Any other state-run program Allowance costs are largely passed on to consumers, encouraging efficiency. 14

15 Examples SO 2 Trading Grandfathering California CO 2 (IOUs) Energy intensive firms (3%) Small business (7%) Residential customers through percustomer-account dividends (58%) and volumetric rate reduction (32%) NO X Budget Trading Grandfathering, Updating OBA & Auction RGGI RE, EE (75%) Residential customers (13%) GHG abatement and admin (12%) EU CO 2 Trading (Phase 3) >50% climate and energy Industry assistance 15

16 Summary: 3 Recipients of Allowance Allocation Electricity Producers Grandfathering (lump-sum) Updating output-based allocation (like a rate-based policy) Electricity Consumers LDCs receive allocation and pass value on to consumers via Electricity bill rebates Lump-sum rebates State Funding for energy efficiency, renewables, other programs Reduce other taxes Any combination of the above options 16

17 Summary of Allocation Options Allocation Producers Grandfathering Updating output-based Consumers Electricity bills Lump-sum State Summary In competitive regions, windfall profits for utility shareholders paid by consumers. Efficiency enhanced by elevated electricity prices. In regulated regions, allowance value goes to ratebase. Effect similar to updating output-based allocation. Rate relief for consumers, subsidy to in-state production. Efficiency discouraged by low electricity prices. Can provide targeted investments. Rate relief for consumers, subsidy to in- and out-of-state production. Efficiency discouraged by low electricity prices. Net consumer costs mitigated. Efficiency enhanced by elevated electricity prices. Flexibility to spend allowance value for any purpose, including EE, renewables, offset pre-existing taxes. Efficiency enhanced by elevated electricity prices. 17

18 Additional Slides 18

19 Grandfathering This approach has fallen out of favor in part because it leads to a change in revenues that is greater than change in costs, e.g. windfalls In cost of service regions firms recover allowance value at original cost, meaning value of allowances does not push up electricity price Company has incentive to reduce emissions because of (a) keep electricity prices low and regulatory oversight, (b) ability to sell and retain a portion of allowance value, or (c) opportunity cost associated with power exports 19

20 Updating output-based allocation (OBA) Allocation provides a production incentive to targeted technologies Targeted technology might include energy efficiency (offsetting cost of EE in rate base), renewables, all covered technologies, or combinations OBA can direct incentives to help implement a state energy plan When an emitting technology (e.g. natural gas) is marginal its expanded production drives up allowance price If incentive is directed to marginal technology it expands production and supply, potentially reducing electricity price in competitive regions In cost of service regions, OBA behaves a lot like grandfathering because allowance value goes into rate base, meaning small change in electricity price. 20

21 Auctions Auctions have gained favor to reduce windfall profits (in competitive states) and to direct value to various purposes: Compensation to ratepayers through allocation to local distribution companies Technology spending on energy efficiency, renewables, other programs Held aside to reduce other taxes Independent power producers and new entrants often prefer auctions to ensure availability of allowances and level playing field Auctions are especially good at price discovery and administrative transparency Auctions lead to higher electricity prices by passing through allowance value. This can be offset through the targeted use of allowance value (as under OBA). 21

22 A Changing Paradigm Carbon price is a payment to access the atmosphere resource (PES) Payment for Environmental Services? View 1: Owned by government Management is a part of the government s planning problem Potential revenue uses: general revenue, tax swaps, earmarked program-related spending, R&D Economic growth Government Individuals View 2: Owned by individuals in common Compensation to owners of the resource PES could be in the form of per capita payments, climate dividends, energy efficiency, R&D Politically reinforcing, opportunity for nudge

23 Provisions for Cost Management A well-designed auction has a reserve price (like ebay) that provides a price floor, which can be valuable for investors (RGGI & California) Price ceiling trigger might make additional allowances available either from future years under the cap (California) or additional to the cap (RGGI). For CPP, inter-annual flexibility would allow for additional allowances under the cap from future years. Alternative compliance payments might be part of a state plan with funds directed to escrow for new investments. Inter-annual emissions cap still applies. Minimum compatibility ( common elements ) pre-approval for use of out-of-state compliance instruments provides automatic reliability safety valve at the market allowance price 23

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