CO 2 Regulation and Electricity Pricing

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1 CO 2 Regulation and Electricity Pricing Stefan Reichelstein Graduate School of Business Stanford University September 2011

2 Introduction CO 2 Regulations Existing and proposed regulations of CO 2 emissions take a variety of forms around the world Direct Regulation EPA Renewable Energy Portfolio Standards Individual States Cap-and-Trade System European ETS and California AB32 Giga-Dollar Questions: Impact of alternative regulatory policies and corresponding CO 2 emission limits on electricity prices? Is there reason to believe that a cap-and-trade system, like that envisioned under the Waxman-Markey legislation, would result in a doubling of electricity prices?

3 Introduction The McKinsey Abatement Cost Curve

4 Introduction CO 2 Emissions from Fossil Fuel Power Plants Fossil fuel power plants are a major source of CO 2 emissions More than 40% of total U.S. emissions Currently known technologies for capturing CO 2 ( and subsequent geological storage) have the potential to reduce emissions by 85-90% Abatement potential of carbon capture capabilities is considerable, but how economical is this approach relative to other abatement strategies? Islegen and Reichelstein (2011) study the incentives of both coal-fired and natural gas plants to adopt Carbon Capture and Storage (CCS) technologies

5 Introduction Carbon Capture and Storage (CCS) Technical feasibility of capturing CO 2 at fossil fuel power plants has been shown in demonstration projects not yet on a commercial scale Massive R&D spending currently underway $ 15 billion appropriated for DOE as part of Economic Stabilization Act of 2008 FutureGen project in Illinois seeks to certify one such technology for a new plant of commercial size CCS capabilities for new commercial power plants (>500 MW) probably not available until the second half of this decade

6 Introduction Two Central Questions in Islegen and Reichelstein (2011) Question 1: How far would the effective" carbon tax market price of CO 2 emissions under a cap-and-trade system have to rise in order for fossil fuel power plants to have an incentive to invest in CCS capabilities for newly constructed power plants? Distinguish two alternative market structures: Power generation is organized competitively Vertically integrated utility subject to Rate-of-Return regulation Question 2: Assuming CCS will become fully operational within the next 5-10 years, by how much and at what rate will electricity prices rise over time for alternative values of the effective carbon tax?

7 Competitive Power Generation The Levelized Cost of Electricity (LCOE) The 2007-MIT study on "The Future of Coal" provides the following verbal definition: "...the levelized cost of electricity is the constant dollar electricity price that would be required over the life of the plant to cover all operating expenses, payment of debt and accrued interest on initial project expenses, and the payment of an acceptable return to investors" Fundamentally, LCOE is a break-even sales price (per kwh) needed to justify an investment in a particular power generation facility. Claim: LCOE can be interpreted as the long-run marginal cost. In a competitive industry for electricity generation, the market price should be equal to the LCOE

8 Competitive Power Generation Alternative Power Plants Consider the following types of fossil fuel power plants: Pulverized Coal (PC), Integrated Gasification Combined Cycle (IGCC), Natural Gas Combined Cycle (NGCC) National Energy Technology Laboratory (NETL, 2007) provides engineering estimates for construction and operating costs of these plants both with and without CCS capabilities

9 Competitive Power Generation Coal-fired Power Plants Result 1 For coal-fired power plants, an investment in CCS technology becomes advantageous once emission charges for CO 2 exceed the break-even price of q = $31 per tonne. For an emission charge of $q per tonne of CO 2, the competitive wholesale price of electricity is projected to increase by the following percentage changes, p: { 1.68 q for q 31 p = (q 31) for q > 31.

10 Competitive Power Generation Observations on Result 1 Up to the break-even point of $31 per tonne, the wholesale price of electricity would go up by 1.68% for every additional dollar in the effective carbon tax At the break-even point of $31 per tonne, firms would find it advantageous to adopt CCS technology and at the same time switch to IGCC plants For an effective carbon tax of q = $31 per tonne, the wholesale LCOE would increase by about 50% Beyond the break-even point of $31 per tonne,wholesale electricity prices would be effectively shielded: further increases limited to.19% per additional $ 1 in the effective carbon tax A risk-averse decision-maker will adopt CCS for an uncertain carbon tax whose expected value exceeds q = $31.

11 Competitive Power Generation Coal versus Natural Gas For natural gas, we obtain a break-even value of around $60 per tonne of CO 2 for CCS adoption Substantial difference in break-even prices $30 vs $60 due to: Without CCS capabilities, natural gas plants emit only about half of the CO 2 of their coal-fired counterparts per kwh % increase in plant construction costs required for CCS capabilities is substantially higher for NGCC plants Nonetheless, for natural gas plants the increase in wholesale electricity prices is limited to 40%, even for a high effective carbon tax in the range of q > $70 Natural gas NGCC plants are cost-competitive for a an effective carbon tax in the range of $25-$50

12 Regulated Power Supply Rate-of-Return Regulation Electricity prices in the U.S. are commonly set so that a regulated utility earns a normal Rate-of-Return (RoR) on its invested capital: NInc t AV t 1 r. NInc t denotes Net-Income (accounting income after taxes) AV t 1 denotes the Book Value of operating assets Regulatory commission is assumed to be consumer-oriented: For a given carbon tax q, invest in CCS only if doing so is advantageous from the perspective of future discounted consumer surpluses Numerical search for next period s investment level and product price such that: (i) Consumer demand is met with current capacity and (ii) RoR constraint is satisfied Track wholesale electricity prices in real time"

13 Regulated Power Supply Coal-fired Plants: 100% Grandfathering Result 2 For coal-fired power plants, a consumer-oriented regulator will instruct the regulated firm to adopt CCS capabilities, provided CO 2 emission permits trade at a price of at least $30.0. Given a policy of 100% grandfathering," the regulated wholesale price of electricity is projected to increase by the following percentages as a function of time and the CO 2 emission charge q: Years Emission Charges: $q

14 Regulated Power Supply Observations on Result 2 Break-even values of $30 remarkably similar in the competitive and regulated scenarios Ultimate percentage price increases in the wholesale price of electricity: 52% for an effective carbon tax of $30 56% for an effective carbon tax of $50 In sharp contrast to the competitive scenario: Under RoR regulation price increases for electricity are phased in gradually over 30 years. Prices are now based on historical cost Approach to new equilibrium price levels is fairly linear over 30-year time window

15 Conclusion Concluding Remarks Carbon capture by fossil fuel power plants emerges as a cost-effective way of reducing CO 2 emissions. Could become a viable medium-term abatement strategy For coal-fired power plants an investment in new plants with CCS becomes advantageous once the market price for CO 2 emission permits moves beyond $30 per tonne. Break-even point for natural gas plants: $60 per tonne These projections obtain in both the competitive and the regulated scenario CCS entails an "option value" in that electricity prices are essentially shielded from increases in the carbon tax beyond the break-even value CCS capabilities suggest that the price increases in electricity at the retail level is effectively bounded by 30-35% Price increases will be phased in rather gradually under RoR regulation

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