Promoting Low-Carbon Electricity Production

Issues in Science and Technology, Spring 2007 by Apt, Jay, Keith, David W, Morgan, M Granger

To encourage utilities to emit less carbon dioxide, the government should implement-soon-a carbon portfolio standard with predictable requirements and guarantee loans for building advanced generating facilities.

The electric power industry is the single largest emitter of carbon dioxide in the United States, accounting for 40% of CO2 emissions in 2006, up from 36% in 1990 and 25% in 1970. The electricity sector is therefore a natural target as federal and state governments begin to get serious about managing CO2 emissions. Moreover, because the marginal cost of reducing emissions in the electricity sector appears to be lower than in other sectors such as transportation, the electricity sector may deliver the largest proportional carbon reductions under an economically efficient climate policy.

Several strategies have been proposed to constrain CO2 emissions. Many economists argue that an emissions tax is the ideal tool. But although such a tax may be a good idea in theory, in the real world there are a variety of problems. The fact that it is called a "tax" may present political obstacles in some locales, even though revenues might be used to offset less efficient and politically less desirable taxes. And unless its future is clearly and irrevocably specified, an emission tax may not provide sufficient leverage to overcome the risks and encourage private investments in large capital projects that can deliver cost-effective emissions control.

Cap-and-trade systems are often advanced as a more practical alternative. Such a system requires an initial allocation of permits for CO2 emissions up to the capped limit. Ideally, emission permits should be auctioned so as not to privilege any party. In reality, there are strong political pressures to allocate permits to existing emitters-to "grandfather" permits-and these pressures can produce ineffective and politically unacceptable transfers of wealth to existing large emitters.

Experience with cap-and-trade systems in the European Union (EU) proved less than encouraging, as the system turned chaotic in 2006. Prices for CO2 allowances in the trading market crashed from 30 euros per metric ton of CO2 to a low of 3 euros, as every EU member but the United Kingdom reported that their emissions were not as high as their too-generous allocations. The resulting mess has stymied investment. Companies that had made plans to install carbon controls that were economical at prices of 25-30 euros per metric ton of CO2 found themselves unable to justify the cost at the lower prices. The temptation for governments to manipulate emissions estimates used for permit allocations may be an intrinsic problem with cap-and-trade.

Some observers have argued that the best bet for promoting reductions in CO2 emissions is for government to establish renewables portfolio standards (RPSs), which mandate that electricity distributors must rely on specific renewable energy sources to provide a set percentage of power supplied to their customers. Twenty U.S. states have enacted some form of RPS, with quotas that range from 1% to 30% of electric power.

RPSs are not without drawbacks, however. Although achieving "energy renewability" is loosely correlated with the objective of reducing carbon emissions, it is not the same thing. An RPS is a policy instrument with many objectives. Recent RPS debates have cited numerous goals, including reducing air pollutants, keeping down fluctuating prices of fossil fuels, encouraging energy independence and diversity of fuel supply, promoting resource sustainability, and creating jobs. Although this kitchen sink approach may make it politically easier to pass RPSs than more focused regulations, there are significant cost penalties. One penalty is that some of the renewable sources encouraged or mandated by an RPS produce electric power only intermittently, making poor use of expensive capital investments. Another is that set-asides and subsidies for sources such as solar photovoltaic, which are now much more expensive than wind, conservation, or new carbon-controlled fossil and uranium energy sources, significantly increase the cost of power provided to consumers.

Given such considerations, we believe that the best method to promote reductions in carbon emissions is for individual states, which typically regulate energy matters, to adopt a carbon emissions portfolio standard (CPS). Under such a strategy, each supplier of electricity would be responsible for assuring that it meets an overall constraint on its carbon emissions. The company must supply the mandated fraction of low-carbon power, from wherever it is purchased. A CPS avoids the thorny problem of allocating permits because it requires distributors to buy a set amount of low-carbon power but allows them to seek the most inexpensive suppliers. Moreover, a CPS can be written to allow trading among those jurisdictions that have similar rules. A CPS can send a clear market signal to generators and provide a robust incentive to make long-term investments in generation technologies with low- or no-carbon emissions.