Achieving Economic Prosperity and Climate Protection [ PDF ]

In this Newsletter:

Output-Based Allowances for Efficient Greenhouse Gas Reductions

By Tom Casten, Chairman, Recycled Energy Development

The public wants a low-cost, low-carbon future. A survey released April 3, 2009, found that the U.S. public strongly believes global warming is a problem (only 17% express deep doubt) and strongly favor actions to reduce carbon emissions (68% to 81%). People agree that high-carbon generators should be penalized and low-carbon generation rewarded. But a strong majority objects to paying more for energy services. Against this, the policy choices under discussion – including a tax on carbon emissions or cap and trade requiring every generator pay for 100% of all carbon emissions – will significantly raise the cost of energy services. These policies face near insurmountable political resistance, not because the public doubts the need for de-carbonization, but because the public demands profitable, or at worst, neutral low-carbon options. A win/win approach – output-based pollution allowances – will gain bipartisan approval, cause rapid private-sector investment in low-carbon energy, and will slash both carbon emissions and heat and power costs to the economy.

Average Output-Based Pollution Allowance Basics:

Provide each electric producer with initial allowances equal to average 2007 emissions, which were roughly 0.62 metric tons of CO2 emissions per delivered megawatt-hour of electricity (MWhE), and 0.32 metric tons of CO2 emissions per delivered megawatt-hour of thermal energy (MWhT).
Require every plant that generates heat and/or power to obtain allowances equal to total CO2 emissions. High-carbon plants purchase extra allowances from low-carbon plants at market prices. Since the total cost of allowance purchases will equal revenue from allowance sales, the consumers of energy services will see no increase in the average cost of heat and power, but low-carbon plants win and high-carbon plants lose.
Repeat these steps for three other pollutants – NOx, SOx and particulate matter.
Schedule these allowances – for each pollutant per unit of output – to drop by a fixed percentage every year and correct for increased output in order to insure total emission reductions. A 3.94% annual drop of carbon allowances will reduce 2050 allowances to 20% of today.
Use these output-based pollutant allowances to drive down pollution, replacing much of the Clean Air Act, including the need for operating permits and the New Source Review bans on major modifications of existing power plants.

Future Years Adjustment and Expected Impact of Output Allowance System

In order to reduce U.S. carbon emissions from heat and power to 20% of present emissions by 2050 – 40 years from now – the allowance for each MWh of electricity and for each MWh of thermal energy must decline each year. We recommend using a percentage carbon reduction each year, forcing larger absolute drops in the early years but slowing down the reductions later after the easy fixes have been wrung out of the energy system. A decline of 3.94% per year in allowances will reduce total allowed CO2 to 20% of 2007 levels by 2050. Figure 3 (below) depicts the allowances for each megawatt-hour of electricity and of thermal energy over time.

No one can predict how this system will affect the price of allowances over time, since price will be impacted by the actions of every generator and every entrepreneur in the entire market. Even starting the output allowance system by allowing 100% of today’s average emissions will encourage every generator to increase fossil efficiency, thus reducing carbon emissions per unit of useful energy. All investments in existing fossil generation plants that increase efficiency will lower the fossil carbon emissions per unit of output. The same effect will occur with the addition of non-fossil fuel generation, such as biomass, recycled waste energy, or solar thermal energy. Any plant that combines the generation of heat and power will earn double allowances from each unit of fuel burned – one for the electric energy produced and one for the thermal energy produced and sold. New generation that has no associated fossil carbon – including all renewables, nuclear, and recycled industrial waste energy – will generate allowances without adding carbon emissions.

This system will encourage all players to seek and deploy low-cost, low-carbon options, which writ large, will profitably de-carbonize production of energy services. We would expect the allowance market to initially clear at low prices, as entrepreneurs deploy proven technology that improves efficiency and reduces costs. Over time, as the output allowances drop, carbon’s clearing price will depend on the pace of introducing new technology and the speed of fuel switching away from fossil resources.

Comparing Two Systems: 100% Charge for all CO2 versus Average Output Allowances

The two figures below compare the economy-wide impact of regulating carbon under two different approaches. Assuming a $20 per metric ton cost of carbon emissions, a system that charges emitters for 100% of their carbon emissions – whether by taxing carbon or by requiring each emitter to purchase allowances – would add net taxes of $76 billion per year from fossil fuel generators of electricity and thermal energy. Low- or no-carbon energy producers avoid this economic stick, but receive no carrot.

With the Average Output Allowance approach described above, the added costs for high-carbon plants in the first year are much lower, and all of the money flows to the low-carbon generators of electricity and thermal energy. Government only collects money as penalties if an emitter fails to purchase permits for their full carbon emissions.

Figure 1 depicts the added costs or revenues to each form of electricity generation per megawatt-hour of production. The red brick bars depicting the 100%-charge approach show that fossil-fueled generation is penalized by $10 to $20 per MWh, representing an average tax of $8 per MWh on all heat and power. By contrast, the solid blue bars, representing average output allowances, show that payments from any specific generator are less than $8.00 per MWh – or just 8% of last year’s average retail prices. Low-carbon generators, in contrast, receive between $2.00 and $12.00 per MWh. This average output approach, therefore, means each stick has an equal carrot that encourages the rapid deployment of increased efficiency and low-carbon generation.

Figure 2 looks at the economy-wide differences between the two approaches, in billions of dollars per year. The approach of charging each heat and power generator for 100% of its emitted carbon, as depicted by the red brick bars, adds an initial tax of $46 billion on electric consumers and $31 billion on residential, commercial, and industrial thermal users. The federal government takes in $76 billion in new tax revenue and then presumably uses the money in a variety of ways which may or may not induce investment in clean energy. By contrast, the average output allowance approach causes no net increase in the cost to electric or thermal consumers, but sends price signals to all generators that reward low-carbon generation and penalize high-carbon generation, all in proportion to each generator’s carbon emissions per unit of useful delivered energy.

These figures demonstrate that the 100%-charge approach harshly penalizes coal and provides billions of dollars to the U.S. Treasury. The output-based-allowance approach, in contrast, limits the government’s role and balances rewards and charges amongst alternative technologies depending upon their carbon emissions. Under the first scenario, a utility with significant coal-fired resources would face significant charges that would lead to substantial rate increases. With output allowances, however, the utility’s charges would be balanced by its receipts for its low- or no-carbon resources.

Output-based Allowance Advantages

Output-based allowances (OBAs) leverage America’s innovative and creative spirit. Carbon taxes or allowance auctions of 100% of carbon emissions transfer all the money to governments that then “pick winners” and distribute the proceeds to selected technologies. OBAs, by contrast, reward all actions that deploy low-carbon generation and penalize continued operation or deployment of high-carbon generation, thereby unleashing innovation and creativity.
OBAs are fiscally neutral. High-carbon generators pay low-carbon generators. This market-based exchange encourages heat and power producers to find and deploy low-cost, low carbon generation, lowering carbon and energy services costs, all without draining public coffers.
OBAs provide carrots to clean energy. Most approaches to GHG mitigation hit high-carbon with a stick, but offer only the absence of the stick as a reward to low-carbon generators. OBAs provide immediate fiscal incentives to low-carbon generation, which helps attract capital.
OBAs make energy efficiency central to GHG control. Electric utility regulations do not reward energy efficiency and the Clean Air Act inadvertently penalizes it. An OBA system, by contrast, encourages efficiency, which lowers GHG and criteria pollutant emissions, saves fossil fuel, and reduces heat and power costs. OBAs stimulate investment in high efficiency while lowering all pollutant emissions.

Spring 2009 Climate Alert