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Time to Rethink Climate Policies

Thomas R. Casten, Chairman, Recycled Energy Development

Summary
It is time to rethink climate change mitigation policies. Cap and trade, as proposed, is dead, mercifully so. Proposed approaches did not address the real problems.

The current climate debate is framed as “economy versus environment”, with both sides assuming the U.S. energy system is economically optimal. It then follows that actions to reduce CO2 emissions will raise energy services costs. One side, fearing economic pain, twists science to deny the climate problem. Mitigation advo-cates, believing markets have failed, propose massive governmental interference.

Markets do not fail, governance fails. Businesses act to benefit their owners, given the rules. Governance that blocks or fails to reward efficiency largely explains why the U.S. has not improved the conversion of fuel into heat and power for five decades, and this sector accounts for 70% of U.S. CO2 emissions. Obtaining more useful energy services from each unit of electricity and thermal energy would also reduce emissions.

Harnessing Market Forces to Reduce CO2
The U.S. conversion of fuel to useful energy services remains at 1990 levels, while other developed nations have continually improved. The U.S. burns 1.5 to 2.5 times more fuel to produce $1.00 of gross domestic product than most developed nations, giving those trad-ing partners significant production cost advantages. The first step to designing policies to profitably reduce CO2 is to understand why the U.S. converts only 12.5%, of fuel into useful energy services, why efficiency has sagged to 1990 levels, and how other nations achieve 20 to 25% efficiency. (i)

Pundits generally assume that the only way to reduce carbon emissions is to use fewer energy services, as though conversion efficiency was fixed. Converting 25% of fuel to useful energy services is possible with today’s technology, only slightly better than Japan, and would cut CO2 without reducing energy services.

Energy and environmental governance bear respon-sibility for this stagnation. Current governance was de-signed to meet yesterday’s goals – speed electrification, reduce local pollution and promote a domestic energy industry – using yesterday’s fuels and technology. This governance hampers achievement of today’s goals of improving U.S. competitiveness and reducing all emis-sions, including CO2.

Reducing CO2 requires improved efficiency. Unlike other regulated pollutants, CO2 cannot be economically filtered, catalyzed, or stored. Options include:

Reduce energy waste
Produce more useful energy per unit of fuel
Switch to lower carbon fuels
Switch to renewable generation
Reduce use of energy services

To achieve both goals, pursue options that cut CO2 and also reduce the cost of energy services. Which op-tions do both? Many options to reduce waste or produce more useful energy with each unit of fuel also reduce energy costs. The economics of switching to natural gas to lower CO2 depend on future natural gas prices and gas plant efficiency. Happily, gas plants can double fuel efficiency versus coal plants, helping reduce costs. Renewable energy value propositions are improving, but still have trouble competing with subsidized conventional generation. The last option, reducing people’s use of energy services will, in general, reduce standards of living.

Win/Win Opportunities
A recent study by McKinsey and Company identified profitable options to avoid 1.4 gigatons of CO2 by 2030 (out of 7 gigatons of U.S. emissions) and save up to $120 per ton of avoided CO2 emissions. Other options would avoid an added 1.8 gigatons, but would only make eco-nomic sense if there was a value for reducing carbon. It would seem that investing in the currently ‘unprofitable’ options would raise the cost of energy services.
But the analysis assumes today’s subsidized energy prices, and ignores the cost to taxpayers for energy sub-sidies and hidden costs of producing energy services. The McKinsey mid-term abatement graph is reprinted below with a new break-even line, assuming that total subsidies and hidden costs of energy are equivalent to about $55 per ton of carbon. Nearly all options save money versus the full societal costs of energy. Deploying all options that save money versus full energy costs could profitably eliminate 3/7ths of U.S. CO2 emissions.

Personal experience with developing combined heat and power generation (CHP) suggests a conservative bias to the study. The study suggests that by 2030, commercial and industrial CHP could avoid about 130 million metric tons of carbon per year and save $20 to $35 per avoided ton. Over the past 35 years, my col-leagues have invested $2 billion in 265 CHP plants, pro-viding a reality check. Each year, these CHP projects save users $500 million and avoid 5 million metric tons of CO2 emissions, or $100 per ton of avoided carbon. These projects, using yesterday’s technology and facing yesterday’s governance flaws, represent almost 4% of the estimated potential for the next 20 years.

The McKinsey CHP estimates are simply too low. Re-cent gas turbines are dramatically more efficient than the current fleet (ii), and can, in CHP applications, turn one unit of fuel into three times more useful energy than today’s coal plants. New gas-fired CHP has lower fuel costs than coal even at gas prices that are three times the price of coal. Natural gas currently sells for 2 to 2.5 times coal after including ash disposal costs. Another form of CHP, recycling industrial waste energy into power, was left out of the study, but has many proven ways to produce power with no added fuel. Value propositions will improve as the CHP market grows.

Why doesn’t capital flood to profitable investments in energy efficiency? Here are the key governance prob-lems that create barriers to more efficient heat and power generation and to other efficiency investments, including transportation:
I. Monopoly regulation does not reward efficien-cy and blocks competition.
II. Regulators ignore local generation benefits.
III. Energy subsidies distort energy decisions.
IV. The Clean Air Act ignores efficiency and tilts economics against new plants.
V. ‘‘Marxist’ utility regulation blocks ‘creative de-struction’ of inefficient generation

Here is a closer look at each governance flaw and suggested changes.

I. Regulators ignore local generation benefits
One unit of local generation, can by shaping electrici-ty characteristics, avoid line losses of .2 to .4 units, plus avoid the need for capital to generate and transmit that power. (iii) Typical local generation also reduces reserve requirements. But regulators have long assumed equal delivery and backup costs for all power and approved rates that do not pay local generation for these savings. This strongly biases decisions against local generation, even where such generation saves society money.

Policy Suggestions

Incorporate savings due to local generation into calculations of avoided costs.
Base generation choices on the delivered cost of power, including all of the above savings for local generation. FERC order 133 FERC 61.059, issued October 21, 2010, moves in this direction.
Reward distribution utilities for reducing line losses.

II. Monopoly regulation does not reward efficiency and blocks competition
Electricity offered immense advantages over candles, whale oil lighting, ice boxes and horse-drawn trams, and every state government, seeking to speed electrification, granted monopoly protection to the generation and dis-tribution of power. In theory, monopoly protection would make cheap capital available to expand electricity service, reducing the cost of power.

The challenge was to ensure that the savings, in the absence of competition, would benefit consumers, so States gave control of utility rates to regulators, who were to approve the prudency of investments and set rates to provide target returns on utility capital.
If utilities could increase profits by reducing costs, this would, in theory, over-reward utilities, and so regu-lators gave all cost savings to consumers. Utility invest-ments in efficiency could be included in the next rate case, but there may not be a new rate case for 5 to 15 years. This biases utility managements towards big capital investments and away from efficiency investments.

The tacit assumption was that market forces and commission supervision would cause utilities to optimize production costs. The data suggest otherwise, showing regulation to be a very weak substitute for competition.

In spite of monopoly protection, electric system effi-ciency improved until 1960 and then stagnated. By then, the technology for converting coal to electricity was approaching theoretical efficiency limits. A new coal-fired electric plant barely differs from a 1955 plant. The slight further efficiency gains have been less than the added parasitic loads required for pollution control, causing coal plant fleet efficiency to decline. U.S. deli-vered electricity efficiency from all generation has been a paltry 33% for 50 years.

But we can do better. Combining heat and power generation doubles theoretical efficiency. Since thermal energy does not travel very far, CHP plants must be lo-cated near thermal users or near factories that vent waste energy, and be sized to the thermal needs/supply. Theoretical efficiency limits are also much higher for plants using two power cycles, but these plants require clean fuel. But utilities have been slow to introduce more efficient generation and, as shown in the following chart, not increased U.S. delivered efficiency since 1960.

To increase fuel conversion efficiency:

Generate heat and power (CHP) in plants near thermal users. Recycle the hot exhaust to dis-place boiler fuel, with efficiencies up to 95%.
Recycle industrial waste energy into heat and power. Use hot exhaust from metals, cement, lime, glass production, or flare gas from blast furnaces and carbon black plants, or steam/gas pressure drop, to generate added power with-out added fuel or emissions.
Generate electricity with a gas turbine, piston engine or fuel cell and then make steam with the exhaust to drive a steam turbine generator. These ‘combined cycle’ plants can reach 60% electricity-only efficiency and achieve 95% effi-ciency in CHP mode. Combined cycle plants re-quire clean gas or liquid fuel.

Monopoly protection is slowly being eased. The 1978 Public Utility Policy Regulatory Act or PURPA spurred construction of CHP plants that now produce about 12% of total power, up from 3% in 1978. U.S. DOE studies identify potential for CHP to generate 40% to 50% of U.S. power, as is the case today in Denmark, Finland and the Netherlands. This would require roughly $500 billion investment in 200,000 megawatts of new CHP capacity.

Utilities have long opposed local generation, for reasons that could be fixed:

Locally generated power that displaces retail purchases by the industrial or commercial host reduces the utility’s sales and profits. But utilities could purchase locally generated power and keep supplying the retail customer, thus main-taining profits.
Many PURPA and renewable energy contracts force utilities to purchase the CHP and renewa-ble power all the time, but system operators must match generation to load as load varies, and resent being forced to reduce generation to make way for local power when this raises sys-tem costs. With relatively small capital invest-ments, CHP plants can vary generation across a significant range and accept economic dispatch.
Local generation reduces system line losses, need for T&D and for peak and redundant gen-eration. However, under current governance, reducing future utility investment in wires re-duces future utility profits.
PURPA allows relatively inefficient CHP plants to qualify, encouraging system gaming.

Policy Suggestions
Modernize PURPA to fix the problems.

Raise the minimum annual efficiency for quali-fying facilities to 60%, assuring CO2 reductions.
Restrict qualifying facility status to CHP plants that sell all power to the grid, avoiding loss of utility sales and profits.
Calculate the avoided capital costs of new cen-tral generation, transmission and distribution of power, and avoided redundancy requirements caused by new local generation, and then offer contracts to local generators at something like 85% of the full avoided costs, splitting the sav-ings between the public and the utility.
Pay for actual generation at the hourly system cost, adjusted for avoided line losses due to lo-cal generation.
Offer contracts to local generators for ancillary services like spinning reserve and voltage stabi-lization.

Modernizing PURPA would stimulate new energy recycling plants to meet today’s goals of improved compe-titiveness and lower carbon emissions.

III. Energy subsidies distort energy decisions
Energy subsidies have pernicious effects; they reduce returns on efficiency investments, encourage over-consumption of energy services and create vested interests in support of continued subsidies. The energy industry is addicted to taxpayer support.
Subsidies include investment tax credits, production tax credits, depletion allowances, cheap oil and gas leas-es from government lands, credit support for nuclear plants, taxpayer funded energy R&D, lifeline rates for low income people, subsidized highways and failure to tax energy’s hidden costs. (iv)

Policy Suggestions
To encourage optimal production, delivery and use of energy services, phase out all energy subsidies and tax the hidden costs of energy services. Charge market rates for leases on government lands. Recover all highway costs from fuel taxes. Pay for energy research with a tax on energy sales. Sending accurate energy price signals will lower energy waste, societal cost of energy and pollution.

IV. The Clean Air Act ignores efficiency and tilts economics against new generation
The 1970 Clean Air Act (CAA) ignores efficiency as a pollution control strategy, making no reference to useful energy output.

This approach has a bizarre result; least efficient plants are permitted three times more emissions than the most efficient plants per unit of useful output. For example, a gas turbine is allowed the same total pollutant emission, whether generating only electricity at 30% efficiency, operating in a combined cycle to achieve 50% efficiency, or used in CHP to achieve 90% efficiency.

The CAA tilts the playing field by placing the entire burden for cleaner air on new plants. Old plants are allowed to emit historic emissions while new plants must limit emissions to those from the ‘best available control technology’, or BACT at the time the plant is permitted. Control technology has improved by one hundred fold (for NOx) since 1970, but has costs to install and operate, which old plants avoid. This governance approach slows replacement of inefficient plants and raises costs and emissions.

The CAA drafters assumed that existing plants would wear out and be replaced with new plants. But power plants do not wear out. Operators replace worn parts and cease production only for economic reasons. Given the cost savings of grandfathered permits, the average age of U.S. coal plants has grown from 10 years to 40 years since the CAA enactment.

Another CAA provision discourages efficiency im-provements. An existing plant’s valuable ‘grandfathered’ air permit is revoked if the operator makes a ‘major modification’, such as investing in improved efficiency. To re-permit, the old plant must reduce emissions to current BACT levels. This is often prohibitively expensive, making it more profitable to operate ineffi-cient old plants at historic pollution levels than to im-prove efficiency but add BACT controls.

Policy Suggestions
Grant pollution allowances not to plants or to tech-nologies, but to each unit of useful energy produced by any generator, regardless of the generator’s age, tech-nology or fuel. In other words, grant every single mega-watt-hour of electricity an identical allowance to emit each regulated pollutant, whether it was from wind, nuclear, old coal, new natural gas, or any other approach. Ditto a unit of useful thermal energy. Plants with emissions less than the earned allowances could sell allowances to plants with above average emissions, and increasing useful output without increasing emissions would increase profits.

Set initial allowances equal to the current average U.S. emissions per unit of useful energy and then reduce the allowances annually by schedule. Correct for in-creases in production of useful energy. This approach:

Is a cap and trade system that will reduce emissions.
Does not raise energy taxes; every ‘stick’ has a matching ‘carrot’, no money to the government.
Levels the playing field for all generation.
Allows markets to decide how to reduce emissions.
Removes the time delay for permitting new plants.
Rewards all efficiency improvements.
Covers both heat and power production.
Reduces administration costs by eliminating com-mand and control processes.

V. ‘‘Marxist’ utility regulation blocks ‘creative de-struction’ of inefficient generation
Market prices balance supply and demand. Entre-preneurs add efficient capacity, expecting to gain market share and profits. With added supply, markets clear at lower prices, driving old factories reduce their costs and prices. Consumers win.

This process was termed ‘creative destruction’ by economist Joseph Schumpeter, and explains how com-petition improves value propositions.

By contrast, electricity governance follows the Karl Marx approach of ‘to each according to their need’. Regulators fear Schumpeter’s ‘creative destruction’, be-lieving that allowing the industry to build excess gene-rating capacity will raise electricity costs. This was true in the old full monopoly environment where returns on all generating investment were guaranteed. Many state regulators still decide how much and what type of new capacity is needed and then set rates to cover the costs of that new capacity – ‘to each according to its need.’

Marxist logic blunts the creativity of an open market where thousands of brains seek cost reductions. Instead, investment decisions are made through a single bureau-cratic process, based on one view of the future. By limit-ing profits to risk-free returns, governance favors low-risk approaches, stifling progress. As a result, the system responds very slowly to changes in technology or goals.

Legislative mandates further compromise energy in-vestment decisions. For example, Illinois legislators granted a new coal plant above market contracts.

As a result of this governance, there is currently a twenty-fold variance in the prices paid generators for a largely fungible commodity – electricity. Recent prices paid for 1 kilowatt-hour range from 1.9 cents to recycled energy plants in Indiana, 4 to 6 cents to wholesale power, 10 cents to some wind farms, 26 cents to an off shore wind farm, and 80 cents for solar power. This distorts decisions and prevents markets from deploying optimal approaches.

Policy Suggestions

Congress/courts treat electricity generation as interstate commerce, ending state regulation.
Put transmission in the hands of independent system operators.
End mandates for specific generating technolo-gies, restricting legislative mandates to the de-sired attributes of power. For example, replace ‘Renewable Portfolio Standards’ with ‘Clean Portfolio Standards’, allowing all clean power to compete without naming technologies.
Legalize private wires across public streets, forcing honest prices for utility wheeling, as is the case with natural gas.

Conclusions
Fixing governance to eliminate barriers to efficiency could profitably cut total U.S. CO2 emissions in half. Given the size of the U.S. market, other countries would have to follow suit or lose market share, and would reduce their energy costs by burning less fuel. Exposing electricity to market discipline worldwide will stimulate vast private efforts to improve efficiency.

This approach to climate mitigation policy will en-courage profitable reduction of CO2, stimulating every possible environmental and economic win/win.

Thomas Casten, founder and chair of Recycled Energy Development, LLC, has spent 35 years developing 250 decentralized energy recycling projects. Mr. Casten served as President of the International District Energy Association, was named a “CHP Champion” by the US Combined Heat and Power Association and received the 2009 Platt’s Global Energy Lifetime Achievement Award. He was the co-founder and Chairman of the World Alliance for Distributed Energy (WADE). He serves on the Board of Directors/Advisory Boards of the Carnegie Melon Electric Industry Center, American Council on Renewable Energy and the Climate Institute. He is the author of Turning off the Heat, as well as a chapter in the books Energy and American Society, Thirteen Myths and Sudden and Disruptive Climate Change. See www.Recycled-Energy.com for further information and articles. For questions or comments, contact Kimberly Hampton at khampton@recycled-energy.com.

End Notes

i. Data from Robert U. Ayres, based on analysis of U.S., UK, Austria and Japan, reported in Robert U. Ayres and Benjamin Warr, The Economic Growth Engine: How Energy and Work Drive Material Prosperity, Edward Elgar Publishing, 2009).
ii. A General Electric LMS100 gas turbine, introduced in De-cember of 2003, is 46% efficient, while the older industrial turbine technology that dominates today’s fleet is only 33% efficient. The technical improvements of the LMS100 can be extended to turbines of all size ranges.
iii. See extensive work of Professor Maria Ilic of Carnegie Mellon and MIT.
iv. The National Academy of Sciences and National Academy of Engineering, responding to a request of Congress, found the average U.S. coal plant to have $32 per megawatt-hour of hidden costs in the form of health and environmental impacts, not counting any estimated impacts from global warming. The hidden costs of the worst 5% of U.S. coal plants were esti-mated to be $120 per MWh. See “Hidden Costs of Energy: Un-priced Consequences of Energy Production and Use”, Committee on Health, Environmental, and Other External Costs and Benefits of Energy Production and Consumption; National Re-search Council

Winter 2011 Climate Alert

COP-16 in Cancun [ PDF ]

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