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Trading on Carbon: How Markets Will Save the World

Utilities should plan for U.S.-wide CO2 emissions restrictions that will be more effective than state efforts.

Fortnightly Magazine - January 2007

shutting down carbon inefficient methods of power production. 8

Setting the allocation mechanism for a U.S.-based ETS will have major strategic implications for regulated companies. Companies first must determine the baseline that will position them to gain maximum economic value as compared with competitors. Each company then will lobby for the baseline that is most favorable for its current and planned operations. We expect that the power-generation industry will be divided based on fuel-mix profile. The industry will be divided primarily between heavy coal users and light coal users. Heavy coal users, like AEP and Duke, will lobby for an “as is” allocation based on historic emission profiles. This means that coal plants will get significantly more CECs/MW output than would other types of plants. Light/non-coal users, such as PG&E, will lobby for an “efficiency” allocation based on CO 2 efficiency (CO 2/MW). This means that operators of coal plants may not be allocated their required number of CECs, and may have to buy CECs from operators that may be allocated more credits than they need.

Furthermore, companies that already have made significant investments in CO 2 abatement technology (including fuel switching and plant shutdowns) will lobby to get credit for past “investments.” Regulators will need to signal that they will consider past investment in abatement when determining an allocation mechanism. To not consider past investment would cause companies to delay abatement options until the allocation mechanism has been set. We expect that regulators will also be sensitive to the significant amount of money utilities already have spent on SOx and NOx abatement to meet the Phase II reductions mandated in the 1990 Clean Air Act. Cost of CO 2 cap-and-trade will be borne by the same companies that faced the greatest costs under the SOx and NOx programs. Regulators probably will account for this by giving companies a longer timeframe to come into compliance.

Another issue is how to allocate CECs to new plants. Since existing plants essentially will be given CECs, new facilities not allocated CECs will be at a significant cost disadvantage. Not allocating CECs to new plants would be a substantial barrier to entry and would keep newer, more energy-efficient plants from being built. For this reason, it is expected that new plants will be allocated, at no cost, at least a portion of their required emissions credits.

Monitoring and Reporting Regulations

Regulators must implement a system for compliance monitoring. The system must be substantially robust for all participants to have confidence that regulators can ensure compliance, manage data, and institute punishments for violators. These interests must be balanced to minimize costs associated with installing expensive and disruptive monitoring equipment. This becomes especially important as the ETS expands to cover smaller emitters, although at this stage it is unclear how small emitters will be monitored. 9

In addition, from an industry-wide perspective, implementation of any ETS scheme will act to increase production costs. To sustain profits, producers must have some ability to pass-through costs to customers. This is especially important for carbon-intensive producers. In this highly regulated