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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

cap-and-trade system, a company will benefit greatly by knowing where its abatement investment will have the most impact. Currently, cost-effective options for CO 2 abatement are rare, as they require changing fuel inputs, reducing output, or capturing and sequestering CO 2. One tactic is to make plants “capture ready” or flex-fuel, essentially buying the option to more cost-effectively reduce CO 2 output in the future. Implementing a carbon capture and sequestration system has been shown to be more cost effective with integrated gasification combined cycle (IGCC) than with pulverized coal (PC). 4 Developing IGCC technology has been a core strategy of AEP in preparing for expected regulations. 5

The Cost of Compliance

The following factors will determine the magnitude of cost imposed by the CO 2 cap-and-trade system on individual businesses:

1. Allocation vs. Auction;

2. Allocation Mechanism and Baseline;

3. Monitoring and Reporting Regulations;

4. Cost Pass-through;

5. Scope;

6. Offsets and Links to Other ETS Programs and Geographies; and

7. Top-level Cap and Reduction Timeline.

The most important driver of cost for holders of CECs will be the decision between allocation vs. auction. Auctioning credits is the most economically efficient way to allocate initial CECs. Auctioning 100 percent of CECs would:

1. Avoid the need to set a baseline allocation mechanism, thus avoiding the possibility of lobbying/favor seeking;

2. Provide a windfall to the issuing government agency; and

3. Require significant expenditure on the part of industries covered by the ETS.

The most likely allocation mechanism for existing sources will combine free allocation according to a set baseline with an auction of possibly 10 to 20 percent of CECs. Additionally, a policy probably will be set for allocating CECs for new sources. This allocation mechanism is probable due to the precedent set by the U.S. SOx/NOx and the EU ETS allocation mechanisms. 6 These two mechanisms were designed to balance efficacy with political and regulatory support, and may act as templates for a future U.S.-based ETS.

Second, recognizing that the initial U.S. ETS may allocate the majority of the CECs, the choice of a baseline for allocating CECs largely will determine winners and losers. In any trading scheme, picking a baseline—the point from which emissions increases and reductions are measured—is controversial. The goal of energy producers will be not only to resist business disruption and high cost, but to fare better than direct competitors.

In choosing a baseline, regulators need to balance the needs of:

1. Rewarding CO 2 efficiency improvement; and

2. Rewarding CO 2 efficient producers.

In many ways, these needs are opposing. Should benchmarking be a driver towards CO 2 efficiency or a compensation for early action? 7 If the goal of CO 2 emissions restrictions is to reduce the carbon intensity of electricity production, the first need should not be considered. However, ignoring improvement when setting a baseline is unrealistic, since carbon intensity differs drastically across plants and producers. Using both needs to set a baseline recognizes that the initial U.S. ETS will be a transitory program that will, in the long term, lead to