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Auction or Allocate

The great debate over emissions allowance distribution.

Fortnightly Magazine - February 2009

the market clearing price that is higher with cost of allowances figured in and pay more for all of their generation even when some portion of it comes from sources not producing carbon ( e.g., nuclear). Revenues obtained based on rates that include the opportunity cost of a free allowance have been characterized, in a similar vein to oil price run ups, as windfall profits.

Although we are focusing on the electric power sector, the basic options available for allowance distribution—allocations, auctions, and a hybrid approach—apply more broadly across the economy.

Allocating Allowances

When opting to allocate allowances, three major elements must be considered: allowance recipients, allocation basis, and how to address future changes. For simplicity, we assume fossil electric generators are responsible for compliance.

Determining the allowance recipient is the most elemental decision in developing an allocation scheme. Previous EPA programs allocated either to generators or to states (who reallocated to generators and at times, others). Another alternative is to distribute allowances to other entities not responsible for compliance. Similar to an auction, this third-party approach effectively requires emitting generators to purchase all allowances from a third-party, removing the distinction in allowance treatment between regulated and restructured markets. 3 The end result is the full passage of allowance costs to consumers, unless the revenue collected by the third-party allocation recipients is used to offset consumer price increases ( e.g., through rebates or energy efficiency improvements). 4

The next major consideration is the metric upon which allocations are based. Commonly discussed metrics in the power sector include input (fuel use, fuel type), emissions, and output (kilowatt hours). EPA’s programs generally have adopted an input-based approach. The ARP allocates based on heat input, while the CAIR NOx program recommends allocations based on fuel-adjusted heat input. An input-based scheme essentially allocates based on emissions potential. Adjusting for fuel type directs more allowances towards generators with higher emissions—those needing to make the most reductions. Another approach is to allocate based on historical emissions. If generators receive the allocations, an emissions-based scheme would direct allowances towards those responsible for compliance. Alternatively, an output-based scheme considers only production and ignores emissions. While this approach rewards cleaner generation, a sector-wide application delivers allowances to sources that do not need them for compliance ( e.g., nuclear, renewables). This outcome could be avoided by allocating to fossil fuel-fired sources only.

The third major consideration stems from the reality that input, output, and emissions behavior likely will change over time for all participants. Some will reduce emissions more than others, some will cease operations, and new generators will enter the market. These changes create a new landscape, where the objectives of the initial allocation scheme no longer may be met. One approach to address these changes is to update allocations at specified intervals ( e.g., every four years). Updating provides a way to allocate to entities consistent with their current or more recent operations. Updating also provides an opportunity to allocate to new sources and discontinue allocations to retired sources. However, updating may influence the decisions of