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Renewables and Carbon Markets

Allowance structures will influence project economics.

Fortnightly Magazine - May 2009

project is implemented—the emission reductions can be calculated over time and certified by an authority, resulting in the creation of the emission-reduction asset. Typically, carbon-offset credits are fungible with carbon allowances and can be used for compliance purposes, depending on the regulations, or sold to voluntary purchasers for marketing claims.

A carbon allowance is essentially a piece of paper granted or sold to an entity by a government as a quota instrument for compliance purposes. Cap-and-trade systems distribute allowances through either an auction or a government allocation formula. Most cap-and-trade systems have relied on allocation formulas that distributed the permits free of charge by grandfathering allowances based on historic emission levels. Allowances also can be allocated based on other metrics such as electrical output levels.

In a cap-and-trade system, the total number of allowances is equal to the system cap. The difference between the cap and actual emissions levels is what creates scarcity for these assets and thus their financial value. Carbon allowance allocation is perhaps the most contentious issue in carbon-market design. Because allowances represent a valuable commodity, how these assets are distributed to large emitting industries is a highly political issue on Capitol Hill.

Renewables, Offsets and Allowances

In an electricity grid governed by a carbon cap-and-trade system, carbon emissions are reduced only by lowering the cap—a policy decision—or by retiring carbon allowances currently on the market. In a cap-and-trade system, fossil-based generators can continue to emit CO 2 as long as they own sufficient allowances or credits, if allowed, to cover their emissions. The market works by creating a direct financial incentive to reduce emissions, namely avoiding the cost of obtaining an allowance, or conversely, selling excess allowances.

Without a fixed emissions cap, increased renewable energy generation can lower emissions by displacing conventional fossil power generation. Under a cap-and-trade system, these emission reductions would be accounted for when initially setting the system cap. However under a fixed emissions cap, increased renewable energy generation beyond this amount does not reduce emissions. Consequently, displacing fossil-based power from new renewable capacity would not necessarily result in lower CO 2 emissions, unless fossil-based generators retire carbon allowances in equal amounts thereby permanently removing them from the market. This, however, is arbitrary as allowances can be retired regardless of the amount of renewable energy coming online.

This situation is further complicated in the case of renewable energy credits (RECs). As typically defined, RECs represent legal title to the environmental attributes associated with the production of renewable energy, although the specific definition isn’t consistent across states that have REC markets. A debate has emerged as to whether the avoided CO 2 benefits from displaced fossil-based generation are included in this definition.

It’s illustrative to look at this through the prism of financial value. Renewable electricity generation has the ability to increase the supply of carbon allowances on the market because displaced fossil-based generating facilities are not burning fossil fuel and therefore do not need the allowances for compliance. These excess allowances retain their market value and can be sold to other fossil-based generators that need