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Carbon In Electricity Markets

Price transparency will drive GHG reductions.

Fortnightly Magazine - August 2009

energy capacity, leading to cleaner generation on the electricity grid.

The most immediate effect a price on CO 2 emissions will have in the power sector is to alter the relative cost of generating electricity with different fuels and technologies. Under a cap-and-trade program, electricity generation costs should reflect the costs of the CO 2 emissions that are produced by a generating plant. In order to appropriately reflect CO 2 emissions costs in dispatch decisions, CO 2 emissions costs (as well as the associated opportunity costs) will need to be factored into all decisions regarding optimal generator dispatch.

Regardless of the eventual structure of GHG regulations, the overall financial impact on generation owners will be determined by the manner in which carbon costs are recovered. In restructured competitive wholesale power markets, carbon costs will be recovered through the wholesale prices received by generators. Since competitive markets are designed to clear at prices set by the marginal generator, market prices reflect marginal generation costs. Suppliers with generating costs that are lower than the marginal cost of production (or the market price) earn a profit on their output. If the marginal generator’s cost of production increases as a function of carbon-compliance costs, then wholesale prices increase, as do the profits accruing to lower-cost generators, therefore rewarding low-carbon generation. Since market prices reflect the carbon costs of the marginal generator, those with carbon costs that are higher than those of the marginal generator will not be able to recover fully their carbon-related expenses. This eventually will lead to the retirement of carbon-intensive generating units.

The ultimate impact of market-based CO 2 regulations on the energy mix will depend on the relative cost of fuels, other variable operating costs, and the cost of carbon emissions. In its recent report on the impact of proposed GHG policies can have on its markets, PJM states, “The greater the relative cost of natural gas to coal, the higher is the CO 2 price required to make the natural gas combined-cycle units less expensive to dispatch than the representative coal unit, and to achieve emission reductions from re-dispatch.” 14

PJM’s analysis points to the interrelationship between carbon costs and fuel costs, and to the importance this relationship has on the dispatch order (see Figure 6) .15

With no CO 2 costs, the dispatch costs of coal-fired generation are lower than those of a gas-fired combined-cycle plant by at least $20/MWh, assuming gas price of $7.50/mmBtu and coal price of $2.50/mmBtu. But an assumed CO 2 price of $40/ton raises the dispatch costs of the coal unit substantially over the dispatch costs of the gas-fired combined-cycle unit, reflecting the higher CO 2 content of coal, as well as the less efficient (higher heat rate) coal-generating process.

The result of this dynamic is the market-clearing price appropriately reflects the marginal cost of carbon emissions. If electricity prices are distorted by erroneous production costs, dispatch decisions will be based on suboptimal information. If the full marginal CO 2 cost of electricity generation isn’t reflected in prices, then GHG policies will not reduce