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Cap and Innovate

An alternative approach to climate regulation.

Fortnightly Magazine - June 2010

no dividend. This will create an instant competitive problem for businesses and industries in states with high carbon emissions.

Any carbon regulation should match costs and benefits in a way that’s effective and fair to consumers in different states and regions.

Additionally, any climate regime that applies to the electric sector should include the following features:

Early Action Protection : Federal legislation should encourage and treat fairly early action taken by states prior to the effective date of the new law. If allowances are allocated based on emissions (as they should be) and if the bill doesn’t deal with the early action issue, some states will be penalized for early action and all states will have the perverse incentive to wait to begin reducing carbon emissions until the bill takes effect. It may be difficult to get this exactly right, but there is a simple rough-justice solution: When allocating allowances, select a suitable historic base period for measuring emissions across LDCs (but only for purposes of apportioning allowances). This approach first appeared in the Dingell-Boucher bill a couple of years ago and is now found in Waxman-Markey.

Complementary State Policies : Many analyses have concluded that relying on a carbon price alone in the electric sector won’t deliver enough emission reductions unless the carbon price is quite high. 5 For this reason, it’s a mistake to put all our hopes on a price on carbon, especially if federal legislation puts a collar on the price that allowances may achieve, as some advocate.

Federal action to cap carbon emissions is essential. But federal legislation should also encourage all states to pursue energy efficiency and low-carbon generation resources. With a federal clean energy and energy efficiency policy in place, states should then have flexibility in how they meet these standards and exactly how they handle emission allowances. The bottom line: States must have the ability to decide (as we do today) how to steer utility investment and how to set electric rates.

State regulation will be critical to meeting carbon goals within the electric sector. The National Association of Regulatory Utility Commissioners (NARUC) has published several policy analyses that stress the foundational role played by state utility regulatory programs such as energy efficiency and renewable energy. 6

Limits on Trading : As discussed, the Acid Rain program efficiently and cost-effectively reduced SO 2. The program also used a fairly boring, if efficient, trading market. For many reasons, the market in carbon allowances in the electric sector should be similarly boring. There are several ways to dampen the trading frenzy that some imagine for the carbon market. One approach is to limit ownership and trading of allowances to those entities to whom the allowances are issued and those entities with a compliance obligation. Brokers will be needed for liquidity, but they should not be permitted to trade for their own account.

Provision for Electric Vehicles : Given the likely migration of the small vehicle fleet to electric vehicles (EVs) and plug-in hybrid electric vehicles (PHEVs), a provision will be needed