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Cap and Innovate

An alternative approach to climate regulation.

Fortnightly Magazine - June 2010

2030 will require major technological innovations, which will require significant funding for R&D.

In addition to establishing a carbon cap and a trading system, federal legislation should levy a thin research tax on carbon emissions within the electric sector, with the proceeds dedicated initially to research carbon capture and storage (CCS), renewable energy and energy storage technologies. A levy of $4 per metric ton on CO 2 emissions would produce around $10 billion annually, while increasing average U.S. electricity prices by less than 3 percent. 2 Not quite a Manhattan project, but a seriously large level of research and demonstration funding.

Moneys raised in this fashion must be protected from diversion to other purposes. Funds should be steered to established research organizations such as National Renewable Energy Laboratory, Lawrence Berkeley National Labs, and the Electric Power Research Institute, to funding channels such as Advanced Research Projects Agency-Energy and made available for at-scale carbon capture and storage demonstrations through the Department of Energy. 3 The research tax would show up in auction prices in organized electric markets and be passed through regulated prices in traditionally regulated markets.

This research funding is especially important if the price of allowances is limited by a price collar, a legislative feature often advocated in Washington D.C. Relatively low allowance prices, constrained by a price collar, are unlikely to produce the incentives for private firms to innovate and fund the research to develop the new technologies needed in the next 20 years. A substantial, national R&D effort is needed to spur innovation in low-carbon generation development.

Reliance on State Regulation : State utility regulation remains a mystery to many involved in the climate debate, leading to a great deal of misunderstanding about how a system of free allowances issued to regulated LDCs would work.

Working within a cap-and-trade regime with free allowances issued to the LDCs is a familiar exercise for state regulators. If federal carbon regulation becomes law, state regulators will retain the obligation to ensure the utility takes the long-term, least-cost path to serve its customers while complying with all applicable requirements, including renewable mandates, energy efficiency requirements, environmental laws and the new federal carbon law. Even though allowances are allocated at no cost, state regulators will be informed by the value ( e.g., the opportunity cost) of emission allowances as we make resource-planning decisions about whether to require, for example, more energy efficiency, another fossil plant, more wind power or more demand response. In other words, our decisions will be informed by the market price of carbon.

Free allowances won’t produce windfall profits for utilities. Across the nation, LDCs are regulated under a variety of ratemaking plans, all of which match allowed revenues with costs. To the extent that a utility profits by selling an allowance, regulators will account for that revenue in setting the company’s retail rates. The costs and revenues may flow through an adjustment mechanism or be considered in a general rate case. Either way, state regulators will make the match of revenues and costs, just as we do today.