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Cap and Innovate

An alternative approach to climate regulation.

Fortnightly Magazine - June 2010

the number of allowances was reduced each year, emissions fell. The result was, by any measure, a great success: SO 2 emissions were reduced more quickly and at less cost than anyone predicted. 1

A similar approach will work for carbon regulation. After an initial allocation, fewer allowances would be issued each year, tightening the sector-wide cap on carbon emissions. Assuming that noncompliance isn’t an option because of the financial penalty, emitters either will purchase an allowance or reduce emissions, possibly by switching fuel or shutting down. There will be no other choices. If an emitter purchases an allowance, it will be available only because another emitter has reduced its emissions.

The disposition of allowances should be a matter for the utilities and their regulators. With the oversight of regulators, utilities with fossil generation could retire the allowances for compliance, bank the allowances for future use, or sell the allowances to pay for low carbon technology or energy efficiency investments, among other choices. The exact strategy will differ from utility to utility, depending on each utility’s generation fleet, growth rate, access to capital, etc.

Utilities that buy power in an organized market will face similar choices. With no generation of their own, they will sell the allowances to emitters that have a compliance obligation. The funds will be used to help pay the resulting higher market prices, to fund investments in energy efficiency, or to make additional investments in low carbon resources, among other choices.

There are two basic approaches to regulating carbon under an industry-wide cap: allocating allowances or auctioning allowances.

We should begin this national carbon regulatory regime using the allocation of free allowances to consumers through their regulated utilities. Prices for electricity will start near today’s levels and then increase gradually over time as the cap is lowered and carbon is reduced. This approach is more consumer-friendly and gives businesses and consumers time to adjust. Although the allowances would be issued at no cost, they would immediately acquire a value due to their opportunity cost, informing the resource choices made by the utility and its regulator.

The competing policy option is for the federal government to auction the allowances. Under this approach, the cost of electricity rises immediately as emitters raise prices to cover the cost of the required allowances, creating a price jolt. Depending on how the auction revenues are spent, various outcomes follow. If auction revenues are used for checks to consumers under a cap-and-dividend approach or to reduce the federal deficit, then electricity prices will have gone up, but the new revenues will have left the system. The obligation to reduce emissions will remain, likely requiring additional increases in electricity rates. If auction revenues are spent on energy efficiency or renewable energy, then we move back to the case where allowances were free and regulators include the costs of those energy efficiency and renewable efforts in rates, as we do today.

Electric Sector Innovation : Meeting 2020 carbon goals for the electric sector with today’s technologies will be difficult but possible. Progress beyond 2020 or