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Cap and Innovate

An alternative approach to climate regulation.

Fortnightly Magazine - June 2010

Regulators will have no more reason to allow a windfall profit on carbon-emission allowance sales than we do on any other transaction the utility undertakes today. Once again, consider the Acid Rain program. State regulators ensured that the regulated utilities cleaned up SO 2 without padding their bottom lines. 4

Allocated emission allowances will take the following path: from the issuing federal agency, through the local electricity-generating utility, though the regulatory process and finally to consumers ( see Figure 1 ). A similar path applies to utilities that purchase power in organized markets.

Allowances Based on Emissions : If emission allowances are allocated to consumers through their local utilities, the allocation should be based primarily on the utility’s baseline level of emissions, as in the Acid Rain program. The Waxman-Markey bill uses a compromise allocation scheme, championed by the Edison Electric Institute (EEI), in which allowances to LDCs are allocated based half on historic emissions and half on electricity sales. This creates regional biases and a mismatch between the mechanics of the cap and the sources of greenhouse gases. Unless allocations are based on emissions, utilities with a preponderance of hydro or nuclear generation will be issued allowances even though they have no compliance obligations for those generation resources. While this may be a boon to such utilities, it comes at the expense of consumers at other utilities.

Wide variation across states and regions will result if allowances are allocated on the 50/50 method advocated by EEI ( see Figure 2 ). Using 2008 data from the Energy Information Administration, we see that states with a relatively large fraction of hydro generation ( e.g., Washington and Oregon) and states with a relatively large fraction of nuclear generation ( e.g., South Carolina and Connecticut) will receive allowances well in excess of their emissions. On the other hand, heavy coal states ( e.g., Indiana, North Dakota and West Virginia), will receive initial allocations that are well short of emissions levels.

Matching Costs and Benefits

Unlike the proposed cap-and-innovate approach, the cap-and-dividend approach uses an allowance auction to raise funds, which are then returned to taxpayers in the form of a dividend. Writing checks to constituents might be politically potent, but taking all that money out of the system will hinder progress on carbon reductions in the electric sector. Higher electric rates at the front end of this process will make it harder for utilities and regulators to raise rates even further to achieve compliance with the cap.

A per-capita dividend is also fundamentally unfair across regions: Why should a consumer in a state with low emissions due to the availability of subsidized federal hydropower get a rebate at all, much less the same rebate as a consumer in the Midwest who faces higher electricity bills because emissions from coal-based generation must be reduced?

The dividend approach also suffers from the fact that commercial and industrial electric customers ( e.g., from mom-and-pop businesses, to hospitals, to government, to manufacturers) will fund the dividend with higher electric prices, but will get