Renewables and Carbon Markets


Allowance structures will influence project economics.

Fortnightly Magazine - May 2009

Carbon-reduction policies are being designed and implemented across the country. Currently, 24 states are moving forward with carbon regulations and the U.S. Congress might pass comprehensive climate-change legislation during this legislative session. One common feature of these regulatory programs is a carbon cap-and-trade system—i.e., a carbon emissions market.

Renewable energy clearly will affect, and be affected by, carbon-reduction policies that assign a price to carbon emissions. The most probable and direct benefit will be the increase in electricity prices caused by carbon-related costs, which would make renewable energy more cost competitive. The degree to which carbon costs affect electricity prices will depend on the confluence of political choices (e.g., setting the level of the cap or allocating compliance targets among regulated sectors) with various regional market situations (e.g., the generation mix and electricity market structures). Regardless of regional differentiation, carbon costs will move forward the timing of grid parity for renewable ßenergy applications. For utilities, renewable energy can aid in potential carbon compliance costs by providing zero carbon generation.

Renewable energy installations also will be affected by the ability to participate in carbon trading. However, precisely how and whether renewable energy installations will be able to trade carbon assets often is misunderstood. In many respects, this confusion is tied to the vernacular of carbon markets and the difference between carbon assets.

Renewable-energy installations will not be allowed to generate and sell carbon offsets from displaced conventional power generation under a system-wide carbon cap. These same installations could, however, receive carbon allow-ances akin to a subsidy that then could be sold on the open market. The elemental difference between the two is how each carbon asset is created.

This issue is not as pedantic as it seems and could result in flawed assumptions about future economic benefits accruing to renewable energy facilities. How each asset is created influences the risk factors affecting its future value, and therefore is important to investors and developers considering carbon revenue for renewable energy projects. Carbon revenue stemming from an allowance allocation represents a policy risk similar to what happens with other subsidies such as the federal tax credits, and therefore should be discounted accordingly.

A cursory examination of this complex subject can help to clarify some of the issues surrounding the intersection of renewable energy’s place in carbon markets.

Two Types of Carbon Assets

GHG regulations that rely on emissions trading will create an entirely new asset class that can be broken down into two categories—allowances and credits. A carbon credit (sometimes also known as a “carbon offset”) is a legally separate asset from allowances and is commonly defined as a quantified emission reduction stemming from the prevention, destruction or sequestration of greenhouse-gas (GHG) emissions generated from projects outside the system cap. GHG-offset credits represent tradable carbon assets that result from qualified projects that reduce GHG emissions against a predetermined baseline. Thus, carbon offsets are created as a project is implemented—the emission reductions can be calculated over time and certified by an authority, resulting in the creation of the emission-reduction asset. Typically, carbon-offset credits are fungible with carbon allowances and can be used for compliance purposes, depending on the regulations, or sold to voluntary purchasers for marketing claims.

A carbon allowance is essentially a piece of paper granted or sold to an entity by a government as a quota instrument for compliance purposes. Cap-and-trade systems distribute allowances through either an auction or a government allocation formula. Most cap-and-trade systems have relied on allocation formulas that distributed the permits free of charge by grandfathering allowances based on historic emission levels. Allowances also can be allocated based on other metrics such as electrical output levels.

In a cap-and-trade system, the total number of allowances is equal to the system cap. The difference between the cap and actual emissions levels is what creates scarcity for these assets and thus their financial value. Carbon allowance allocation is perhaps the most contentious issue in carbon-market design. Because allowances represent a valuable commodity, how these assets are distributed to large emitting industries is a highly political issue on Capitol Hill.

Renewables, Offsets and Allowances

In an electricity grid governed by a carbon cap-and-trade system, carbon emissions are reduced only by lowering the cap—a policy decision—or by retiring carbon allowances currently on the market. In a cap-and-trade system, fossil-based generators can continue to emit CO2 as long as they own sufficient allowances or credits, if allowed, to cover their emissions. The market works by creating a direct financial incentive to reduce emissions, namely avoiding the cost of obtaining an allowance, or conversely, selling excess allowances.

Without a fixed emissions cap, increased renewable energy generation can lower emissions by displacing conventional fossil power generation. Under a cap-and-trade system, these emission reductions would be accounted for when initially setting the system cap. However under a fixed emissions cap, increased renewable energy generation beyond this amount does not reduce emissions. Consequently, displacing fossil-based power from new renewable capacity would not necessarily result in lower CO2 emissions, unless fossil-based generators retire carbon allowances in equal amounts thereby permanently removing them from the market. This, however, is arbitrary as allowances can be retired regardless of the amount of renewable energy coming online.

This situation is further complicated in the case of renewable energy credits (RECs). As typically defined, RECs represent legal title to the environmental attributes associated with the production of renewable energy, although the specific definition isn’t consistent across states that have REC markets. A debate has emerged as to whether the avoided CO2 benefits from displaced fossil-based generation are included in this definition.

It’s illustrative to look at this through the prism of financial value. Renewable electricity generation has the ability to increase the supply of carbon allowances on the market because displaced fossil-based generating facilities are not burning fossil fuel and therefore do not need the allowances for compliance. These excess allowances retain their market value and can be sold to other fossil-based generators that need them to continue operating on the margin. Allowing renewable installations to profit from selling offset credits arising from displaced power, coupled with permitting the fossil-based generator to retain monetary value associated with the displaced allowances, results in double counting from a carbon-accounting perspective. Because increased renewable energy will free up allowances, issuing offset credits to these facilities would result in two permits—the allowance and the credit—entering the market for every ton of reduced emissions. Emissions would rise above the cap instead of staying even with it. Therefore, rewarding the renewable facility for emissions reductions achieved under a system cap is technically flawed.

Renewable energy installations can, however, benefit from allocation of carbon allowances. As most renewable energy projects are non-emitting (the notable exception being biomass) and do not need allowances for compliance, owners of these installations could sell any carbon allowances they receive to entities with carbon-compliance obligations.

Allowance allocation decisions can benefit renewable energy entities either through receiving subsidies funded from auctioning allowances or by receiving allowan-ces outright. This can happen in three ways:

• Renewable energy installations could receive carbon allowances through a set-aside, meaning a portion of the total allowances created by the government would be set aside and granted to renewable energy installations based on a predetermined formula set by the government.

• An allocation formula based on electrical output (as opposed to historic emissions) could be used. While similar to a set-aside, allocation based on electrical output is insulated to some degree from political interference because a tangible metric is used (e.g., megawatt-hours of electricity produced) to determine the number of allowances received.

• Renewable energy projects can receive subsidies funded through revenue recycling of allowance auction proceeds, if auctions are present in the eventual legislation. This can benefit renewable energy through a direct cash subsidy or by funding tax credits or other fiscal mechanisms designed to stimulate renewable energy investment.

Regardless of the manner in which renewable energy installations receive carbon allowances, each of these scenarios are subject to policy risks as they will be subject to periodic review and approval by a governmental entity.

Green Value

Under a cap-and-trade system, renewable energy installations only can participate in carbon trading if they receive allowances allocated to them by the government. They will not be able to generate carbon-offset credits. This distinction is important because future carbon values for renewable energy will be fundamentally tied to political decisions, and that exposes renewable projects that rely on assumptions of future carbon revenue to considerable carbon-policy risk.

Apart from carbon trading, renewable energy development is more likely to be stimulated by the effect carbon costs have on regional electricity rates. The degree to which carbon policies increases the cost of fossil-based generation will move forward the timing of grid parity for renewable-energy applications. This depends on the interface between the renewable technology considered, its application in the market and the underlying regional generation mix. In regions that are heavily reliant on carbon-intensive generation, investment in renewable generation could increase as a result of cost parity, not necessarily carbon revenue. Renewable energy developers should increasingly consider the regional aspect of this dynamic as the United States moves closer to instituting a cost on carbon emissions.