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Cap and Innovate

An alternative approach to climate regulation.

Fortnightly Magazine - June 2010

The central conundrum in the politics of federal climate legislation is that relatively low, constrained carbon prices might not produce sufficient incentives for firms to innovate and reduce emissions in the long run. But relatively high carbon prices can be politically unacceptable and invite consumer backlash. Where’s the right balance?

In this article, I outline a “cap-and-innovate” approach to carbon regulation within the electric sector that attempts to resolve this conundrum. This approach caps carbon emissions, while greatly increasing funding for research and development (R&D) in low-carbon generation technologies. If we stimulate innovation and avoid rate shock by allocating emission allowances to consumers through their regulated electric utilities, we’ll effectively reduce carbon emissions using a regime that’s acceptable to consumers.

I write from the perspective of a state utility regulator in Colorado, where we’re making huge strides on carbon reductions, pursuing a 30-percent renewable portfolio standard, robust energy efficiency programs, enlightened resource planning, smart-grid technology and smart pricing. Under Governor Bill Ritter’s leadership we’re moving away from a mostly coal-based electric economy to a new energy economy without much (to this point) leadership from the federal government.

Despite our considerable progress, Colorado and other states need federal climate legislation capping carbon emissions. Regulators routinely make 40-year, billion dollar decisions about power plants, transmission lines, fuel sources and customer rates. We can’t postpone these decisions; federal leadership is needed now so we can make and justify these decisions with full information.

Effective Incentives

The five components of the proposed cap-and-innovate approach can reduce greenhouse-gas emissions in a sensible and cost-effective way.

Sector-by-Sector Approach : An idea that seems to be gaining support in Washington would create a carbon regulatory regime that’s specific to the electric sector, an approach I have supported for a couple of years. Carbon emissions in other sectors would be regulated in various other ways, e.g., through taxes or performance standards.

While a single economy-wide carbon market might arguably be the most efficient, there are clear advantages to the sector-by-sector approach. It’s easier to address the distributional equities that are special to each sector; it’s easier to harmonize new regulations with existing regulations and with market structures specific to each sector; and finally, the electric sector can move forward without additional delay because we already know how to reduce emissions using a cap-and-trade mechanism: Witness the success of the Acid Rain program. A sector-by-sector approach, however, does require that we carefully address the boundaries between the sectors, especially as we consider the migration of the small vehicle fleet from liquid fuels to electric vehicles and plug-in hybrid vehicles.

Allowances to Consumers through LDCs : In the Acid Rain program, allowances to emit SO 2 were allocated to utilities at no cost, traded among those recipients and then retired for compliance. As