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 SO2 were allocated to utilities at no cost, traded among those recipients and then retired for compliance. As the number of allowances was reduced each year, emissions fell. The result was, by any measure, a great success: SO2 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 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 CO2 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. 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 SO2 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 no dividend. This will create an instant competitive problem for businesses and industries in states with high carbon emissions.

Any carbon regulation should match costs and benefits in a way that’s effective and fair to consumers in different states and regions.

Additionally, any climate regime that applies to the electric sector should include the following features:

Early Action Protection: Federal legislation should encourage and treat fairly early action taken by states prior to the effective date of the new law. If allowances are allocated based on emissions (as they should be) and if the bill doesn’t deal with the early action issue, some states will be penalized for early action and all states will have the perverse incentive to wait to begin reducing carbon emissions until the bill takes effect. It may be difficult to get this exactly right, but there is a simple rough-justice solution: When allocating allowances, select a suitable historic base period for measuring emissions across LDCs (but only for purposes of apportioning allowances). This approach first appeared in the Dingell-Boucher bill a couple of years ago and is now found in Waxman-Markey.

Complementary State Policies: Many analyses have concluded that relying on a carbon price alone in the electric sector won’t deliver enough emission reductions unless the carbon price is quite high.5 For this reason, it’s a mistake to put all our hopes on a price on carbon, especially if federal legislation puts a collar on the price that allowances may achieve, as some advocate.

Federal action to cap carbon emissions is essential. But federal legislation should also encourage all states to pursue energy efficiency and low-carbon generation resources. With a federal clean energy and energy efficiency policy in place, states should then have flexibility in how they meet these standards and exactly how they handle emission allowances. The bottom line: States must have the ability to decide (as we do today) how to steer utility investment and how to set electric rates.

State regulation will be critical to meeting carbon goals within the electric sector. The National Association of Regulatory Utility Commissioners (NARUC) has published several policy analyses that stress the foundational role played by state utility regulatory programs such as energy efficiency and renewable energy.6

Limits on Trading: As discussed, the Acid Rain program efficiently and cost-effectively reduced SO2. The program also used a fairly boring, if efficient, trading market. For many reasons, the market in carbon allowances in the electric sector should be similarly boring. There are several ways to dampen the trading frenzy that some imagine for the carbon market. One approach is to limit ownership and trading of allowances to those entities to whom the allowances are issued and those entities with a compliance obligation. Brokers will be needed for liquidity, but they should not be permitted to trade for their own account.

Provision for Electric Vehicles: Given the likely migration of the small vehicle fleet to electric vehicles (EVs) and plug-in hybrid electric vehicles (PHEVs), a provision will be needed linking the electric sector regulatory regime to the liquid fuel regulatory regime. We should expect electric energy requirements to go up as EVs and PHEVs proliferate. The electric sector must get credit (e.g., offsets) for the net reductions in carbon emissions attributable to this migration.

Attention to Details

We may be approaching an inflection point in the debate over climate legislation. It’s critical that we get the details right. Cap and innovate is a common-sense approach that will efficiently reduce carbon emissions, be less disruptive to the economy, protect consumers and businesses, and avoid regional disparities.



1. See, e.g., Ellerman, A. Denny, “Ex Post Evaluation of Tradable Permits: The U.S. SO2 Cap-and-Trade Program,” Massachusetts Institute of Technology, February 2003 and Burtraw, Dallas and Palmer, Karen, “The Paparazzi Take a Look at a Living Legend: The SO2 Cap-and-Trade Program for Power Plants in the United States,” Discussion Paper 03-15, Resources for the Future, April 2003.

2. The Energy Information Administration reports that U.S. electricity sector produced 2,477.2 MMt (million metric tons) of carbon dioxide in 2008. A fee of $4 per ton would produce an annual research fund of $9.9 billion. This equates to 2.7 percent of the electric industry’s 2008 total revenues of $363.7 billion. Source: Energy Information Administration, “Electric Power Annual for 2008, Table ES-1,” released Jan. 21, 2010.

3. The 2010 budget line for the Department of Energy’s research into “low carbon” energy sources is $3.1 billion. Source: Department of Energy Office of the Chief Financial Officer. “FY2011 Congressional Budget Request: Budget Highlights.” February 2010.

4. Lile, Ron and Dallas Burtraw, “State-Level Policies and Regulatory Guidance for Compliance in the Early Years of the SO2 Emission Allowance Trading Program,” Resources for the Future, May 1998.

5. See, e.g., Niemeyer, Victor, Electric Power Research Institute, “The Change in Profit Climate: How Will Carbon-Emissions Policies Affect the Generation Fleet?” Public Utilities Fortnightly, May 2007.

6. The NARUC Climate Issue Briefs are available at: