The current national policy vacuum affecting the US electric power sector will undermine efficient climate change policies.
When the U.S. adopts a serious policy to constrain CO2 emissions, and I think it is a question of when and how, not whether, the electric power sector will be a central target of the associated policy initiatives. The sector produces 40% of U.S. CO2 emissions and it is generally believed that the most economical opportunities to reduce CO2 emissions in the U.S. are on the supply and demand sides of the electricity sector.
As a practical matter it is almost a certainty that the U.S. will adopt a cap and trade program rather than an emissions tax. In this case, many economists have argued that all allowances should be auctioned because, they say, giving emissions allowances away for free to electricity generators, will result in windfall profits for generating facilities and because the auction revenues can be used to cut “bad taxes.” There is a good case for auctioning allowances, but the first argument for doing so flows from reasoning based on the assumption that the generation segment of this industry is competitive rather than regulated. However, a large fraction of the CO2 emissions in the electric power sector come from power plants owned by traditional regulated vertically integrated utilities and are regulated based on traditional cost of service principles.
When emissions allowances are given away for free to regulated utilities their cost — zero — will be passed through in retail prices so that the primary beneficiary of free CO2 allowances is given to consumers rather than to the utilities. The problem here is not “windfall profits” for generators in states with cost of service regulation, but rather that in regulated jurisdictions retail prices will be too low, failing properly to reflect the marginal social cost of electricity production, discouraging conservation and investments by consumers in energy efficiency.
On the other hand, in jurisdictions with wholesale and retail competition, the price of emission allowances will be reflected in bothwholesale and retail prices whether or not they are given away for free. This creates inequities between consumers in different states, complicates implementing a national CO2 policy, and further undermines our ability to sustain competition in those states that have chosen to adopt a competitive market framework.
Almost every model that examines the efficient responses in the electricity sector to carbon prices set to achieve specific atmospheric GHG stabilization goals efficiently yields similar results. On the demand side there are relatively low cost ways to reduce electricity consumption by increasing energy efficiency in building, lighting, heating, ventilating, air conditioning and other equipment. That’s why getting the retail price signals right is important and why muting them with regulation based on traditional cost of service models is inconsistent with promoting adoption of economical energy efficiency opportunities. Auctioning allowances to regulated generators will partially compensate for the inefficiencies of regulated prices in the states that have not deregulated generation since the market value of these allowances will then be passed through to electricity consumers. That’s a better argument for auctioning allowances than concerns about windfall profits and the dream of replacing bad taxes with good taxes. It is likely, however, that a large fraction of the allowances will be allocated free and, absent appropriate policies for distributing the “rents” associated with the free allowances, regulated retail prices will, as a result, be too low.
Second, the GHG mitigation models typically spit out significant investments in nuclear power plants, carbon capture and storage facilities and renewable energy. Can we avoid the cost overruns and inefficiencies that were experienced under regulation during the last wave of investment as regulated utilities begin to build power plants again? I see little evidence that the states that have stuck with regulation have implemented available incentive regulation mechanisms. Moreover, traditional vertically integrated utilities no longer have any experience managing large construction projects. Most traditional vertically integrated utilities have not built major generation projects for 15 years or more. Whatever expertise they may have once had in managing major generation construction projects is gone. This increases the likelihood that absent appropriate incentives to control costs, regulated generation projects will be excessively costly and that the cost overruns will be largely borne by consumers.
In the other hand, in the states that have implemented competitive generation market models, cost and performance risks are shifted to investors from consumers, properly aligning construction and operating efficiency incentives.
Let me turn to renewable energy as another example of why the current system is poorly adapted to respond efficiently to GHG mitigation goals as they are reflected in policies to promote renewable energy. The most efficient sites for renewable energy facilities, especially wind and large scale solar facilities, are often located far from load centers — on shore and off-shore. To take advantage of these opportunities very significant investments in new long-distance transmission facilities will be required. The organizational and regulatory framework that presently governs much of the U.S. electric power sector is not conducive to supporting these transmission investments. If remote sources of renewable energy are not available to meet state or potential future federal renewable energy portfolio standards or to respond to the incentives provided by CO2 emissions prices, CO2 mitigation goals will be even more costly to achieve.
Paul Joskow, Alfred P. Sloan Fundation and Department of Economics, MIT
The opinions expressed here are my own and do not represent the views of the Alfred P. Sloan Foundation or MIT
(This post is an excerpt from “Challenges for Creating A Comprehensive National Electricity Policy“)