Opinion

The Great Debate

Emissions prices in 2020

February 18, 2010


kemp

– John Kemp is a Reuters columnist. The views expressed are his own —

Uncertainty about the future cost of emissions allowances for greenhouse gases is one of the biggest obstacles to winning consent for a cap and trade or cap and refund programme in the U.S. Congress. To have any realistic prospect of passing emissions legislation, lawmakers must find a way to reduce it.
Proponents argue a trading programme would ensure emissions reductions are achieved in the most cost-effective manner. They point to the success of the Environmental Protection Agency (EPA)’s Acid Rain Program in cutting sulphur dioxide (SO2) emissions much more quickly and at a fraction of the expected costs during the 1990s.

Title IV of the Clean Air Act Amendments (CAAA) 1990 established a trading programme for SO2 emissions from power plants. Phase I, beginning in 1995, covered the 110 dirtiest coal-fired electricity generating facilities.

Phase II, starting from 2000, covered all facilities with more than 25 megawatts of capacity, plus smaller plants using fuel with a sulphur content of more than 0.05 percent.

Estimates prepared before the programme’s launch put marginal compliance costs, and therefore the price of permits, at $579-760 per tonne (in 1995 dollars). In reality, compliance costs proved lower. Allowances started trading close to $150 per tonne, falling to just $70 in early 1996. While prices climbed above $200 per tonne in 1999 they fell again towards $150 in 2000. In the early years of Phase II, allowance prices fluctuated between $70 and $120.

Phase I also saw much more dramatic cuts in emissions than required by the cap. Covered facilities over-complied, cutting emissions by more than the required amount, and banking surplus credits for use in later years.

DESIGN SENSITIVITY

The Acid Rain Program’s success achieving rapid reductions in emissions at much less than the anticipated cost is cited as a reason to favour the creation of other environmental markets, particularly to deal with greenhouse gas emissions.

The problem is that no one really knows whether it could be replicated on the much larger scale required by a greenhouse gas programme. Government agencies and reputable researchers have produced a number of estimates for the future costs of CO2 allowances, of which some of the most important are set out in the attached table.

Most forecasts put prices at a relatively low level of $20 to $60 per tonne of CO2 equivalent in 2020 (2007 dollars), though prices would rise after that as the emissions cap becomes much stricter. But the forecasts are tremendously sensitive to assumptions about programme design and how quickly energy efficiency and clean technologies could be introduced.
For some scenarios, forecasts range as high as $93 (Energy Information Administration) or $160-214 (Roland-Holst, cited by the Economic and Allocation Advisory Committee in a study for the California Air Resources Board).
Costs are sensitive to whether the programme is limited to power producers or extended to the whole economy; whether national and international offsets are allowed; and whether the programme permits banking and borrowing of surplus and deficit allowances between different vintages or years.

OFFSETS CRUCIAL
In a briefing to Congress in August 2009, the respected, non-partisan Congressional Budget Office (CBO) examined the role of offsets in lowering compliance costs and permit prices as part of the American Clean Energy and Security Act (HR 2454). CBO assumed a cap of 3,427 million metric tonnes of CO2 equivalent would be set for 2030:
* Without offsets, covered sources would have to reduce their emissions to 3,555 million tonnes (virtually identical to the cap, slightly exceeding it because they would “spend” surplus credits accumulated in previous years). Allowances would cost $138 per tonne and raise $474 billion in auction revenues.

* With offsets, covered sources would release 5,031 million tonnes (1,476 million tonnes or 40 percent more than in the no-offsets scenario) countering this with 1,790 million tonnes of offsets. But allowance prices would be cut more than 70 percent to just $40 and auction revenues to $136 billion.

Decisions about offsets, as well as how many sectors are covered by the cap, are therefore not minor technical details. They play a decisive role in modelled emissions prices and the programme’s impact and political acceptability.

POLITICAL SUPPORT

Allowance prices do not measure the net cost of complying with reduction targets. For the most part, the cost of acquiring permits is simply an income transfer from sellers (the government and covered sources with surplus allowances) to direct buyers (covered sources with excess emissions) and indirect buyers (households and businesses consuming energy-intensive goods and services).

But prices have a significant impact on income transfers. Higher prices create bigger income transfers. So the distributional impact of a cap and trade programme is directly related to future allowance prices.

Uncertainty about the future path for allowance prices, and therefore the distributional impact on businesses and consumers, has been one of the key factors holding back public support for climate change legislation in the current Congress. The wide dispersion of forecasts is not reassuring. Voters are (rationally) reluctant to commit themselves to a programme the costs of which are so unknown in advance.

CANTWELL COLLAR

The solution is to reduce the ex ante uncertainty by imposing maximum and minimum values on the prices the market can take. This is the approach adopted by Senators Maria Cantwell (Dem, Washington) and Susan Collins (Rep, Maine) in their cap and refund bill.

Purists will argue the collar means there is no guarantee emissions targets will be met in full. The bill could fail to reduce emissions sufficiently if the marginal cost of abatement turns out to be above the collar.
In fact the collar is set at a relatively high level. It implies a minimum price of just over $42 in 2020 (which is above the forecast price under most scenarios). And it would allow prices to rise to as much as $118 before triggering the ceiling. Cantwell-Collins is therefore a relatively tough piece of legislation.

The high minimum would guarantee strong returns on investment in energy efficiency technologies and renewable power generation. The high maximum would allow prices to rise substantially if necessary to force the required level of decarbonisation.

If it turned out the marginal cost of compliance was above $118, Cantwell-Collins would not achieve all the required emissions reductions. A further political decision would have to be taken as to whether abatement costs of more than $118 were worth it. But this is far above the level that most proponents of cap and trade have been using to build public support. If abatement costs really did rise this much, voters would be right to demand a fresh debate.

The Cantwell-Collins also minimises the distributive consequences, since the value of emissions allowances would be recycled back to households directly through a refund system. The higher prices rose, the more funding would be returned to households through rebates.

The main criticism is its failure to address inter-state income transfers (especially the disproportionate burden on coal and oil producing states, and the heavy industrial states of the Midwest). The main cap and trade bills tried to offset these through allocations of free permits (though the resulting distribution of winners and losers is intensely controversial).

But even there transitional assistance to coal, oil and energy-intensive industries is likely to prove inadequate to compensate states for the massive structural transformation that would be required over the next two decades.
In practice, the only real way to meet these structural requirements is through the general budget. If limiting emissions by pricing carbon is a worthwhile objective, taxpayers will have to get used to the idea of large-scale subsidies to offset the impact on the worst affected states.

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