Robert M.
La Follette School of Public Affairs
at the University of Wisconsin-Madison
Working Paper Series
La Follette School Working Paper No. 2009-015
http://www.lafollette.wisc.edu/publications/workingpapers
Implications of Climate Policy
in a Carbon-Intensive Region: Estimating
Abatement Costs under Deep Policy Uncertainty
J.P. Muller
La Follette School of Public Affairs, University of Wisconsin-Madison
Gregory F. Nemet
La Follette School of Public Affairs and the Nelson Institute for Environmental Studies
at the University of Wisconsin-Madison
gnemet@lafollette.wisc.edu
Robert M. La Follette School of Public Affairs
1225 Observatory Drive, Madison, Wisconsin 53706
Phone: 608.262.3581 / Fax: 608.265-3233
info@lafollette.wisc.edu / http://www.lafollette.wisc.edu
The La Follette School takes no stand on policy issues;
opinions expressed within these papers reflect the
views of individual researchers and authors.
Implications of Climate Policy in a
Carbon-Intensive Region:
Estimating Abatement costs under Deep
Policy Uncertainty
September 2009
__________________________
J.P. Muller
Masters of International Public Affairs, Graduate Student,
La Follette School of Public Affairs, University of Wisconsin, Madison
Prof. Gregory Nemet
Assistant Professor of Public Affairs and Environmental Studies,
Center for Sustainability and the Global Environment and
La Follette School of Public Affairs, University of Wisconsin, Madison
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Implications of Climate Policy in a CarbonIntensive Region:
Estimating Abatement Costs under Deep
Policy Uncertainty
Executive Summary
Climate change presents unprecedented challenges for human societies and its mitigation
requires transformations of the basic infrastructure of modern economies. Warming
associated with the emission of greenhouse gases into the atmosphere and the destruction
or inundation of terrestrial and marine sinks is currently disrupting established
meteorological and ecological patterns. Likely future effects include more frequent
intense storms, degradation of coral reefs and other marine ecosystems via ocean
acidification, and changes in the timing of seasons. Moreover, estimates of warming and
its effects are generally increasing, and the actual emissions path worldwide mirrors the
most pessimistic assumptions of the range projected at the beginning of the current
decade (PCGCC 2009). New studies suggest that irreversible climate impacts are already
underway due to the prolonged persistence of greenhouse gases in the atmosphere and the
delayed release of heat accumulating in the world’s oceans (Solomon, Plattner et al.
2009).
The effects of climate change vary across geography. In Wisconsin, warming is expected
to increase average temperatures by more than five degrees Fahrenheit by the end of the
2100s. Projections forecast hotter, drier, and longer summers with more frequent
droughts and heat waves, while winters will likely have more precipitation. More
numerous severe storms will mean more instances of flooding and other catastrophic
damages. Agriculturalists may benefit from a longer growing season, but will need to
adjust to more punctuated rainfall, drier soil conditions, and the different pests typical of
warmer temperatures. Greater evaporation will change the ecological quality and
recreational possibilities of the state’s waterways. In addition, if warming exacerbates
water security problems in neighboring states or regions, then pressure could increase on
the freshwater supplies in the Great Lakes (Wittman, Trenberth et al. 2008).
Discussions of policy responses intended to curb US greenhouse gas emissions have
intensified over the last several years. However, establishing climate change mitigation
policy that is both effective and politically feasible has been fraught with difficulty.
Consensus on certain aspects of climate science has been reached, but estimates of
damages to both natural systems and human economies are highly uncertain. Abatement
costs are also uncertain. As a result, a societally preferable level of emission reductions
has been hard to ascertain. Compounding the challenge of arriving at what our
willingness to pay for abatement ought to be is the question of how steeply to discount
the value of future benefits from mitigating climate change. If investing in greenhouse
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gas emission reduction can be understood as buying insurance against global warmingrelated calamity, then it is not clear what premium our society should be paying.
As in any policy debate, climate change policy will create winners and losers. In terms of
damages, Wisconsinites need not worry about sea level rise to the same extent as
residents of low-lying coastal areas. By virtue of geography, Wisconsin may adapt more
easily to further warming than other states and regions. However, mitigation of
greenhouse gas emissions could place a relatively heavy burden on Wisconsin
consumers. A high level of coal-fired electric generation makes the Wisconsin economy
relatively carbon-intensive. The state is dependent on out-of-state providers for natural
gas, hydroelectric power, geologic sites for carbon sequestration, and most wind and
solar power potential. At present, state policy explicitly prohibits new nuclear generating
stations. As a result, Wisconsin consumers are vulnerable as federal and regional
authorities go through the process of implementing a policy that puts a price on
greenhouse gas emissions. This report looks at the most important uncertain details of
climate change mitigation policy, depicts the dispersion of implementation details in
existing policy proposals, assesses which ones will have greater cost impacts, and then
describes the type of scenarios that could have major direct economic impacts on
Wisconsin utility consumers.
In order to recognize combinations of events that would have a relatively large effect on
Wisconsin consumers, we utilized the process of scenario planning. Scenario planning
seeks to construct plausible, internally consistent depictions of the future without
assigning probabilities to their likelihood. In this case, the scenarios of interest involve
key policy mechanisms and cost drivers external to policy formation that could plausibly
coexist and raise costs substantially for Wisconsin consumers. As envisioned, climate
change mitigation policy will be in place for several decades. What seem to be unlikely
events now may not remain so for the duration of the period in which the US and other
countries adapt to a carbon-constrained world.
Of the 10 policy implementation details examined in this report, we find that half of them
may have a strong impact on the costs faced by Wisconsin consumers. Most of the
policy mechanisms examined are related to the implementation of a cap and trade system;
a carbon tax is not included because a price-based mechanism generates much less cost
uncertainty. Those strong cost drivers are 1) the stringency of an emissions cap, 2) the
level of international offsets available for compliance, 3) the presence of explicit, binding
cost containment such as a safety valve or price collar, 4) the banking of emission
allowances, and 5) the distribution of allowance value via free allocation or the recycling
of allowance auction revenue. This report uses a short timeframe in assessing the costs
of policy for Wisconsin consumers, looking at impacts in 2018. As a result, the
successful pursuit of cost-effective energy efficiency is an important wild card in the cost
of emissions reductions.
Though all of these policies could have major impacts on the cost of climate policy, no
one particular policy mechanism can drive consumer costs to intolerable levels if policy
makers are determined to use other policy levers to compensate. For instance, a very
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stringent cap can be alleviated by allowing greater use of offsets, aggressively seeking
out energy efficiency opportunities, and channeling a large portion of allowance value to
consumers. Looking at a longer time horizon, a stringent cap may be more difficult to
counteract due to the twin technological challenges of deploying sufficient low- or zerocarbon baseload electric generation and dramatically reducing automobile tailpipe
emissions. These factors are two of the strong external drivers that we integrate into this
report. The other external drivers are 1) population and economic growth that drives
business as usual emissions, 2) the evolution of climate science and perceptions of
climate change, 3) the price of fuels such as oil and natural gas, 4) the extent and nature
of international action to reduce greenhouse gas emissions, and 5) decisions of the
Wisconsin Public Service Commission. Scenarios that promise the highest costs typically
link policy decisions with external drivers. The two tables below list these drivers and
the mechanisms affecting costs for each.
TABLE 1 STRONG POLICY DRIVERS INFLUENCING THE COST OF
CLIMATE POLICY
Strong Policy Drivers
Cap Stringency
Int’l. Offsets
Safety Valve
Banking
Disposition of
Allowance Value
Energy Efficiency
Core Issues
Without challenging caps, compliance is easy, allowance
prices low, and cost containment irrelevant
Potential large pool of inexpensive abatement options outside
capped sectors
Hard cost constraint, may not coexist with firm cap
Allows for pricing of future compliance risks
Permits policy designers to protect vulnerable groups,
including low-income consumers
Higher business as usual energy demand requires more costly
abatement
TABLE 2 STRONG EXTERNAL DRIVERS INFLUENCING COST OF
CLIMATE CHANGE MITIGATION POLICY
Strong External Drivers
Population and Economic
Growth
Climate Science
Fuel Prices
Low, Zero Carbon
Baseload
Transport Emissions
International Action
PSC Decisions
Key Issues
Higher growth rates drive up baseline emissions, require
more actual abatement
Drives broad policy framework, including level and time
path of caps; public perception is crucial
Oil and gas prices open/constrain options and influence
conservation behavior
Limited options to replace coal and eventually gas, notion
of baseload may not survive
Major reductions could relieve pressure on electric sector
Impacts sustainability of policy and availability of offsets
Influences generation and mitigation decisions that directly
impact Wisconsin consumers
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Whereas single policy mechanisms should not, on their own, lead to skyrocketing
compliance costs for Wisconsin consumers, combinations of inauspicious policy choices
surely could do so. The diversion of allowance value away from electricity and gas
consumers is a plausible starting point for a high impact combination of policies. Free
allocation of allowances to utility consumers insulates them from high secondary market
prices for emission allowances. A shift of allowance value away from consumers could
hypothetically happen with the expansion of allowance auctions and the diversion of
auction revenues to budget deficit reduction. Constrained access to offsets, weak energy
efficiency targets, the absence of explicit cost containment, and tightening emissions caps
could coincide with depriving consumers of allowance value. In this scenario, costs for
Wisconsin consumers (on electric bills) hinge on the ability of electric utilities both
inside and outside Wisconsin to decarbonize their generation portfolio. External drivers
could exacerbate an already challenging set of policy circumstances. High and sustained
economic growth would raise business as usual emissions and increase the level of
abatement required at given cap levels. Likewise, continued high demand for gasoline
would put greater pressure on the electric sector to reduce emissions.
Details related to the Waxman-Markey bill are noted in the text of this report, particularly
as they relate to the 10 key policy mechanisms. Waxman-Markey takes cost containment
very seriously. The cap in the early years requires major reductions, but not as steep as
domestic and international critics would like. Its offsets provisions are generous,
particularly for international credits. A strategic reserve of allowances allows for
economy-wide borrowing of allowances from future cap years. Energy efficiency
provisions are numerous, and some are quite aggressive. However, an external shock,
such as a dramatic event that changes global perceptions of the pace and seriousness of
global warming could strain even a well-designed policy. A climate shock would likely
trigger tighter emission caps in the US and abroad. Quick changes in required abatement
levels would increase demand for offsets putting pressure on the market for reductions
outside of capped sectors. A strategic reserve that relies in part on international offset
credits to be restocked could be depleted. In addition, updated notions of the need for
long-term emission reductions could lead to expectations of even tighter future targets,
putting a premium on allowance banking for future years and further raising allowance
prices.
As climate change mitigation policy insures against catastrophic damages from climatic
change, the design of key policy mechanisms attempts to insulate a cap and trade system
from external shocks that drive up costs or even threaten to undermine the program itself.
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Table of Contents
Executive Summary .......................................................................................................... 2
1 Introduction............................................................................................................... 10
2 Levels of Key Policy Mechanisms in Climate Policy Proposals............................ 11
2.1 Methodology ........................................................................................................ 11
2.1.1 Rationale for the 10 KPMs ........................................................................... 11
2.1.2 Proposals evaluated....................................................................................... 11
2.2 Descriptions of key policy mechanisms and their levels ..................................... 13
2.2.1 Cap Stringency in 2018................................................................................. 13
2.2.2 International Offsets...................................................................................... 16
2.2.3 Cost Containment and Safety Valves ........................................................... 18
2.2.4 Banking and Borrowing................................................................................ 20
2.2.5 Revenue Recycling and Allowance Value.................................................... 22
2.2.6 Energy Efficiency Improvements ................................................................. 24
2.2.7 Domestic Offsets........................................................................................... 26
2.2.8 Renewable Portfolio Standard ...................................................................... 28
2.2.9 Emission Permit Auctioning ......................................................................... 30
2.2.10 Allowance Distribution Methodology ........................................................ 32
2.3 Other Key Issues .................................................................................................. 34
2.3.1 Treatment of Unregulated vs. Regulated Electricity Producers.................... 34
2.3.2 Transportation Sector Emissions .................................................................. 34
2.4 Policy Assumptions ............................................................................................. 35
2.4.1 First Year of Implementation........................................................................ 35
2.4.2 6-7 Gas Policy............................................................................................... 35
2.4.3 Carbon Tax.................................................................................................... 36
2.4.4 No New Nuclear, CCS until after 2018 ........................................................ 36
3 Estimating Cost Impacts .......................................................................................... 38
3.1 Costs Associated with KPMs............................................................................... 40
3.1.1 Cap Stringency in 2018................................................................................. 40
3.1.2 International Offsets...................................................................................... 42
3.1.3 Cost Containment and Safety Valves ........................................................... 44
3.1.4 Banking and Borrowing................................................................................ 46
3.1.5 Revenue Recycling and Allowance Value.................................................... 50
3.1.6 Energy Efficiency Improvements ................................................................. 52
3.1.7 Domestic Offsets........................................................................................... 55
3.1.8 Renewable Portfolio Standard ...................................................................... 56
3.1.9 Emission Permit Auctioning ......................................................................... 58
3.1.10 Allowance Distribution Methodology ........................................................ 59
4 Identification of High Impact Policy Combinations .............................................. 62
4.1 High Impact Scenarios Rooted in Policy ............................................................. 62
4.1.1 Few International Offsets.............................................................................. 63
4.1.2 Decline in Free Allocation of Allowance Value........................................... 63
4.2 High Impact Scenarios from External Events...................................................... 64
4.2.1 Shock in the Public Perception of Global Warming..................................... 65
4.2.2 Nuclear Accident .......................................................................................... 66
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Conclusion ................................................................................................................. 68
Appendix: Table of KPM Values in Proposals Evaluated .................................... 69
References.................................................................................................................. 73
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List of Figures
Figure 1 Example of worldwide marginal abatement cost curve for 2030....................... 14
Figure 2 Emission reductions in 2018 .............................................................................. 16
Figure 3 Highest percentage of compliance allowed from international offsets .............. 18
Figure 4 Cost containment mechanisms in various bills .................................................. 20
Figure 5 Treatment of allowance banking in cap and trade proposals ............................. 21
Figure 6 Maximum years in the future allowances may be borrowed.............................. 22
Figure 7 EERS targets in 2018.......................................................................................... 26
Figure 8 Highest percentage of compliance allowed from domestic offsets .................... 28
Figure 9 Trajectories of Required RPS Compliance, 2006-2025 ..................................... 29
Figure 10 RPS Targets in 2018 in various policy proposals............................................. 30
Figure 11 Percentage of emission allowances auctioned in 2018..................................... 32
Figure 12 Frequency of different allowance distribution methodologies in cap and trade
proposals ................................................................................................................... 34
Figure 13 Cost estimates for different levels of cap and trade policy stringency............. 41
Figure 14 Cost estimates for cap and trade proposals by stringency with analyses based
on aeo 2009 removed ................................................................................................ 42
Figure 15 Allowance costs for varying levels of international offsets ............................. 44
Figure 16 Allowance price ranges with and without a safety valve ................................. 46
Figure 17 Emission allowance price in 2018 with and without banking.......................... 47
Figure 18 Macroeconomic costs of allowance borrowing................................................ 49
Figure 19 Impacts of the level of allowance value distributed to wisconsin ratepayers... 51
Figure 20 Wisconsin and national energy efficiency potential studies............................. 54
Figure 21 Allowance costs by level of domestic offsets allowed..................................... 55
Figure 22 Cost estimates of ratepayer impacts for state RPS mandates ........................... 57
Figure 23 Emission allowance prices with differing auction levels in 2018 .................... 59
Figure 24 Extra cost impacts resulting from a delivered electric standard or 50/50
allocation methodology compared to an emissions-based standard ......................... 61
List of Tables
Table 1 Strong policy drivers influencing the cost of climate policy ................................. 4
Table 2 Strong external drivers influencing cost of climate change mitigation policy ...... 4
Table 3 Early action reward provisions in selected proposals.......................................... 24
Table 4 Safety valve impacts in modeling of the low carbon economy act of 2007 ........ 45
Table 5 Premium on marginal ratepayer impact in comparison with emissions-based
standards ................................................................................................................... 60
Table 6 Strong policy drivers influencing costs of climate policy ................................... 66
Table 7 Strong external drivers of costs of climate change mitigation policy.................. 67
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Acknowledgments
The authors would like to thank Madison Gas & Electric for its generous financial
support and staff at MG&E for helpful feedback in the process of the production of
this report.
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September 2009
Introduction
A wide variety of measures to reduce emissions of greenhouse gases (GHGs) have been
proposed at the municipal, state, regional, federal, and international levels of governance.
The impacts of these public policies on Wisconsin consumers may be quite substantial.
More precisely, the scale of the impact depends heavily on the implementation details
that are included in the final version of these initiatives. If the range of alternatives in
current proposals is so large that the eventual configuration of these policies is not
predictable, how can impacts be evaluated? This project seeks to understand the impacts
of climate policy implementation details, which are both critical for decision-making and
highly uncertain over the next 10-20 years. The most direct legislative approach to
anthropogenic climate change puts a per unit price on the emission of greenhouse gases.
Climate change mitigation policy introduces important new costs and incentives into the
economy, though many key aspects of cap and trade frameworks remain to be
negotiated.1
This report is divided into four main sections. Section 2 describes each of 10 key policy
mechanisms (KPMs). In order to show the range of uncertainty in existing policy
proposals, we construct histograms that show the dispersion of values for each
mechanism. The level written into the Waxman-Markey bill appears in red in each
histogram. Section 3 uses existing cost analyses of climate change mitigation policy
proposals to sort policy mechanisms by significance. The metric used in section 3 to
assess costs is the price per ton of carbon dioxide equivalent in the secondary market for
emission allowances in a cap and trade structure. Section 4 deploys a scenario planning
approach to join key policy mechanisms together and integrate them with important cost
drivers that are external to the design of climate change mitigation policy. These
scenarios are not probabilistic, but rather illustrate the types of high impact combinations
that could generate major cost increases for Wisconsin consumers. Finally, Section 5
concludes.
Though this report does not examine them, price-based mechanisms to controlling
greenhouse gas emissions have some advantages, namely certainty of cost for emitters
and consumers. See, for example, Nordhaus, W. D. (2007). "To Tax or Not to Tax:
Alternative Approaches to Slowing Global Warming." Review of Environmental
Economics and Policy 1(1): 26-44.
1
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Levels of Key Policy Mechanisms in Climate Policy Proposals
In this section, we identify and evaluate the most important policy mechanisms
associated with the implementation of greenhouse gas reduction policy. This report
addresses 10 key policy mechanisms (KPMs). We examine how each of these
mechanisms function and elaborate on the issues at stake in their implementation. Along
with discussions of each mechanism, we survey a list of current climate policy proposal
and construct a distribution of values for each from these documents. First, we describe
our approach and data sources and then report the observed values.
2.1
2.1.1
Methodology
Rationale for the 10 KPMs
Key policy mechanisms were chosen that have the potential to drive up or rein in costs
for Wisconsin consumers. The implementation of these mechanisms exhibits some
meaningful level of uncertainty. A cap on emissions and quantitative standards that
mandate very low or zero-carbon supply and demand side energy savings are included
because they place firm constraints on emitters over time. Though this paper focuses
primarily on quantity-based cap and trade policies, policy design is characterized by a
strong interest in containing costs for consumers. Multiple cost mitigation strategies are
key policy mechanisms, with the recognition that they offer further flexibility in
achieving compliance for covered entities. These cost containment mechanisms include
banking and borrowing of emission allowances, safety valves, and the use of domestic
and international offsets.
2.1.2
Proposals evaluated
Having identified policy design elements, we next evaluate the status of these items in
nascent and proposed greenhouse gas reduction policies affecting Wisconsin. This
section includes analysis of bills and proposals at the federal government, the state of
Wisconsin, and regional initiatives, such as the Midwest Greenhouse Gas Reduction
Accord. We selected a set of 17 proposals using the following criteria: 1) have at least
indirect relevance to WI consumers, 2) be specific enough to include at least some
detailed descriptions of policy mechanisms, 3) be serious enough to be relevant to policy
makers, and 4) have some quantitative values specified within the proposal. Negotiations
toward a post-Kyoto (post-2012) architecture at the international level did not meet our
criteria. While these proposals do have the potential to be relevant to Wisconsin
consumers by 2018, they are not yet at a stage where they are close enough to agreement
to have specified crucial implementation details. BOX 1 summarizes the policies and
proposals we assessed in this study.
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BOX 1: LIST OF PROPOSALS EVALUATED
Proposals for Federal Action:
American Clean Energy and Security Act of 2009 (ACESA), HR 2454, May 2009,
Passed by the House of Representatives, 6/26/09, now under preliminary consideration in
the Senate (Waxman and Markey 2009).
Climate 2030 Blueprint by Union of Concerned Scientists, May 2009, civil society
proposal contains aggressive targets for emission reductions, renewable energy
deployment, and energy efficiency (Cleetus, Clemmer et al. 2009)
Cap and Dividend Act of 2009, H.R. 1862, April 2009, Introduced in House Energy &
Commerce and Ways & Means, offers quantity-based alternative to Waxman-Markey cap
and trade system in current Congress (Hollen 2009).
Dingell-Boucher Discussion Draft, October 2008, Proposals shaping parts of ACESA,
though no bill was introduced before Dingell was defeated for House Energy and
Commerce committee chairmanship in 111th Congress (Boucher and Dingell 2008).
Investing in Climate Action and Protection Act, H.R. 6186, June 2008, No current action
(Markey 2008).
Lieberman-Warner Climate Security Act of 2008, S 3036, May 2008, Likely basis for
2009 Senate bill to be introduced in Environment and Public Works committee (Boxer,
Lieberman et al. 2008).
America’s Climate Security Act of 2007, S. 2191, October 2007, Filibustered in the
Senate in June 2008, no current action (Lieberman and Warner 2007).
Low Carbon Economy Act of 2007, S. 1766, July 2007, No current action (Bingaman and
Specter 2007).
Safe Climate Act of 2007, H.R. 1590, March 2007, No current action (Waxman 2007).
Global Warming Reduction Act of 2007, S. 485, February 2007, No current action (Kerry
2007).
Global Warming Pollution Reduction Act of 2007, S. 309, January 2007, No current
action (Sanders and Boxer 2007).
Climate Stewardship and Innovation Act of 2007, S. 280, January 2007, No current
action (Lieberman and McCain 2007).
Climate Stewardship Act of 2007, H.R. 620, January 2007, No current action (Olver
2007).
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Proposals for Regional Action:
Midwest Greenhouse Gas Reduction Accord, June 2009, Policy Recommendations
completed and submitted to participating governors for review in June 2009. Regional
cap and trade may be preempted by federal legislation (MGA 2009).
Western Climate Initiative Design Recommendations, September 2008, Design
recommendations released, implementation details still under development (WCI 2008).
Regional Greenhouse Gas Initiative, December 2005, First 3-year compliance period
underway, 2009-2011. Quarterly emission allowance auctions began in September 2008.
Emissions target for 2018 appears very easy to meet at present (RGGI 2007).
Proposals for State Action:
Wisconsin Global Warming Task Force, July 2008, Cap and trade working group
recommended that geographic scope should be regional or broader. Complementary
policies like renewable energy grants are in trouble unless they are budget neutral in
current fiscal environment (GWTF 2008)
2.2
Descriptions of key policy mechanisms and their levels
In this section we include: 1) a description of each KPM, 2) why we selected it, and 3)
the levels specified in the 17 proposals analyzed, if any. We include histograms showing
the distribution of proposed values for each KPM. Detailed descriptions of the levels
specified in the Waxman-Markey bill are in italics. As of mid-summer 2009, H.R. 2454
was particularly relevant, acting as a focal point for ongoing policy deliberation. The
KPMs are described in general order of their importance, beginning with those we expect
to have the greatest impact.
2.2.1
Cap Stringency in 2018
A cap placed on greenhouse gas emissions is the defining regulatory mechanism in a cap
and trade policy proposal. Responding to growing scientific understanding of
anthropogenic climate change, policy makers want to be certain that greenhouse gas
emissions will not rise above a predetermined level. As a result, there must be a limited
quantity of allowances that give emitters the right to release greenhouse gases into the
atmosphere. All schemes eventually may also price emissions from non-combustion
sources, such as land-use change, although most do not do so from the outset. The cap
refers to the total number of emission allowances issued by the government for a
particular year, typically denoted in tons of CO2 equivalents (tCO2eq.). The cap creates
scarcity and presents emitters with two options for compliance: reduce emissions or
acquire allowances.
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A cap, however, does not cover all emissions for a particular geographic area. The scope
of the cap defines what type of emissions fall under the cap and determines which
facilities must take direct responsibility for their greenhouse gas emissions. Economywide emission caps typically cover between 80% and 90% of total greenhouse gases
emitted. There is more than one reason for excluding emissions from coverage under a
cap. Some emission quantities are difficult to measure, particularly those in the
agriculture and forestry sectors. Others come from facilities with sufficiently low
emission levels that measurement is not cost-effective from an administrative point of
view. Typical lower emission thresholds for facility coverage are 10,000 or 25,000 tons
of CO2 equivalent per year. In a narrow sense, the exemption of low-emitting facilities
sacrifices cap stringency in order to reduce program cost, but only a program without
offsets prevents emissions reductions at these facilities from playing a role in meeting
overall reduction targets. Some proposals also phase in compliance by sector, increasing
the scope of cap coverage over time.
FIGURE 1 EXAMPLE OF WORLDWIDE MARGINAL ABATEMENT COST
CURVE FOR 2030
A cap becomes more stringent as it imposes more challenging and (it is assumed) costly
emission reductions on entities regulated by a cap and trade system and their customers.2
A stringent cap forces particular emitters—and the economy as a whole—further up the
marginal abatement curve. Figure 1 shows an example of a marginal abatement cost
curve. A more stringent cap increases emitters’ willingness to pay for emission
allowances or emission reductions resulting from offsets. As a result, an increasingly
stringent cap drives up the cost of economy-wide compliance with a quantity-based
climate policy. The scarcity created by a cap generates costs that policy designers seek to
rein in with various cost containment provisions.
This policy variable reflects the discretion that policy makers have to decide when
permitted emissions peak and how tightly a cap and trade policy constrains emitters in its
The marginal cost of abatement need not trend upward regularly. A technological
breakthrough that accelerates the cost decline of a key zero-carbon technology may lower
abatement costs even as the cap is tightening.
2
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initial years. The trajectory of permitted emissions in the early years of a cap and trade
program is a political negotiation. It defines the level of action required by emitters in
the near future. Valid reasons exist for implementing either a lenient or a strict cap in a
program’s early years. Arguments for strict caps include calls to action by climate
scientists, a desire to make reductions deep enough to spur action among other major
emitting countries, and the perceived presence of low- or zero-cost emission reductions.
Among the reasons to opt for a more lenient cap that puts off deeper cuts in GHG
emissions is the expectation that new low-emission technologies will emerge at scale
within several years. Alternatively, an interest among policy makers in avoiding painful
adjustments for effected parties while a cap and trade program is young and not well
established could also lead to less stringent short-term emission targets.
Base years and business as usual projections
Two methods of measuring the stringency of an emissions cap bring into focus different
policy choices and uncertainties that characterize climate change mitigation policy. The
conventional way to measure emission reductions is for policy designers to arbitrarily
choose a particular year’s emissions to serve as the base year against which reductions
will be measured. The establishment of a base year creates certainty in the level of
economy-wide emissions to be achieved in the jurisdiction governed by the cap during
specified timeframes. The choice of a base year also creates winners and losers. In
international climate change negotiations, the choice of 1990 as a base year privileged
Soviet bloc countries with economies that slowed dramatically after 1990 as the Soviet
system disintegrated. With emissions tied in part to the level of economic activity, those
countries faced easy targets once the Kyoto Protocol went into effect. In the United
States, discussions of cap stringency have coalesced around the use of 2005 as a base
year. The use of 2005 responds to multiple policy design imperatives. It was a year of
strong economic activity, easing the required reductions by setting a high baseline. In
addition, it lays the foundation for compensating recent emission reductions that reflected
an understanding of forthcoming climate change policy. At the same time, post-2005
investment in facilities with relatively high emissions may be penalized. Though 2005 is
the most utilized baseline in the US debate, international observers simultaneously view
all proposals against the 1990 baseline typical for international negotiations. US
emissions in 2005 were already 16% higher than 1990 levels (EIA 2008a).
Another method of measuring cap stringency is to view emission reductions against a
business as usual projection of future emissions levels without climate policy. This
method of measurement sacrifices the certainty associated with a fixed base year
approach. In place of that certainty, looking at emission levels relative to a business as
usual case seeks to offer insight into the difficulty of meeting economy-wide emission
targets, taking into account economic growth. Assumptions about future weather,
population growth, economic activity, market conditions, and geopolitical developments
combine to suggest a baseline emissions path. It is the difference between the world
without a policy and the cap level written into legislation that determines the stringency
of the cap in this approach. A popular conceptualization of the area between the business
as usual emissions projection and the cap uses the notion of stabilization wedges (Pacala
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September 2009
and Socolow 2004). A stabilization wedge is a major greenhouse gas mitigation strategy
that can broadly help the economy adjust to a carbon-constrained world. In successive
years, the Energy Information Administration has revised its predicted emission levels
downward to reflect newly passed legislation and contemporary economic conditions.
These revisions demonstrate a drawback of this method of measurement, namely that
projected future reference case emission levels can change significantly from year to year
(EPA 2009b). Figure 2 shows the distribution of emissions reductions mandated for 2018
(WRI 2007; WRI 2008; WRI 2009).
Waxman-Markey currently sets a target of 17% below 2005 levels by 2020, which is
approximately 4% below 1990 levels. The 2020 emission reduction target is among the
provisions most often cited with dissatisfaction by those critics who would prefer to
strengthen the bill (from an environmental perspective). Emission reduction goals are
found in Sections 702 and 703. The number of emission allowances for each year is set
out in section 721 (natural gas distribution companies are only included in 2016).
FIGURE 2 EMISSION REDUCTIONS IN 2018
2.2.2
International Offsets
The notion of an international offset refers to a certificate of emission reduction that takes
place outside the United States and in some cases an emission allowance issued by a
foreign greenhouse gas reduction regime. The underlying scientific rationale for
allowing international offsets as part of climate change mitigation policy is that the
geographic source of greenhouse gas emissions is irrelevant when considering the
warming of the Earth’s climate. As a result, from the perspective of reversing the growth
of greenhouse gas concentrations in the atmosphere, the site of reductions is not
important. Nevertheless, emission reductions from offsets originating outside US borders
face legitimacy concerns that also adhere with domestic offsets. The important extra
factor is that other national systems of emission accounting must be trustworthy,
sufficiently strict, and reliably audited by the particular country. In addition, doublecounting of emission reductions is a concern. This administrative challenge originates
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from the fact that covered entities in other countries may also seek to exploit the same
pool of international offsets. Confusion may also arise if countries that sell offsets have
their own national emissions targets.
International offsets are an important policy mechanism for several reasons. First,
emission reductions in many low-income countries are less expensive than equivalent
reductions in the United States. If emissions mitigation strategies such as cap and trade
aim to initiate the least expensive emission reductions first, then the inclusion of a variety
of projects in poorer countries serves to keep costs down in the short run. It is not clear,
however, whether the demand for international offsets will be inexpensively met if a new
international climate agreement adds a large number of new regulated entities to the
demand side of the market for international offsets. Second, the issue of tropical
deforestation demands significant action as part of the global response to climate change
since deforestation accounts for approximately 20% of global annual greenhouse gas
emissions (Boucher, Movius et al. 2009). International offsets offer a vehicle for
channeling payments toward forest preservation, while some proposals make special
provision through set-asides for action to avoid deforestation.3 Third, international
offsets can further involve countries that may not—as a result of the principle of
common, but differentiated responsibilities—be required to limit emissions by a new
international climate change agreement. Figure 3 depicts the frequency of different limits
on the proportion of compliance that can come from international offsets. Similar to the
previous section, the quantitative limit on offsets used in the Waxman-Markey bill is
translated into a percentage based on the cap level in 2018.
Waxman-Markey limits international offsets to 1 billion tons per year, but also allows up
to 1.5 billion tons if domestic offsets fall short of their maximum allocation. Beginning in
2018, international offsets are discounted. From that year forward, 1.25 international
offsets must be submitted for each emission allowance required for compliance. In
addition, the bill makes special provision for the purchase of international credits related
to avoiding deforestation. The quantitative limit for international offsets is spelled out in
722(d) and content is provided in Sections 731-743.
Set-asides earmark a particularly percentage or quantity of a given year’s cap for certain
types of emission reductions or classes of allowance recipients.
3
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FIGURE 3 HIGHEST PERCENTAGE OF COMPLIANCE ALLOWED FROM
INTERNATIONAL OFFSETS
2.2.3
Cost Containment and Safety Valves
Cost containment mechanisms are crucial for the political viability of climate change
policy proposals. By their nature, cap and trade systems control emission quantities and
let emission allowance prices fluctuate. Cost containment provisions balance the
integrity of a cap with the desire for a stable, constrained price signal. They also send a
signal that policy makers are looking out for low and middle income energy consumers,
carbon-intensive industries facing stiff competition, and other groups worried about rises
in the prices they will see for primary energy and energy-intensive goods. Banking and
borrowing of allowances and offset provisions are often referred to as “cost containment”
measures as well, though this report breaks them out for the purpose of analyzing them
separately.
The safety valve functions like a price ceiling in the secondary market for emission
allowances. It is the most explicit of a range of policy mechanisms geared toward cost
containment. Depending on the level at which the safety valve is set, it can be used
predominantly to guard against price spikes or as a tighter emission allowance price
constraint. A very high safety valve price (relative to the expected emission allowance
price) might only serve the former function, whereas a safety valve at or below the
expected emission allowance price will be a dominant factor in the secondary market.4
The safety valve can act like a de facto greenhouse gas emission tax if it is low and
unlimited allowances may be purchased at a predetermined price. Alternatively, a fixed
price cap could trigger the sale of extra allowances from future year allowance vintages.
With international trading linking various cap and trade programs, a safety valve in one
national system may tend to act as a global price ceiling. As a result, international
climate negotiations may jettison safety valves or seek to harmonize them.
4
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As a result, a safety valve may or may not affect the integrity of the overall emissions
cap. The presence of a constraining safety valve also prioritizes the concerns of energy
consumers over the potential returns for investors in low carbon technologies. The
relationship between cost containment and incentives for technological change is an
important tradeoff in climate change policy design (Nemet 2008).
Policy designers may also seek to contain program costs by setting up a discretionary
advisory board. A discretionary board, by its nature, would intervene unpredictably and
could easily become the object of political pressure to help individual entities or classes
of entities cope more easily with cap and trade compliance obligations. The Carbon
Market Efficiency Board (CMEB) written into S. 3036 is an example of a discretionary
advisory board. Its powers mainly allow for expanded firm-level and economy-wide
borrowing along with relaxed limits on the percentage of a covered entity’s compliance
obligation that may be met using offsets or international emission allowances. It is
important to note that the CMEB is not given the authority to undermine the integrity of
the cumulative emissions cap or change the way emission allowances are distributed
(Boxer, Lieberman et al. 2008).
The Midwest Greenhouse Gas Reduction Accord (MGGRA) also puts in place a
discretionary advisory board, the Market Oversight and Cost Containment Committee
(MOCCC). Its mission is explicitly to deal with an emission allowance market price that
is either too high or too low. As a result, its actions may result in effects similar to a
binding price collar.5 The MOCCC would convene in response to price triggers in the
secondary market. Like the CMEB, the MOCCC may expand or constrain borrowing
and offset availability in order to keep the market price for allowances within a desirable
range. The MOCCC mandate seems to represent an evolution of climate policy design
toward an understanding that low allowance prices also threaten program goals in a cap
and trade system (MGA 2009). Figure 4 shows the prevalence of different types of cost
containment strategies among surveyed proposals.
Waxman-Markey uses a strategic allowance reserve with quarterly auctions as its most
explicit cost containment measure. Only covered entities may participate in strategic
reserve auctions. The strategic reserve allowances will be drawn from future cap
years—1% of allowances from cap years 2012-2019, 2% of allowances from cap years
2020-2029, and 3% of allowances from cap years 2030-2050. The bill stipulates
minimum prices for auctioned allowances: $28 in 2012 (in 2009 dollars), increasing by
5% plus the rate of inflation in 2013-2014, and thereafter set at 60% above a 36-month
rolling average of daily closing prices for that year’s allowance vintage. From 2012 to
2016, the maximum number of allowances sold in the strategic reserve auctions may not
exceed 5% of that year’s cap; that limit rises to 10% beginning in 2017. A particular
covered entity may not purchase more than 20% of its most recent compliance obligation
The binding price collar mechanism would likely work by mandating that the
government or its agent purchase emission allowances in the secondary market when the
price falls to a certain prescribed level, adding a symmetric process to the ceiling
established with a safety valve.
5
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from the strategic reserve. Further provisions deal with supplementing the strategic
allowance with international offset credits, some of which will be purchased with the
auction proceeds. Strategic Reserve provisions are found in Section 726.
FIGURE 4 COST CONTAINMENT MECHANISMS IN VARIOUS BILLS
2.2.4
Banking and Borrowing
The provision of intertemporal flexibility, or “when”-flexibility, in the use of emission
permits allows for entities covered by a cap and trade program to have some discretion in
scheduling emission reductions. If covered entities have an ongoing choice about
whether to pursue abatement or hold emission allowances, then that choice is expanded if
they can utilize allowances held over from a previous compliance period or borrow
allowances from a future period. Banking of allowances is more widely accepted as a
policy instrument. It can reduce price volatility in the secondary market for emission
allowances and provide an incentive to covered entities to make emission reductions in
the present rather than put them off. It also has the benefit of generating and maintaining
political support for an increasingly stringent program among entities with banked
permits. Banking is a very important cost containment mechanism. Almost every cap
and trade proposal explicitly states that emission allowances from a current particular
vintage do not decrease in value after that year, though that does not mean that a policy
could not be designed with allowances that depreciate or expire. In fact, the Wisconsin
renewable portfolio standard rules stipulate that renewable energy credits—that
program’s version of tradable emission permits—do expire after four years (UCS 2008).
Legislation ordinarily specifies that emission allowances will be given serial numbers and
tracked by the managing agency in order to facilitate the orderly acquisition, banking,
trading and surrender of allowances. However, one possible problem resulting from
allowance banking is that over time market manipulation could take hold through the
accumulation of emission allowances by colluding entities. This cornering of the market
may lead lawmakers to include a caveat that regulations to prevent market manipulation
will be enforced despite the right to bank allowances (WCI 2008). It is perhaps with this
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eventuality in mind that all federal cap and trade proposals note that emission allowances
do not constitute property rights. Figure 5 shows the overwhelming popularity of
allowance banking in cap and trade proposals surveyed in this report.
FIGURE 5 TREATMENT OF ALLOWANCE BANKING IN CAP AND TRADE
PROPOSALS
Borrowing allowances from future vintages is more controversial than banking. Like
banking, borrowing offers flexibility across time and can reduce price volatility. Unlike
banking, the basic rationale for a covered entity borrowing allowances is to delay
emission reductions or allowance purchases. With uncertain damages resulting from
human manipulation of the climate system, there is reluctance to let emission reductions
wait. Borrowing can move beyond delaying emission reduction to threatening to
undermine the integrity of a cap if many covered entities were to default on their
obligations.6 If covered entities are excused from their missed obligations, it penalizes
those entities that do undertake emissions reductions in a timely manner. For a report
like this one that is focused on the short term, borrowing is a particularly salient issue.
Short-term volatility in the secondary market price for emission allowances and
uncertainty about market fundamentals may create incentives to achieve compliance in
the present while market participants are calibrating their expectations.
All proposals that mention borrowing either allow firm-level borrowing or use a
compliance period longer than one year. The histogram below treats multi-year
compliance periods as functionally equivalent to allowing borrowing.7 Several proposals
It is also true, however, that interest rate penalties on borrowing that are paid in
allowances slightly reduce cap levels. Allowances used to pay for borrowing never
correspond to actual emissions.
6
In addition, the application of an interest rate does not factor into the histogram. An
allowance can only be borrowed if it can be acquired. An interest rate assessed per
vintage year acts as an interest rate cap.
7
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set a limit on the percentage of borrowed allowances that a covered entity can use to
satisfy a particular compliance obligation. All but one of those proposals limits the use of
borrowing to 15% of compliance. In addition, the various proposals establish an interest
rate that a covered entity must pay in order to borrow future year allowances. Five
proposals offer borrowing with a 10% interest rate, but the newest federal cap and trade
bills only seek to charge 8% on borrowed allowances (Boucher and Dingell 2008;
Waxman and Markey 2009). The Lieberman-Warner bill that was debated in the US
Senate in the spring of 2008 treats the interest rate for allowance borrowing as one of the
provisions that the CMEB could ease in order to achieve its mission of mitigating
program costs. Figure 6 shows the variation among different proposals in terms of how
far in the future an individual entity may borrow allowances.
Waxman-Markey allows unlimited banking of emission allowances. It permits unlimited
borrowing one year into the future—that is, allowances from the year in which
compliance happens (the calendar year after the actual emissions) are fungible with
respect to all prior years’ allowances. Allowances with vintages between two and five
years in the future may satisfy 15% of a covered entity’s compliance obligation. The
interest rate for borrowing beyond one year is 8% per year. Banking and borrowing
language is found in section 725.
FIGURE 6 MAXIMUM YEARS IN THE FUTURE ALLOWANCES MAY BE
BORROWED
2.2.5
Revenue Recycling and Allowance Value
The concept of revenue recycling refers to the decisions that governments face when they
prioritize the use of revenue raised from auctioning emission allowances and collecting
noncompliance penalties. Like any use of government funds, the creation of a pot of
money from auction revenues opens the policy making process to a debate about the
proper appropriation of scarce funds. A fundamental argument is over whether the use of
auction revenues should reinforce the greenhouse gas mitigation goals of a cap and trade
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program or be used for some other purpose. Climate policy proposals typically use
government revenue resulting from the auction of emission allowances and the collection
of fines for three basic purposes: 1) Return money collected to vulnerable ratepayers,
current taxpayers, or future taxpayers through deficit reduction, 2) Invest in low-carbon
and energy efficiency technologies, 3) Aid adaptation to climate change. The existing
auctions held by the RGGI have recycled revenues into energy efficiency and renewable
energy projects with prioritization on a state-by-state basis.
Choices in revenue recycling disperse benefits differently across geography and
demographics and through time. Revenues may be refunded directly to residents,
ratepayers, or taxpayers. Different methods of channeling money back to the population
generate varying distributional consequences. For example, using auction revenue to
lower corporate income taxes tends to favor high-income families that own a large
proportion of company stocks, while equal lump-sum rebates favor lower-income
households (CBO 2007). Investment in research, development, demonstration and
deployment of new technologies applies current public revenues to the long-term
challenge of achieving steep reductions in greenhouse gas emissions with manageable
costs. Investments intended to bring down the cost of solar energy technologies or to
demonstrate the viability of carbon capture and sequestration are examples of forwardlooking allocations of revenue. Finally, adaptation aid seeks help human and natural
communities prepare for and deal with the changes to natural systems believed to be
exacerbated by climate change. For instance, S. 3036 allocates some of the proceeds
from the sale of emission allowances to improving firefighting capabilities at the Bureau
of Land Management and the Forest Service (Boxer, Lieberman et al. 2008).
Revenue recycling is a subset of the broader notion of distributing “allowance value.”
Allowance value takes account of the value embedded in the free allocation of emission
allowances. From the perspective of allowance value, it does not matter whether
emission allowances or auction revenues are the vehicle through which the government
aids a particular group. As a result, the comments above about the use of auction funds
can apply equally to the allowance value inherent in freely distributed allowances.
However, the transfer of value is more complex when the allowances are distributed
through free allocation. This is the attraction of Representative Chris Van Hollen’s “cap
and dividend” bill (H.R. 1862, 111th Congress), which would auction 100% of
allowances and simply return the entire pool of revenue to the population via a lump-sum
rebate. However, the federal proposals that have garnered the most support have opted to
freely allocate a majority of emission allowances in the early years of the program. For
electric and gas utilities, the distribution of allowance value via lump-sum rebates
preserves the incentive for energy conservation resulting from higher prices per kilowatt
hour while muting the overall impact on consumers (Stavins 2009). The myriad
possibilities, and lack of specificity in some proposals, for the use of allowance value
preclude an analysis of frequency distributions for this KPM.
Since Waxman-Markey allocates most allowances in the early years of the program,
there is only one major channel for sending money directly back to consumers, the
Energy Refund Program (Section 2201, amending the Social Security Act). Refunds
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associated with this program are based on an estimate of the lost purchasing power of
households below a predetermined income threshold, thus they take into account the
allowance value distributed to individual households through free allocations. Electric
and gas consumers should benefit from transfers of allowance value. Electric consumers
receive 43.75% of emission allowances in 2012-13, 38.89% in 2014-15, and 35%
through 2025. Gas consumers receive 9% from 2016 (when natural gas distribution
companies must first comply) through 2025.
2.2.6
Energy Efficiency Improvements
Energy efficiency and conservation are typically viewed as the least expensive methods
of responding to new electricity demand or reducing greenhouse gas emissions.
Significant greenhouse gas reductions are available through energy efficiency both in
Wisconsin and across the US (ASE and ACEEE 2009; ECW 2009). One of the
advantages of cap and trade legislation is that its design encourages the ordering of
emission reductions beginning with the lowest cost. Entities that can attain major energy
efficiency improvements at low or negative cost will likely have low compliance costs
during the early years of a cap and trade program. If Wisconsin utilities previously
exploited the most economical energy efficiency opportunities, then compliance costs
could be relatively high as they pursue reductions further along the marginal abatement
curve. Access to early action credits could compensate for recently completed
greenhouse gas reduction projects, depending on policy design details.
TABLE 3 EARLY ACTION REWARD PROVISIONS IN SELECTED
PROPOSALS
Proposal
H.R. 2454, WaxmanMarkey
S. 2191/3036, BoxerLieberman-Warner
S. 280, LiebermanMcCain
S. 1766, BingamanSpecter
H.R. 6186, Markey
MGGRA
Early Action Compensation
1% of allowances in 2012 go to mitigation actions before
1/1/2009. Sections 782(t), 795.
Actions since 1/1/94 eligible via EPA, EIA, state, or voluntary
programs. 5% of allowances in 2012, declining to 1% in 2016.
Sections 3201-3202.
Reductions in National Greenhouse Gas Database before 2012 or
issued by sufficiently stringent state programs may be redeemed
for allocations. No total limit, any entity may use up to 40% in a
given compliance year. Sections 164-165.
Maximum of 1% of allocation annually, 2012-2020. Rules for
allocation established through subsequent regulation similar to S.
2191/3036. Sections 201(a), 206.
Allocation only to industry, thus early action is unrewarded.
Typical of systems with most or all of permits auctioned.
Early action award carve-out delegated to states with
harmonization of dates for eligible reductions. Section 3.9.
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An energy efficiency resource standard (EERS) brings regular goals to the demand side
management approach of a given jurisdiction to greenhouse gas emission reduction. The
EERS can be framed in terms of yearly targets or as a percentage goal by a certain future
year. EERS programs have been implemented in 18 states (Cleetus, Clemmer et al.
2009). Two federal proposals have sought to mandate peak electric load percentage
reductions as part of an EERS (Kerry 2007; Sanders and Boxer 2007). An EERS would
create uncertainty around costs (or benefits) because costs will vary when quantity is
fixed. This type of mandate forces the economy to confront the “$20 dollar bill
problem,” a euphemism for the idea that all cost-effective energy efficiency projects
should in theory already have been implemented. Building code standards, vehicle
mileage standards, and appliance efficiency standards are among the major
complementary policies that address the demand side of greenhouse gas mitigation. An
EERS can act as an umbrella for many distinct energy efficiency programs, though
mandated efficiency improvements may not count toward the energy savings required.
Though transportation policies will be important to the success of overall climate policy
and the achievement of energy security goals, the EERS as a policy mechanism typically
applies only to demand for electricity and natural gas. Like a renewable portfolio
standard, an EERS may commodify energy savings and allow them to be traded to
increase flexibility for complying entities. Flexibility may also be achieved by using
multi-year compliance periods (GWTF 2008). Fees for noncompliance range from $25
to $40 per megawatt hour (Kerry 2007; Waxman and Markey 2009).
An EERS presents measurement challenges that are reflected in its policy implementation
details. Some issues are similar to the policy design problems associated with offsets.8
Agreeing on a baseline of electricity or gas usage in the absence of efficiency measures is
an inexact process. “Normal” usage can vary based on weather, the business cycle, and
facility management or individual behavior. Likewise, the question of additionality
arises here. Regulatory additionality is translated into the exclusion of energy savings
achieved through other mandated efficiency programs. Physical additionality would be
questionable if, for example, mild winter weather led to weak demand for natural gas use
in space heating. No proposal included in this paper contemplates a standard based on
financial additionality. In theory, it would require an arbitrary assessment of time
preferences to establish a discount rate standard that decides which payback periods are
long enough that they would not have been desirable without a policy. Figure 7 shows
the different energy efficiency targets envisioned as components of multidimensional
proposals to mitigate greenhouse gases.
The combined energy efficiency and renewable energy standard (Section 610, amending
PURPA) stipulates a 5-8% electricity savings by 2020. In addition, the entirety of Title II
of Waxman-Markey is devoted to energy efficiency programs, including strong building
code standards.
An extended discussion of offset issues, and particularly additionality, is in the next
section on “domestic offsets.”
8
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FIGURE 7 EERS TARGETS IN 2018
2.2.7
Domestic Offsets
Offsets exist in cap and trade programs for two important reasons. First, no proposed cap
covers 100% of the greenhouse gas emissions for a given jurisdiction. Second, the
amount of greenhouse gases that end up in the atmosphere is a function of both sources of
GHG pollution and the natural sinks that absorb CO2 out of the air. Reduction,
avoidance, or sequestration of emissions from sources uncovered by a cap can still be
pursued in lieu of emission reductions in covered sectors. These reductions outside of a
cap are called offsets. Offsets are a contentious issue, in part due to the inherent
challenge in measuring the abatement of some types of emissions and the difficulty of
assuring abatement through time. A voluntary market currently matches individuals,
businesses, and governments with projects that offset greenhouse gas emissions.
Concerns stemming from the legitimacy of emission reductions in these transactions
indicate the challenges for policy makers seeking to incorporate offsets into US cap and
trade programs (Story 2008). Though it is widely presumed that the use of offsets will
lower the cost of a cap and trade program, offsets also remain problematic because their
availability may weaken the incentive for movement toward the low-carbon energy
technology necessary to meet long-term emission reduction goals. This diluted incentive
is the main reason for the quantitative limits represented in this section and the next.
Policy proposals typically begin with the ground rules that offsets must be real,
verifiable, additional, permanent, and enforceable. That offsets are real simply means
that they credibly exist. To be verifiable, offsets must provide emission reductions that
are measurable, documented, and auditable by third parties. Questions of additionality
have multiple dimensions. First, additional emission reductions must go beyond actions
that are required by legal mandates. Second, emission reductions must occur above a
credible emissions baseline. This need to understand the reductions relative to a business
as usual emissions level might be deemed physical additionality. Finally, what is most
challenging to know is whether a mitigation action would have been undertaken without
the financial incentive provided by the price on greenhouse gas emissions generated by a
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cap and trade system. It is desirable to assess whether the marginal benefit provided by a
market for greenhouse gas emission reduction creates the decisive incentive for a project
that would have been lacking otherwise. Multiple standards exist to assess whether a
project can qualify as additional from a financial perspective. The UN’s Clean
Development Mechanism uses three different types of analysis to decide whether a
project is additional—investment analysis, barriers analysis, and common practice
assessment. An important policy design factor is whether the administrator of an offset
program uses a standardized or a project-based assessment of issues like financial
additionality (PCGCC 2008).
Emission reductions also must be permanent and enforceable in order to be counted as
offsets under a cap and trade program. In practice, permanence may not actually be the
goal of an offset project. The principle of permanence corresponds to a matching of the
project’s actual emission reductions with the offset credits issued to the buyer. For
geologic sequestration of emissions, the goal is literally that no leakage of CO2 into the
atmosphere ever occurs. Other types of emission reductions may receive credits for
discrete numbers of years based on the duration of avoided or reduced emissions
resulting from a particular type of offset project. It is also relevant for offset program
managers to consider when a project is no longer additional by either regulatory or
financial standards. As a result, the continued issuance of offset credits may be subject to
periodic review. This concern about the permanence of offsets is related to their
enforceability. The ability to monitor emission reductions is the fundamental check that
allows offset projects to be treated on par with emission reductions in capped sectors.
With this attention to legitimacy comes an administrative burden for both market
participants and the government entities that will manage the offset program. Cap and
trade policy designers and legislators delegate the development of detailed offset project
standards and the ongoing management of the offset program to an administrative body.
The type of projects available for offsets and especially the rules governing an offset
program will not necessarily be known at the time of the passage of legislation
establishing a cap and trade system. Program rules may evolve over time, creating
uncertainty for market participants in using offsets to attain compliance under climate
policy. In assessing the overall cost of cap and trade policy proposals, the availability of
legitimate and relatively inexpensive offsets is a key uncertainty alongside the
development of new, low-carbon technology options. Figure 8 shows the distribution of
percentages of domestic offsets allowed to achieve compliance with the cap in a
particular year. The quantitative limit on offsets used in the Waxman-Markey bill is
translated into a percentage based on the cap level in 2018.
Waxman-Markey uses a quantitative limit on offsets available for use under the cap and
trade program. The quantitative limit is a departure from previous legislation, and it
prevents the eligible use of offsets from decreasing proportionately with the overall
compliance obligation once offset limits are binding. Domestic offsets are capped at one
billion tons per year. There is no discounting of domestic offsets with respect to emission
allowances. Section 722(d) establishes the quantitative limits and Sections 731-742 flesh
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out the rules for the offset program, including the establishment of an Advisory Board
that makes recommendations on offset policies.
FIGURE 8 HIGHEST PERCENTAGE OF COMPLIANCE ALLOWED FROM
DOMESTIC OFFSETS
2.2.8
Renewable Portfolio Standard
The renewable portfolio standard (RPS) motivates electricity providers to address the
supply side of a greenhouse gas emission reduction regime outside the context of fuel
switching. An RPS defines the types of electric generation that qualify as renewable and
prescribes levels required for compliance. Wisconsin is among the 28 states in which an
RPS is already written into the law. The development of the Wisconsin RPS shows two
methods for establishing a standard. The initial 50 megawatt requirement used capacity
as the basic metric. The succeeding and current standard measures compliance based on
megawatt hours of renewable generation generated at the facility bus bar (UCS 2008).
Currently, 10% of generation statewide must be met by renewable generation by the end
of 2015. The state Global Warming Task Force (GWTF) called for a more aggressive
target that would require 10% renewable resource by 2013—instead of 2015—and 25%
by 2025 (GWTF 2008). The ambitious GWTF standard proposal was advanced in the
context of 100% compliance with the current targets by regulated Wisconsin entities
(PSCW 2009a).
Though an RPS is a mandate, it uses a market mechanism to create more flexibility in
compliance. Whereas the emission allowance is the basic unit of a cap and trade system,
the renewable resource credit is the fundamental unit of compliance for an RPS. A
renewable resource credit (RRC) corresponds to a megawatt hour of electric generation.
In August of 2007, the Midwest Renewable Energy Tracking System (M-RETS) began to
track renewable generation across several midwestern states and a Canadian province.
M-RETS also manages RRCs for the state of Wisconsin, facilitating the market for
renewable energy and compliance with the state RPS (M-RETS 2009).
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Like any mandate on a production quantity, the RPS introduces uncertainty in the costs of
meeting targets. For Wisconsin actors, the existing RPS may have allowed for the
resolution of some of this uncertainty through ongoing compliance. Most proposed
federal standards do not envision a higher percentage mandate than the enhanced state
RPS proposal. The transition from a period of state-level innovation to serious
discussions of a federal RPS raises questions about the relationship between a federal
standard and existing state mandates. At the extreme, federal preemption of state laws
would dampen the development of renewable resources in many parts of the country. A
more likely friction point is how the definition of “renewable” will be constructed in a
federal standard and whether utilities could face multiple compliance standards due to
different state and federal definitions.
Further issues for RPS implementation include policy details designed to contain costs.
Banking of RRCs and off-ramps are cost containment provisions contemplated by
proposals reviewed for this report. Currently, banking is available under Wisconsin RPS
rules, but it is limited to three years. The GWTF enhanced RPS proposal would allow for
unlimited banking, perhaps as a precaution associated with raising the mandated
percentage of renewable electricity that state utilities must produce or acquire (GWTF
2008). The Waxman-Markey bill specifies that banking is limited to three years. Offramps that can limit costly compliance obligations take different forms. At the state
level, the Wisconsin Public Service Commission can act to exempt particular utilities
from compliance based on cost or reliability concerns. In addition to cost containment,
an RPS may be concerned with promoting particular technologies or methods of
generation. Credit multipliers for solar electric generation or distributed generation offer
subsidies within the context of a flexible mandate. Figure 9 plots the trajectories of RPS
targets for the period 2006-2025, and figure 10 shows the distribution of RPS targets
contemplated for 2018 in different climate change mitigation proposals.
FIGURE 9 TRAJECTORIES OF REQUIRED RPS COMPLIANCE, 2006-2025
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Waxman-Markey establishes a combined renewable electricity and energy efficiency
portfolio standard of 20% by the year 2020. Of that 20%, three quarters must come from
renewable electricity, with yearly targets specified in the legislation. State governors may
petition to reduce a state’s renewable electricity target to 12%, though the energy
efficiency mandate then rises to 8%. Renewable resources include solar, wind,
geothermal, biogas and biofuels from renewable biomass, qualified hydropower, and
marine and hydrokinetic generation. A $25 fee may be paid in lieu of each megawatt
hour or renewable electricity not produced by a covered entity. Retail electric suppliers
must deliver at least 4,000,000 megawatt hours in order to be covered by the national
RPS. The RPS is detailed in Section 610 (as a PURPA amendment).
FIGURE 10 RPS TARGETS IN 2018 IN VARIOUS POLICY PROPOSALS
2.2.9
Emission Permit Auctioning
Emission allowances are the fundamental currency of a cap and trade system. Legislative
proposals ordinarily call for allowances denominated in units of one metric ton of carbon
dioxide equivalent. The question of what percentage of permits should be auctioned
arises from the need to administer the transfer of allowances from governments that
create them to the emitters that must hold them to attain compliance. Auctions transfer
the emission allowances by virtue of bidders’ willingness to pay, while free or fee-based
allocation results from policy design and political decisions about which entities should
directly obtain permits. Once permits are auctioned or allocated, permit holders may
freely trade those allowances in a secondary market, though trading may be limited to
entities that have an obligation to submit allowances. The auctioning and trading of
allowances facilitates price discovery, the process through which market participants
continually assess the market’s fundamentals. In addition, regular auctions provide
liquidity in the secondary allowance market, facilitating trading and easing price
volatility (Parsons, Ellerman et al. 2009).
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The proportion of emission allowances distributed via auction is a contentious issue in
climate policy design. Some policy proposals opt for a full auction from the beginning of
a cap and trade program. The Regional Greenhouse Gas Initiative pursued by a group of
northeastern states has conducted four auctions after all participating states agreed to
auction 100% of emission permits. If free allocation is considered desirable or politically
necessary in the short term, typical policy designs gradually reduce the percentage of
freely allocated permits as the cap shrinks and picking recipients becomes more difficult.
The Markey bill from the 110th Congress (H.R. 6186) auctions all permits except some
reserved for trade-sensitive industries. The Markey proposal suggests that protecting
industry may be the first political priority once policy makers contemplate free allocation.
As opposed to a system that auctions most or all permits to emit, Wisconsin consumers
should benefit from the free allocation of permits in the early years of a cap and trade
program due largely to the preponderance of coal-fired generators used to power the
state’s economic activity. The wide gap between proposals that auction all or nearly all
permits and a group that auction only 15-35% in the early cap years indicates that policy
designers begin from one extreme or another. Permits should either be allocated or
auctioned, and then compromises from that first principle result in the distribution visible
across many proposals. Beginning from the notion that permits should be allocated, the
auction of some allowances supports liquidity in the secondary market. Early year
auctioning also establishes the practice and procedures for auctions so that market
participants are acclimated to them if they later become the most important method of
allowance distribution.
At first glance, free permits and costly permits are simple concepts. A portion of the
political debate around allowance allocation treats free permits as a gift and costly
permits as an expression of the polluter pays principle. For Wisconsin consumers, the
cost of purchasing auctioned permits will be visible in increased energy prices. However,
the impact of free allocation on consumers is less obvious. The ambiguity results from
the idea that recipients of freely allocated allowances may seek to pass along to
consumers the opportunity cost of holding allowances (CBO 2007). The notion of
allowance value is crucial to understanding whether consumers benefit from free
allocation. Legislation may stipulate that the value of freely allocated allowances must
be passed through to consumers. This transfer of value to consumers may also be
achieved through traditional rate regulation at the state level that prevents the passthrough of the opportunity cost of holding allowances. Figure 11 shows the distribution
of percentages of emission allowances that are auctioned in different proposals.
Waxman-Markey auctions 15% of emission allowances and sets aside the proceeds for
low-income consumers. Additional allowances may be auctioned and proceeds assigned
to deficit reduction and/or US residents generally. Allowance allocation to electricity
consumers amounts to 35% of the total cap between 2016 and 2025. This allocation is
phased out in the period between 2025 and 2030. Natural gas consumers will be
allocated 9% of the total cap during the 2016-2025 period, with this allocation also
reduced to zero by 2030. Emission allowance allocation is found in section 782.
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FIGURE 11 PERCENTAGE OF EMISSION ALLOWANCES AUCTIONED IN
2018
2.2.10 Allowance Distribution Methodology
In the creation of a cap and trade program, policy makers must decide how to determine a
formula for allocating scarce emission allowances to covered entities. “Covered entities”
is a term that refers to the economic actors that must directly comply with greenhouse gas
reduction policy by surrendering emission allowances periodically to the government.
For example, policy designers typically choose to require emission allowances from oil
refiners rather than contemplate an overwhelmingly complex system in which individual
drivers must hold allowances that cover their tailpipe emissions. In this case, the point of
regulation is the oil refinery, and the rationale is administrative simplicity. An important
assumption behind the equivalence between upstream and downstream pricing is that the
additional costs are fully passed on to consumers.
When free allocation is a part of the distribution methodology, then the details that
govern allocation in a particular sector can give an advantage to certain market
participants or geographical regions. Climate proposals that utilize free allocation of
allowances give different percentages of allowances to different sectors. Then, within a
given sector, a formula establishes criteria for allocating allowances among emitting
entities. For electric utilities, the key distinction is whether the allocation formula uses
previous emissions or delivered electricity as the standard for apportioning allowances
between utilities. In addition, policy makers must choose how entities benchmark their
emissions or levels of delivered electricity. Finally, there is the question of whether an
entity should count only emissions from generating units that it controls or if purchased
power should be added to the total. For this last choice, double-counting of emissions is
clearly a problem to be avoided.
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Allowance distribution methodology is important to Wisconsin consumers because an
emissions basis for allocation protects utilities and consumers in areas that use highemission generation like coal-fired power plants. Allocation based on delivered
electricity authorizes utilities that derive significant amounts of power from nuclear and
hydroelectric sources to receive a disproportionate amount of allowances compared to
their compliance obligation. A delivered electricity standard would mean a cross-subsidy
from regions with more coal-fired power to those utilizing more nuclear, hydroelectric,
and natural gas. If free allocation were meant to aid the transition of GHG-intensive
regions and industries to a carbon-constrained economy, then fairness would dictate an
emissions-based allocation standard.
Rules that determine how particular emitters establish a benchmark of emissions or
delivered electricity hinge on a concept equivalent to the base year for economy-wide
emission reduction targets. Policy designers can select a particular year or consecutive
set of years for the benchmark, similar to the set of years used to define utility obligations
under the Wisconsin RPS. However, several proposals allow individual emitters to
choose their preferred benchmark during a predetermined period of several years. As a
result, for an emissions-based standard, a particular utility would have an incentive to
pick its highest year or years in order to maximize its allocation. For example, the
Dingell-Boucher discussion draft proposed that electric distribution utilities would have
the discretion to use a 3-year average of emissions between 1997 and 2007 to provide a
benchmark for an emissions-based allocation (Boucher and Dingell 2008). Figure 12
depicts the frequency of different methodologies for emission allowance distribution.
For electric distribution utilities, Waxman-Markey uses a 50-50 split allocation
methodology between an emissions basis and a delivered electricity standard. The
delivered electricity standard is updated beginning in 2015. For gas distribution utilities,
delivered gas is the standard for allocation (though delivery of gas to covered entities
does not count toward gas distribution utility obligations) with delivery level revisited
beginning in 2019. These details are in Sections 722, 783 and 784.
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FIGURE 12 FREQUENCY OF DIFFERENT ALLOWANCE DISTRIBUTION
METHODOLOGIES IN CAP AND TRADE PROPOSALS
2.3
Other Key Issues
Here we include discussion of other policy mechanisms that we did not explicitly
evaluate, for the reasons specified below.
2.3.1
Treatment of Unregulated vs. Regulated Electricity Producers
Electric and gas providers operating in deregulated environments may have an advantage
in terms of being able to retain windfall profits from free allowance allocations—whereas
regulated utilities will likely be required to pass on allowance value to customers. A
related issue is whether unregulated producers will be able to pass on the cost of emission
allowances to consumers. The means through which power is sold and price discovered
in the wholesale market will be crucial. If the market price for power is determined by
the marginal cost of the generation necessary to clear the market, then low-cost coal
generation that has been able to profit from market rules will be less profitable if the
clearing price rises less than the cost of compliance. Most proposals do not contain
sufficient detail on this issue to assess it explicitly. Basically, consumers will suffer if the
typical market price for wholesale power rises, which may be influenced as much by
wholesale market rules as allowance costs for merchant generators.
2.3.2
Transportation Sector Emissions
Greenhouse gas emissions from mobile sources constitute just under 30% of all US
greenhouse gas emissions (EIA 2008a). Though the transportation sector is included in
economy-wide cap and trade proposals examined in this report, it is assumed that the
price signal resulting from compliance costs alone will do very little to reduce vehicle
miles traveled and sectoral emissions. Economic analyses that assume that all
transportation sector emission reductions will arise from the pricing of GHG emissions
most likely underestimate the sector’s contribution to climate change mitigation and
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exaggerate the adjustments required in other parts of the economy. On the other hand,
the broad deployment of plug-in hybrid electric, fully electric, or natural gas-fueled
vehicles could radically change the service and emission reduction demands faced by
traditional gas and electric utilities. Complementary policies such as vehicle mileage
standards, subsidies to mass transit, and incentives for dense urban environments will be
important to augment the price signal established by an emissions cap.
2.4
Policy Assumptions
In Section 2.2, we described KPMs that were both important and uncertain. Other
mechanisms are similarly important, but have little or no variation in values across
proposals, permit little uncertainty of costs in the first place, or are very unlikely to
exhibit variation in the relevant timeframe. We describe these here.
2.4.1
First Year of Implementation
This policy detail is only relevant in the initial years of climate change policy. However,
given the timeframe for our analysis (2009-2018), it is reasonable that the costs of a cap
and trade program in 2018 could fluctuate depending on the year it starts. It is possible to
imagine an extended economic recession, a troubled international negotiation process, or
legislative gridlock pushing back the implementation of greenhouse gas reduction targets.
A later year of implementation could drive policy makers to set more stringent caps in
early years, or alternatively a long recession could create an effective peak in emissions
by virtue of a prolonged contraction in economic activity. In the latter case, decision
makers may feel little pressure to implement strong caps right away.
The year of implementation is related to the discussion above about cap stringency. It
will establish the onset of compliance and influence the timing of decisions that move
actors toward emission reductions. However, there is little variation at present across
proposals in their year of implementation. Cap and trade systems are typically
envisioned to begin in 2012, in sync with the next international negotiated agreement. As
a result, analyses of plans with different beginning dates largely are not available to try to
predict whether the year of implementation will be an important cost driver in 2018.
2.4.2
6-7 Gas Policy
One aspect of the scope of a climate change policy is its coverage of different global
warming gases. Though carbon dioxide makes up more than 80% of US greenhouse gas
emissions, all serious climate policies include multiple greenhouse gases (EIA 2008a).
The other known, important heat-trapping gases are methane (CH4), nitrous oxide (N2O),
hydro-fluorocarbons (HFCs), perfluorocarbons, and sulfur hexafluoride (SF6). Policy
designs translate these other gases into carbon dioxide equivalents by using an estimate
of their global warming potential (GWP). There is some variation in the inclusion of
high-GWP gases because some proposals create a separate cap for HFCs. The
importance of this assumption lies in the relatively low cost of emission reductions of
non-CO2 gases. Economic modeling has suggested that a greenhouse gas mitigation
program will cost 20%-50% more in terms of GDP if it totally excludes the non-CO2
gases (Aldy, Krupnick et al. 2009).
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September 2009
Carbon Tax
A “carbon tax” is an alternative policy mechanism that places a price on each ton of
carbon dioxide emitted in a given jurisdiction. In general, a carbon tax may easily be
broadened to cover all greenhouse gas emissions, using global warming potential
calculations. The fundamental drawback of a carbon tax is that it fails to firmly limit the
quantity of greenhouse gas emissions released. This tradeoff is important because the
core goal of climate change policy is to limit the dangerous effects of anthropogenic
climate change on humans, other species, and planetary ecosystems in general. The
observed and projected changes due to climate change follow from increases in global
warming pollution in the atmosphere. A carbon tax creates a price signal that should lead
to a reduction in the activities that lead to greenhouse gas emissions, but the coherence of
the price signal and consumers’ willingness to pay generate uncertainty with respect to
the emissions impact of such a tax. As a result, most climate change policy proposals
seek to control emission quantities first and then attempt secondarily to influence levels
and volatility of greenhouse gas emission allowance prices.
The key advantage of a carbon tax is its relative simplicity and predictability. There are
relatively few factors that change the price path. The tax will have an initial level and a
mode of escalation, assuming its specific levels are not fixed by legislation. The
escalation could be composed of specific dollar value increases, percentage increases, or
both. The use of an inflation index is typical. Other choices associated with the
implementation of a carbon tax include the point of tax collection for different emitting
activities, the frequency of review of the tax level and escalation, and the use of the tax
revenue. Policy makers must make choices about these issues whether they opt for a
carbon tax or a cap and trade system that collects revenue. Two representatives have
introduced carbon tax bills in successive sessions of Congress. The bills authored by
Representatives Pete Stark of California and John Larson of Connecticut vary in their
details, but generally emitting entities face much less uncertainty than they do when
assessing future cap and trade systems (Larson 2009; Stark 2009). As a result, in a report
focused on cost uncertainties, we do not explicitly analyze carbon tax systems. That said,
a hybrid proposal that started with a price mechanism and contained a trigger for a
quantity-based system resulting from high emission levels has also been suggested and
could develop into a more politically relevant policy option (Metcalf 2008).
Finally, it is useful to remain aware that one important motivation for cost containment
mechanisms is to reduce compliance cost uncertainty within a market structure. Thus, if
a safety valve exists and is below the market price for a ton of carbon dioxide equivalent,
then a cap and trade system will effectively operate like a carbon tax.
2.4.4
No New Nuclear, CCS until after 2018
Major plans to expand zero-carbon baseload generation using current fuels envision a
future of dramatically expanded nuclear power and carbon capture and sequestration
(CCS) for coal-fired power plants. For example, Environmental Protection Agency
modeling of cap and trade proposals assumes more than a doubling of nuclear generation
in their baseline future electric supply projections (EPA 2008b). These are ambitious
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assumptions about the future and they have an impact on the social cost of compliance
with carbon caps. However, the completion of new nuclear plants in Wisconsin is highly
unlikely in the period before 2018. Most importantly, the state legislature would need to
debate and repeal its moratorium on new nuclear power plants. The GWTF report
contemplates the repeal of the moratorium, but its authors are explicit that serious energy
conservation and efficiency efforts should precede the consideration of nuclear power as
an option to meet greenhouse gas mitigation goals (GWTF 2008). Wisconsin clearly
intends to be a follower if there is a movement back toward nuclear power in the United
States.
Carbon capture and sequestration technology offers a lifeline to coal-fired electric
generation in a future of tight constraints on greenhouse gas pollution. At this time, CCS
technology is not deployed at scale anywhere in the world. Even so, important provisions
in climate change mitigation proposals create incentives for the development of CCS.
One strategy offers bonus emission allowances to early adopters of CCS in order to
reward investors and generate momentum to overcome technical and economic barriers.
In addition, the Department of Energy has revived its support for the FutureGen
demonstration project in Mattoon, Illinois (DOE 2009). The Midwest may be at the
forefront of CCS technological development, but we assume that the FutureGen facility,
abandoned once already due to high costs, does not portend significant market
penetration of CCS facilities prior to 2018. With the issue of CCS currently under
investigation by the Wisconsin Public Service Commission, the future of CCS in
Wisconsin will soon be clearer.
For Wisconsin consumers, the safe and successful deployment of nuclear power and CCS
need not be in Wisconsin in order to have a major impact on the cost of compliance in
Wisconsin. Deployment of zero-carbon generation anywhere will reduce the demand for
emission allowances and lower the price for consumers where shifting away from coal
without CCS is physically or politically difficult.
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September 2009
Estimating Cost Impacts
The cost of greenhouse gas mitigation policy is now among the key factors that must be
accounted for by electric and gas utilities in future planning. The newest Wisconsin
Strategic Energy Assessment sets forth as a matter of policy that the monetization of
GHG costs in utility rates will now be integrated into the baseline analyses of the costs of
future electric generation options (PSCW 2009b). As a result, the varying cost of
different policy designs will directly influence the electric generation mix and utility
prices in Wisconsin. Both utilities and consumers have a stake in the consequences of
mandated GHG emission reductions and can benefit from a well-informed response to
whatever laws and regulations control the social and economic process of limiting the
emissions that drive global warming.
Our Approach to Costs
To frame this analysis, we must introduce a number of qualifications that contextualize
our focus on costs. The first of these is to note that we have not attempted to utilize a
cost-benefit approach to understanding the future impacts of climate change mitigation
policy. Despite the firm consensus around the anthropogenic aspect of global warming,
critical uncertainties remain with respect to both the climate system itself and the
economic valuation of climate change damages. For instance, the level of greenhouse
gases that may be released from permafrost and the way that rising temperatures could
initiate a positive feedback that accelerates such emissions was not well enough
understood to be factored into the Fourth Assessment Report of the Intergovernmental
Panel on Climate Change (Romm 2008). Uncertainty about the workings of the climate
system leads to widely divergent estimates of the damages that will result from climate
change. Understanding the direct benefits of climate change mitigation policy relies on
estimation of the corresponding avoided damages, which is still a highly contentious
process and may remain so indefinitely. In addition, the valuation of climate stability for
future generations of humanity also raises ethical and economic problems that preclude
consensus on the financial damages associated with a warming climate (Aldy, Krupnick
et al. 2009). If the costs of climate change mitigation can be viewed as a social and
ecological insurance policy, then the loss against which humanity is insuring itself is
unknown and without precedent. We confine our analysis to the cost of this “insurance
premium.”
In order to gauge the cost of climate policy to Wisconsin consumers, it is necessary to
clarify what is meant by “the cost of climate policy.”9 There are both direct and indirect
costs that will be felt by Wisconsin ratepayers and consumers. Direct costs include
higher electric and gas bills and higher gasoline and diesel prices for transportation. The
A useful summary of different cost measures can be found in Appendix B of Paltsev, S.,
J. M. Reilly, et al. (2009). The Cost of Climate Policy in the United States. Joint Program
Report Series, MIT Joint Program on the Science and Policy of Global Change.
9
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notion of indirect costs refers to the higher prices that result from the cost of greenhouse
gas emission allowances and mitigation actions that are embedded in the prices of nonenergy goods and services (Hassett, Mathur et al. 2009). Economists also regularly use
macroeconomic cost measures such as the impact of a cap and trade policy on GDP,
consumption, or overall economic welfare (Ross, Murray et al. 2008). These measures
seek to understand the total cost to the economy. However, such figures are rather
abstract and their rhetorical use can cast the same impacts as relatively benign or
economically damaging. Arguments against aggressive climate change mitigation policy
tend to emphasize the dollar value difference in expected GDP or consumption in 2020,
2030 or 2050 that would result from policy implementation. Advocates for a tough
climate policy may counter that the GDP or consumption levels expected without a
policy would only require several more months to achieve if a policy is in place. In
essence, these arguments boil down to one nebulous question: Do we believe that an
analysis suggests that we, as Americans, have to pay a high price or a low price to avoid
dangerous climate change? For Wisconsin consumers, we believe that the impact of
climate policy in the next decade is better understood through a more tangible approach
to costs.
Another method of assessing the cost of a cap and trade policy has been to point to its
impacts across the income distribution. This discussion often centers on how to return
allowance auction revenue to the public. In general, lowering income taxes on
individuals or businesses will favor upper income brackets. Lower income folks tend to
benefit from lump-sum payments to individuals or an expansion of the Earned Income
Tax Credit (Burtraw, Sweeney et al. 2009). The question of distributional fairness must
be addressed in the process of pricing GHG emissions because a government policy is
deliberately raising the price of necessities like electricity, natural gas for heating, and
gasoline for transportation to and from jobs. Though this framework is important for
balancing the interests in the process of policy design, it is not suitable for understanding
the costs that result from a variety of key policy mechanisms.
The political discussion of costs focuses on the direct costs of climate change, whether
they are viewed as an investment in maintaining a safe climate or as an “energy tax” on
consumers. For public utilities and their customers, the direct costs associated with rate
increases are likely to be the most immediate concern. Direct costs vary more by region
than indirect costs, underlying the perception that Wisconsin will face more difficult
economic adjustments than some other states in adapting to a climate change policy
regime (Marrero 2009). Furthermore, it is easier to address direct costs through policy
because the relative carbon intensity of particular households’ consumption is a much
less tractable analytical question. As a result, this report focuses on the expected direct
impacts of climate policy mechanisms on Wisconsin consumers.
A metric commonly used to represent direct consumer costs is the expected price of an
emission allowance for a ton carbon dioxide equivalent in the secondary market for
allowances. This price emerges from the supply and demand for emission allowances,
thus it theoretically corresponds to the marginal cost of the next unit of greenhouse gas
emissions reduction. As the market price for emission allowances, it refers to the part of
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the cost of compliance that will come about from the purchase of the right to pollute
rather than the cost of reducing emissions. The cost of reducing the next ton of CO2 is
the marginal cost of abatement. By definition, most abatement projects will be below the
marginal cost of abatement.10 The emission allowance price is especially useful because
it functions as a hinge between the microeconomic decisions of covered entities in
Wisconsin and the broader economic impacts and costs of compliance experienced in the
larger US or world economy.11 The cost of compliance—whether in the form of
investment in emission reduction or emission allowances—is then the broader amount
that will be realized in marginal changes on consumers’ electricity and natural gas bills.
These are the amounts that will be agreed upon in rate cases as prudently incurred
compliance costs. The following section uses the cost an emission allowance as a proxy
for the impact of particular key policy mechanisms.
3.1
Costs Associated with KPMs
The following section discusses the costs impacts of each of the KPMs that were
introduced in Section 2. To reiterate, the cost metric used is the expected emission
allowance price in 2018. Cost analyses of cap and trade proposals are ordinarily not
sophisticated enough to include confidence intervals that express uncertainty, but rather
only contain point estimates of expected cost. As a result, the cost figures below should
be treated as best guesses. This analysis aims to utilize existing analyses to anticipate
what will be the most important policy mechanisms from a cost perspective. Cost
analyses associated with proposals in Box 1 form the basis for several of the graphics
below (EIA 2007; EPA 2007b; WCI 2008; EPA 2008a; EIA 2008b; EPA 2008b; Cleetus,
Clemmer et al. 2009; Montgomery, Baron et al. 2009; EPA 2009a; EPA 2009b). Other
analyses will be integrated when appropriate.
3.1.1
Cap Stringency in 2018
Cap stringency is the fundamental cost driver for a cap and trade policy. A cap that
tracks expected emissions will require very little or no action by emitters and negligible
extra costs. One that is very tight in the short run will lead to high allowance prices and
noncompliance that threaten the political sustainability of the cap and trade program
itself. The cost impact of cap stringency has multiple dimensions. Most fundamentally,
holding the emissions baseline year and the future business as usual emissions path
constant, a more stringent cap requires greater emission reductions. Greater emission
reductions mean higher abatement costs, assuming a smoothly rising marginal abatement
More precisely, the expected abatement cost at the time of the investment decision will
typically be below the price the marginal cost of abatement reflected in the emissions
allowance market price.
10
The same principle applies if there is only a Midwest regional cap and trade program,
linked with other regional and/or foreign systems.
11
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curve. With higher abatement costs comes a higher willingness to pay for emission
allowances. Another dimension of the cost of cap stringency is the time path of
emissions. Broad emission goals are measured according to targeted concentrations of
greenhouse gases in the atmosphere, thus the same level of emissions over a given period
of time can be achieved with more and less stringent caps early in the period. As a result,
the choice of more stringent targets in the early years of a program will raise costs in the
short run without necessarily improving the chances of avoiding damages associated with
a warming climate. Finally, cap stringency as a function of expected business as usual
emissions is examined below.
FIGURE 13 COST ESTIMATES FOR DIFFERENT LEVELS OF CAP AND
TRADE POLICY STRINGENCY
Figure 13 shows cost estimates for economic modeling runs of various cap and trade
proposals.12 The metric on the horizontal axis is the percentage reductions below 2005
levels required in 2018. Corresponding to the histogram in Section 2.2.1, the distribution
of cap stringencies among surveyed proposals is bimodal, with programs either calling
for almost no drop below 2005 levels or at least a 10% reduction. The linear regression
line in Figure 13 suggests only a weak correlation between cap stringency and emission
allowance price. Even so, the expected allowance price rises from approximately
$20/tCO2e at 2005 levels in 2018 to a price of approximately $30 with the stringency
level of Waxman-Markey. Perhaps more significant than the simple expected value, the
dispersion of allowance price values in the 10% to 18% range of the figure indicates that
the risk of a much higher allowance price increases with a more stringent cap. This
report is concerned with disruptive scenarios that could create particularly negative
consequences for Wisconsin consumers. This data suggests that a more stringent and
politically feasible cap could contribute to relatively high future prices for Wisconsin
utility consumers.
In this style of figure, each blue dot represents a separate model run. Runs with a firm
safety valve were excluded from the sample.
12
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Different business as usual emission projections can change the effective stringency of a
given cap level. In reality, hotter summers, slower deployment of energy efficiency,
stronger economic growth, and other factors force economic actors to reduce emissions
more—given the same cap level—than if these exogenous drivers generated lower
emissions growth. Following that logic, weaker assumptions about future economic
activity and emission levels should bias cost estimates downward in economic modeling
of climate change policy. Figure 14 shows the same data as Figure 13 except that all
model runs based on economic projections from the EIA’s Annual Energy Outlook
(AEO) 2009 are excluded. The AEO 2009 lowered economic growth and electricity
demand forecasts and raised expectations of future oil and gas prices; it also included the
fuel efficiency upgrades and other provisions from the Energy Independence and Security
Act of 2007 (EIA 2009). Specifically, AEO 2009 assumes energy demand growth of
approximately 1% per year as opposed to 1.5% per year in AEO 2008. Figure 14 shows
a regression line with a more notable upward slope, as this sensitivity removed several
data points with higher stringency and lower projected allowance costs. Other features of
the Waxman-Markey bill—the only one modeled with AEO 2009—may account for
some portion of its lower forecasted costs compared to similarly stringent bills. In
particular, the offset provisions in Waxman-Markey are intended to more aggressively
hold down costs, but the change of business as usual values seems to be an important
factor in depressing expected allowance prices across model runs.
FIGURE 14 COST ESTIMATES FOR CAP AND TRADE PROPOSALS BY
STRINGENCY WITH ANALYSES BASED ON AEO 2009 REMOVED
3.1.2
International Offsets
International offsets (or credits) are a crucial cost containment tool. They limit allowance
costs by broadening the options for compliance that covered entities may pursue, opening
emission reduction opportunities and flattening the marginal abatement curve. In this
case, cost containment is a question of inexpensive abatement supply. The two variables
that contribute to cost reductions through the use of international offsets are the actual
supply of inexpensive offsets that are brought to market and the number of those that may
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be purchased by covered entities in accordance with limits set by policy. The supply of
credits will be impacted by the global demand for such emission reduction credits, the
market price expected by offset credit suppliers, and the maintenance of the legitimacy of
the trade in international offset credits. Global demand for international offsets will in
turn be a function of cap and trade program rules in foreign countries and the price of
domestic abatement in those countries. The market price for international offsets should
mirror the market price for emission allowances, though rules about the discounting of
credits that are not harmonized across borders could lead covered entities in capped
countries to be willing to pay different amounts for credits. Finally, the legitimacy of
some international offsets will inevitably be questioned, if only due to inherently difficult
measurement and monitoring issues. As a result, there is a risk in relying on low
compliance costs that hinge on the easy and uncontroversial availability of international
offsets.13
Policy limits on international offsets also constrain their use in cost containment. In this
respect, the quantitative limits adopted in Waxman-Markey are a dramatic innovation.
The cost impact of international offsets results from the percentage of compliance they
can be used to achieve. With a declining cap, the actual amount emissions for which
covered entities must hold allowances falls over time. Using traditional percentage
limits, the number of offsets that can be used falls with the emissions cap, while the
amount of abatement rises to meet that cap. Fewer permissible offsets combined with
more abatement equals a dwindling role for offsets in total economy-wide abatement. In
the Waxman-Markey scheme, the role of offsets in compliance increases over time
because the percentage of compliance that may be fulfilled with offsets is a fixed two
billion tons divided by a decreasing emissions cap. Each year the cap declines and the
percentage of offsets allowed increases (EPA 2009a). Consequently, the role of offsets in
economy-wide abatement falls at a slower rate than under a traditional percentage
constraint.
Economic modeling suggests that prohibitions on the use of international offsets for
compliance would dramatically raise the price of allowances in the secondary market.
Model runs that exclude only international offsets are expected to drive up the price of
emission allowances in 2018 by 35%-200% when compared with a core policy scenario.
For instance, the EIA analysis of S. 2191 predicts that the allowance price would be 65%
higher in 2018 if no international offsets are allowed (EIA 2008b). Figure 15 shows the
declining allowance cost expected as international offsets can be used for a larger
percentage of compliance. It also shows a cluster of very high short-term allowance
prices that correspond to scenarios with limited international offsets. A low level of
international offsets exacerbates the risk of very high secondary market prices. This
figure is particularly salient when thinking about the offset rules in the Waxman-Markey
A risk for program managers, covered entities, and offset suppliers is the possibility
offsets suffer from a general loss of confidence, as opposed to a shadow cast over one
particular type of project. A contraction of the international offset market could trigger
an allowance price spike.
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bill. The quantitative limit on offsets means that through time the effective percentage
limit on international offsets is moving across this figure to the right.
FIGURE 15 ALLOWANCE COSTS FOR VARYING LEVELS OF
INTERNATIONAL OFFSETS
3.1.3
Cost Containment and Safety Valves
Safety valves and price collars are the most blatant forms of cost containment in the
secondary market for emission allowances. The price ceiling in each mechanism can
function like an emissions tax and the price floor associated with a price collar can
behave like subsidy to low-carbon technology investment and energy efficiency. From a
macroeconomic point of view, taxes on greenhouse gas emissions are typically found to
be more economically efficient than a comparable cap and trade system. Despite this
conclusion, the lack of firm emission limits undermines the political feasibility of a tax,
making it unpopular with those who place more stock in warnings about the potential for
catastrophic climate change. From a cost perspective, a binding safety valve and a price
collar with a tight emission allowance price range tend to lower program costs, while
leaving emission levels uncertain.
Fell and Morgenstern (2009) look at the macroeconomic costs of a variety of different
cost containment mechanisms, using a model that holds constant the point estimate of
emissions in various scenarios. Safety valve and price collar proposals are only slightly
more expensive than an emissions tax. What is more, multiple scenarios show a cost
advantage for the policy runs with safety valves and price collars as opposed to pure cap
and trade proposals. Price collars even tend to yield slightly lower modeled costs than
safety valves. Another advantage of price collars demonstrated by this modeling exercise
is that the possibility for lower emissions is, in theory, symmetrical to the risk of missing
the emissions target on the high side.14 If other policy mechanisms and market conditions
This symmetry rests on the notion that policy designers construct a collar that is equally
likely to be triggered on the high side or the low side and that the actual market for
14
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lead to a lower than expected allowance price, then the price floor may remove more
allowances than the price ceiling injects into the market (Fell and Morgenstern 2009).
The impact on allowance prices of a firm safety valve or price collar is straightforward.
The key variable is whether the price ceiling or floor is expected to be binding on the
market price for emission allowances. Given a binding price constraint, the scheduled
escalation of the ceiling or floor and the rate of inflation will control the allowance price
and directly influence the total cost of compliance. Though a firm price collar may
appear in future legislative proposals, cost containment has focused on the potential for
high emission allowance costs within a cap and trade system. When Senators Jeff
Bingaman and Arlen Specter co-sponsored the Low Carbon Economy Act of 2007, they
inserted a safety valve mechanism, deemed the Technology Accelerator Payment (TAP).
Economic modeling done by the EPA shows that even in the early years of a cap the TAP
can be a crucial determinant of the expected results of the policy’s implementation (EPA
2008a). Table 4 catalogs the effect that a binding safety valve can have on the marginal
cost of compliance. Among the sensitivity analyses pursued, only the availability of
unlimited international offsets (a condition found in no extant policy proposals) prevents
the safety valve from controlling the price of allowances in 2018.
TABLE 4 SAFETY VALVE IMPACTS IN MODELING OF THE LOW CARBON
ECONOMY ACT OF 2007
Policy Scenario
S. 1766 Core
S. 1766 Core with high
technology
S. 1766 with 10%
international offsets
S. 1766 with high
technology, 10%
international offsets
S. 1766 with unlimited
international offsets
S. 1766 with high
technology and unlimited
international offsets
S. 1766 without a CCS
subsidy
S. 1766 with high
technology, no CCS
subsidy
Allowance Price
in 2018 with TAP
14
14
Allowance Price
in 2018 without
TAP
34
29
% Increase of
Allowance Price
without TAP
143%
107%
14
25
79%
14
20
43%
12
12
0%
12
12
0%
14
33
136%
14
25
79%
emission allowances resembles these predictions.
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Figure 16 depicts the range of allowance prices in scenarios with a safety valve and those
without. The highest expected allowance price among model runs without a safety valve
is approximately two and a half times the maximum observed with the TAP. It is
important to note also that the cap level mandated by S. 1766 was the least stringent of all
the proposals examined. As a result, it is reasonable to believe that the disparity between
the expected price with and without a safety valve could be even starker than Figure 16
indicates.
FIGURE 16 GHG PRICE RANGES WITH AND WITHOUT A SAFETY VALVE
Other cost containment mechanisms are not amenable to economic modeling due to their
specific characteristics. Discretionary advisory boards do not impose clear rules that can
be used to model their future impact. A committee tasked with managing challenges in
the secondary market may bring more insight and flexibility to solving problems that
arise in the market for emission allowances. However, the unpredictability of a board’s
actions precludes the quantification of its impact on Wisconsin consumers whether
operating at the regional or federal level. The main cost containment mechanism
contained in the Waxman-Markey bill, the strategic allowance reserve, does not rely on
the judgments and whims of an appointed board. Even so, the economic analyses of H.R.
2454 do not model price volatility in the secondary market, thus ignoring the effect of the
strategic reserve.
3.1.4
Banking and Borrowing
Banking
Though there is no variation observed among various cap and trade proposals with
respect to the unlimited banking of allowances, it is still a very important cost
containment measure. Sensitivity runs by MIT with banking prohibited confirm this
intuition. Allowance prices in 2015 are 3-4 times higher than identical model runs with
banking, depending on the cap stringency of the policy. By 2020, the “no banking” runs
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show allowance prices that are only 35%-100% higher than scenarios with banking. For
example, modeling runs corresponding to more stringent targets that are comparable to
the Waxman-Markey bill show an allowance price $17-$19 higher in 2020 than in runs
without banking. By contrast, modeling suggests that banking of allowances holds down
emission costs in the latter years of a cap and trade program when emission reduction
targets are more aggressive (Paltsev, Reilly et al. 2007). In the same way that banked
allowances can dampen short-term price volatility, banking as a policy mechanism is
thought to undermine the magnitude of marginal abatement costs over multiple decades.
Thus, cost analyses show banking to be a smoothing force in the secondary market for
emission allowance in the long run. Figure 17 depicts the allowance price difference
envisioned by economic modeling that isolates the impact of banking allowances.
FIGURE 17 EMISSION ALLOWANCE PRICE IN 2018 WITH AND WITHOUT
BANKING
A corollary to this insight is that a longer modeling timeframe will include more of the
higher costs of a radically carbon-constrained economy. In the real world of planning for
compliance with GHG regulation, this longer modeling horizon corresponds to the
planning horizon of utilities and other regulated firms. If a planner believes that later
year targets are credible, then the economy-wide compliance decisions in those years
become relevant to contemporary planning. If a covered entity anticipates and trusts that
the market value of emission permits will appreciate, then there is an incentive to bank
more permits and further reduce emissions in the early cap years. If assumptions about
the price of future compliance (whether it be via emission allowances or GHG
abatement) influence compliance decisions in the present, then prices in the present may
rise as the modeling referenced above predicts.
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Attitudes about the future could differ in multiple dimensions. Planning horizons will
likely vary across covered entities both as a result of traditional differences and after
adjusting for the reality of multi-decadal emission reduction targets. Regulated utilities
with an indefinite obligation to serve may view long-term compliance differently from
industrial facilities, refineries, or independent power producers. The impact of different
banking strategies is an important unknown in this context. Aside from such structural
differences, entities will have different expectations about the future. Firms will harbor
conflicting assumptions about the development of low-carbon technologies, and the
relevance of those expectations will vary with geographical location. In addition, firm
discount rates may not match up, leading them to value future compliance differently.
At the level of an individual firm, banked permits are both a saleable asset and form of
insurance against various problems that compliance may bring up.15 Banked permits can
substitute for more expensive compliance options like borrowing with interest or
purchasing allowances from a strategic reserve auction. For Wisconsin consumers, the
ability of covered utilities to use banked permits to avoid more expensive compliance
scenarios will tend to lower the variable costs that they cover in their bills. Finally, it is
an open question whether the upward macroeconomic effect of banking will overwhelm
the downward pressure on compliance costs brought about by the flexibility banked
permits allow.
Borrowing
Firm-level borrowing as a policy mechanism helps covered entities avoid unforeseen
high prices for the emission allowances needed for compliance. From an economy-wide
perspective, the impacts of borrowing are relatively negligible, especially given the
typical constraints placed on borrowing by contemporary policy proposals. Modeling by
economists from Resources for the Future suggests that unlimited borrowing could lower
the net present value costs of a cap and trade program by 3%-13% compared with
scenarios that constrain or outlaw borrowing, depending on the time path of emissions set
forth by a cap and trade program. However, the constrained borrowing in current cap and
trade proposals offers no savings compared with a scenario in which firm-level
borrowing is prohibited (Fell and Morgenstern 2009). Borrowing is not modeled in
analyses of cap and trade systems issued by the EPA and EIA. Computable general
equilibrium (CGE) models do not take into account the price volatility that allows
borrowing to add value to policy design.
One design element that increases the importance of banking is the use of steep, stepwise changes in policy mechanisms cap reduction timetable. Banking behavior would
likely be an important strategy for coping with precipitous drops in cap levels or free
allocations of allowances and the price uncertainty that could accompany them.
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FIGURE 18 MACROECONOMIC COSTS OF ALLOWANCE BORROWING
In Figure 18, unlike the previous figures in this section, the vertical axis refers to a
macroeconomic measure of costs rather than dollars per ton of CO2eq. That said, this
figure offers multiple interesting insights. The shape of the surface diagram on the NESW axis shows that no macroeconomic impact results from borrowing at interest rates of
8%-10%, which are the borrowing penalties found in existing greenhouse gas mitigation
proposals. On the NW-SE axis, the figure suggests that the most significant cost savings
accrue once the first year of borrowing is allowed. This modeling result fits with the
short-term benefits of borrowing that will be discussed below. One final point to
underline is that the terminus of the NW-SE axis in the foreground corresponds to
unlimited borrowing.
Firm-level borrowing is fundamentally a built-in hedge against allowance price volatility
and other pitfalls of compliance. In particular, borrowing may be useful in the days and
weeks near the end of a compliance period. It is reasonable to foresee that the end of
compliance periods could produce extra volatility in the secondary market as entities
prepare to surrender allowances to the government. A covered entity may be in need of
last-minute allowances due to poor planning, an unusually cold December that drives up
gas deliveries, or the failure of energy efficiency measures or low-carbon generation
facilities to perform as expected. The need for more allowances near the end of a
compliance period creates a decision matrix. Using banked allowances that had been set
aside for future compliance periods is one available option. The firm can also go to the
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secondary market to buy allowances from the current or a previous vintage year that can
be used for compliance without penalty. A third option is to purchase allowances at
auction, if another auction remains before the compliance deadline. If the auction is
selling permits from a strategic reserve, however, then the minimum price will likely be
set relatively high. In several policy proposals, borrowing up to 15% of the allowances
required for that compliance period is another option for covered entities. Finally, paying
a fine and submitting the missing allowances in the next compliance period is a standard
consequence of noncompliance.
In part, the decision among these options will be based on cost. For Wisconsin
consumers, smart compliance decisions on the part of entities that can pass through costs
will reduce the impact of cap and trade legislation. Thus, in a situation like the one
sketched out above, there are two factors: 1) what is the least expensive way to comply?
2) are there compliance costs that the Public Service Commission will prevent utilities
from passing through to consumers of electricity and gas? In the early years of the cap
and trade program, the view of the PSC toward certain compliance strategies and tactics
may not yet be clear. Over time, the differing compliance strategies of various covered
entities may incline the PSC toward or against treating different compliance costs as
prudently undertaken. Decisions taken during extraordinary market conditions like those
at the end of a compliance period could contribute unexpected costs. If the price of
allowances spikes and/or there is an attempt to manipulate the market during those
periods, then the secondary market may not be a wise choice. Borrowing future vintage
year allowances and paying interest may be the easiest and most cost-effective method to
obtain the necessary allowances.
3.1.5
Revenue Recycling and Allowance Value
The distribution by government of allowance auction revenue and the allowance value
embedded in free allocations can be categorized under three broad headings: 1) consumer
and business protection, 2) technological investment, and 3) adaptation funding. Looking
forward only as far as 2018, most of the cost impact of these government decisions will
result from its willingness to cushion the transition for vulnerable consumers and
businesses. Technological investment may be decisive for Wisconsin consumers in the
later years of a cap and trade program, as more aggressive targets require wholesale
changes in the energy delivery infrastructure. However, in the short term, funding for
energy efficiency is likely to be the most important segment of technology investment. It
will be discussed in the next subsection.
Wisconsinites will be affected by both how much allowance value is distributed to
consumers and how they receive that value through different policy formulations. We
assess the importance of the level of allowance value distributed by looking at a 2009
study completed for the Midwest Consumer Utilities (Armstrong, Edelston et al. 2009).
That report examines six allowance allocation scenarios. In scenario 1, no allowance
value is returned to ratepayers; scenarios 2 and 3 redistribute half of the allowance value;
and scenarios 4, 5, and 6 give all allowance value back to ratepayers. In Figure 17, the
Wisconsin ratepayer impacts are translated into emission allowance prices (EPA
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2007a).16 The horizontal axis in Figure 19 also uses “Emission Allowance Price” as its
metric, but allowance price is here a proxy for cap stringency. As we would expect,
ratepayer impacts in every allocation scenario rise with a more stringent cap. In this
subsection, however, the difference between the allowance price impacts within each
stringency case is most relevant. Greater redistribution of allowance value lowers
consumer costs, and the ratepayer benefit seems to accelerate as allowance the percentage
of allowance value returned increases. The benefit of shifting from 50% to 100%
redistribution appears greater than increasing it from 0% to 50%.
FIGURE 19 IMPACTS OF THE LEVEL OF ALLOWANCE VALUE
DISTRIBUTED TO WISCONSIN RATEPAYERS
At a more granular level, consumer impacts will vary by virtue of how policy makers
choose to manage this redistribution of allowance value. In the introduction to this
section, we briefly discussed ways that auction revenues can be recycled that create
winners and losers across the income distribution. In practice, consumers will accrue
allowance value both via the distribution of free allowances and as a result of the direct
refund of allowance auction revenue. The same households could receive a rebate on
their utility bill associated with the free allocation of allowances to electricity consumers
and a refund designated for low-income folks. More particularistic benefits might accrue
to households and businesses that receive help in implementing energy efficiency
measures or landowners and businesses that can act as producers of domestic offsets
eligible for set-asides. Likewise, distribution of allowance value to industrial facilities
that face international competition may avoid plant closures and job losses. Similar to
Ratepayer impacts are converted into allowance prices by using two simple steps.
First, the carbon intensity of the grid in Wisconsin is used to estimate the impact of a $1
price for a ton of CO2eq. The ratepayer impact calculated in the Midwest Consumer
Utilities Study is then divided by that impact per ton of CO2eq. to yield a representation
of the ratepayer impact in terms of allowance prices.
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the distinction made above between direct and indirect costs, transfers of allowance value
that mitigate costs for consumers can be construed as direct and indirect as well. The
most relevant allocation of allowance value in the context of this report is the distribution
of allowance value to electric and gas utilities and their ratepayers.
It is very likely that legislators and/or state-level regulators will require that electric and
gas utilities use the free allocations of allowances to mitigate the cost to ratepayers
resulting from the pricing of GHG emissions. In other words, policy designers would
prohibit utilities from passing along to their ratepayers the opportunity cost of not selling
freely allocated allowances. This scenario is typically described as a windfall for
utilities. However, ruling out windfalls still leaves several questions about how free
allocations will translate into impacts on utility ratepayers. Given a sufficient free
allocation, the utility could hold the allowances and then return them to the government
in order to achieve compliance. In this case, the ratepayers see no cost difference. The
scenario envisioned by Waxman-Markey would require that the cost of compliance
would be passed through in the charge per kilowatt hour to each ratepayer, while the
benefit of free allocation is rebated as a lump sum payment independent of electric usage
(Waxman and Markey 2009). This latter case intends to preserve the extra incentive for
conservation and efficiency by allowing the per kilowatt hour price to rise, though it is
questionable how coherent this price signal will be for consumers.
3.1.6
Energy Efficiency Improvements
Costs related to energy efficiency improvements can come from a variety of standards
and market-based and voluntary activities. The current Wisconsin Focus on Energy
program takes money from the public benefits fund assessed on all utility customers and
puts it toward energy efficiency and customer-sited renewable energy. An energy
efficiency resource standard would change the current Focus on Energy-managed
program from an effort constrained by the budget raised by the public benefits fund to a
more aggressive effort based on annual energy efficiency (or emission reduction) targets.
The cost of an EERS would depend on the ability of the program to efficiently extract
energy savings. What is more, the existence of new and existing mandatory standards
limit the menu of additional energy efficiency options available beyond those prescribed
by law. As a result, the lion’s share of the opportunities to satisfy an EERS is likely to be
in retrofits.
More aggressive codes and standards have a multidimensional impact on climate change
mitigation policy. They may push the savings required for an EERS farther up the
marginal abatement curve, increasing the cost of meeting savings targets. At the same
time, energy savings from mandates and EERS compliance ease the cost of meeting
emissions caps by helping to reduce energy demand. From the state-level perspective,
more aggressive standards make it more difficult to meet an EERS with additional energy
reductions. However, federal energy or cap and trade legislation that includes appliance
standards, building codes, and other efficiency programs will dampen demand across the
country and thus place downward pressure on the price that covered entities will face in
the secondary market for emission allowances. In sum, energy efficiency measures both
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in Wisconsin and elsewhere reduce the level of mitigation required and the price at which
compliance is achieved.
A challenge involved in moving toward an EERS in Wisconsin is the incongruity
between the point of regulation envisioned by climate change mitigation policy and the
management of energy efficiency programs in a public benefits state like Wisconsin.
With Focus on Energy as the initiator of energy efficiency projects, it will experience
somewhat different incentives than the distribution utilities that will be required to submit
emission allowances and/or offsets to the government. At least two key questions arise
related to the potential mandate of Focus on Energy under an EERS. First, will energy
efficiency projects be pursued by a least cost methodology or will they be approximately
apportioned according to the compliance obligation of the state’s utilities in order to
distribute the proceeds and energy savings “equitably?” Such political considerations
may impact the cost of an EERS. Second, will Focus on Energy pursue the least cost
energy efficiency projects if they fall outside the scope of energy use and emissions that
impact the compliance of the state’s electric and gas utilities? For example, will low-cost
reductions related to the use of liquefied petroleum and home heating oil be pursued
though they less directly benefit the state’s utilities that have traditionally financed state
energy efficiency programs? Electric and gas distribution utilities may have a renewed
incentive to initiate separate energy efficiency projects in order to more easily comply
with emission allowance requirements and/or because the ability to bank emission
allowances may be attractive to particular covered entities. These misaligned incentives
correspond to the difficulties found in implementing energy efficiency in other situations,
like that between landlord and tenant or homebuilder and homeowner.
One way of characterizing the relationship between energy efficiency and climate change
mitigation policy is as a feedback mechanism. The introduction of a price on GHG
emissions spurs greater energy efficiency and conservation, which tends to put downward
pressure on the emission allowance price by constraining energy demand. Through time,
the cap declines, pushing allowance prices upward, once more spurring more efficient use
of energy. Two basic questions remain: what level of efficiency can be achieved and
what investment is necessary to achieve those savings? The Wisconsin energy potential
study recently completed by the Energy Center of Wisconsin projects that 13% of
Wisconsin electric demand and 8% of natural gas demand can be reduced by 2018 at an
upfront cost of $340 million per year (ECW 2009). This is an estimate with a great deal
of uncertainty embedded in it. Even so, with current federal legislation calling for a 14%
reduction in emissions in the same timeframe, energy efficiency can clearly play a major
part in meeting short-term emission reduction targets.
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FIGURE 20 WISCONSIN AND NATIONAL ENERGY EFFICIENCY
POTENTIAL STUDIES
Figure 20 tells multiple stories about the potential for energy efficiency in short-term
climate policy. The blue segments of the bars show that energy efficiency can be
expected to reduce emissions below current levels rather than just prevent the growth of
energy demand.17 The dark blue and dark red bar in the center of the graph depicts the
point estimate of potential savings in the ECW study. A $30 price per ton of CO2e is
assumed in those calculations. The lighter colored bars correspond to a sensitivity
analysis of energy efficiency potential study taking into account the entire US (Granade,
Creyts et al. 2009). At first glance, it appears that Wisconsin has less potential for
savings, but the lighter colored bars correspond to economic potential for energy
efficiency. Estimates of economic potential assume that individuals and businesses will
take up cost-effective energy efficiency despite the information barriers and empirical
adoption rates that constrain studies of achievable potential like the Wisconsin study.
Estimates of achievable potential for Wisconsin may actually be very similar to those for
the entire U.S.
The other important message in Figure 18 is that national energy efficiency potential
varies relatively little when moving from a world with no GHG emission price to one
with a price of $50/ton. To be sure, there are extra projects made desirable by the pricing
of GHG emissions, but the largest part of the projected energy savings comes from a
willingness to invest the necessary funds and implement policies that break through
market barriers to energy efficiency. Reducing market barriers could include finding a
durable and fair way to compensate utility shareholders for investments in energy
efficiency so that it is treated as a resource on par with electric generation and gas
delivery. Though these potential figures cannot be precise due at least in part to the
dispersed nature of energy efficiency spending and energy consumer behavior, the
This magnitude of reduction in energy use below current levels is plausible because
demand for natural gas is not growing.
17
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September 2009
magnitude of potential savings foreseen by these studies warrants considering energy
efficiency alongside the previous five policy mechanisms as major drivers of the cost of
climate change policy.
3.1.7
Domestic Offsets
Offsets have typically been written into legislation with two clear goals: 1) open
uncapped sectors to investment in GHG emission reductions, 2) lower short-term costs of
GHG mitigation. As a cost containment mechanism, offsets buy time for the energy and
transportation sectors to deploy at scale appropriate technology for a carbon-constrained
economy. In this report, focusing particularly on the period out to 2018, offsets are a
core cost containment mechanism. However, international offsets seem to be more
important than domestic offsets. Modeling of the Waxman-Markey bill by the EPA
anticipates that domestic offsets will only be utilized at 10%-20% the rate of international
offsets. In addition, the same analysis projects that domestic offsets will never be used in
the quantity that the bill permits (EPA 2009a). The cost impact of the level of domestic
offsets permitted depends on the supply and price of projects offered within the US, and
the general assumption is that international offsets will be more plentiful and less
expensive.
From a policy design perspective, the cost impact is also predicated on whether a
proposal distinguishes between domestic offsets and international offsets or treats them
as fungible. Essentially, to ensure that domestic projects are pursued, they should not
have to compete for the same segment of an entity’s compliance. One caveat to the
presumed preference for international offsets is that a preference for domestic offsets may
evolve based on a perception—true or false—that domestic projects are less likely over
time to suffer from legitimacy concerns. Waxman-Markey employs a hybrid design by
establishing separate quantitative limits for domestic and international offsets, but then
permitting the use of up to 500 million more tons of international offsets each year if
domestic offsets are not attractive enough to be purchased near their prescribed limit.
The cost impact of reaching such a legislated limit is that offsets then become less
expensive than emission allowances due to the fact that offset providers must accept a
lower price to participate in the market.
FIGURE 21 ALLOWANCE COSTS BY LEVEL OF DOMESTIC OFFSETS
ALLOWED
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Figure 21 shows the regression line corresponding to the level of domestic offsets
allowed in various policy modeling runs and the allowance cost projected in 2018. In
particular, the expected cost difference is very limited in the 10%-30% range, which most
proposals utilize. It should be noted, however, that the dispersion of values is greater at
lower levels of domestic offsets allowed. The permitted level of domestic offsets alone
seems to have a relatively weak impact on the emission allowance price.
3.1.8
Renewable Portfolio Standard
The cost of a renewable portfolio standard for Wisconsin consumers depends on many
factors, most importantly the stringency of the target set by the policy mandate. Other
important cost drivers may be divided into three groups: 1) factors determined by the
controlling RPS itself, 2) drivers that originate in exogenous policy decisions, 3) market
factors that have important impacts on RPS compliance. Wisconsin consumers will pay
the prudently incurred extra costs of utilities complying with an enhanced Wisconsin RPS
or a federal mandate. Given the level of the combined RPS and EERS in the WaxmanMarkey bill, a federal RPS could require little extra effort in 2018 beyond the actions
Wisconsin utilities are taking to satisfy the current state RPS. Other RPS policy
mechanisms that could affect costs are the level of non-compliance penalties and the
existence of RRC banking.
The cost of an RPS also could fluctuate with policy decisions taken by other states or at
the federal level. Most obviously, the establishment of a GHG emission price would
signal the need to expand zero-carbon, renewable generation options to facilitate longterm compliance with emission reduction targets. The resulting technology development
and deployment would ease compliance with a given RPS. A steady investment climate
has also been important for renewable deployment, as the build-out of wind energy in the
US demonstrates. The regular renewal or production tax credits, investment tax credits,
and grant programs also promises to hold down the cost of compliance with an RPS.
Working against inexpensive RPS compliance in Wisconsin are more aggressive state
RPS targets and the establishment of a federal RPS. Similar to the unknowns
surrounding the future demand for international offsets, the expansion of demand for
renewables to meet RPS targets and achieve GHG emission reductions will put pressure
on the supply of renewable resources and could raise the cost of procuring renewable
power. A key factor in expanding the supply of renewables is the availability of
transmission. State and local decisions about transmission line siting and the potential for
greater federal involvement in transmission planning will also have an impact on actual
RPS costs (Chen, Wiser et al. 2007).
Not all RPS cost drivers originate in policy decisions. The commodity price boom that
was partly responsible for rising cost of new wind energy projects over the last several
years is the type of market-based factor that can change the cost of an RPS mandate.
Similarly, the availability of reasonably low-cost financing facilitates the expansion of
renewable generation. The current credit crunch undermines the ability of utilities and
other project developers secure construction loans for new generation. Finally, the price
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of natural gas is an important factor in the understanding the effective cost of complying
with an RPS. If the wind generation that has supplied the vast majority of RPSassociated generation displaces natural gas, then high gas prices make an RPS a relative
bargain.
The cost drivers of RPS compliance are many and complex, but the impact of the RPS on
the cost of a cap and trade system is clear. The RPS disrupts the inertia on the supply
side of the electric generation market, forcing the electric utility industry to diversify its
generation portfolio and acclimate itself to new and sometimes intermittent technologies.
Therefore, RPS mandates respond to the long-term needs of a cap and trade program that
envisions 50%-90% emission reductions over the next 40 years. The RPS might be seen
then as another kind of insurance policy, similar to the climate policy as a whole. It spurs
the process of diversifying the options for adapting to a carbon constrained economy,
providing some measure of insurance against difficulties with nuclear power, efficient
gas-fired generation, and coal-fired power with carbon capture and sequestration. The
recent trend toward set-asides for solar power and distributed generation seek, in effect,
to further broaden the possibilities available for transforming the energy system to
mitigate dangerous climate change.
Change in Rates in 1st Peak Target Yr.
FIGURE 22 COST ESTIMATES OF RATEPAYER IMPACTS FOR STATE RPS
MANDATES
>5%
4%-5%
3%-4%
2%-3%
1%-2%
0-1%
-1%-0
<-1%
0
2
4
6
8
10
12
14
16
Number of Studies
Figure 22 shows a distribution of cost estimates for RPS mandates in terms of ratepayer
impacts (Wiser 2006). The main message in this figure is that most assessments of the
costs of meeting RPS targets reveal negligible impacts or outright savings. A further
report including actual data from financial impacts of RPS mandates in 2007 shows only
very modest rate hikes. All of a dozen functioning RPS policies for which data was
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Muller and Nemet
September 2009
available cost consumers less than 1.2% in per kilowatt hour increases (Wiser and
Barbose 2008). State and possibly federal RPS legislation will drive renewable energy
development concurrent with a cap and trade system. In line with comments in Section
3.1.5, investment in low- and zero-carbon technology can have a major impact on climate
policy in the longer term (beyond 2018). In the meantime, incremental renewable energy
development will create cost impacts for Wisconsin consumers, but we do not expect
those to be significant in comparison with several of the policy mechanisms mentioned
above.
3.1.9
Emission Permit Auctioning
In a macroeconomic sense, an important argument for auctioning emission allowances
states that economic efficiency is improved if government uses revenue from putting a
price on environmental externalities to lower taxes on income from labor. This double
dividend—environmental and efficiency gains—offers a compelling way to tax pollution
that people dislike and simultaneously reward work. All consumers see higher prices and
have an incentive to behave in ways that pollute less. The double dividend appears to be
a win-win from the bird’s-eye view of the entire economy (Parry and Bento 1999).
However, both of these policy choices would be politically difficult. The full auction
ignores the political clout of emitting entities and aggrieved consumers, while the tax
reduction writes into law a regressive distributional outcome when viewed across the
income spectrum. Consequently, a number of proposals seek to implement a full auction,
but all those that have reached the stage of serious contemplation at the federal level put
off auctioning a majority of the emission allowances until several years after
implementation. Though perhaps a less economically efficient course of action, direct
costs for Wisconsin consumers should be lower when regulated utilities need not
purchase emission allowances at auction. More than the percentage of allowances
auctioned, it is the use of the auction revenue that is decisive for consumers both in terms
of the amount of revenue returned to the public and the distribution of that revenue.
Broad analyses of cap and trade bills tend not to conduct sensitivities based on the
auction/free allocation split. In evaluating S. 280, the EIA conducted one set of runs with
different levels of auctioning. The core policy starts by auctioning 30% of allowances,
with that percentage escalating to 90% in 2030. The alternative policy scenario changes
the initial auction level to 70%, similarly trending toward a 90% auction level in 2030.
The resulting comparison shows less than a dollar difference in allowance price in 2018
between the two scenarios and infinitesimal differences in GDP and consumption (EIA
2007). To be clear, the issue of allowance allocation is important, but CGE models do
not pick up the relevant distributional distinctions. These models also treat auction and
free allocation as equivalent so long as the cap and trade policy is revenue neutral for the
government. They assume that all revenue is returned lump sum to a single consumer
who represents the entire economy.
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Muller and Nemet
September 2009
FIGURE 23 EMISSION ALLOWANCE PRICES WITH DIFFERING AUCTION
LEVELS IN 2018
Figure 23 shows the relationship between the percentage of emission allowances that are
auctioned and the allowance price. There is a weak positive relationship in the data
between more auctioning and higher allowance prices. However, if the points on the
right side of the graph are treated as outliers, then the regression line is almost entirely
flat (graph not shown). Though some free allocations of allowances do lead to windfall
profits for recipients, the level of auctioning seems to receive more attention than it
deserves when compared to its impact on consumers.
3.1.10 Allowance Distribution Methodology
The costs associated with the formula for distribution of emission allowances to covered
entities are essentially a function of the difference between the number of allowances
received and the quantity of emissions for which an entity is responsible. There is policy
uncertainty about the general formula for the distribution of allowances, as demonstrated
by the dispersion of approaches across the policy proposals examined in this report.
However, that uncertainty should lessen significantly once it is clear what methodology
will be used, particularly to the extent that the benchmarks for allowance distribution are
fixed. Cost uncertainty, then, is tied to the initial policy framework and the reworking of
the benchmark ratios if periodic updates are mandated in legislation or subsequent rules.
In addition, it is useful to recognize that if all utilities have an opportunity to choose a
baseline level of emissions and/or delivered electricity, then it is likely that the broad
allowance allocation for the electric utility sector will be oversubscribed. As a result, the
relationship between the number of allowances allocated and the compliance obligation
of utilities may vary, even in areas with similar fuel mixes for electric generation. The
use of an historical baseline also implicitly rewards demand reduction pursued by utilities
in the interim.
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Muller and Nemet
September 2009
The relatively high percentage of coal-fired power generation in Wisconsin is the core
reason that allowance distribution methodology is a concern from the perspective of
Wisconsin consumers. It is a policy design choice that can help to ease the transition to a
carbon-constrained era for states with carbon-intensive economies. Buffering the
economic liability of coal-fired electricity in the early years of a cap and trade program
will lower costs for Wisconsin consumers. The question remains: by how much?
Sharpening this concern is the fact that MG&E, as a utility without nuclear power under
contract, may experience the difference in distribution methodology somewhat more
keenly than other Wisconsin utilities that utilize large blocks of zero-carbon electricity.
The MCU study decomposes ratepayer costs according to how allowances are distributed.
The study employs three scenarios with freely allocated allowances. One uses an
emissions standard, the second a retail load standard, and the third a 50/50 split between
those two methodologies. The study is particularly useful because the Waxman-Markey
legislation uses this 50/50 standard as the basis for its allowance distribution
methodology. According to the MCU study, an emissions-based methodology aids
Wisconsin consumers. In the high and medium allowance price scenarios, rate impacts
are projected to be 15-27% higher with a delivered electricity standard as opposed to an
emissions-based standard, using figures for 2015 and 2020. The impacts of the 50/50
methodology are 7-14% higher than the emission standard. The relatively higher costs of
the delivered electricity and 50/50 standards are more pronounced in the low allowance
price scenarios. In 2015, ratepayers are projected to pay approximately three times as
much extra with a delivered electricity standard and twice as much extra with a 50/50
standard. In 2020, the percentage impacts fall to 72% and 36%, respectively. The
bottom line for these short timeframes is that the lighter cost impact associated with a less
stringent cap tends to make the impact of the allowance distribution methodology more
visible at the margin (Armstrong, Edelston et al. 2009).
TABLE 5 PREMIUM ON MARGINAL RATEPAYER IMPACT IN
COMPARISON WITH EMISSIONS-BASED STANDARDS
Allowance Price and Allowance
Distribution Methodology
Low, Delivered Electric Standard
Low, 50/50 Electric/Emissions Standard
Medium, Delivered Electric Standard
Medium, 50/50 Electric/Emissions Standard
High, Delivered Electric Standard
High, 50/50 Electric/Emissions Standard
Year
2015
215%
107%
28%
14%
23%
11%
2020
72%
36%
17%
8%
15%
7%
Though the percentage changes in impact from different distribution methodologies may
indicate that this is an important policy mechanism for Wisconsin consumers. However,
translating the impacts into allowance prices suggests that the difference between an
emissions-based standard and a delivered electric standard is not very significant. Figure
24 shows that the extra impact of a delivered electric standard or a 50/50 standard only
amounts to a dollar or two per ton of CO2eq.
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Muller and Nemet
September 2009
FIGURE 24 EXTRA COST IMPACTS RESULTING FROM A DELIVERED
ELECTRIC STANDARD OR 50/50 ALLOCATION METHODOLOGY
COMPARED TO AN EMISSIONS-BASED STANDARD
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Muller and Nemet
4
September 2009
Identification of High Impact Policy Combinations
In this section we assemble combinations of policy details and external events into
scenarios—internally consistent descriptions of future policy states—and identify some
that are likely to have particularly high impacts on Wisconsin energy consumers. We
take the approach of scenario planning, a useful tool in decision analysis for preparing to
deal with high impact events when the likelihood of them occurring is unknown. The
goal is not to assign probabilities to scenarios, but rather to explore an illustrative set of
high impact configurations of policy mechanisms. Scenario planning also allows us to
look further into the future of climate policy and contemplate some of its longer-term
dynamics.
It is our assessment that some high impact scenarios originate from the policy details
themselves, while others are triggered by events that are external to the design of climate
change policy. These latter shocks may be exacerbated or absorbed by policy design
features. In addition, we expect that high impact scenarios may create feedbacks between
policy mechanisms and external forces. In the final analysis, consumer impacts will
always result from multiple causes because in our estimation no single KPM can
overpower all other policy design choices.
4.1
High Impact Scenarios Rooted in Policy
Scenario analysis is particularly appropriate for grappling with climate change mitigation
policy because all high impact scenarios result from the alignment of at least two major
mechanisms. It is clear that external drivers can also either diminish or heighten the
impact of potential crises. Before exploring some particular scenarios, it should be noted
that high impact scenarios are all contingent upon the political sustainability of a cap and
trade system. If society is willing to scrap the program or weaken it fundamentally by
giving up on firm caps, then consumer impacts will always be muted and the risk of
climate warming-related damages will rise. As a result, a safety valve or price collar
plays a special role in the creation of high impact scenarios because the implementation
of price controls shifts the nature of the policy away from a quantity-based system.
Similarly, the credibility of targets is a very important factor in the cost of climate
change. If long term targets can be weakened and aggressive reductions delayed, then the
cap is no longer firm, though that loosening of the cap may be closely managed rather
than triggered by a panicked response to the price of allowances in the secondary market.
Aggressive, credible targets spur research, development and demonstration projects.
Without targets decades in the future, the environment for innovation would be
dampened and the market would simply think in terms of the targets elucidated. The
expectation of a long-term, ongoing GHG constraint is a crucial dimension of a
fundamentally firm cap.
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Muller and Nemet
4.1.1
September 2009
Few International Offsets
The absence of a large number of international offsets could be the result of a policy
constraint or a problem in the market for the offsets. Policy makers could choose to
constrain the amount of international offsets allowed for compliance. This decision
might be part of a deal to achieve an international climate policy agreement. Another
path that could lead to a dearth of offsets is one in which regulators respond to offset
legitimacy concerns by creating rules that limit the number of offsets available in the
process of protecting the quality of those emission reduction credits that are created.
Alternatively, rules could be drawn up that are insufficiently tight, leading to the
possibility of scandal, lawsuits, and a cloud of corruption hanging over the international
offset market. The market for international offsets could also be responsible for a
shortage of inexpensive abatement. Lenient rules in the other capped countries could
introduce so much demand into the market for these offsets that supply is strained. The
possibility for corruption and mismanagement also could easily arise from a kind of
boom in the offset market after the establishment of a new international climate
agreement.
For conditions related to one key policy mechanism to generate a high impact scenario,
other plausible circumstances must make a contribution. If the loss of international
offsets is essentially a loss of a low-cost abatement option, then constrained availability
of other low cost abatement options will exacerbate the situation. Treating energy
efficiency as a low-cost resource, a scenario with sluggish spending on energy efficiency
and/or a recognition that efficiency potential is less available or more expensive could
further reduce the economy’s likelihood of meeting targets at a modest cost to consumers.
Weakness in pursuing energy efficiency goals would also leave covered entities more
susceptible to higher prices brought about by strong economic growth.
Over time, the lack of a low-cost abatement option outside of domestic capped sectors
means that covered entities will be able to bank fewer allowances. They will use freely
allocated allowances for compliance if offsets are less available, leaving themselves with
less cushion and fewer options as caps tighten. As the perception of more difficult future
compliance takes hold, the allowance price in the present may rise further if unlimited
banking drives firms into the secondary market to purchase allowances with the
expectation that they will become more expensive in the future.
However, the lack of a large number of international offsets need not create a high impact
scenario. Compounding factors such as weak energy efficiency gains and high economic
growth do not seem inherently linked to a crisis in the supply of international offsets.
Policy makers could try to adapt by allowing more domestic offsets and using a strategic
reserve mechanism to borrow allowances wholesale from future compliance years.
4.1.2
Decline in Free Allocation of Allowance Value
Free allocation of allowances to electricity and gas distribution companies is a key way
that cap and trade policy designers can protect Wisconsin consumers. Whether by virtue
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Muller and Nemet
September 2009
of statutory language or state regulatory edict, the allowance value from free allocations
can aid consumers rather than enriching utility shareholders. On its face, the decline in
free allocation appears to be related to the increase of auctioning as the mode of
periodically transferring allowances to the public. However, the real issue is the
distribution of allowance value, whether it is through free allocation or revenue recycling.
As free allocation is phased out, there may be a temptation to use auction revenue for
purposes unrelated to the welfare of current utility consumers. Given the fiscal position
of the United States, it is easy to imagine the diversion of funds to deficit reduction. It
also possible that wartime expenditure desires could create political pressure to dip into
emission allowance auction revenue. If so, utility consumers could be faced with rapidly
increasing costs.
It is also possible that a decline in the transfer of allowance value to consumers could
coincide with acceleration in the decline of emission caps. In the same timeframe, the
economy could be confronted with the difficulty of reducing emissions from coal-fired
baseload power plants at a reasonable cost. A tight or very volatile natural gas market
could further undermine the challenge of coal-fired power plant emissions by raising
barriers against investment in fuel switching. Stubbornly high transportation sector
emissions could also put pressure on the price in the allowance market once more
aggressive, intermediate emission targets are approaching. Linked to the process of
constrained abatement options is the possibility that the Wisconsin Public Service
Commission could play a decisive role in a period of rising costs and persistent
uncertainty. Similar to the previous scenario, low availability of offsets, weak progress in
lowering the energy intensity of the economy, and/or high economic growth could
exacerbate the consumer cost resulting from the cap and trade system.
Policy makers and consumer advocates could help to prevent this high impact scenario by
propagating the notion of allowance value. If public debate draws a firm distinction
between auctioning and allocation rather than equating revenue recycling and allowance
value distribution, then political support for lump-sum revenue recycling (or other ways
of returning auction value to the public) could be flimsier. It is also possible that the axis
of this debate will be whether or not free allocation is phased out at all. Then political
discussions will need to determine what sectors continue to deserve free allocation as the
emissions cap declines. Solidifying the notion of allowance value could contribute to
insulating the cap and trade system from the demands of other public priorities, as the
Highway Trust Fund has for road maintenance and construction.
4.2
High Impact Scenarios from External Events
Particular kinds of external shocks could disrupt a smoothly functioning cap and trade
system and create important impacts for utility consumers. External shocks could
exacerbate the scenarios painted in the previous section, but we have chosen to treat them
separately because they raise somewhat different issues than scenarios that are identified
with offset supply or the distribution of allowance value. By their nature, external shocks
test the resiliency of the policy design, but those we highlight here strike at the scientific
and technological underpinnings of successful climate change mitigation policy.
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Muller and Nemet
4.2.1
September 2009
Shock in the Public Perception of Global Warming
The costs associated with a cap and trade mechanism could spike and possibly remain
high in response to a climate perception shock. The development of consensus on
understanding aspects of the climate system is a slow discursive process. There is no
reason to believe that one headline from the scientific community will change broad
social perceptions of the dangers of climate change. Another factor limiting the type of
event that could catalyze a climate shock is that the effects expected to unfold in a
warming world differ across geographical regions. If warming temperatures catalyze
both heavy precipitation and drought, then a cohesive cultural signal of dangerous
climate change may not translate in a way that shifts policy and market expectations
quickly. However, a future event like Hurricane Katrina that the public broadly
attributes to a warming climate could have a traumatic effect that could rapidly change
policy options and radically alter market expectations of the level and pace of needed
mitigation.
The main policy mechanism through which a climate shock would be translated is the
stringency of the cap. A climate shock would also put enormous pressure on policy
makers to abandon a safety valve if one were in place. A climate shock could not only
press legislators to revisit not only the level of emissions caps, but also the time path of
reductions. Quicker reductions would almost certainly mean significantly more
expensive abatement. In addition, a climate shock might lead to a discussion of whether
later year targets are sufficiently tight and if they should be moved forward. If some
scientific observers believe that GHG emissions must ultimately be phased out entirely,
then their voices could become more credible after a climate shock.
Beyond the changes in targets themselves, shifts in market expectations of future
abatement targets could drive up prices of allowances to be banked for future use. The
status of banked allowances held by entities across the economy could become uncertain
if the total quantity of emissions allowed over the program period were to be reduced.18
Pressure to achieve very aggressive energy efficiency and zero-carbon baseload
deployment would intensify. At bottom, if anthropogenic climate change were broadly
viewed as the culprit of a major event that harmed the health and welfare of a large
number of people, then the policy landscape would be likely to shift overnight.
Consumer costs for adjustment to a carbon-constrained economy could increase in
tandem.
Though it could be non-binding, instituting a mechanism—like a discretionary advisory
board—with the authority to buy allowances from the market in order to support the
allowance price could pave the way for the withdrawal of allowances in response to a
climate shock.
18
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Muller and Nemet
4.2.2
September 2009
Nuclear Accident
The problem of the need for low or zero-carbon baseload electric generation in a carbonconstrained world raises the possibility that a new fleet of nuclear power plants will be
built to address the supply side of GHG emission reduction. The previous round of
nuclear plant construction floundered after high costs, long construction delays, and fears
about the safety of the plants and their radioactive waste produced intense public
opposition. Though social acceptance of nuclear power may have rebounded somewhat,
an accident sufficiently bad that it leads to human health impacts and the perception of a
dangerous release of radioactive material could halt the rebirth of the industry
(Ansolabehere 2007). If nuclear power is taken off the table as a major part of the energy
solution to a carbon-constrained economy, then that puts a great deal of pressure on the
deployment of natural gas baseload, renewables, and carbon capture with sequestration.
A nuclear accident in the US is also likely to dampen enthusiasm for nuclear abroad,
increasing the difficulty of complying with aggressive mitigation targets in multiple highemission countries.
Direct consumer impacts in Wisconsin could be somewhat limited if an accident were to
happen before the state makes any moves toward building new nuclear facilities.
However, consumers could be burdened if the existing nuclear facilities in Wisconsin are
retired early due to public fear in the wake of an accident. Replacing two gigawatts of
zero-carbon baseload in a carbon-constrained world could be an expensive project.
Wisconsin consumers would be saddled with cost hikes related to higher emission
allowances. Allowances prices would likely factor in the greater difficulty of meeting
future emission caps without the benefit of new nuclear power (and the possibility that
the licenses of other older plants would not be renewed). Similar to other scenarios, a
lack of available offsets and limited progress on energy efficiency could exacerbate the
economic challenges in the wake of a curtailed nuclear renascence. In terms of electric
supply, a failure to deploy CCS at a reasonable cost would remove the two conventional
zero-carbon baseload options, potentially threatening the political sustainability of
aggressive emission reduction targets. High gas prices would worsen the cost picture
further.
TABLE 6 STRONG POLICY DRIVERS INFLUENCING COSTS OF CLIMATE
POLICY
Strong Policy Drivers
Cap Stringency
Int’l. Offsets
Safety Valve
Banking
Disposition of
Allowance Value
Energy Efficiency
Core Issues
Without challenging caps, compliance is easy, allowance
prices low, and cost containment irrelevant
Potential large pool of inexpensive abatement options outside
capped sectors
Hard cost constraint, may not coexist with firm cap
Allows for pricing of future compliance risks
Permits policy designers to protect vulnerable groups,
including low-income consumers
Higher business as usual energy demand requires more costly
abatement
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Muller and Nemet
September 2009
TABLE 7 STRONG EXTERNAL DRIVERS OF COSTS OF CLIMATE CHANGE
MITIGATION POLICY
Strong External Drivers
Population and Economic
Growth
Climate Science
Fuel Prices
Low, Zero Carbon
Baseload
Transport Emissions
International Action
PSC Decisions
Key Issues
Higher growth drives up baseline emissions, requires more
actual abatement
Drives broad policy framework, including level and timepath of caps; public perception is crucial
Oil and gas prices open/constrain options and influence
conservation behavior
Limited options to replace coal and eventually gas, notion
of baseload may not survive
Major reductions could relieve pressure on electric sector
Impacts sustainability of policy and availability of offsets
Influences generation and mitigation decisions that directly
impact Wisconsin consumers
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Muller and Nemet
5
September 2009
Conclusion
Several policy mechanisms examined in this paper could significantly influence the costs
of climate policy faced by Wisconsin consumers. In particular, the stringency of the cap,
the use of international offsets, explicit cost containment mechanisms, banking, and the
distribution of allowance value generate notable cost impacts. However, no single key
policy mechanism is likely to drive up costs if other implementation details are used to
constrain its effect. Various combinations of policy mechanism—such as tight emission
caps, constrained offsets, and a distribution of allowance value that does not protect
consumers—could amplify the effects of a cap and trade program on Wisconsinites. In
addition, various external cost drivers can dampen or exacerbate cost impacts. The most
high impact scenarios for utility consumers link combinations of costly policy choices
with external drivers like robust economic growth, limited low- and zero-carbon electric
generation options, and a high level of transportation sector emissions. In its current
form, the Waxman-Markey bill makes several policy choices to attempt to contain costs,
though it is quite possible that the external drivers noted in this report could strain the
cost containment mechanisms of a well-designed bill. In this sense, cost conscious policy
design choices—like climate policy itself—should be seen as insurance against
catastrophic damages.
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Muller and Nemet
6
September 2009
Appendix: Table of KPM Values in Proposals Evaluated
Cap
Stringency
in 2018,
Intermediate
GHG Target
14% below
2005 by 2018
Total
Offsets,
2018
Domestic,
International
Offset Rules,
2018
Safety Valve,
Cost
Containment
Entity
Emission
Allowance
Revenue
Recycling
Energy
Efficiency
Resource
Standard
Renewable
Portfolio
Standard
Borrowing,
Compliance
Period
Emission
Allowance
Auctioning
in 2018
Allowance
Distribution
Methodology
2 billion
tons worth
of offsets
per year
Up to 1
billion tons
domestic, 1.5
billion tons
international
if domestic
supply fails
Strategic
Allowance
Reserve
15% via
energy tax
refund or
monthly
energy
refund
5-8% in
combination
with RPS
by 2020
12-15% by
2020
One year
free
borrowing,
max. 5 years
forward
15% and
increasing
B. Van
Hollen Cap
and
Dividend
H.R. 1862
16% below
2005 in 2018
NVS
NVS
Strategic
Allowance
Reserve
NVS
NVS
NVS
100%
C. BoxerLiebermanWarner
S. 3036
5,137
MMtCO2e,
14% below
2005 levels
in 2018 for
covered
sectors
Up to 30%
Up to 15%
each for
domestic,
international
offsets
Discretionary
Advisory
Board
100% of
auction
proceeds
and
penalties
refunded
No direct
rebates,
18% to
Energy
Assistance
Fund for
energy
consumers
50% based on
3 years of
emissions,
1999-2008,
50% by
delivered
kWh with
baseline
reviews
No allocation
NVS
NVS
Max. 5
years
forward
33.5% and
increasing
D.
LiebermanWarner
S. 2191
4,624
MMtCO2e,
14% below
2005 levels
in 2018 for
covered
sectors
Up to 30%
Up to 15%
each for
domestic,
international
offsets
Discretionary
Advisory
Board
No direct
rebates,
some low
income
assistance
NVS
NVS
Max. 5
years
forward
33% and
increasing
A.
WaxmanMarkey
H.R. 2454
- 69 -
Allocation
based on
kWh/gas
delivered in
previous 3
years with
adjustment
for consumer
energy
efficiency
Same as S
3036, but no
provision for
gas
Muller and Nemet
September 2009
Cap
Stringency
in 2018,
Intermediate
GHG Target
6,130
MMtCO2e,
1% below
2005 levels
in 2018 for
covered
sectors
Total
Offsets,
2018
Domestic,
International
Offset Rules,
2018
Safety Valve,
Cost
Containment
Entity
Emission
Allowance
Revenue
Recycling
Energy
Efficiency
Resource
Standard
Renewable
Portfolio
Standard
Borrowing,
Compliance
Period
Emission
Allowance
Auctioning
in 2018
Allowance
Distribution
Methodology
Up to 30%
No Policy
Unspecified,
via Climate
Change
Credit
Corporation
NVS
NVS
Max. 5
years
forward
NVS
F.
BingamanSpecter
S. 1766
6,301
MMtCO2e,
2005 levels
in 2018,
though not a
binding cap
Unlimited
from
specific
domestic
categories
Limit rises
from 15% to
30% after
1.5%
agricultural
sequestration
offset
purchase
Only 10% of
compliance
via
international
offsets
Safety Valve
Set in Bill
(TAP)
No direct
rebates, 4%
for energy
assistance
NVS
NVS
NVS
Max. 28%,
increasing
annually
Point source
allocation
specified,
implicitly
suggests
emissions
basis for
allocation
Emissions
basis for
allocation:
“carbon
content
allocation
factor”
G. KerrySnowe
S. 485
12% below
2005 levels
in 2018
NVS
NVS
No Policy
NVS, via
Climate Reinvestment
Fund
6.75% less
electric use
by 2018
(8.75%
lower peak
demand)
15% in
years
2016-2020
NVS
NVS
Transition
assistance
based on
region a
stated goal,
but no
specific
allocation
basis
H. SandersBoxer
S. 309
12% below
2005 levels
in 2018,
without
technologybased price
cap
NVS
NVS
Price Cap
based on
Available
Technology
NVS
6.75% less
electric use
by 2018
(8.75%
lower peak
demand)
15% in
years
2016-2020
NVS
NVS
No reference
to allocation
basis
E.
LiebermanMcCain
S. 280
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Muller and Nemet
September 2009
Cap
Stringency
in 2018,
Intermediate
GHG Target
6,150
MMtCO2e,
10% below
2005 levels
in 2018
Total
Offsets,
2018
Domestic,
International
Offset Rules,
2018
Safety Valve,
Cost
Containment
Entity
Emission
Allowance
Revenue
Recycling
Energy
Efficiency
Resource
Standard
Renewable
Portfolio
Standard
Borrowing,
Compliance
Period
Emission
Allowance
Auctioning
in 2018
Allowance
Distribution
Methodology
Up to 15%
No division
specified
between
domestic,
international
offsets
No Policy
Unspecified
via Climate
Change
Credit
Corporation
NVS
NVS
Max. 5
years
forward,
with
contracted,
permitted
project in
place
NVS
Delegates
allocation
decisions to
the EPA
J. Waxman
H.R. 1590
12% below
2005 levels
in 2018
NVS
NVS
No Policy
NVS, via
Climate Reinvestment
Fund
7.5%
electric
demand
reduction
by 2018
20% by
2020
NVS
NVS
K. Markey
H.R. 6186
5,186
MMtCO2e,
16% below
2005 levels
in 2018
6,043
MMtCO2e,
1% below
2005 levels
in 2018
Up to 30%
Up to 15%
each for
domestic,
international
offsets
No division
specified
between
domestic,
international
offsets
No Policy
7.5% of
revenue to
Climate
Rebate Fund
NVS
NVS
Max. 5
years
forward
95%
Strategic
Allowance
Reserve
0-50% via
Consumer
Climate
Change
Rebate
NVS
NVS
Max. 5
years
forward
Lowest: Up
to 43.25%;
Highest:
100%
8% below
2005 levels
in 2018
3.3% to
10%,
depending
on
allowance
price
No
international
offsets until
price trigger
is tripped
Allowance
price triggers
cost
containment
By
jurisdiction:
e.g., MA:
revenue for
energy
efficiency
NVS
NVS
3 (or 4) year
compliance
period
(price
trigger may
extend)
100%
Transition
assistance
based on
region, but no
specific
allocation
basis
Allocation
only for
“tradeexposed”
industries
Emissions
based
allocation:
utilities
choose a 3
year period,
1997-2007 as
baseline
No allocation
I. OlverGilchrest
H.R. 620
L. DingellBoucher
Discussion
Draft
M.
Regional
Greenhouse
Gas
Initiative
Up to 15%
- 71 -
Muller and Nemet
September 2009
Cap
Stringency
in 2018,
Intermediate
GHG Target
10% below
2005 by 2018
Total
Offsets,
2018
Domestic,
International
Offset Rules,
2018
Safety Valve,
Cost
Containment
Entity
Emission
Allowance
Revenue
Recycling
Energy
Efficiency
Resource
Standard
Renewable
Portfolio
Standard
Borrowing,
Compliance
Period
Emission
Allowance
Auctioning
in 2018
Allowance
Distribution
Methodology
Up to 6.5%
of
compliance
obligation
No division
specified
between
domestic,
international
offsets
No Policy
No specified
level of
consumer
rebates
Reduction
of 1% in
demand
growth of
electricity
and gas
NVS
3 year
compliance
period
Minimum
20% with
intention for
higher
percentage
O. Midwest
Greenhouse
Gas
Reduction
Accord
13% below
2005 levels
in 2018
Up to 20%
Discretionary
board,
allowance
price triggers
soft price
collar
10% by
2015, 20%
by 2020
Max. 2
years
beyond 3
year
compliance
period
18% below
2005 levels
by 2018
Up to 15%
Explicit
allowance
value
framework,
protection to
households,
industry
No specified
level of
consumer
rebates
2%/year
beginning
in 2015:
electric/gas
P. Union of
Concerned
Scientists:
Climate
2030
Blueprint
No
international
offsets now;
by 2018,
some CDM
may be
available
Up to 10%
via domestic
offsets, 5%
via
international
offsets
40% by
2030
Max. 3
years
forward
Q.
Wisconsin
Global
Warming
Task Force
NVS:
regional cap
preferred via
MGGRA
NVS
NVS
Price Cap to
protect
against price
spikes
Electric:
10% by
2020, then
1%/year;
Gas: 5% by
2020, then
.5%/year
Electric:
Rising to
2%/year in
2015; Gas:
Rising to
1%/year in
2015
Mix of
free/fee with
auction for
3
compliance
periods,
then 100%
100%
Allocation
left to each
jurisdiction,
no
specification
of allocation
basis
Emissions
based
allocation
Enhanced
RPS: 25%
by 2025
3 year
compliance
period
N. Western
Climate
Initiative
- 72 -
No Policy
Advocates
for revenue
to be
recycled to
Wisconsin
residents
and
businesses
NVS:
Allowance
fee for
utilities and
industry,
auction
increase
No allocation
Implicitly
supports
emissions
based
allocation
Muller and Nemet
7
September 2009
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