"Cap and Innovate" for Electric Utilities

The Kerry-Graham-Lieberman bill is expected to be released in the coming weeks. [Ed. note: The draft legislation was released on May 12.] It is a very important step forward in the climate debate. We need federal action on climate legislation now. And we need to get it right.

I write from the perspective of a state utility regulator in Colorado. With a 30 percent renewable energy standard, enlightened resource planning, rigorous energy efficiency programs, and smart grid and smart pricing, we are making major strides on carbon reduction.

The main conundrum of climate politics is that relatively low, constrained carbon prices may not produce sufficient incentives for firms to innovate. But relatively high carbon prices can be politically unacceptable and invite consumer backlash. Where is the right balance?

I propose a hybrid approach to carbon regulation within the electric sector that I call "cap and innovate." This approach will keep electricity prices affordable while reducing carbon emissions and sparking the innovation essential to making deep carbon cuts over the next forty years.

Allowances to Consumers Through Regulated Utilities

State utility regulators already know how to reduce emissions using a cap-and-trade mechanism: the successful experience of the acid rain program in the early 1990s. In this program, sulfur dioxide (SO2) allowances were allocated at no cost to utilities, traded among the recipients and then retired for compliance. As the number of allowances fell each year, so did SO2 emissions. The program was a great success: emissions were reduced more quickly and at less cost than anyone predicted.

A similar approach should be applied to carbon regulation in the electric sector.

Using a baseline level of emissions, allowances should be allocated at no cost to regulated utilities. The number of allowances should be reduced over time, lowering the total carbon emissions allowed for the sector and forcing technological innovation. In a familiar exercise that occurs routinely now, state utility commissions will oversee this process, making sure that the value of allowances are protected and benefits flow to consumers. Such oversight will ensure there are no windfall profits.

Electricity prices will start out near today’s levels and then gradually increase over time as carbon is reduced. Importantly, this gradual introduction will allow consumers time to adjust to changing prices and address the fundamental conundrum I discussed earlier. It is an even-handed approach that channels the value of allowances back to utilities to fund emission reductions.

The competing approach is to auction allowances at the start of the market. This will raise rates immediately and create a large pool of funds, perhaps $50 billion in the first year. If these revenues are given to consumers in the form of a dividend check, emitters will have paid for allowances without producing any of the needed innovations. Utilities will have to spend yet more money to meet compliance obligations.

Electric Sector Innovation

Meeting carbon goals for 2020 with today’s technologies will be difficult but possible. Progress beyond 2020 or 2030 requires major technological innovations, which will require significant funding for research and development.

We should stimulate this needed innovation with a thin "research tax" on carbon emissions within the electric sector, separate from the carbon allowance market. A fee of $4 per metric ton on carbon dioxide (CO2) emissions would produce about $10 billion annually—an increase in U.S. electric rates of less than 3 percent. The proceeds should be dedicated initially to R&D on carbon capture and sequestration, renewable energy and energy storage technologies. Not quite a Manhattan project, but a seriously large amount of funding to produce the needed technological innovation. Research funding of this magnitude is especially important if allowance prices are constrained by a price collar, a feature rumored to be in the forthcoming legislation. [Ed.: A price collar is included. See the summary of the American Power Act in this issue of COAL POWER.]

Use Historic Emissions

Allocations should be based on historical emissions, otherwise unacceptable regional disparities will arise. Utilities with significant hydro, wind or nuclear generation will get allowances even though they have no compliance obligations for those resources. While this may be a boon to such utilities and their customers, it comes at the expense of other consumers. New legislation should reject the industry compromise that allocates allowances half on historic emissions and half on electricity sales. Nor should merchant generators, who have little rate oversight and, therefore, no mechanism to ensure customer benefit, be included in the allocations.

Trading Limits

The carbon trading market for the electric sector should be boring. The acid rain program efficiently and cost-effectively reduced SO2; it also had a fairly boring trading market. Allowance ownership and trading should be limited to utilities that receive allowances or those with a compliance obligation. Brokers will be needed for liquidity purposes but should not be allowed to trade for their own account. This should dampen the trading frenzy that some imagine for a new carbon market and keep speculation to a minimum.

Early Action Protection

The legislation should address "early action" taken by states prior to the effective date of the new law. If not, some states will be penalized for early action and all states will have the perverse incentive to wait to begin reducing carbon emissions until the bill takes effect. There is an easy "rough justice" solution that first appeared in the Dingell-Boucher bill a couple years ago: allocate emissions based on a suitable historic base period across regulated utilities.

Electric Vehicles

Finally, to enable the migration of small vehicle fleets to electric vehicles and plug-in hybrid electric vehicles, the electric sector must get credit (offsets) for the net reductions in carbon emission attributable to this migration.

"Cap and Innovate" is a common-sense approach that will efficiently reduce carbon emissions, be less disruptive to the economy, avoid regional disparities, and protect consumers and businesses. It is an efficient, cost-effective, consumer-friendly solution to our carbon conundrum.

— Ron Binz is chairman of the Colorado Public Utilities Commission and vice chairman of the Task Force on Climate Policy of the National Association of Regulatory Utility Commissioners. This commentary was originally published in The Energy Daily, a sister publication of COAL POWER.

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