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RGGI Still Falls Short of Real Carbon Pricing

Last February, The Regional Greenhouse Gas Initiative (RGGI) announced changes to its rules (known as “The Model Rule”). The most significant change was the lowering of the system’s cap 45% in 2014 to 91 million tons per year in 2014. The cap will steadily decrease at 2.5% per annum thereafter. Other changes included measures for dealing with excess bank permits, minor changes to offset provisions, price triggers for the cost containment reserve (CCR), and the ability to retire unsold permits.

RGGI’s design changes have received wide praise, and have even been called a model for the beleaguered European Emissions Trading System. RGGI’s designers deserve credit for responding to the oversupply of credits in the system, but the reforms fall short of creating the critical feature of any successful emissions trading system—a strong carbon price.

This post discusses how RGGI’s new cap not only falls short of creating real price pressures due to its closeness to baseline emissions, its excessive compensatory measures, and its failure to deal with leakage, but also runs the risk of locking in emissions for the long run and diluting the calls for real action.   

Best Fitting the Cap to the Baseline Scenario

Like the EU-ETS, RGGI was over-allocated from its inception. The 45% drop in RGGI’s cap is merely a correction for its over-allocation. The extent of the over-allocation can be clearly seen in Chart 1, which shows actua1 2012 emissions against the 2012 cap.

Chart 1

Chart 1

Chart 1 further shows RGGI’s own reference, high and low emissions baseline scenarios for the 2012 to 2020 period. One can see at a glance the drastic over-allocation of the pre-adjusted cap. The adjustment and removal of banked permits were critical—not in order to strengthen to the system, but simply to make it function by eliminating the 180% over-allocation.


Price Pressure

In looking at the price pressure created by the system, we will start by examining RGGI’s baseline emissions assumptions. Each scenario displayed in Chart 1 above represents different baseline scenarios for power demand, gas pricing, and power generation.

Table 1 below, taken from RGGI, shows how the high and low baselines have been adjusted from the reference scenario. From the table, it is easy to see that some factors, such as the closures of nuclear power generation, will be influenced by local political decisions. Other factors, such as weather and gas price, are beyond local control. 

Table 1 (from RGGI)

Table 1

 
 
 
 
 
 
 
 
 
 
 
 
It is worth noting that the reference and high cases above assume the timely retirement of Entergy’s Vermont Yankee Nuclear Power Plant and Indian Point 1 and 2 reactors in 2013 and 2015 respectively. Indian Point 1 and 2 and Vermont Yankee generate about 16.4 TWh per year, or 4-5% of RGGI’s total demand. Note that as nuclear power plants are zero emissions sources a replacement of the nuclear generation even with natural gas generation would represent a significant increase in RGGI’s emissions trajectory.

Nuclear plants in the United States are not required to cease operation on the expiration of their licenses if a request for license renewal has been submitted. Entergy applied to renew the operating license of both its Vermont Yankee and Indian Point plants in 2007. At this point, the retirement of the Indian Point plant is far from certain. Vermont Yankee has not only applied for, but been granted a license extension until 2023. The Vermont Senate protested the NRC’s extension, but two court rulings have found in in favor of Vermont Yankee’s continued operation. Entergy itself correctly noted in its stakeholder comments to RGGI that the elimination of the nuclear plants is an appropriate assumption for the high emissions baseline scenario, but too aggressive an assumption for the reference scenario that has resulted in upwardly skewed emissions trajectories.

It is further worth noting that the pricing scenarios in the model came from EIA’s 2012 Annual Energy Outlook. Due to changed projections from the hydraulic fracturing boom, EIA, in its 2013 Outlook, has significantly cut it its estimates for the price of gas.

Chart 2 depicts the sensitivity of emissions trajectories to small changes in pricing assumptions. By regressing the natural gas prices used in constructing the emissions projections for RGGI’s low and reference baseline scenarios, it is possible to crudely approximate the influence of gas prices in RGGI’s emissions model and plot new trajectories based on the EIA’s 2013 Short Term Energy Outlook for 2013-2014 and Long Term Energy Outlook for 2015-2020. The redone numbers also give an impression of what a ‘reference case’ without the nuclear retirement would look like. Note that the comparison is not perfect—the recalibrated ‘no retirement’ scenario still represents a lower demand scenario than the ‘retirement’ scenario.    

Chart 2

Chart 2

 

In the scenario “EIA 2013, Nuke Retirement,” total emissions reductions for the third commitment period from 2014-2020 would be 32 million tons. In the “EIA 2013, No Nuke Retirement” scenario, the cap would exceed actual emissions for the commitment period by 12 million tons.

Emission Reductions Forbearance

Going back to Chart 1, emissions are below the cap in the low scenario. Only in the reference and high scenarios would some reductions have to take place in order to meet the requirements of the revised cap.

But RGGI has designed emission reduction forbearance into the system in the event of a high emissions scenario through the creation of its Cost Containment Reserve (CCR). The CCR allows additional offsets to be released into the system when certain carbon price levels are achieved in specific years. The price triggers are $US 4 in 2014, $US 6 in 2015, $US 8 in 2016, and $US 10 in 2017. Starting in 2018, the price trigger will increase at 2.5% per annum, roughly in tandem with inflation. The CCR will release 5 million additional carbon dioxide allowances in 2014 and 10 million tons each year thereafter.

The sheer size of the CCR—10% to 13% of the cap in any given year—and the low prices at which it will trigger make it unlikely that the system will ever come under price pressure. In comparison to the EU-ETS, RGGI deserves credit for amending systemic over allocation by dropping its cap and sterilizing banked allowances. But it should be noted that RGGI’s reformed system is designed so that maximum achievable prices—between $US 4 and $US 10—are at a level that the proponents of the EU-ETS consider to be a price collapse and too low to drive emission reductions. 

Chart 3

Chart 3

In addition to the CCR, RGGI-compliant entities can use offsets for 3.3% of their compliance cap. The effect of the inclusion of both offsets and the CCR is that RGGI’s total cap has the potential to be expanded by 14%. Chart 3 shows the potential effect of the CCR and offsets on the cap and their potential to shrink total required emissions reductions from the reference scenario to a mere 23 million tons during total the 2014-2020 compliance period of the program.                     

Of course, not one of the baseline scenarios above reflects what will actually occur. Each scenario shows a specific set of conditions, low or high demand and prices, remaining constant over the seven-year span of the third RGGI commitment period. It is unlikely that the CCR will be utilized in every year, as depicted in the outwardly expanded CCR horizons in Chart 3. In reality, price and demand conditions will change from year to year, with actual emissions representing some combination of the scenarios above, resulting in CCR release in some years and banking in others. But the point is that there is a very high probability that emissions scenarios will net out very close to the cap and that ample price relief will be triggered in the event that they don’t.

Whither Carbon Pricing?

Economists and investors call the process by which a market determines a price ‘discovery’, a word choice that confers an aura of objectivity on the price in question. As though the true price existed in the manner of True North, unfettered by human influence, its intrinsic properties revealed through scientific inquiry.      

Pricing is, of course, subjective. Opponents of environmental markets often charge that they are artificial, devoid of natural demand, and unduly influenced by government regulation. But all prices—or their absence—are a concrete translation of the non-material values of society. From the prices of our food, to our energy supplies, our transportation and infrastructure choices, the amount we pay for healthcare, our cell phones and financial services, our preference or willingness to pay more for expensive brand—all are informed by the ethical choices of policy makers or an individual’s subjective beliefs about quality or image. Carbon prices are not unique in that that they are influenced by design.

The legitimacy and level of carbon pricing has two primary theoretical underpinnings: pricing of marginal abatement costs and pricing of environmental damages.

In plain English, abatement costs are the amount of money that would have to be invested to achieve a given level of emissions reductions. Target abatement prices are set at the per-ton carbon price at which a polluting technology is no longer competitive with its cleaner alternative. 

The second methodology for carbon pricing—the social cost of carbon—measures the social damages caused by increased levels of carbon dioxide in the atmosphere. In this methodology, the per-ton carbon prices are meant to reflect the marginal social cost implied in the emission of a ton of carbon if one were to add up cumulative impacts of climate change damage such sea-level rise, crop failure, species loss, disease, etc.

Estimates of abatement costs and marginal damages are, by nature, theoretical. Approximation through either method requires the modeler to carefully select limited parameters from a vast possible list and then make judgment calls on the quantification and weight of the selected parameters. Results inevitably reflect the subjective ideas of the modeler as much as the actual situation. Thusly flawed, the numbers still serve as a useful starting point for a conversation, a way to begin to think about whether the prices in our policies will accomplish what we pretend they will.

So what are some guidelines for setting the right price in an emissions pricing system? William Cline of the Peterson Institute uses two models—one created by the Energy Modeling Forum’s (EMF) survey of integrated assessment models (Clarke et al, 2009) and one from the William Nordhaus’s 2010 Regional Integrated Model of Climate and the Economy (RICE) to evaluate the marginal abatement costs to different economies at a 450 ppm scenario.

Cline assumes all countries making cuts to their baseline emissions arrive at average emissions of 1.4 tons of carbon dioxide per person per year. Cuts are moderate in early years and then become steeper after 2013, accounting for the steep uptick in prices after 2020.

The prices given by each abatement model for the respective years of 2020 and 2050 are, in 2005 dollars—$US 12 and $US 58 per ton in the RICE Model, and $US 83 and $US 166 per ton in the EMF model. 

Estimates for the marginal damages caused by carbon dioxide vary just as widely. The U.K. Government’s 2007 Stern Review put current marginal social damages from climate change at $US 85 per ton of carbon dioxide. In 2010, The U.S. Government, estimating marginal social damages for the first time, put the number at $US 21 per ton of carbon dioxide. The U.S. government’s number was widely criticized (also see here, here, and here) for being too low and discounting critical aspects of climate change damages. At the time the U.S. government released its carbon price for marginal social damages, Scientific American quoted one EPA official as saying, “If $US 21 a ton actually drove policy, where would we end up? Well, we’d end up with a whole lot more warming…$US 21 a ton doesn’t really justify much.”

And RGGI?

As of April 12, RGGI allowances were at $US 3.35 per short ton of carbon dioxide[1], a price that already anticipates the 2014 drop in the cap. Prior to the announcement of Model Rule reform, allowances traded at the $US 1.86 floor.

To state the obvious, RGGI’s price levels clearly signal that the intent of the program is neither to drive an energy transition nor to price in the marginal damages caused by the region’s pollutants. More likely, the system is designed to raise revenue with a carbon surcharge, but not drive emission reduction directly. And raise revenue it has. RGGI’s last auction on March 13th raised $US 105.9 million.

Even if RGGI’s price does pick up, the size of the cost containment reserve will be sufficient to ensure that it will not go above $US 4 a ton in the early years and $US 10.75 in the final year of the program.

Price Pressure?

What can $US 4 to $US 10.75 do to drive emission reductions? Estimates for the per-ton carbon price for driving a renewable energy transition often start at around $US 50 per ton. RGGI is nowhere in the ballpark and won’t be any time soon. 

While RGGI’s prices do cover low-hanging fruit on the marginal cost curve such as energy efficiency projects, typically these types of projects are already profitable. The additional incentive of a $US 4 or $US 10 carbon price does nothing to push along a profitable project that is lying fallow for non-financial reasons.

RGGI has neatly dealt with this problem by using revenue from its auctions to directly finance energy efficiency projects through the investments of more than 50% of the program’s revenue into rebates and grants for residential and large-scale industrial energy efficiency projects. These investments have gained RGGI an estimated 27 TWh of energy efficiency since the start of the program. The program is effective and financed by carbon revenue, but its emission reductions are not the result of a carbon price. 

Gas Switching

The conventional wisdom is that RGGI’s drastic emission cuts have and will be met through gas switching, a narrative that merits examining. The solid lines in Charts 4, 5, and 6 are the EIA regional estimates for RGGI states for prices paid by power plants per MMBTU for gas and per 1.2 MMBTU for coal. Note that coal has been rescaled due to its higher heat rate to allow for equivalent pricing of gas on an output basis.

Image

The dotted lines in the charts represent price trajectories for each fuel with a carbon price built in, with the longer dashes representing the carbon prices projected by RGGI for the reference case scenario under the proposed 91 million ton cap, and the shorter dashes representing the maximum possible carbon price, as bounded by the CCR. 

Charts 4, 5, and 6 show that, with the exception of the New England Region, coal is still cheaper than gas even at the highest possible carbon price achieved under RGGI. In the New England Region the increment by which coal prices are higher is still well within the margin of error for EIA price projections. 

The carbon price in RGGI is not set at a level to drive gas switching. Increased gas use will be driven by replacement of aging coal-fired power plants with gas plants. The replacement will be driven by the threat future of EPA regulation of newly built power plants and lower gas prices from hydro-fracturing. Gas switching is and will remain largely unaffected by RGGI pricing.

Chart 4

Chart 4

 
Chart 5
Chart 5Chart 6
 

Chart 6

Were it a more tightly allocated system with less cost containment, RGGI could have an effect on gas switching even at such a low allowance price because of the penalty for exceeding the cap. The carbon price shown in the Charts 5, 6, and 7 is the allowance price, different to the penalty for exceeding the cap (and CCR and offsets), which is triple the allowance price (known as “triple penalties”). A generator expecting high emissions for the compliance period would preventatively engage in gas switching to avoid being penalized for hitting the maximum.

However, in the event that emissions exceed the cap, or that operating under the maximum simply becomes expensive due to gas prices, generators have an even lower cost option for abatement than gas switching and paying the comparatively lower allowance cost, which is to import power and incur no allowance cost at all.

Backdoor Reductions

A quick look at RGGI’s own models for power demand within the RGGI region in 2020 in the baselines verses the capped scenarios reveals that most of the shift in power supply induced by the cap is expected to be an increase in uncapped imports. In both the capped and uncapped scenarios, net energy for regional demand holds constant at 393 TWh, but the generation mix used to achieve those TWh changes.

Chart 7

Chart 7Indeed, Chart 7 shows gas use going down in the capped verses the baseline scenario. Coal generation will also decrease. The difference will be made up by net imports from the non-RGGI units within the PJM and from Canada. RGGI, in short, will be exporting its emissions. 

Does it Matter?

RGGI’s defenders often acknowledge its faults while appealing to gradualism in defense of the program—prove out the program infrastructure first, bring in serious reductions later. Incremental changes will allow the public, politicians, and industry to get used to the idea and will avoid the chaos of precipitous change. A small price is better than no price at all. Unfortunately, the logic of incremental change doesn’t make sense given the short timelines needed for action on climate change.

A recently released IEA report came to the non-revelatory conclusion that renewable energy is developing at a rate too slow to curtail serious climate disruption and that stronger carbon pricing and climate change policies are needed. The reductions in U.S. emissions trajectories that are being driven by policies promoting efficiency and gas switching will not meet the 2020 Copenhagen targets of 17% reductions below 2005 levels. Additional policy measures will be needed to push the country towards the 83% trajectory pledged by 2050. RGGI provides policy measures at the state level without providing meaningful—or indeed any—downward pressure on emissions.   

The Wrong Trajectory

RGGI’s low carbon price is a missed opportunity to incentivize clean energy development. Despite additional regulation, replacements for retirements within the RGGI region will be met primarily with natural gas and increased imports. Renewable energy generation (defined as wind and solar) in the region is projected to grow to a mere 2% of the region’s output and stay behind national (and non-capped) averages for wind and solar.      

Natural gas is not enough. If the United States switched 100% of its power emissions to natural gas today, emissions would only be reduced from their present level by about 27% percent—far short of the 80% emission reductions required.

The Folly of Gradual Change

A policy favoring incremental change runs the risk of locking in incremental reductions and meeting short-term targets at the expense of the future. The broad statement often used by economists quoting discount rates that emission reductions now are more expensive than emission reductions in the future ignores the dynamics of investments.

Starting in 2014, RGGI’s cap is set to ratchet down at 2.5% per year until 2020. Were its cap to continue to decrease at 2.5% until 2050, it would imply a 60% reduction from current levels. Providing thesetargets were achieved without exporting emissions, cheap offsets, or dilution by the cost containment reserve (all counterfactual caveats), 60% would represent a respectable decrease, if still far short of the 83% targets. Legal adoption today of the 2.5% target until 2050 would significantly lower the attractiveness of a present day investment in new natural gas power plants with 30-year project lives.   

But the commitment period only runs until 2020, and new natural gas power plants will be the most economical option for meeting near-term emission reduction targets even if their construction will make the steeper cuts required in 2030 and beyond uneconomical.

RGGI’s caps are not unique in that they have been designed to track emissions trends in the near-term with ample escape hatches in the event of price pressure. To a greater or lesser degree, the over-allocated EU-ETS, the Australian CPRS, and China’s Copenhagen targets have all put a mantel of policy around existing emissions trends. The policy practices of setting loose emission reductions targets that run for short timespans, normally through 2020, makes many emitters willing to risk that a policy change will not price out their fossil fuels investments in the long run. The nascent history of emissions targets has given investors nothing but good reason to be confident.

In the United States, political action on climate change has been hampered by the lack of a groundswell in favor of carbon pricing. The pro-climate movement has not been equal to the industry pressure for inaction. RGGI’s founders deserve every credit for putting a carbon price in place despite formidable political barriers. But there is a danger that RGGI’s illusory progress will drain impetus for real change by hiding its weaknesses behind mechanisms that the public can neither understand nor protest. RGGI has made significant changes to its Model Rule, but structurally simple and politically complex reforms are still required to push the region’s emissions trajectories beyond the status quo.

 


[1] Note that for marginal damages and marginal abatements costs are given in metric tons. 1 short ton=1.1 metric tons.


Sieren Ernst's picture

Thank Sieren for the Post!

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Edward Kee's picture
Edward Kee on May 15, 2013 1:13 pm GMT

Excellent article – thanks for taking the time to research and write this!

Sieren Ernst's picture
Sieren Ernst on May 15, 2013 4:09 pm GMT

Dear Willem, 

Thank you for your comments. I absolutely agree that low-cost efficiency projects should be implemented to deal with the demand side of emissions. I also agree that there is a political perception that carbon pricing cannot be put in place in the near term due to depressed economic conditions. However, there are several fallacies in seeing carbon pricing as expensive. 

First, short-term negative impacts on vulnerable populations can be dealt with through a partial refund of the tax. Second, economic calculations of the depressive effects of steep carbon pricing often entirely discount the negative impacts of fossil fuel extraction including the costs to the economy of immediate local health effects (see here for a report on the economic burden of asthma alone), tangible negative impacts of climate change, and stimulatory effects of the emergence of new industries investment needed for a clean energy transition.  

Kind regards, 

Sieren

 

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