Cap-and-Trade Success Requires Ratepayer Fairness in Distribution of Emission Allowances

by Dan Watkiss, Bracewell & Giuliani

When the jockeying over allocation of carbon dioxide emission allowances ends, Congressional stewards of the legislation must ensure the distribution of allowances is fair and sustainable.

A cap-and-trade program—like the U.S. program to cut acid rain in the 1990s—can reduce greenhouse gas (GHG) emissions at the lowest cost.

Under Waxman-Markey, the federal government sets a declining cap on overall emissions and issues tradable allowances that authorize holders to emit a metric ton of carbon equivalent within the cap. Those that reduce emissions more cheaply may sell extra allowances to others that otherwise must pay more than the price of an allowance to comply. The acid rain program has achieved greater reductions at lower costs than anticipated.

Distributing tradable allowances is independent of the magnitude and cost of the emissions reduced. Dr. David Montgomery demonstrated this in a 1972 “Journal of Economic Theory” article. Cap and trade frees science to drive the cap and avoided-cost economics to drive the cost of achieving the cap. The allocation of allowances alone is relegated to the hurly-burly of political power and compromise. The optimal result of choosing allocation over auctioning or otherwise selling allowances should be to subsidize the cost of transitioning from high carbon emissions for those most dependent on processes that emit high levels of GHGs.

Waxman-Markey sets interim caps and an ultimate cap to reduce GHG emissions 80 percent below 2005 levels (7.2 billion tons of CO2) by 2050. The electric power industry—responsible for 40 percent of U.S. GHG emissions—is allocated just more than 35 percent of total allowances from 2012 to 2025.

Waxman-Markey distributes allowances to the electric power industry in two tranches. The first distributes allowances ratably based on the annual average CO2 emissions attributable to a local distribution company’s electricity delivered during a base period (2006-2008 or three consecutive years between 1999 and 2008). The second distributes allowances ratably based on a local distribution company’s annual average retail electricity deliveries for the same alternative base periods, adjusted over time for changes in the size of the company’s franchise. A distribution of allowances based purely on retail sales untethered to historical dependence on GHG-emitting resources is not defensible and could erode the political will to enact a cap-and-trade program that applies to all major emitting sources within the electric power industry. Rather, it transfers wealth from customers of coal-dependent retail electricity providers to customers of other providers less dependent on coal.

It strains credulity to argue that ratepayers of distribution companies that have relied on coal-fired generation deserve a lesser share of allowances than they need to transition to their mandated emission reductions as some form of moral judgment on their historical fuel choices. Their service providers, without ratepayer input, chose coal because it was close and cheap. Utilities built hydroelectric dams and nuclear plants for the same reasons, not to limit GHG emissions.

Until recently, nearly all utilities denied climate change. They invested in generating technologies because of availability, cost or both. Belated acknowledgement for GHG controls is welcome but should not be rewarded with unjustified, inequitable wealth transfers among ratepayers.

Unprincipled wealth transfers in connection with GHG controls could deprive the proposed cap-and-trade program of political legitimacy. Comparable wealth transfers undermined international political support for the Kyoto accords. The allocation of “hot air” allowances to former Soviet Union (FSU) countries of Russia and Ukraine resulted in material wealth transfers and attendant resentment from Japan and other disproportionately allowance-purchasing nations. For the Russian hot air allowances, there was at least the political-historical rationale that the FSU countries’ industries had collapsed because of regime change and should be allowed to rebound with a sufficient distribution of allowances. But no equally plausible justification supports a U.S. distribution to electric distribution utilities based on retail sales as opposed to economic need to transition to a lower-carbon generation future.

Waxman-Markey requires recipients of allowance distributions remit the proceeds in lump-sum payments to their rate-regulated customers. This should correct allocated allowances based on the annual average CO2 emissions attributable to delivered electricity from becoming a subsidy for increased consumption from GHG-emitting resources. To make the program environmentally and economically effective and politically viable, those who will shoulder the greatest cost in achieving the capped emissions should be the primary (if not exclusive) beneficiaries of freely distributed carbon allowances during the transition to a carbon-capped economy.

Author

Dan Watkiss is a partner with Bracewell & Giuliani in Washington, D.C., representing power companies, exploration and production and midmarket companies, natural gas pipelines, power and liquefied natural gas project developers and lenders, as well as government agencies and regulators. Reach him at dan.watkiss@bgllp.com.

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