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by Frank Stern, Espen Odderbo and Stephen Becker
Climate change regulation in the U.S., discussed in this country for more than two decades and now being set in California and the Northeast, is gaining acceptance in the electric utility industry and is likely to be federally mandated in the next few years. The nature of the regulatory action is uncertain, but could have a profound impact on cash flows and power plant values. Utility planners are increasingly asking what the coming regulations will look like as they attempt to determine the best plan for new plants and environmental capital expenditures. Given the billions of dollars that these types of investments require, the stakes are enormous.
As the wave of regulation approaches, the image of likely regulation is becoming clear. Current and proposed state regulations, proposed federal legislation, and the European Trading Scheme offer the best indication of future regulation.
The increasing acceptance of climate change regulation
Electric utilities and generators are increasingly calling for federal action or endorsing specific policies. Undoubtedly, the coming regulations will bring business opportunities related to technology, products and trading. In anticipation of regulatory activity, companies are positioning themselves to take advantage of these opportunities, either by taking leadership in shaping the policy or by strengthening their public image.
This year started with a flurry of announcements associated with climate change regulation. Five bills related to climate change were introduced in Congress before the end of February. One of these bills was endorsed by six major U.S. energy companies-Calpine Corp., Entergy Corp., Exelon Corp., FPL Group, PG&E, and Public Service Enterprise Group Inc. Sen. John McCain has predicted President Bush would sign carbon legislation passed by Congress. AES President and CEO Paul Hanrahan called for a U.S. carbon policy that is “expansive, efficient, equitable and equivalent” and said that cap-and-trade programs are more effective than a diverse set of regional programs. A new coalition of energy and environmental groups, which includes Alcoa, BP America, Caterpillar, Duke Energy, DuPont, FPL, General Electric, Lehman Brothers, PG&E and PNM Resources, called for swift federal action to reduce greenhouse gas emissions, and specifically called for a cap-and-trade program. And the president of the American Public Power Association, Alan Richardson, said that his constituents are cognizant that federal action against global warming is imminent. “My members are past the denial stage,” he said.
Developing climate change policy
The simplest policies would address only the electric power sector, while the most comprehensive would attempt to cover all emissions. Greenhouse gases (GHGs) coverage could target only CO2 or all six major GHGs-CO2, CH4, NO2, HFCs, PFCs, and SF6. The two broadest types of regulation are cap-and-trade and carbon tax. Cap-and-trade, first implemented in the U.S. to regulate SO2, provides a cap on emissions within a system, allowances to emit the pollutant(s), and a system that enables emitters to trade allowances, thereby increasing economic efficiency. Other approaches include renewable portfolio standards and fuel efficiency standards. Economists tend to favor cap-and-trade as the most economically efficient approach because it relies on the market to find the best solution to meet a specific GHG target, rather than government attempting to select the right carbon tax level or the right level of renewables or efficiency.
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The quantity of allowances in cap-and-trade programs is allocated. Regulators may auction off allowances or allocate based on prior emissions (“grandfathering”). Generators tend to favor grandfathering, while load serving entities favor auctioning and using the proceeds to reduce rates. The portion of allowances allocated can have major impacts on power plant gross margins, particularly a coal plant. (See Figure 1.) Allowances may not be granted or may be partially granted, to plants, particularly coal plants, constructed after a certain date.
States take the lead
Several states, unsatisfied with the federal response to climate change risk, are developing their own regulations. Most significant are the Regional Greenhouse Gas Initiative and California’s Global Warming Solutions Act.
The Regional Greenhouse Gas Initiative (RGGI) is an agreement by nine Northeastern and Mid-Atlantic states. RGGI has tasked itself with the development of a multi-state CO2 regulation, with the eventual goal of including additional GHGs. This program is directed only at the electric power sector.
RGGI released a model rule in August 2006 that sets forth the details of the proposed program. The model rule is non-binding, but governors of participating states have agreed to propose similar rules before their state legislatures before Dec. 31, 2008. The initiative is slated to take effect at the beginning of 2009.
The RGGI program will be a cap-and-trade system. According to the model rule, RGGI states will individually place limits on total state-wide emissions from power plants. Each state will have an annual emissions budget approximately equal to the current annual one, and will have one emissions allowance to be allocated per ton of CO2 emitted. States will be given the latitude to decide how and to whom their allowances are allocated, except that they must appropriate 25 percent of their allowances for “consumer benefit or strategic energy” purposes. The RGGI program also includes provisions for “offsets,” and includes safety valves in case the price for allowances rises beyond expectations. Under the offsets program, parties are awarded allowances for taking actions that reduce CO2 loading in a way that is “real, additional, verifiable, enforceable, and permanent.” As a safety valve, the limit for offsets can be extended to 5 percent of an emission source’s total emissions if the price of allowances surpasses $7. The limit increases to 10 percent if allowances go beyond $10.
California’s Global Warming Solutions Act, passed Sept. 27, 2006, requires the California Air Resources Board (CARB) to implement a state-wide GHG (not just CO2) emissions cap beginning in 2012. The bill mandates GHG emissions reductions to 1990 levels by 2020, constituting a 25 percent to 30 percent reduction, by placing an annual limit on emissions from significant sources. The 1990 emissions level will be determined by CARB by 2008, and limits will go into effect in 2012 and tighten incrementally to reach the 1990 level by 2020.
CARB will be responsible for developing a plan to achieve the “maximum technologically feasible and cost-effective reductions” using “direct emission reduction measures, alternative compliance mechanisms, market mechanisms, and potential monetary and non-monetary incentives” to meet the requirements by the beginning of 2009. The bill requires CARB to evaluate the relative contribution of each emissions source and source category, and determine the minimum threshold emissions level above which sources must comply with regulations. The regulatory framework must be adopted by the beginning of 2011.
CARB is required to consult with the California Public Utilities Commission in the development of GHG regulations for the electricity sector. The CPUC intends to design the regulations for application to all electricity consumed in the state and has indicated that the requirements will be imposed on the load-serving entities, rather than generators. The intention is to address the significant imports of coal-based energy into California. A cap-and-trade system is encouraged.
Federal legislation on the wave’s crest
The 110th Congress began with the quick introduction of five significant climate change bills. The Senate chairmanship of the Environment Committee has passed from James Inhofe, who described climate change as “the greatest hoax ever perpetrated on the American people” to Barbara Boxer, who is a strong advocate of quick action on the subject.
In January 2007, House Speaker Nancy Pelosi was engaged in creating a special committee that would actively work on resolving global warming issues and introduce a bill by July 4 of this year. The committee would hold hearings and recommend legislation on how to reduce greenhouse gases, primarily carbon dioxide generated by fossil fuels. All of the five climate change bills include cap-and-trade provisions. (See sidebar.)
European reduction targets
The European Trade Scheme was introduced to get EU member states on a path to the legally binding Kyoto reduction targets. The “bubble” target for EU member states is GHG emissions at 8 percent below 1990 levels, with individual targets for each country.
The EU ETS was introduced as a cap-and-trade system. An emissions allowance amount is given to companies in selected industries that are given the opportunity to trade allowances to comply with the allowance cap and maximize profits. Each member state must submit to the EU commission a national allocation plan specifying allowances to companies that would lead the country on its path to Kyoto compliance. Countries must allocate at least 95 percent of the allowances for free for the first trading period, and at least 90 percent for the second period, 2008 to 2012.
Two years into the ETS, we observe several key results.
The market has succeeded in terms of price response and liquidity, albeit with volatility. After the official start, the market quickly began reacting to fundamentals like precipitation, temperature and fuel prices. On a steady increase in liquidity, the market rose to new record levels starting in 2005. Simultaneously, several exchanges started quoting allowances in a market that so far had traded over-the-counter only. Then in, April 2006, new emission data were released, which plummeted the market overnight. In the opinion of most analysts, the market went from being near neutral to long allowances as a result of the realization.
Liquidity showed substantial growth. Early data are uncertain, but for 2004, the market probably traded around 8 million to 10 million tonnes CO2. This increased tremendously in 2005 to approximatly 250 million tonnes. In 2006, the growth continued and more than 800 million tonnes was likely traded. Compared to a total allocation of more than 2 billion tonnes for the total three years, this may not seem as much of a “churn” compared to mature markets. However, liquidity has reached a stage where trading related to most companies’ fundamental needs does not cause significant price moves.
Over-allocation made it difficult to establish emission reductions. What is perhaps considered the major flaw of the ETS is the over-allocation of allowances. This was a key factor contributing to the price collapse witnessed in 2006. Due to the long position of the market, it is difficult to prove that the basic mechanisms of the market worked to the benefit of emission reductions, since a persistent short market is a prerequisite for reductions. The general anticipation was that the market would mainly abate through fuel switching in the first allocation period. It is likely that this has happened to a certain degree, but not to the extent that was anticipated. It is important to keep in mind that this is a trial period where lessons are learned, and a basis for improvements is made.
Many parties have enjoyed higher profits with the ETS than they would have without it. All emissions were given for free. Power companies add the cost of GHG as a variable cost in their price bids. As coal and gas are often the marginal source of production, windfall profits from increased prices flow to a large proportion of the sector, with wind, hydro and nuclear, without allowance costs, being the big winners.
The other industries in the ETS, especially metals, cement, pulp and paper, received more generous allocations, and many benefited from an over-allocation. However, this benefit was balanced by an increase in power prices. One major criticism is that for industries with international competition, the ETS only moves emissions to countries without emission restrictions. The short term effect of this has not been significant, but the long term threat of industry export is real and calls for a global solution.
Come to the table
Climate change regulation in the U.S. appears increasingly inevitable, and taking into account the EU ETS, RGGI, California developments and the position of many industry leaders, some type of cap-and-trade program appears most likely. And, as the regulatory wave approaches, it’s important to consider the possibility that coverage could be significantly broadened. A wide range of stringency is possible and a broad array of details must be worked out. These changes will have profound effects on electric utilities, but whether this effect is positive or negative will depend on whether utilities are out in front of this wave or caught by surprise. Or, as James Rogers, chairman and CEO of Duke Energy said, “If you’re not at the table when these negotiations are going on, you’re going to be on the menu.”
Frank Stern and Stephen Becker are managing consultants in PA Consulting Group’s global energy practice, located in Denver. Espen Odderbo is a principal consultant in PA Consulting Group’s business operations and performance practice, located in Lysaker, Norway. The authors would also like to thank Salem Esber for his contributions to this article.
Proposed Federal Legislation
Climate Stewardship Act – Reintroduction
In January 2007, Sen. Barack Obama joined Sens. McCain and Joseph Lieberman in re-introducing a bill that would set mandatory caps on greenhouse emissions for power plants, industry and oil refineries. The proposal assumes a market-based cap-and-trade system, which includes two phases of emission allowance caps. The plan would limit greenhouse gas emissions to 2004 levels by 2012 (Phase 1) and to 1990 levels by 2020 (Phase 2). The bill provides an incentive for non-covered entities to make reductions, register them and then sell them to covered entities that can use them in place of allowances. Allowance and reduction trading under the proposal would be done through a National Greenhouse Gas Database, which would contain an inventory of emissions and registry of reductions. The proposal also provides credit for early action and past reduction efforts.
In January 2006, Sens. Dianne Feinstein and Thomas Carper introduced a bill that would reduce electricity emissions to 25 percent below what they are expected to be by 2020. This bill is supported by PG&E, Calpine, Entergy, Exelon, FPL, and PSEG. Energy companies can meet the cap by participating in a cap-and-trade program that sets a cap at 2006 levels in 2011, reduces the cap to 2001 levels by 2015, reduces the cap by 1 percent per year from 2016 to 2020, and after 2020 reduces the cap by an additional 1.5 percent a year. If EPA determines more needs to be done, it can reduce the post 2020 cap by more than 1.5 percent. Allowances would be auctioned.
Global Warming Pollution Reduction Act of 2007
In January 2007, Sens. Bernie Sanders and Patrick Leahy re-introduced Sen. Jim Jefford’s bill. The proposed bill would require, between 2010 and 2020, that greenhouse gas emissions be reduced to 1990 levels. By 2030, greenhouse gas emissions must be reduced by one-third of 80 percent below 1990 levels. By 2040, emissions must be reduced by two-thirds of 80 percent below 1990 levels. By 2050, emissions must be reduced to a level that is 80 percent below 1990 levels. This is one of the most stringent, if not the most stringent, greenhouse gas proposals.
National Energy and Environment Security Act of 2007
In December 2006, Sens. Jeff Bingaman, Harry Reid, and Boxer introduced a bill that, according to Reid’s staff, implied a cap-and-trade program. The bill requires GHG emission stabilization at 2013 levels by 2020. It proposes increased biofuel production, a commitment to energy efficiency measures, rolling back incentives that sponsor the oil industry, and promoting alternative forms of energy, such as wind and solar.
Grandfathering of allowances appears unlikely under this bill. Sens. Bingaman and Boxer (both committee chairs) said in a joint opinion piece of recently proposed coal plants, “Apparently part of the motivation for building these plants is that the companies mistakenly believe that these new plants will garner “Ëœgrandfathered’ emission allowances under some future law . . . We do not envision that any successful legislative proposal will contain a provision that would allow those building traditional coal-fired power plants to economically benefit from coming in “Ëœunder the wire’ and being considered part of the emissions baseline – in fact, the opposite is likely to occur.”
Global Warming Reduction Act
In February, Sens. John Kerry and Olympia Snowe reintroduced legislation aiming to cut GHGs by 60 percent below 1990 levels by 2050. The bill is economy-wide, and includes cap-and-trade provisions. Reductions start out at 1.5 percent for the first 10 years. The bill also includes a national renewable energy standard of 20 percent.