Utilities and Auctions: There Is No Free Power Lunch

Under cap and trade, cheap carbon trumps cheap power.

An economy-wide cap on climate warming emissions—our preferred climate policy —has one enormous sticking point:  once the cap is in place, who gets the right to pollute?

That’s the core of the debate over the “allocation” of emissions permits.  Literally billions of dollars are at stake.  And not too surprisingly, just about every industry you can think of believes that, once strict emissions limits are imposed, they should get a generous slice of permits for free.

Much of this is just money-grubbing, plain and simple.  Permits will have a market value, so giving away permits is a lot like giving away free money.  Free permits will mean big windfall profits to large emitters—an idea that shareholders and execs LOVE, but consumers and taxpayers should hate.

But in some cases, the arguments against free emissions permits aren’t so clear-cut.  In much of the US West, for example, investor-owned electric utilities can’t set their own prices; instead, their rates are set by public utility commissions. And if those commissions are attentive and careful, the investor-owned utilities have a pretty hard time raising prices to capture “windfall” profits. Moreover, some utilities are actually owned by the public, or by the customers they serve—which makes the whole “windfall” issue moot.

Many utilities are arguing—in good faith, we think—that it would be better to simply give utilities permits, so that customers don’t have to pay for the cost of buying permits at an auction.  Free permits will benefit consumers, their argument goes, by limiting electricity rate increases.

Are the utilities right about this? Could free allocation to utilities be a real boon to consumers?

We don’t think so.  In fact, handing out permits to utilities for free has the potential to backfire, raising the overall cost of emissions reductions—thereby increasing the cost that consumers pay for all of their other energy needs.

There are four reasons that “protecting” electricity consumers from rate increases would likely backfire, raising costs for everyone in an economy-wide cap.  Three reasons are economic, one is political.  Taking each in turn…

1.  Lower power prices discourage efficiency.

If electricity stays cheap—and, in particular, if electricity prices don’t reflect the true cost of emissions—fewer people will upgrade their old fridges, unplug the extra freezers in the garage, or install super-efficient ground-source heat pumps. (If power’s cheap, why not just stick with the old fridge?)

More generally, cheap electricity means that it takes longer for any efficiency upgrade to pay for itself—which undermines the incentive for paying for the upgrade in the first place.  As a result, keeping electricity prices low could undermine incentives for households and businesses to trim their consumption—which is often among the cheapest ways to reduce emissions.

2.  Inconsistent prices encourage climate-disrupting fuel choices.

If electricity rates remain low, but natural gas and fuel oil prices have a “carbon price” attached to them—as they will under a comprehensive cap-and-trade system—then electric power prices will look awfully enticing. Some folks will likely switch from, say, gas heat to electric heat.  And others will choose to stick with their electric heat rather than switch to gas.

From the consumer’s perspective, this makes sense:  they’re choosing a cheaper fuel option.  But from the climate’s perspective, electric resistance heat is a bad deal.  As long as the western power grid gets its marginal electric power from natural gas and coal, switching to electric resistance heat is a far worse choice for the climate than heating directly with natural gas.

In the same way, if gas prices rise but electricity stays cheap, we could see big boosts in electric cars or plug-in hybrids.  If the electricity comes from renewable sources—great!  But if it’s from coal-fired plants, it could be worse for the climate than plain-old gasoline.

So in general, until we squeeze most of the fossil power out of the electricity grid, switching away from direct fossil fuel use, and towards electricity, can increase climate-disrupting emissions.

3. Once a cap is in place, lower electricity prices might increase total household spending on energy.

This is counterintuitive, we know.  But here’s why.

Electricity is a great place to find cheap emissions reductions. There are already low-carbon alternatives to coal-fired power—especially new wind and solar—and the Northwest Power and Conservation Council, among others, has already identified scores of low-cost ways to reduce end-use consumption.

However, if low power prices boost consumption (see points 1 and 2 above) then it gets harder to satisfy demand with efficiency and new renewables alone.  A boost in power demand could give old, dirty coal-fired power plants a stay of execution—with a much slower phase-out of coal from the West’s generation mix.

If coal-fired power plants remain active for longer, the emissions cap will force steeper reductions in transportation and industrial emissions. Those kinds of reductions could easily cost more per ton than reductions in coal power—and those higher costs will translate into higher market prices for carbon permits.  Higher permit costs, in turn, will get passed through to households as higher prices for gas, diesel, heating oil, natural gas, manufactured products, food, you name it.

So in the end, free permits to electricity could mean that consumers face lower prices for electricity, but far higher costs for all other fossil energy.  And on balance, since electricity represents a relatively small share of household emissions—particularly here in the hydro-rich Northwest—the modest savings on power could be overwhelmed by higher permit costs in other sectors.

The whole point of a cap-and-trade system is to find the cheapest emissions reductions, wherever they may be. By diluting the price signal in electricity, we may wind up creating higher permit costs in other sectors—costs that, in the aggregate, loom larger in family budgets.

4. Granting free permits to one part of the energy industry—utilities—makes it far more likely that we’ll grant free permits to other parts as well.

This is a political argument rather than an economic one. If utilities get free allowances, other energy companies will insist on getting the same treatment. They’ll howl. They’ll rail. They’ll insinuate and lobby and grease palms. (They’ll do all these things anyway.)

So if the electric utilities carry the day, and successfully argue for free permits, it’ll be a lot harder to say “no” to the natural gas utilities, the propane distributors, the big industrial emitters, the pipeline companies, and ultimately even big oil—the industries that really can extract windfall profits from their customers.

These are four reasons to think that handing out free permits to the utility sector is a mistake. Our impression, and it’s only that, is that all too often, utility sector folks—even the public-spirited ones—tend to overemphasize electricity in their thinking. (Not surprising.) Electricity is a small part of the carbon game in the Northwest.

But we’re convinced that arguing for free allowances for electric utilities is NOT standing up for utility customers. Utility customers don’t just buy electricity. They also drive, heat their homes, and pay for food and manufactured goods. The way to serve them is not to keep electricity prices low, it’s to keep carbon prices low.

And that means utilites should buy their permits at auction, just like everyone else.

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  1. Greg Nickels says:

    Thank you for this thoughtful post on cap and trade policy implications. Until Congress turned over in the 2006 election there was really no serious policy debate occurring at the federal level and precious little at the state level. There is need for early action in the next administration but it needs to be well informed by attention to the details and effects of various proposals. This post helps outline many of the larger issues we face in that debate.Best wishes –Greg NickelsMayor of Seattle

  2. morgan says:

    Sorry for the long post. The reading got me stirred up on a number of topics. I think Point 3 is the strongest and most trenchant. It also draws attention to the influence of the emerging carbon-price-component to the prices of goods and services. [The CBPP paper Alan posted a while back really affected my thinking.]Is there something different about electricity supply ownership from the nat gas supply ownership that is driving this allocation debate? Or, is it just that the electricty producers got a bug?Point 1—certainly this is all true, but I don’t see this topic addressing economy wide costs except in so far as we’ll have to make those reductions later and in more of a hurry, which adds to cost.Regarding Point 2, my long term vision of residential and commercial heating is for 100% electrical and 100% carbon-neutral onsite sources, like heat pumps, solar, etc. I don’t think we can advocate for long term investments in natural gas heating systems and the requisite infrastructure to new construction just because its carbon footprint is a little smaller right today. What are the predictions for expansion in clean-electricity following a cap on coal and gas fired sources?You argue that clean electricity should precede electric cars. Simply speaking, yes. but It seems to me that it’s going to take us so long to design our way into practical EVs and to retire the existing fleet that we need to be working at it harder than we are. I’m not sold on the notion that more electric vehicles right now would be a bad thing in the long run. Btw, do you have a handy reference to the GHG comparisons for gasoline power vehicle travel vs dirty electricity powered travel?

  3. Clark Williams-Derry says:

    Morgan—HUGELY important issue, I think. When do we transition from arguing against electrification for transportation/heating, and start arguing for it? My simple answer is that until we have comprehensive, economy-wide emissions limits that ratchet coal power out of the supply grid—or possibly sequester, if that turns out to be feasible—I’ll probably be against electrification.But once we do have a cap on emissions, then I’ll either be neutral (“who cares how we power our cars, as long as emissions come down?”) or pro-electrification, on the grounds that there are other economic & social benefits of switching from oil to home-grown power.As for clean vs. dirty cars, p.7 of this phev report (http://www.epri-reports.org/PHEV-ExecSum-vol1.pdf) might help.

  4. Dave says:

    5. BIOHEAT will help conserve 400 million gallons of regular household oil. Hopefully resulting in lower oil prices over time.This is a true fact. I found out about it while working for NORA. Here’s the site I came across that gave me the info: http://oilheatamerica.com/index.mv?screen=bioheatIt's pretty neat to know that existing oilheat users can just by a different blend of oil and manage to go “green”. Amazing, I know.

  5. Andy Andersson says:

    It is almost self-evident that all carbon emissions should be affected by the permit process regardless of what uses they serve. Costs must be passed on to the user and rules for utilities changed for this to take place. After all, the purpose is to reduce emissions. Technological solutions should not be prescribed but let develop naturally in a balanced fashion in response to the increased costs of emissions.With permits owned equally by all individuals and sold at prices set by them, few individuals will be hurt by the permit costs in the short run but be given an opportunity in the long run to benefit from redistributing their own energy use.

  6. Barry says:

    I agree with Morgan’s comment: ” “my long term vision of residential and commercial heating is for 100% electrical and 100% carbon-neutral onsite sources, like heat pumps, solar, etc. I don’t think we can advocate for long term investments in natural gas heating systems and the requisite infrastructure to new construction just because its carbon footprint is a little smaller right today.”My only difference is that i think we need the grid to pull it off…not just onsite sources. Sure the marginal grid might be coal dominated now…but how likely is that over the lifetime of a new gas heater or gas car? Very unlikely if we are going to have a survivable society. If we aren’t, who cares what we use now. Also, as Morgan points out, people can clean their portion of the grid by purchasing green power. And places like BC have said all new grid gen must be zero ghg by 2012. A new gas home heater will last for decades.We are seeing it in airplanes, cars, ships, trucking and buildings. Our leeway to cut fossil fuel use and thus ghg emissions requires the multi-decade slow turnover of millions of expensive, long lasting, fossil fuel infrastructure pieces.I find it confusing that people who are looking for a solution to climate change are advocating we buy millions more of them. Statements like: “from the climate’s perspective, electric resistance heat is a bad deal” and “until we squeeze most of the fossil power out of the electricity grid, switching away from direct fossil fuel use, and towards electricity, can increase climate-disrupting emissions” advocate for a more difficult and costly transition to low ghg future. Climate change success requires BOTH that we clean the grid AND we eliminate local fossil fuel burning infrastructure. I think we should be promoting the best case scenario: stop buying new fossil fuel infrastructure and instead buy electric alternatives PLUS green power sources to power it.

  7. Clark Williams-Derry says:

    No question, Barry—that’s my preferred route. It’s just that, without a firm, economy-wide cap on emissions, I’m not convinced that converting to electric actually helps (at least, as a general rule—some applications make sense, but others make less sense). Of course, I’m very optimistic that we’ll have an economy-wide cap in place fairly soon. But I was also optimistic about national health care in the early 1990s—and I was very wrong about that. So without understanding the policy environment, I personally can’t recommend that people spend a bunch of money to shift certain applications to electricity. What I *can* recommend is that we change the policy context, ASAP.

  8. Ron says:

    Dear Clark, AlanI recently came across your article. While I fully concur with its conclusions, some of the arguments presented are not strictly correct. Clearly, an ETS is intended to increase the costs of carbon intensive energy relative to its competitors. Our analysis (in Australia) supported by analysis and experience in the EU ETS, indicates that handing-out free permits does not lower the expected price of energy. The market price will be set by the marginal supplier in the energy market—driving up prices received by all producers.Whether free permits are granted or not, does not alter this dynamic. In other words, handing out free permits to the most carbon intensive energy producers is unlikly to alter the market clearing price. This is not to say their profits and balance sheets won’t be adversely affected. They probably will.So it comes down to a matter of equity. Who has a greater claim to compensation—energy consumers (particularly low income households) faced with higher prices or energy producers faced with lower profits?I agree with your conclusion but for different reasons.Ron

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