EPA's CO2 Rule and the Back Door to Cap & Trade

• Significant differences in EPA's proposed state CO2 targets for the power sector are reviving interest in cap & trade as a way to reduce compliance costs.
• This compounds the EPA plan's controversy and raises serious concerns about how the resulting revenue would be used.

Earlier this month the US Environmental Protection Agency released for comment its proposal for regulating the CO2 emissions from existing power plants. It follows EPA’s emissions rule for new power plants published late last year but takes a different, more expansive approach.  If implemented, the “Clean Power Plan” would reduce US emissions in the utility sector by around 25% by 2020 and 30% by 2030.

One of its most surprising features is that instead of setting emissions standards for each type of power plant or mandating a single, across-the-board emissions-reduction percentage, it imposes distinct emissions targets on each state. Based on analysis by Bloomberg New Energy Finance, some states could actually increase emissions, while others would be required to make deep cuts. The resulting disparities have apparently triggered new interest in state and regional emissions trading as a means of managing the rule’s cost.

Although emissions trading has become more controversial in recent years, it proved its worth in holding down the cost of implementing previous environmental regulations, such as the effort to reduce sulfur pollution associated with acid rain. It works by enabling facilities or companies with lower-than-average abatement costs to profit from maximizing their reductions and then selling their excess reductions to others with higher costs. The desired overall reductions are thus achieved at a lower cost to the economy than if each company or facility were required to reduce its emissions by the same amount.

Although the Clean Power Plan doesn’t require that states establish such emissions trading markets, its lengthy preamble includes a discussion of existing state greenhouse gas “cap-and-trade” markets in California and the Northeast. It also points out that measures to comply with the new rule may generate benefits in the markets for conventional pollutants, including those for the recent cross-state pollution rule. Administrator McCarthy also mentioned the benefits of multi-state markets in her speech announcing the new rule.

A patchwork of cap and trade markets across the US, including the addition of new states to mechanisms like the Regional Greenhouse Gas Initiative (RGGI), might help mitigate some of the cost of complying with 50 different CO2 targets. However, it would still be a far cry from the kind of economy-wide, comprehensive CO2 cap-and-trade system once contemplated by the US Congress.

Cap and trade was an idea that had gained significant momentum and even begun to appear inevitable, prior to the onset of the financial crisis in 2008. To supporters, it looked like a better way to limit and eventually cut greenhouse gas emissions than through command-and-control regulations. And the price it would establish for emissions would be based on the cost of achieving a desired level of reductions, rather than being set arbitrarily, as a carbon tax would be, without any guarantee of actual emissions reductions. Opponents viewed it as an unnecessary or unnecessarily complicated drag on the economy and a tax by another name, coining the pejorative term “cap-and-tax”.

Although early US cap-and-trade bills were bipartisan, including one co-sponsored by Senator McCain, the 2008 Republican Presidential nominee, the debate over cap and trade took on an increasingly partisan tone in a period of widening polarization on most major issues. The Waxman-Markey climate bill, with cap and trade as a major provision, was narrowly passed when Democrats controlled the House of Representatives in 2009, but various Senate versions failed to attract sufficient support, even when Democrats held a filibuster-proof supermajority in that body. The chances of enacting cap and trade legislation effectively died when a Republican won the vacant Senate seat for Massachusetts in January 2010. However, viewing this as a purely partisan divide is simplistic, at best.

Aside from opposition by key Senate Democrats, including one whose campaign included a vivid demonstration of his stand against Waxman-Markey, the versions of “cap and trade” debated in 2009 and 2010 bore little resemblance to the original idea. Waxman-Markey was a 1400-page monstrosity, laden with extraneous provisions and pork. Its embedded allocation of free allowances strongly favored the same electricity sector now being targeted by EPA’s Clean Power Plan, at the expense of transportation energy, for which low-carbon options remain fewer and more costly. It would have created a de facto gasoline tax, while yielding fewer net emissions reductions than a system with a level playing field. Subsequent bills, such as the Kerry-Lieberman bill in 2010, took this a step farther, removing transportation fuels from cap and trade and effectively taxing them at a rate based on the price of emissions credits.

Along the way, national CO2 cap-and-trade legislation evolved from a fairly straightforward way to harness market forces to deliver the cheapest emissions cuts available, to a mechanism for raising and redistributing large sums of money outside the tax code. In some cases that would have been done directly, such as in the gratifyingly brief Cantwell-Collins “cap-and-dividend” bill, or as indirectly and inefficiently as in Waxman-Markey. It’s no wonder the whole idea became toxic at the federal level.

Although emissions trading for greenhouse gas reduction came up short in the US Congress, it took hold elsewhere. The EU’s Emissions Trading System (ETS) is an outgrowth of the Kyoto Protocol’s emissions trading mechanism, which was included largely at the urging of the US delegation to the Kyoto climate conference in 1997. The ETS is focused on the industrial and power sectors and covers 43% of EU emissions. It has experienced significant ups and downs over the sale and allocation of emissions credits.

Cap and trade also emerged as a preferred approach for some US states seeking to reduce their emissions. California’s emissions market was established via a provision of the 2006 Climate Solutions Act (A.B. 32), and RGGI currently facilitates trading among 9 mostly northeastern states. The relatively low prices of emissions allowances in these systems–particularly in RGGI, which has traded in the range of $3-$5/ton of CO2–suggests that they may still be capturing low-hanging fruit in the early phases of steadily declining emissions caps. Their effectiveness at facilitating future low-cost emissions cuts is hard to gauge, because they also don’t exist in a vacuum.

Except for Vermont, all of the states involved have renewable electricity mandates that by their nature deliver more prescriptive emissions cuts. These markets have also been implemented in a generally weak US economy, which has constrained energy demand, and against the backdrop of the shale revolution, which has yielded significant non-mandated emissions reductions. Nor have these state and regional approaches to cap and trade entirely avoided the debates over how to spend their substantial proceeds that plagued federal cap-and-trade legislation.

For many years my view of cap and trade was that if we needed to put a price on GHG emissions, this was a better, more efficient option than an arbitrary carbon tax, or other top-down method. My experience analyzing more recent “cap-and-trade” legislation left me with serious doubts about our ability to implement a fair and effective national cap-and-trade market for CO2 and other greenhouse gases within the current political environment. Whether on a unified basis or in aggregate across many smaller systems, the enormous sums it could eventually generate are simply too tempting to expect our legislators and government agencies to administer even-handedly.

Whatever its potential benefits and pitfalls, I can’t help seeing cap and trade as a distraction in the context of the EPA’s proposed Clean Power Plan. Even at its most efficient, cap and trade couldn’t render painless the wide disparities of a plan that would require Arizona to cut emissions per megawatt-hour by more than half, and states like Texas and Oklahoma to cut by 36-38%, while Kansas, Kentucky, Missouri, Montana and even California cut by less than a quarter–and under some scenarios might even increase their overall emissions. Cap and trade would merely be a footnote on the scale of transformation the EPA’s plan envisions for the US electricity sector.

A different version of this posting was previously published on Energy Trends Insider.