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Performance-based Allocation of Allowances Enables Lowest Cost CPP Compliance

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Performance-based Allocation of Allowances Enables
Clean Power Plan Compliance at Lowest Cost

White paper proposes a performance-based approach for allocating allowances, rather than historical emissions, to foster market competition, reduce costs for mass-based compliance with EPA rule

[Washington, D.C. – Feb. 25, 2016] – The U.S. Environmental Protection Agency’s final Clean Power Plan allows states to reduce emissions using either a mass-based or a rate-based plan, with flexibility to adopt efficient market-based solutions under either plan type. The mass-based plan option sets a compliance goal measured in total tons of carbon emissions, rather than emission rates, and those states choosing to develop a mass-based plan have their hands on a lever that can either promote or dampen market competition — with substantial implications for the cost of compliance. That lever is the initial allocation of allowances, each equal to one ton of carbon emissions, which fossil-fueled power plants are required to obtain in an amount equal to their total emissions in order to demonstrate compliance.

Advanced Energy Economy Institute (AEE Institute), a nonprofit educational organization, today released a white paper, A Performance-Based Approach to Allowance Allocation for Clean Power Plan Compliance, outlining an option for allowance distribution that avoids the pitfalls of distribution based on historical patterns of power plant emissions, an approach that is likely to skew compliance decisions and drive up costs relative to alternative allocation options. AEE Institute proposes a performance-based allocation process that provides a clear pathway for market participation by all eligible measures, ensuring compliance outcomes at lowest cost by enabling competition on a technology-neutral basis.

“AEE Institute shines a bright light on a centerpiece of efficient and fair carbon regulation,” said Dallas Burtraw, Darius Gaskins Senior Fellow at Resources for the Future (RFF), an expert on allocation in mass-based tradable permit systems. “A mass-based system with trading creates new value and initially distributing that value wisely can help us achieve prosperity along with emissions reduction.”

Mass-based trading systems for regulating carbon emissions, in the U.S. and in Europe, have used a variety of allocation approaches—with varied success. For example, the Regional Greenhouse Gas Initiative (RGGI) in the northeast has lowered carbon emissions while delivering ratepayer savings by allocating allowances via auction and reinvesting revenues into energy efficiency programs, renewable energy, and ratepayer rebates. In contrast, the European Union emission trading system (EU ETS) was costly for consumers in early years due to its initial reliance on an upfront allocation to affected entities based on historical generation, which overcompensated affected industry at the expense of ratepayers. In the latter case, the allocation system was eventually changed to address the issue.

Performance-based allocation is based on a simple principle: allow all eligible technologies to participate and compete on the basis of performance and cost. While this goal may seem easy enough to achieve, the paper explains that some allocation schemes would actually prevent equal participation and reinforce existing market barriers that often prevent deployment of beyond-the-fence measures.

In particular, upfront allocation to existing electricity generating units on the basis of historical generation—the proposed approach under EPA’s proposed mass-based Federal Plan and Model Trading Rule— is the least attractive of the many approaches available to states. For states that decide to adopt it, the historical generation approach to allocation will limit compliance options, hamper competition, and introduce significant market uncertainty, which is likely to ultimately drive higher compliance costs for electricity customers relative to other allocation systems available to the states. One market failure likely to materialize under a mass-based system that does not credit all eligible measures is the “tragedy of the commons,” illustrated below, which will cause utilities to undervalue and overlook beyond-the-fenceline measures even when they provide cost-effective emission reductions.

A performance-based approach, in contrast, ensures that emission reduction measures will be deployed on the basis of cost and ability to meet system needs. The performance-based allocation offers a straightforward process that has at its core an allocation methodology that awards allowances on a technology-neutral basis according to actual emission reductions.

“States have a key choice to make,” said Malcolm Woolf, Senior Vice President for Policy and Government Affairs for Advanced Energy Economy, a national business association affiliated with the AEE Institute. “They can lock themselves into the electricity system of the past, and forego opportunities to lower costs, or they can trust that market competition among all eligible measures will lead to the best outcome – a strategy with a demonstrated track-record.”

Figure 1

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Figure 1: Allocation based on historical generation is likely to result in a "tragedy of the commons," because the cost of measures (such as developing a wind farm) are borne by the investing utility, but the emissions reduction benefits accrue to all that use the grid (including other utilities and power generators).

Under performance-based allocation, allowances would be distributed annually to emission reduction measures based on actual megawatt-hours (MWh) of generation or savings from the previous year and adjusted to reflect the level of emission reductions achieved. Just as under a rate-based system, zero-emitting measures would get full “credit” for each MWh of generation or savings, while low-emitting resources (including affected units operating below their relevant subcategorized performance rate) would receive credit on a pro-rated basis determined by their emission profile.

Affected units would be able to turn to the full suite of cost-effective measures to purchase allowances for compliance purposes, which would create a market opportunity for emission reduction measures while offering assurance to utilities and other market actors that any purchases or investments they make in renewable energy, energy efficiency, and other measures will bring them direct compliance benefits.

AEE Institute’s plan for performance-based allocation also provides for the Clean Energy Incentive Program, provides controls for the risk of leakage to new power plants not regulated by CPP as required by EPA, and still leaves states with several choices for how to distribute the remaining allowances, which will constitute a significant portion of each state’s total emissions budget. These options include an auction, allocation to load-serving entities, and updating output-based allocation. Auctions have many advantages, such as overall efficiency and transparency, but the paper notes that this is an area where individual state goals and needs will be important considerations.

"This paper has helped clarify a concept that many people have struggled with: how to make sure that advanced energy can deliver its value for emission reduction and electric power system improvement under a mass-based system,” said Richard Caperton, Director of National Policy and Partnerships for Opower, a leading customer engagement platform for utilities. “This solution may not be the only one, but AEE Institute has shown it can be done."

About Advanced Energy Economy Institute

The Advanced Energy Economy Institute is a 501 (c)(3) charitable organization whose mission is to raise awareness of the public benefits and opportunities of advanced energy. AEE Institute provides critical data to drive the policy discussion on key issues through commissioned research and reports, data aggregation and analytic tools. AEE Institute also provides a forum where leaders can address energy challenges and opportunities facing the United States. AEE Institute is affiliated with Advanced Energy Economy (AEE), a 501(c)(6) business association, whose purpose is to advance and promote the common business interests of its members and the advanced energy industry as a whole. AEE and its State and Regional Partner organizations are active in 26 states across the country, representing more than 1,000 companies and organizations in the advanced energy industry.
 

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