cap-and-trade Archives - Page 32 of 35 - An Economic View of the Environment

What is the Future of U.S. Coal?

Climate concerns have gone mainstream, even in the United States. This has been reflected in the passage by the U.S. House of Representatives of HR 2454, the so-called Waxman-Markey bill, and will soon be reflected in the debates in the U.S. Senate. (I have written a number of blog posts on this topic. If you’re interested, please see: “Opportunity for a Defining Moment” (February 6, 2009); “The Wonderful Politics of Cap-and-Trade: A Closer Look at Waxman-Markey” (May 27, 2009); “Worried About International Competitiveness? Another Look at the Waxman-Markey Cap-and-Trade Proposal” (June 18, 2009); “National Climate Change Policy: A Quick Look Back at Waxman-Markey and the Road Ahead” (June 29, 2009). For a more detailed account, see my Hamilton Project paper, A U.S. Cap-and-Trade System to Address Global Climate Change.)

At the center of much political attention in the United States is “the future of coal,” a subject that was illuminated by the 2007 MIT study with that title, authored by John Deutch and Ernest Moniz, as well as several reports issued by the U.S. Energy Information Administration (EIA).

CO₂ emissions from coal consumption accounted for 30 percent of U.S. greenhouse gas emissions in 2005, and nearly all resulted from coal’s use in generating electricity. According to EIA forecasts, the vast majority of coal demand over the coming decades will be from existing power plants, with currently existing plants still accounting for two-thirds of total demand in 2030. Therefore, while much attention has been given to how climate policy and technological advances may affect new power plants, over the next two decades a policy that affects both existing and new coal-fired power plants would have far greater impacts than a policy that affects only new plants.

Potential climate policies can be grouped into four major categories: standards, subsidies or credit-based programs, carbon taxes, and cap-and-trade (like Waxman-Markey). The cost of retrofitting existing plants to meet CO₂ emission standards would likely be so high that standards could be imposed only on new plants. While such standards may dampen investments in new coal-fired power plants – as they may require expensive carbon-capture-and-storage at any new coal plant (see below) – standards would be unlikely to affect operations of existing plants. In fact, by increasing the cost of new plants, such standards can encourage generators to extend the life of existing plants. Hence, new source standards hold little promise in this domain.

Likewise, while subsidies or credit-based programs – including renewable portfolio standards — may displace some new coal-fired generation with other types of generation, they will have little, if any, effect on the operation of existing coal-fired power plants. And carbon taxes are opposed by the regulated community because of the additional costs they would place on private industry, and are opposed by environmentalists because of the political challenges.

This leaves cap-and-trade. Such a system would cover both new and existing emission sources, and could have a more pervasive effect on coal use than standards, subsidies, or credit-based programs. For this and other reasons, most policy attention in the United States has been focused on potential cap-and-trade systems.

Coal combustion generates the most CO₂ emissions per unit of energy. As a result, a cap-and-trade system’s effect on the cost of coal use would be significantly greater than its effect on the cost of gasoline or natural gas consumption. For example, a $100 per ton of CO₂ allowance price would increase the average cost of electricity generation from coal-fired power plants by about 400%, the average cost of electricity generation from natural gas plants by about 100%, and gasoline prices by about $1.00 per gallon.

The competitiveness of conventional coal-fired electricity generation relative to other technologies diminishes as the stringency of an emissions cap increases. Therefore, much attention is being given to opportunities to employ carbon-capture-and-storage (or CCS) technologies, which would separate carbon dioxide from other stack gases, liquify it, and store it underground for long periods of time.

Three important caveats about CCS should be considered. First, it is likely that CCS will be economically practical only for new plants, and only when CO₂allowance prices exceed $100 per ton of CO₂ for early adopters (cost estimates have increased over the past few years, as technological and institutional challenges have become clearer). Second, there is significant uncertainty about the cost of CCS, because it has not yet been commercially demonstrated. And third, CCS significantly reduces, but does not eliminate, CO₂ emissions from coal-fired generation.

In light of the growing momentum toward a mandatory U.S. climate policy, the anticipated impacts of such policies on coal use are an important issue. But the remaining uncertainties are great. Impacts of a climate policy on coal use will depend upon the type of climate policy employed, the stringency of the policy, the future price of natural gas, the future cost and penetration of nuclear and renewable technologies, and the cost of coal-fired generation with carbon capture and storage technologies. Are all promising topics for future posts.

Cap-and-Trade: A Fly in the Ointment? Not Really

For more than two decades, environmental law and regulation was dominated by command-and-control approaches — typically either mandated pollution control technologies or inflexible discharge standards on a smokestack-by-smokestack basis. But in the 1980s, policy makers increasingly explored market-based environmental policy instruments, mechanisms that provide economic incentives for firms and individuals to carry out cost-effective pollution control. Cap-and-trade systems, in which emission permits or allowances can be traded among potential polluters, continue today to be at the center of this action.

Most recently, this has been in the context of deliberations regarding possible U.S. actions to reduced carbon dioxide and other greenhouse gas emissions linked with global climate change, as in HR 2454, the Waxman-Markey bill approved by the U.S. House of Representatives, as well as in proposals developing in the Senate. (I have written a number of blog posts on this topic. If you’re interested, please see: “Opportunity for a Defining Moment” (February 6, 2009); “The Wonderful Politics of Cap-and-Trade: A Closer Look at Waxman-Markey” (May 27, 2009); “Worried About International Competitiveness? Another Look at the Waxman-Markey Cap-and-Trade Proposal” (June 18, 2009); “National Climate Change Policy: A Quick Look Back at Waxman-Markey and the Road Ahead” (June 29, 2009). For a more detailed account, see my Hamilton Project paper, A U.S. Cap-and-Trade System to Address Global Climate Change.)

But the transition from command-and-control regulation to market-based policy instruments has not always been easy. Sometimes policy can outrun basic understanding, and the claims made for the cost-effectiveness of cap-and-trade systems can exceed what can be reasonably anticipated. Among the factors that can adversely affect the performance of such systems are transaction costs.

In general, transaction costs — those costs that arise from the exchange, not the production, of goods and services — are ubiquitous in market economies. They can arise from any exchange: after all, parties to transactions must find one another, communicate, and exchange information. It may be necessary to inspect and sometimes even measure goods to be transferred, draw up contracts, consult with lawyers or other experts, and transfer title.

In cap-and-trade markets, there are three potential sources of transaction costs. The first source, searching and information-collection, arises because it can take time for a potential buyer of a discharge permit to find a seller, though — for a fee — brokers can facilitate the process. Although less obvious, a second source of transaction costs — bargaining and deciding — is potentially as important. A firm entering into negotiations incurs real resource costs, including time and/or fees for brokerage, legal, and insurance services. Likewise, the third source — monitoring and enforcing — can be significant, although these costs are typically borne by the responsible governmental authority and not by trading partners.

The cost savings that may be realized through cap-and-trade systems depend upon active trading. But transaction costs are an impediment to trading, and such impediments thereby can limit savings. So, transaction costs reduce the overall economic benefits of allowance trading, partly by absorbing resources directly and partly by suppressing exchanges that otherwise would have been mutually (indeed socially) beneficial. But when transaction costs can be kept to a minimum, high levels of trading — and significant cost savings – are the result.

Since David Montgomery’s path-breaking work in 1972, economists have asserted that the post-trading allocation of control responsibility among sources and hence the aggregate costs of control are independent from the initial permit allocation. This is an extremely important political property, but does this still hold in the presence of transaction costs? This is a question I investigated in an article titled, “Transaction Costs and Tradable Permits,” which was published in the Journal of Environmental Economics and Management in 1995 (and which the publisher lists as one of the ten most cited articles in the journal’s history, going back to 1974).

The answer to this question is: “it depends.” If incremental transaction costs are independent of the size of individual transactions, the initial allocation of permits has no effect on the post-trading allocation of control responsibility and aggregate control costs. But if incremental transaction costs decrease with the size of individual trades, then the initial allocation will affect the post-trading outcome.

This is of great political importance, because it means that in the presence of transaction costs, the initial distribution of permits can matter not only in terms of distributional equity, but in terms of cost-effectiveness or efficiency. This can reduce the discretion of the Congress (or other legislature or agency) to distribute allowances as they please (in order to generate a constituency of support for the program), and may thereby reduce the political attractiveness and feasibility of a cap-and-trade system.

Empirical evidence, however, indicates that transaction costs have been minimal, indeed trivial, in enacted and implemented cap-and-trade systems, including the U.S. EPA’s leaded-gasoline phasedown in the 1980s, and the well-known SO₂allowance trading system, enacted as part of the Clean Air Act amendments of 1990.

That’s good news, surely. But nevertheless, going forward, choices between conventional, command-and-control environmental policies and market-based instruments should reflect the imperfect world in which these instruments are applied. Such choices are not simple, because no policy panacea exists.

On the one hand, even if transaction costs prevent significant levels of trade from occurring, aggregate costs of control will most likely be less than those of a conventional command-and-control approach. A trading system with no trading taking place will likely be less costly than a technology standard (because the trading system provides flexibility to firms regarding their chosen means of control) and no more costly than a uniform performance standard.

But the existence of transaction costs may make the choice between conventional approaches and cap-and-trade more difficult because of the ambiguities that are introduced. With transaction costs — as with other departures from frictionless markets — greater attention is required to the details of designing specific systems. This is the way to lessen the risk of over-selling such policy ideas and ultimately creating systems that stand the best chance of being implemented successfully.

What Role for U.S. Carbon Sequestration?

With the development of climate legislation proceeding in the U.S. Senate, a key question is whether the United States can cost-effectively reduce a significant share of its contributions to increased atmospheric CO₂ concentrations through forest-based carbon sequestration. Should biological carbon sequestration be part of the domestic portfolio of compliance activities?

The potential costs of carbon sequestration policies should be one major criterion, and so it can be helpful to assess the cost of supplying forest-based carbon sequestration. This is a topic which I’ve investigated in a series of papers with various co-authors over the past ten years (“Land-Use Change and Carbon Sinks: Econometric Estimation of the Carbon Sequestration Supply Function.” Journal of Environmental Economics and Management 51(2006): 135-152, with Ruben Lubowski and Andrew Plantinga; “Climate Change and Forest Sinks: Factors Affecting the Costs of Carbon Sequestration.” Journal of Environmental Economics and Management 40(2000):211-235, with Richard Newell; and “The Costs of Carbon Sequestration: A Revealed-Preference Approach.” American Economic Review, volume 89, number 4, September 1999, pp. 994-1009.) Most useful for policy purposes is probably the 2005 report Kenneth Richards and I wrote for the Pew Center on Global Climate Change (“The Cost of U.S. Forest-Based Carbon Sequestration”). In that report, we surveyed and synthesized the best cost estimates from all available sources.

Human activities — particularly the extraction and burning of fossil fuels and the depletion of forests — are causing the level of CO₂ in the atmosphere to rise. It may be possible to increase the rate at which ecosystems remove CO₂ from the atmosphere and store the carbon in plant material, decomposing detritus, and organic soil. In essence, forests and other highly productive ecosystems can become biological scrubbers by removing (sequestering) CO₂ from the atmosphere. Much of the current interest in carbon sequestration has been prompted by suggestions that sufficient lands are available to use sequestration for mitigating significant shares of annual CO₂ emissions, and related claims that this approach provides a relatively inexpensive means of addressing climate change. In other words, the fact that policy makers are giving serious attention to carbon sequestration can partly be explained by (implicit) assertions about its marginal cost, or (in economists’ parlance) its supply function, relative to other mitigation options.

Among the key factors that affect estimates of the cost of forest carbon sequestration are: (1) the tree species involved, forestry practices utilized, and related rates of carbon uptake over time; (2) the opportunity cost of the land-that is, the value of the affected land for alternative uses; (3) the disposition of biomass through burning, harvesting, and forest product sinks; (4) anticipated changes in forest and agricultural product prices; (5) the analytical methods used to account for carbon flows over time; (6) the discount rate employed in the analysis; and (7) the policy instruments used to achieve a given carbon sequestration target.

Given the diverse set of factors that affect the cost and quantity of potential forest carbon sequestration in the United States, it should not be surprising that cost studies have produced a broad range of estimates. Ken Richards and I identified eleven previous analyses that were good candidates for comparison and synthesis, and we made their results mutually consistent by adjusting them for constant-year dollars, use of equivalent annual costs as outcome measures, identical discount rates, and identical geographic scope. We also employed econometric methods to estimate the central tendency (or “best-fit”) of the normalized marginal cost functions from the eleven studies as a rough guide for policy makers of the projected availability of carbon sequestration at various costs.

Three major conclusions emerged from our survey and synthesis. First, there is a broad range of possible forest-based carbon sequestration opportunities available at various magnitudes and associated costs. The range depends upon underlying biological and economic assumptions, as well as analytical cost-estimation methods employed.

Second, a systematic comparison of sequestration supply estimates from national studies produces a range of $25 to $75 per ton for a program size of 300 million tons of annual carbon sequestration. The range increases somewhat- to $30-$90 per ton of carbon-for programs sequestering 500 million tons annually.

Third, when a transparent and accessible econometric technique was employed to estimate the central tendency (or “best-fit”) of costs estimated in the studies, the resulting supply function for forest-based carbon sequestration in the United States is approximately linear up to 500 million tons of carbon per year, at which point marginal costs reach approximately $70 per ton.

A 500 million ton per year sequestration program would be very significant, offsetting approximately one-third of annual U.S. carbon emissions. At this level, the estimated costs of carbon sequestration are comparable to typical estimates of the costs of emissions abatement through fuel switching and energy efficiency improvements. This result indicates that sequestration opportunities ought to be included in the economic modeling of climate policies. And it further suggest that if it is possible to design and implement a domestic carbon sequestration program, then such a program ought to be included in a cost-effective portfolio of compliance strategies when the United States enacts a mandatory domestic greenhouse gas reduction program. Large-scale forest-based carbon sequestration can be a cost-effective tool that should be considered seriously by policy makers.

Of course, this raises the question of whether a policy that will bring about such biological carbon sequestration cost-effectively can be developed, whether as part of a cap-and-trade system, a related offset scheme, or through some other policy mechanism. That is a question without easy answers (as I’ve noted in a previous post on the Waxman-Markey legislation), but the cost analyses I’ve reviewed in this post suggest that it is important to explore possible ways of incorporating biological carbon sequestration in future U.S. climate policy.