Climate Change Legislation: What the Senate Might Do

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Thomas Hewson:“Climate Change Is Likely to Pass”

Thomas Hewson, principal, Energy Ventures AnalysisClick here to enlarge image

Make no doubt about it, climate change, in my mind, is likely to pass. It is an important issue in terms of Washington, D.C. The Democrats are looking for issues in order to say they are successful before the upcoming midterm elections (in 2010). And so, I believe that there are going to be a lot of changes made between what we saw happen in the House and what’s actually going to pass out of Congress.

First of all, it is going to be a cap-and-trade program. Many people have tried the carbon taxes; economists have tried to convince them to no end. It seems it will be a cap-and-trade program because that’s the only way we can achieve a given limit. It is going to cover more than just the power industry. It is going to cover most all our energy use in the United States, as well as all those greenhouse gases that are used in things like air conditioning.

We are going to permit domestic and international offsets in lieu of rate reductions. We will allow that and you will see the reason why we want to do that is as a way to contain costs. There will be provisions for carbon capture and sequestration incentives. It’s very important in terms of the future of the industry if we are really going to achieve more than 80 percent reduction from current levels. We need to have a viable technology that is able to achieve it. So I believe there will be a lot of incentives incorporated into the final legislation.

And finally, there will be energy efficiency and renewable energy. It’s obviously a favorite topic for most of the politicians. But a lot of these energy efficiency and renewable expectations will not be fulfilled. There are great challenges associated with meeting as great an energy efficiency level as many would like to have. So, we’ll set the goals but we’ll probably likely fall short of the goals.

Emission Reduction Targets

What’s remaining? If Sen. (Barbara) Boxer (D-Calif. and Chair of the Senate Environmental and Public Works committee) wants something passed, she’s going to have to make a lot more concessions than what she apparently has been willing to make. One is on the emission reduction target. We’re talking about reducing it from 17 percent from 2020 levels. We’re talking about allowance distribution. As you might remember, when we passed the 1990 Clean Air Act there were allowances to hand out and politicians do very well at handing out allowances because allowances are money. And so there are going to be a lot more in terms of allowance distributions and free allocations. And there are going to be a lot of specific programs.

Keep in mind the House program was only 1,427 pages of which a lot of that was dictated in terms of trying to meet certain needs for various constituencies. I think probably we’re going to need to get price control measures. We believe the current strategic reserve approach is going to be non-effective in terms of controlling costs and so we’re likely to go to price control measures. And then, we’re going to have to do something about offsets.

Three Phases

Whenever you look at climate change legislation, it’s important to understand we will go through three phases. First is going to be offsets. It’s a lot cheaper to plant a tree than to reduce emissions from energy use. We’re talking about more than 10 years of which up to 2 billion tons of offsets can be used in lieu of direct reductions.

We will then go to a second phase, which is when we actually have direct reduction abatement measures. This is when we’re going to have to reduce emissions. We believe it is likely the power industry is going to become the swing supplier of incremental CO₂ reductions. So, that’s primarily going to come from displacing coal with gas.

The third phase, which is what everyone is hoping or depending on, is that we get viable carbon capture technology, which we can retrofit technologies which will set up, in essence, a price cap on CO₂ prices.

Carbon offsets are, in essence, Mother Nature in terms of forests, in terms of grasses; all of which capture carbon dioxide. And if we can increase the carbon capture rate, we will get credit for it. Or, we can decrease emissions by non-regulated sources. In the international market, which is believed to be the largest source of offsets in the world, we have right now 624 million tons a year that are being created in developing nations.

Keep in mind that 80 percent of all those offsets in the international marketplace are controlled by four countries. Forty-five percent of all offsets in the world are in China. When you take India, you get up to two-thirds of the offsets that currently exist. Then you go to Korea and Brazil and among those four nations, 90 percent of all offsets in the world today come from one of those four countries.

In the U.S., we do not have as many options because we are going to regulate most of those sources. When you become a regulated source you’re no longer an offset source. We have significant concerns that the U.S. is going to have problems creating many offset credits because of the forced conversion to meet increasing renewable fuel standards; for ethanol using either corn or cellulose and the renewable energy standards associated with expanding our renewable energy. Those will probably make us a very small source of carbon offsets in the U.S. If indeed China and India become part of the (climate change) program, keep in mind that would also destroy a lot more of our offsets. We believe that, fundamentally, we have significantly underestimated the costs of offsets in the world.

We then go into this next phase, which is whenever we run out of offsets we’re going to go to direct reductions. But if the coal industry becomes the swing supplier of emissions allowances, it is going to be from switching from coal to gas; it is going to be the incremental ways we can get CO₂ reductions. If you take all the emissions that are handed out and you subtract all the ones given to the other industries and you come down to what’s left over for baseloaded power and you divide that by the amount of generation that’s required to meet the base load, you get this ratio of how many pounds of CO₂ will be allowed per megawatt hour produced. As it becomes stricter with time, if we do not have CCS (carbon capture and storage), we are going to be backing out greater and greater amounts of coal. However, once we establish CCS, it is likely that we can go back and displace lots of gas, because—in essence—coal with carbon capture is going to be less than natural gas without. So, if the industry becomes a swing supplier of allowances it ultimately sets the price in this period.

That means that the CO₂ penalty will have to increase to offset the higher cost of natural gas. And so, we expect that if natural gas prices were to go higher, you’re going to need a higher CO₂ penalty. Fundamentally, the natural gas prices will have an effect just like energy efficiency: the more energy efficiency we have, the greater amount of coal, the higher the cap, the more coal we have, the more domestic offsets, the greater amounts of coal we can have in our mix. And also, the more nuclear that is built, the greater amount of coal that can be in the mix.

The final phase is when we develop CCS technologies. In the current legislation, we are talking about developing over $1 billion a year for charges that will go toward CCS development. We also have incentives in terms of tax credits coming from the allocation. If you can get 80 percent removal rate you will get $90 a ton and another $10 a ton if you’re willing to make that commitment before Jan. 1, 2012. After we go through the first 6 GW there will be a reverse auction, meaning you bid into the system how much money you need to develop CCS, in order to spend the amount of money that’s being created by special offsets. This is one way we are going to build new coal plants, but it’s also going to mean a lot more needs to make our coal fleet cleaner.

Finally, if I’m wrong about (getting) cap-and-trade programs passed, that will mean the continuing initiatives that are going in the regions and the states. Keep in mind that once the federal government adopts cap-and-trade legislation, it will pre-empt any state or regional cap-and-trade programs. You start adding up all those votes and I believe this is part of the reason why this legislation will pass. So, we will have cap-and-trade programs in these regions.

Neal Cabral: “Geography and Region Influence Climate Change Politics”

Neal Cabral, partner with the Washington, D.C., law firm McGuireWoods, briefs the Coal-Gen audience.Click here to enlarge image

The United States House voted on landmark climate change legislation on June 26 by a 219-212 vote. That vote included seven Republicans for it; 46 Democrats voting against it. You can conclude that climate change politics are influenced as much by geography and region as by party affiliation. Many states in the Midwest and Southeast have very coal-dependent (power) supply, very few quality renewable resources and economies reliant in part on manufacturing. Many of the agreements of Waxman-Markey were intended to mitigate the costs to these states, but those states—as opposed to the states on the left and right coasts—will pay a disproportionate share of the costs of any climate change legislation.

The Senate has moved rapidly from a next-year approach to a goal of a floor vote in December 2009. (Sen. Barbara) Boxer’s (D-Calif.) committee (Environmental and Public Works) will produce a draft for markup to be done by Sept. 28. Boxer’s EPW committee is a much more liberal committee than the House Energy of Commerce Committee. Consequently, we can see her revisiting a lot of the issues that were compromised and nailed down in Waxman-Markey, including size of free allocations of allowances, the size of the renewable mandate and the rate of cap decline to 2020, three of the big issues. Once she’s done, getting to 60 votes will turn on convincing two dozen conservative Democrats and moderate Republicans. You need almost all of them to vote the bill, and that’s going to be a tough row. Many of the changes made to Waxman-Markey in the House will appeal to this group, but it’s not clear if this group is ready to vote on another big legislative program.

Cap and Trade

The centerpiece of Waxman-Markey is the economy-wide cap- and-trade program. Cap starts in 2012 with the power sector and transportation sector. Industrial sources become covered in 2014 and natural gas becomes covered in 2016. There’s a separate cap for hydrofluorocarbon emissions. About 87 percent of U.S. 2005 greenhouse gas emissions are covered by the cap. The cap reduces emissions from capped sources 3 percent below 2005 levels at the start; it declines to 17 percent below 2005 levels in 2020 and, ultimately, 83 percent below 2005 levels by 2050. The legislation also has several off-cap complimentary policies. In one set of policies, the EPA is obligated to issue performance standards to reduce greenhouse gas emissions from a series of uncapped sources based on a formula. In addition, 5 percent of allowances are allocated to be spent on reducing international deforestation and obtaining other reductions.

Our research has done a preliminary calculation of what those off-cap reductions would get along with capped reductions. The initial estimates of the cap, plus the complimentary policies, suggest overall reductions in 2020 of 28 percent below 2005 emissions. Fifteen percent of that is the cap and the other 13 percent is the complimentary policies. That suggests Congress does have some wiggle room in mitigating the impacts of the cap on capped sources and still being able to get substantial reductions by 2020.

The key issue is cost containment mechanisms in the Senate. The allowance battle was fought in the House and industry prevailed fairly well in that allocation. There’s a big concern in the industry in the ability to develop and deploy technology in time to meet the 2020 and 2025 carbon capture and storage and renewable mandates. There’s also a concern to meet the initial decline in 2012; it’s a 3 percent decline from 2005 levels, but that equals—for a lot of the utilities—about a 10 percent decline up front. That ain’t gonna happen in three years, so the prediction is there will be a need for large allowance purchases. Those allowances might become very expensive very quickly.

So, the argument is that technology cannot deploy consistently with the cap reduction timetable. The result is going to be high allowances and costly switches to natural gas. The power sector is proposing a price collar, which is a minimum allowance price floor. One of the reasons you want that is to stop the boom-and-bust cycle that occurred in Europe when allowance prices went from $28 to $3 back to $28 to sustain investment in low-carbon technologies, and then a ceiling price which, if triggered, would allow the purchase of an unlimited amount of allowances at the ceiling price to mitigate the price of the actual allowances under the cap.

Cost Containment Options

The Senate has really three cost containment options. One is a lower rate of decline by 2020. Currently the cap is down 17 percent by 2020. If you slow the rate of decline to 2020, you will get some level of cost mitigation. The second approach is an improved strategic allowance reserve. The third approach is a price collar.

Waxman-Markey is at 17 percent by 2020, Boxer would like 20 percent. I wouldn’t be surprised to see that in her committee bill. The power industry is going to push for something like (President Barack) Obama’s proposed 15 percent decline to 2020. A 15 percent decline to 2020 will mitigate costs some but not a lot. To really mitigate costs by slowing the rate of decline, you have to get that number probably down to what (Rep. Rick) Boucher (D-Virginia)had proposed, which is 6 percent by 2020. But the politics behind dropping that number to 6 percent are too hard and that’s probably not going to happen.

An alternative is the strategic allowance reserve, included in Waxman-Markey. It takes allowances from future years and makes them available to anybody at a specified trigger price. That price starts at $28 a ton and goes up. There are two flaws in the way this is structured. One is allowances shall only be taken from the out years—2030 and beyond—and not from all years, which is what Waxman-Markey does. It doesn’t make sense to take allowances from the early years to mitigate costs because then you’re reducing the pool of allowances available in the first place.

The second problem with Waxman-Markey is the allowance price reserve should be based on a fixed formula that escalates under a specific formula. The way it’s actually priced is that it includes the prior three years’ average allowance price costs and then prices it at 60 percent of that. So if you have a skyrocketing allowance price situation, the pricing for the allowance reserve begins to incorporate that in the price of the reserve. It defeats the entire purpose of the reserve mitigating allowance price costs. But, with those two fixes, the strategic reserve is a viable option for cost mitigation.

With a properly structure strategic reserve, you can replicate the cap based on the 6 percent decline to 2020. You place in reserve the amount of allowances that would equal a 6 percent rate of decline to 2020 and you replicated the effect of going to 6 percent by 2020 the number of allowances available in the out years under either scenario is less. But the number of allowances available in the early years is higher if the price trigger is met. It’s a much more palatable solution to changing the rate of decline to 2020. No one seems to be upset about this, but if you suggest that the rate of decline to 2020 should be changed, everybody freaks out. So, that’s another possibility to mitigate costs.

The third option is a price collar. Power companies are going to push for a price collar. The big issue here is that if the price cap is reached, an unlimited amount of allowances (new allowances, extra allowances) are injected into the system at the price cap cost. That would break the integrity of the emissions cap. Not all of the reductions will be made if new allowances are entered into the system.

Price Collar Politics

There are going to be politics involved with the price collar approach. Politically, a price collar may appeal to moderate senators who face political pressure if they vote for a greenhouse gas bill. We can be certain about the costs and we can be certain about the impacts on consumers. However, environmental groups and liberal congressmen in the House gave up virtually all of their pet issues in Waxman-Markey. They got a lower level of renewables than they wanted, they got a lower level of rate of decline to 2020, they got a very high amount of offsets available and they got free allowance allocations where they wanted an auction. Those were their five key issues; they gave up on all of them and all they got was a cap. The price ceiling takes that cap away, so the response by them may be that they put free allowance allocation back on the table, and we’re sort of right back where we were at the beginning of the politics involved with Waxman-Markey.

Waxman-Markey gives away most of the allowances for free. Thirty five percent goes to the power industry to cover roughly 40 percent of emissions, 30 percent goes to local distribution companies for the benefit of ratepayers, 3.5 percent goes to merchant coal (that was a big win for the industry although merchant units are capped at 50 percent of their baseline and the rest goes to independent power producers with long-term contracts), natural gas gets 9 percent, low-income consumers get 15 percent because climate change is always regressive economically, carbon capture and storage early deployment gets 2 percent and there are several other programs set up with additional allowance funding. The allowance allocations decline slowly and may phase out by 2029. There’s also a provision to fund early deployment of carbon capture and storage.

The Senate may revisit the allocation. Boxer loves to auction stuff and fund all sorts of pet projects. It would not be surprising to see her revisit that issue. The power industry wants a longer phase out. The phase out of free allowances occurs over four years, between 2025 to 2029. They want to extend that out a little bit farther. Industrial sources got shut out of allowances. Fifteen percent of allowances are allocated to industrials but only to trade-sensitive, greenhouse-gas- intensive industries. So, not every industry is going to qualify and a lot of them are not going to get allowances, so they’re going to scream for their share of the allowances.

Natural gas didn’t do very well on the allowance allocation either, so they are generating a push to get additional allocations. Local distribution companies are obligated to use the free allowances for the benefit of all ratepayers, which presumably means you use that to dampen rate increases. The National Association of Regulatory Utility Commissioners wants more flexibility in how the allowances that are allocated to local distribution companies can be used. They haven’t put out a particular position, but I suspect they would like to sell some of them and use them to develop energy efficiency programs to dampen rates rather than dampen rates purely through monetary rebates.

So, undoing the House compromise on allowance allocations is really going to crater this whole bill and whether or not that comes up or not remains to be seen. But, that was a big fight in the House and may be reopened in the Senate.

The last issue that’s probably going to come up in the Senate is a proposed 25 percent renewable standard and a 15 percent energy efficiency standard. That’s not a good standard for states in the Southeast and Midwest, which Environmental Protection Agency modeling shows meet a 10 percent renewable standard with biomass and that’s about it. Everything else they buy renewable energy credits for, which means they send ratepayer money out of state to the places with better wind sources. So, they got that into a combined renewable energy standard and energy efficiency standard of 20 percent by 2020. Of the 20 percent, the base standard’s 15 percent for renewables and 5 percent for energy efficiency. But you can alter that mix: 12 percent renewables and a maximum of 8 percent energy efficiency through a state election.