A Guide to the Clean Air Act
for the Renewable Energy Community
Emissions Trading Under the Clean Air Act
What does all this have to do with renewables? Not much at the momentbut the CAA is potentially the foundation on which to build a multibillion-dollar revenue stream for renewable energy firms. Part of that foundation is in place: Congress has both specifically and generally recognized the air pollution control potential of wind, solar, and biomass technologies in existing and emerging emissions trading programs.17
The 1990 CAA amendments contain many provisions that require or encourage use of emissions trading or other forms of economic instruments to control air pollution.18 These programs seek to increase economic efficiency by giving regulated industries greater flexibility to comply with anti-pollution regulations. Through emissions trading options, overall emission control costs are lowered by encouraging the largest reductions to occur at facilities that can reduce pollution at the lowest cost.
Emissions trading provisions remain controversial within the environmental community. Some groups, such as numerous environmental justice groups and the Sierra Club,19 object to trading since it can create local pollution "hotspots"where emissions and human health impacts remain high due to sources that comply by purchasing emissions allowances from cleaner sources elsewhere. Such hotspots can disproportionately affect low-income and minority communities. Without taking a position in this debate, it is worth noting that if trading programs exist or are on the drawing board, they need to have an explicit role for renewables.
Emissions trading mechanisms can take many different forms, but most are based on the "cap-and-trade" concept and contain common structural elements.
What is an emission cap? Most emissions trading mechanisms are based on a "cap," expressed as a limit on tons of pollutant that can be emitted in a given period. Typically, caps (or emission budgets) limit emissions in tons per year or, in the case of summertime smog pollutants, tons per season. Caps are set based on a judgment (often by political leaders) about the level of emissions that can be tolerated without adverse effects on health or the environment.
Emission caps may be specific to geographic areas or even to industries. For example, a global CO2 control strategies may contain emission caps applicable to each nation. National CO2 caps may be implemented through separate caps applicable to utility, commercial, and mobile source pollution sectors. As described later, the cap on eastern U.S. NOx emissions has 22 separate state caps, which may ultimately be translated into industry-specific caps (such as seasonal tonnage limits on NOx emissions from electric power plants).
A properly set emission cap generally increases the costs of higher polluting producers and gives cleaner sources a competitive boost. For example, in the electric power sector, the national cap on SO2 emissions increased costs for coal-fired electric generation without affecting generators using natural gas (a non-sulfur-bearing fuel).20 A national or global CO2 cap would narrow the gap between the costs of conventional fossil-fuel-based electric power and renewable energy resources. For this reason, emission caps are generally favorable for renewables industries.
By itself, however, the creation of a cap-and-trade system does not necessarily benefit renewable energy industries. If the difference between the cost of production of conventional generation and renewables is too great, then the cap may only serve to encourage the relatively cleaner but nonrenewable forms of production (such as natural gas over coal). In such cases, supplemental forms of incentives and other governmental support for renewable energy resources may be needed. As described later, allocating allowances directly to renewables or creating a "set-aside" of allowances for renewables are two ways to ensure that a cap-and-trade system encourages development of renewable energy effectively.
What currency is used in a cap-and-trade system? Environmental regulators often grant permission to emit under an emission cap in the form of "allowances." These are distributed to or earned by the affected emission sources on an annual basis. An allowance usually represents permission to emit one ton of the pollutant per year (or season). For example, the state environmental agency may allow a power plant in New York to emit 1,000 tons of NOx each summer season. At the end of the season, the source must demonstrate that it has not emitted more than this amount. Alternatively, the source could emit fewer tons than the number of allowance it holds and sell its "surplus" allowances to other emission source operators, who comply with the cap using a combination of allocated and purchased allowances. The revenues from the sale of "excess" allowances helps the seller recoup some of the costs of achieving the better-than-required level of emissions.
How are allowances distributed among affected sources? Once the cap is set, there must be an "allocation" mechanism to decide each source's emission control obligation. Regulators can allocate the allowances directly or they can auction the allowances to all regulated facilities. In the latter case, renewables projects would not participate in the auction if they do not emit, but they could engage in trading if allowances were "set aside" for them, as described later. (An alternative method of awarding pollution control value to renewables in a cap-and-trade system is to auction the allowances and use the revenues to pay for incentives to renewable energy developers.)
In the CAA acid rain provisions, Congress specified the number of SO2 allowances that each electric power plant source would receive, based roughly on a uniform emission rate (1.2 lbs/mmBtu) applied to the plant's historic (annual) electric power production. In other systems, the states make the allocation decision, often in a rule-making procedure preceded by a massive negotiation session among the interested industries. To date, renewable energy advocates have not participated in these negotiations. Distributing allowances based solely on historical emissions can hurt new renewable energy projects that did not exist during the period selected as the basis of historical emissions.
An alternative to relying on historical emissions is to assign a certain number of allowances for each unit of actual heat input or electricity production ("output") going forward ("earn as you burn" or "forward looking").
The choice between input- and output-based allocation is also a key design decision. An input-based allocation gives allowances to sources based on emissions per unit of boiler heat input (measured in Btus). Many environmental groups strongly prefer an output-based allocation since it provides greater incentives to reduce emissions through plant operational efficiency. For example, under a forward-looking, output-based allocation method, CO2 emissions could be allocated to all fossil and renewable power plants on the basis of X allowances for each megawatt-hour of actual electric power production. A regulatory structure that imposes a uniform emissions limit on generators based on a set ratio of mass emissions to electric production (lbs/mWh) is sometimes referred to as a generation performance standard (GPS).21
How will a purchaser verify the allowances offered for sale? Every cap-and-trade system must have a mechanism to record initial allocations and trades among affected parties, plus an effective system to monitor compliance. In the acid rain program, Congress assigned this job to EPA, which has constructed an elaborate electronic system to record trades, so that purchasers can be assured that traded allowances can be used for compliance purposes.
How do buyers and sellers of allowances find each other? Congress set up several mechanisms in the acid rain program to ensure that a robust market in allowance trading would occur. It required EPA to hold periodic allowance auctions to help define market prices and to give affected industries an easy place to find transaction partners. Private market exchanges and brokerage associations soon emerged, however.22
How does a renewable energy resource with no emissions end up with allowances to sell? This is the key question, since if renewable industries are not active in the development of emissions trading programs, they will not be allocated any allowances and the pollution control effects of their technologies may go uncompensated. Air regulators are not used to thinking of renewable energy resources as a pollution control strategy, so renewable energy representatives need to lobby actively for direct allocation or set-aside for renewables.
There are at least three ways to allocate emission allowances to renewables. The first method awards them on the same basis as other electric generation resources. For example, a regulator may set a cap on total emissions of NOx from the non-nuclear and non-hydro electric generators, and then allocate allowances to new and existing generators by dividing the cap by the total amount of expected generation (for example, a certain number of allowances would be awarded for each megawatt-hour of electricity produced).23 The result is that each unit of generation from a renewable resource would earn the same number of allowances as an equivalent amount of electrical output from fossil fuel generators. Allowances earned by renewables would be sold in allowance trading markets.
The second way is to assign an avoided emission value for each unit of electric power produced or avoided by clean technology. In other words, a regulator (primarily as a way to evaluate the effect of the policy mechanism) might decide to award allowances to a wind generator based on an estimate of the amount of pollution from conventional electric generation that would have occurred if the wind turbine did not exist. In most cases, the electric power generation displaced by renewables is associated with fossil-fired units that are "on the margin" (generating units that are able to increase or decrease electric power output in response to changing patterns of electric power supply and demand). Thus the emissions avoided by clean electric power technologies are not the average emissions resulting from all conventional generation, but rather the emissions from a subset of generators that are displaced.
This method can be problematic, however, since avoided emissions may be difficult to calculate. Emissions from conventional utility generators vary greatly by geographic region (low in the hydro-dominated Northwest and in the natural-gas-dominated Northeast, but high in the coal-dominated Midwest), by season, or even by time of day.
A third way renewables may gain emission allowances is through a set-aside. In the acid rain program, Congress set aside allowances for renewable energy and energy efficiency measures directly in the statute. In other cases, however, a renewables set-aside in an allowance allocation will occur administratively, often at the state level. For example, in the recent program to cut summer-time NOx emissions, renewable advocates convinced EPA to develop a "model" trading program, encouraging states to set aside a portion of the total allowances to renewables and energy efficiency. Under this rule, states have discretion on whether to give allowances to renewables, and several have done so. But in many states there is little prospect of this happening, given the political power of the fossil fuel industry and the natural inclination of coal-based utilities to obtain as many allowances as possible.
How much are the allowances worth to the renewables industry, and are they worth enough to justify the costs of going after them? The value of an individual allowance will be determined by the market demand for allowances and the cost of emission controls. If the cap is set too high and if compliance is relatively easy to achieve with low-cost emission controls, then the market price for allowances will be low, since few emission sources will need to buy them in order to comply. In contrast, a tighter cap and costly emission control technology options will stimulate higher allowance prices.
If the cap is set properly, economic theory would predict the price of allowances to be comparable to the marginal cost per ton of reducing emissions with fuel switching or emission control technology. Experience under the CAA acid rain program confirms a consistent relationship between allowance trading price and marginal costs of reducing emissions. Caution should be exercised, however, in regard to emission allowance price predictions. Historic projections of control costs and market values for allowances have been extremely inaccurate. Actual values for SO2 allowances under the Title IV acid rain program up to 1996 were only 16-23% of conservative predictions made at the time of their adoption.24 With these uncertainties in mind, a later section provides a range of possible market values for emission allowances, with an estimate of the financial benefits of a renewable allowance allocation to sample renewable energy facilities.
Renewables' Past Experience: The SO2 Cap-and-Trade Program
A driving force behind the passage of the 1990 Clean Air Act amendments was the highly charged issue of acid rain. The interstate and international dimensions of the issue popularized awareness that air pollution is not just a local problem, nor simply a matter of preventing harm to humans from acute exposure. Ecosystems, scenic beauty, wildlife, and human health each suffer from chronic, low-level, and subcontinental scale exposure to sulfur and nitrogen compounds. In the most severe cases, acidity has killed entire fish populations in lakes and streams.
Title IV of the amended Act establishes a nationwide cap on SO2 emissions and a pioneering emissions trading program. The program requires a permanent 10-million-ton reduction in annual SO2 emissions below 1980 levels by 2010.25 When fully implemented, Phase II of the program will limit total U.S. annual sulfur dioxide emissions to 8.9 million tons. The acid rain provisions have already achieved much of this reduction, along with a 2-million-ton-per-year reduction in utility NOx emissions.
These acid rain provisions were a historic achievement, one not diminished by the fact that the emission reductions were not nearly deep enough to protect human health and the environment from acid gas emissions. The emission trading program for SO2 emissions has worked well and and succeeded in incorporating pollution control costs into electricity prices.
The law permits power plant operators to trade SO2 emission allowances. Allowances were trading at roughly $210 during the summer of 1999.
The acid rain program also includes a direct financial incentive to encourage utilities to reduce SO2 emissions through energy conservation and renewables. By investing in these, utilities could earn special emission allowance awards that could be used to meet SO2 compliance obligations or be sold at a profit to other utilities. This incentive for renewables is of historical importance only, however, since the program did not achieve any significant benefit for the renewables industry and has now expired. Understanding why the program fell short of its goals may be important to the design of a more effective future program for SO2 and other pollutants.
Under §404(f)(g), EPA established a Conservation and Renewable Energy Reserve (CRER) that contained 300,000 SO2 allowances.26 The allowances were set aside from the emissions cap imposed on power plants. Allowances were awarded for SO2 emissions avoided through energy conservation, biomass (including landfill gas), solar, geothermal, and wind energy projects implemented between 1992 and 1999. Renewable energy's minimum share of the CRER was a set-aside of 60,000 allowances. An allowance could be earned for every 500 megawatt-hours of energy produced by a qualified utility through renewable energy generation measures.27 If fully used, over time the CRER would have displaced 885 million pounds of SO2. Unhappily, this will never occur. As of June 1999, less than 12% of the 300,000 allowances had been allocated (about 36,000 allowances). Of this, only about 6,700 allowances went to renewable energy projects.
There are several reasons for the CRER's disappointing performance. The program was designed primarily to encourage early reductions (to occur before the statutory deadlines) and not as a long-term incentive for renewables. In addition, most utilities did not draw from the CRER by developing or purchasing power from renewable projects since they were easily able to meet their emissions limits with low-sulfur coal and other, more conventional means. Since cost of compliance was low, so was the price of allowances. This was a blow to the CRER, especially in light of the unreasonably low conversion rate (i.e., one allowance per 500 MWh) by which renewables and energy efficiency could earn sulfur credits.
The CRER also contained harmful restrictions on how to earn allowances from the reserve. For example, only utilities could earn allowances. They were required to engage in least-cost planning28 processes in the acquisition of new generation sources and to adopt an unpopular income neutrality element in their rate structure to prevent revenue erosion from investments in energy efficiency. These concepts were cutting edge in 1990, but quickly became largely obsolete with the restructuring of the industry. Restructuring has forced divestiture of generation, loss of retail monopolies, and associated cost-cutting pressures. In short, the participants in the debate over the 1990 Amendments failed to anticipate electricity industry restructuring. As a result Congress conditioned the eligibility for CRER credits on requirements that were increasing impossible to meet under a restructured industry.29
If Congress is interested in correcting these defects, it could make several changes. In particular, Congress could:
An even better approach, however, could be to change the whole program in favor of an acid gas generation performance standard, with a direct allocation of SO2 credits to renewable generation (see discussion above on "Cap and Trade Systems").
Emissions Trading: A Significant Source of Revenue
In light of the disappointing results of the CRER program, why should the renewable energy community care to put resources into the fight for future allowances? The answer lies in the financial consequences if Congress set a cap that was tight enough to force alternatives to fossil generation and awarded tradable emission allowances directly for electric power generation from renewable energy projects.
To examine this scenario, let's look at the number of allowances that might be awarded to renewables under a trading mechanism based on actual generation (either through a GPS or through a set-aside).30 In this case, assume an allocation method in which renewables (like other generators) would earn allowances based on the following estimates of tons of pollutant avoided for each megawatt-hour of electric output: 0.6 tons of CO2, 0.00075 tons of NOx, and 0.006 tons of SO2.
Table 4 combines these allowance allocation rates with possible values for emissions allowances. It assumes fixed values of $2,000 per ton of NOx and $200 per ton of SO2, and considers the impact of three values for CO2 allowances: $5, $20, and $60 per ton. This analysis includes three values since pegging a CO2 allowance value is highly speculative, and demands a range of values to reflect uncertainty.
Multiplying the hypothetical allowance allocation (in allowances/unit of generation) by the expected value of the emissions allowances yields estimates of the value of emissions trading to the renewables industry in dollars/MWh of energy production. (See Table 5.) This can be applied to estimate the financial benefit of four renewable energy technologies industry-wide and of a sample facility. (See Table 6.)31
At an emissions trading value of $5 per ton for CO2 (the low allowance value considered), a properly constructed multipollutant cap-and-trade system would generate nearly $1.3 billion a year in revenue for the renewables industries. These values represent the product of the total energy generated in 2010 by each renewable energy technology and the value in dollars per kilowatt-hour for the various pollutants.32
Individual renewable energy facilities would have much to gain from participation in an emissions trading program. Using the allowance allocation rates for renewable energy generation estimated earlier, Table 6 estimates the annual revenue benefit to facilities of a cap-and-trade system that allocates NOx, SO2, and CO2 emission allowances to renewable energy facilities in the same amounts as are currently allocated to fossil generators.
To estimate total generation for each facility, the table assumes installed capacity at 20 MW for each technology. To estimate the power generated by each plant, the table assumes the plants have capacity factors (the annual average percentage of maximum plant capacity actually used) as estimated in projections for 2010 for each technology by the Electric Power Research Institute and the U.S. Department of Energy.
Low-value CO2 allowances ($5 per ton) combined with NOx and SO2 allowances could thus earn the following for renewable energy facilities:
It is important to note that a biopower operation will release no net carbon to the atmosphere only if the biomass comes from a supplier who manages stock so that planted biomass stores carbon equivalent to that released by the biomass burned. Since this condition is not directly related to combustion, it is not yet clear how air regulators can account for the full fuel cycle of biomassfrom planting, harvesting, transport, and combustionin a trading program.
Possible Impacts of a Trading Scheme on Renewables
Properly constructed, a cap-and-trade system could provide a powerful financial incentive for renewables. A poorly designed system, however, can have the opposite effect. To illustrate, consider the following situations.
An undesirable outcome for renewables could occur as follows:
Under this scenario, the only parties able to take advantage of the pollution effect of renewables' generation are the fossil generators. These companies may invest in renewables, as a sideline, to improve their public image and to balance demand, generation, and emissions as necessary to meet obligations under the cap, but they cannot be expected to invest so heavily in renewables as to create any real competition with fossil or nuclear plants. Due to market power, these companies or their subsidiaries will be in a better position to capture "green premiums" for their limited amounts of renewables. Since their commitment to renewables is thin, however, the companies fail to maximize renewable energy performance, and the green kilowatts remain a marginal boutique product, temporarily attractive to wealthy residential customers only.
It does not have to be this way. Imagine for a moment a different future:
Thus the design of future emissions trading programs is extremely important to the renewable industry.
A Guide to the Clean Air Act for the Renewable Energy Community