Carbon Goes to Market

Late this month, 10 Northeastern states will conclude an auction like no other in American history. What's up for grabs is not art or property. It's...
by | September 1, 2008 AT 1:00 AM

Late this month, 10 Northeastern states will conclude an auction like no other in American history. What's up for grabs is not art or property. It's carbon -- or more specifically, the right to emit carbon dioxide from a power plant. As anyone familiar with what's causing global warming knows, carbon has a cost. Soon, in Baltimore, Boston and Buffalo, carbon also will have a price.

The auction is the opening act of a daring plan to put a big dent in greenhouse gas emissions. Another part of that plan is to impose a region-wide limit on carbon emissions from power plants, which the Northeastern states will begin enforcing on January 1. Once those two pieces are in place -- a price for carbon and a cap on carbon -- the states expect market forces will take over. Utilities will buy, sell or trade their carbon allowances amongst themselves. They'll begin building the environmental toll of their greenhouse gas emissions into the cost of electric power. And over time, as states clamp down on the carbon cap and the price of carbon goes up, utilities will emit less CO2 overall.

What the Northeastern states are putting in place is called a "cap-and-trade" system. They're not the only ones interested in the approach. In the West, seven states and four Canadian provinces are developing a parallel regime of their own; negotiators expect to have a blueprint ready for their governors by the end of this month. In the Midwest, six more states are starting work on a third regional carbon-trading scheme. Florida also is developing a program.

Collectively, these initiatives rank among the most serious efforts ever aimed at mitigating the effects of global warming. But what is emerging is something of a continental mishmash of rules and affinities. Ontario and Quebec, provinces located in central and eastern Canada, joined the system under construction in the West. That's in part because those provinces rely heavily on hydroelectric power, as does much of the West, so they see the plan unfolding thousands of miles away as a better fit than the one just south of the border. Just as incongruously, Florida may hitch up with either the West or the Northeast on cap-and-trade, although for now, Governor Charlie Crist seems content to go it alone.

Nearly everyone involved, from both the public and private sectors, would rather see a more coherent national carbon policy. But in the absence of federal leadership, the states (and provinces) have gone to work on their own. "We've got to get started," says Douglas Foy, who helped negotiate the beginnings of the Northeastern system while working for former Governor Mitt Romney of Massachusetts. "The Northeastern states are big players. They can create a market that's viable and can control carbon emissions."

Map of regional initiatives, click to enlarge

The rush to put a price on carbon carries some risks. Some worry that cap-and-trade schemes will only drive up the cost of energy at a time when consumers and businesses already are struggling with rate hikes and expensive gasoline. What's more, gaps in the current region-by-region approach may open windows for gaming the system. In the Northeast, for example, it would be easy enough for a big industrial customer in New York, which is part of the new carbon order, to look for cheaper power generated by dirty coal plants in Pennsylvania or Ohio, which are not. If that occurs, says Kenneth Pokalsky, a regulatory analyst for the Business Council of New York State, "We'll have the worst of both worlds: higher energy costs in New York to implement a program that has no discernible impact on worldwide greenhouse gas emissions."

Nobody doubts that the states are entering an era of thorny questions -- legislatures will be debating them for years to come. Yet the growing interest in cap-and-trade, from Democratic and Republican governors alike, demonstrates the power of a big idea: that carbon, a ubiquitous element that you're exhaling even as you read this, can be commoditized, marketized and ultimately downsized as a threat to the Earth. Once carbon emissions carry a price, amazing things are expected to happen. Utilities will burn less coal, fuel oil and natural gas, not because government is telling them to but because it's in their economic interest. Carbon-free energy alternatives, such as wind and solar power, will become more attractive. And utilities will have more reason to purchase carbon "offsets," which could drive promising new ideas such as storing carbon dioxide underground where it won't worsen climate change (see, " Locked Up ").

And it's all just beginning.

Reggie Is Born

There is some precedent for the cap-and-trade approach. In the 1990s, the feds applied the same market principles to combat acid rain and smog. So carbon trading was a logical mechanism for states to consider five years ago when then-New York Governor George Pataki invited his neighbors to come up with a common strategy for responding to global warming. Six states initially joined with New York to form the Regional Greenhouse Gas Initiative, or RGGI (pronounced "Reggie"). To negotiate the details, each state volunteered two high-level officials -- their environmental protection commissioner and the chair of their utility regulatory commission. It was an unprecedented collaboration between two sets of regulators who don't normally talk to each other.

Right at the start, they honed in on electricity generating stations, as opposed to emissions from other industrial users or automobiles. For one thing, power plants produce one-quarter of the Northeast's CO2 emissions. Also, utilities were already familiar with the cap-and-trade idea, and were hungry for some regulatory certainty about how to handle carbon. Even with the tight focus on power generation, the talks were difficult.

In fact, RGGI occasionally appeared doomed. As negotiators put final touches on a cap-and-trade outline, Massachusetts industries balked and Romney backed out. Rhode Island Governor Donald Carcieri quickly followed. Massachusetts later rejoined when Deval Patrick became governor, and Rhode Island also returned rather than risk being the single holdout in New England's electricity grid. Maryland signed on last year, too. Still, there remains a giant gap in RGGI's portfolio: Pennsylvania. Coal mining is still an economic mainstay in Pennsylvania; the state is the nation's third-biggest power generator and produces nearly as much CO2 as the 10 RGGI states combined.

There were many sticking points besides the question of whether Pennsylvania would participate. What level to set the carbon cap at was one of them. The RGGI states agreed to keep CO2 emissions flat for six years starting in 2009. After that, emissions from power plants are to be ratcheted downward 2.5 percent a year through 2018. Another key issue was how to distribute carbon allowances among the utilities. Power generators hoped RGGI would follow earlier cap-and-trade models by giving away most allowances free of charge. But state officials worried that utilities would reap windfall profits. So most states will put nearly all of their allowances up for auction instead. They'll plow most of the proceeds into fostering renewable energy sources and helping consumers to insulate their homes and buy energy-efficient appliances.

Price Points

The big question now is what those carbon allowances will sell for. This spring, futures markets saw rights to RGGI allowances trading at $7 per ton. Until the first bids come in, however, "we really don't know" what price the carbon auction will bring, says Gina McCarthy, Connecticut's environmental protection commissioner.

Where the market settles is just as important to power consumers as it is to the utilities themselves. Most of the Northeastern states have deregulated electric industries; some of the resulting price increase will be passed on to customers, as was the case in Europe, where carbon trading has hit ratepayers hard (see, " Cap Trap "). RGGI has designed a safety valve for customers should auction prices climb to $10 per ton or higher. But some states are wary of the price reaching even that high. In Connecticut, Governor Jodi Rell has proposed rebating revenues to ratepayers if auction prices rise above $5 per ton. The New Hampshire Legislature has mandated rebates if the price reaches $6 per ton.

If the impact on power rates is one big unknown, so is the absence of Pennsylvania and other states from the cap-and-trade regime. The big worry is that customers will undermine the system by engaging in a new form of smokestack chasing: buying cheaper power from outside the compact. New Jersey's legislature is concerned enough about this so-called "leakage" problem that it ordered state utility regulators to come up with a strategy for keeping it under control. It won't be easy: New Jersey, Delaware and Maryland are all linked to a power grid that stretches west through Pennsylvania and all the way to Illinois. Meanwhile, federal regulators and power transmission companies are mapping out more high-voltage corridors to bring cheaper coal-fired electricity in from the Midwest. As Seth Kaplan, an attorney for the Conservation Law Foundation, puts it, if those lines are built, they "would be the leakage highway."

Ambitious as RGGI is, the cap-and-trade system being developed in the West is even bolder. The Western Climate Initiative is targeting not just carbon dioxide -- by far the biggest culprit in global warming -- but five other greenhouse gases as well. What's more, WCI isn't limiting its scope to power plants. It's trying to bring all major industries, transportation fuels, and even private citizens' furnaces, stoves and hot water heaters into an emissions-trading regime that covers 20 percent of the U.S. economy and nearly three-quarters of Canada's.

Such an all-encompassing strategy is "the logical progression for cap-and-trade programs," says Michael Gibbs, the California Environmental Protection Agency's assistant secretary for climate change. It's also much more controversial, since the approach touches nearly every corner of the economy. That was apparent in May, when environmental regulators from the seven states and four provinces met in a dingy Salt Lake City hotel ballroom to go over a cap-and-trade blueprint. Business leaders from around the West came to vent their concerns. For the first time, organized labor also showed up: AFL-CIO leaders from California, Oregon and Washington State said they're catching on that employers might flee across state lines or even overseas where greenhouse-gas caps don't apply.

Nearly 250 stakeholders packed the ballroom. They lined up at microphones, sometimes twenty-deep, to remind negotiators of what's at stake. Cement manufacturers, facing stiff competition from Chinese imports, said there's no way to revamp their production process to meet low-carbon standards. Local governments said they're worried about how municipal electric utilities can cope with complex trading rules -- and whether methane gas that comes out of landfills will be covered. And businesses from Washington and Oregon said they're afraid of getting outbid on carbon markets by California firms with deeper pockets. Grant Nelson, the government affairs director for the Association of Washington Business, says "a volatile, unpredictable and high-priced allowances market" could throw the region into "economic pandemonium."

Since the Salt Lake City session, WCI has been fine-tuning its draft. The states and provinces are reconsidering a plan to auction between 25 and 75 percent of emission allowances and have discussed giving them away for free instead. They have weighed offering industries more leeway to buy emissions offsets anywhere in North America. And they have considered devoting resources to protecting vulnerable companies, retraining workers and subsidizing low-income consumers' energy bills.

Other crucial points remain to be worked out. Under the WCI plan, fuels for transportation and heating systems would not fall under carbon caps until 2015 -- three years after caps on industrial emissions would go into place. That buys time to figure out one of the most important, but politically volatile, pieces of the carbon puzzle: cars and trucks. When oil refineries and fuel distributors are brought into the scheme, Western gas prices will almost certainly go up.

All of these issues will soon shift into the legislatures. Within WCI, only California and British Columbia have laws in place explicitly authorizing a cap-and-trade system. The rest will have to pass legislation for the system to fully take effect. Meanwhile, Colorado, Idaho, Nevada and Wyoming all have stayed on the sidelines by sending observers to WCI's meetings but not joining as members. Colorado Governor Bill Ritter, for one, has been supportive of the project, but says he wants to see whether Congress enacts a nationwide cap-and-trade program in 2009 before he'll commit to a state-level effort.

Ritter isn't the only one keeping an eye on Washington, D.C. The U.S. Senate debated a national cap-and-trade regime for carbon this summer. Although the plan got sidetracked, a federal solution may have better chances next year, no matter who moves into the White House. A key question will be whether to reward the states for leading the way or to punish them for taking on a task that was best suited for a national policy all along.

One view is represented by U.S. Senator Jeff Bingaman, a New Mexico Democrat who chairs the Energy and Natural Resources Committee. To prevent confusion, Bingaman says, a federal cap-and-trade law should preempt RGGI, WCI and other state or regional systems. Senator Barbara Boxer, a California Democrat who chairs the Environment and Public Works Committee, takes a different view. Legislation she's drafted would let the regional systems keep going. But her plan also would penalize participating states by denying them shares of $560 billion worth of federally issued carbon allowances. Companies that have bought state-issued allowances and offset credits could exchange them for federal equivalents if the state-level programs were disbanded.

Whatever Congress decides, states have already done much of the legwork. They haven't solved all of the tough political trade-offs involved in cap-and-trade. But they've explored almost all of them, and made the country a little more comfortable with a new way of looking at carbon. "At the end of the day, what we obviously need is a national program," says John Cahill, Pataki's chief of staff who now practices climate change law with the former governor. "It's a toe in the water, but RGGI has created the momentum to do cap-and-trade throughout the country."