Common Tragedies

Thoughts on Environmental Economics

Evidenceless Grist argument of the day

Posted by Rich Sweeney on March 10, 2009

Sean Casten explains that “carbon pricing does not necessarily cause higher energy prices” because………. well because it just doesn’t.  While I’m fine with his point that we shouldn’t assume that pricing carbon will lead to higher prices (just as I think we shouldn’t assume green jobs = net jobs), he provides no evidence for his assertion, and ignores the significant literature available showing that precisely the opposite is true (EIA’s L-W runs are an example). This is because carbon intensive energy generation is currently significantly cheaper than clean energy generation, and because our current, stranded, capital is built around dirty energy. Even if you transfer all the carbon revenue to clean technologies, it still won’t compensate for these losses, at least in the short run. Here at RFF I help maintain a highly parametrized US electricity market model which incorporates the two additional costs I mentioned. If anyone has an idea how to design a carbon policy that won’t raise electricity prices I would honestly love to hear it.

Finally, before Jigga Romm’s anti-econ crusaders jump on this post, I’d like to reiterate that my criticism of Casten’s argument (?) does not mean that I am against pricing carbon. In fact I wan’t to do so precisely because it will raise energy prices, which are artificially low right now since they don’t incorporate emissions externalities.

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27 Responses to “Evidenceless Grist argument of the day”

  1. Matt said

    Your last point is by far the most important one. Thanks for saying it.

  2. odograph said

    If someone tells you CO2 is not energy, he’s got the chemistry right. There is no reason, other than that we are at this particular place and time that they be bound (imagine the universe).

    One would certainly hope that long-term the binding will be broken … or if you have a dark view of human nature, you might hope that it will be broken sooner rather than later. Rich hopes for energy prices which will change behavior in this time an place. I’m not so sure our population (our species) is willing to suffer those.

    Catch-22.

  3. Rich,

    I won’t say much — maybe Sean will speak for himself — but he’s not saying that Lieberman-Warner won’t raise energy prices. He’s saying that reducing emissions need not raise energy prices. That’s because it’s possible to create lots more energy (and energy services) with no additional fuel. Sean’s offered plenty of evidence in previous posts, and in his professional life. He does it for a living; unlike academic econometric modelers, he’s been out into the world to witness and realize some the many opportunities. The DOE recently handed his company $2B in capital to do more. I’ll leave the rest to him; it’s his argument, not “Grist’s”.

    Also, pretending that anyone who criticizes economists is some kind of acolyte of Joe Romm’s is juvenile.

  4. Thanks for reading – allow me to rebut.

    First off, the fact that a specific GHG policy will raise energy prices does not a priori imply that all GHG policies will raise energy prices. Indeed, as I pointed out in a five-part series on Grist, Lieberman-Warner was a massively bad policy that would have raised energy prices even while simultaneously providing no explicit incentive to invest in CO2 reduction. It would be hard to do GHG policy worse than L-W – but it does at least mean that I am in agreement with EIA. (See here to the link to part 5 of that series; the remainder can be linked back to from that start.)

    The problem with L-W goes to the heart of point two. Namely, the whole theory of a cap & trade is that you have a cap, and that you trade. Headlines notwithstanding, there isn’t a single GHG bill I’m aware of in DC that actually follows that formula – they are simply taxes under different headlines, where the emissions source is charged for their emissions, the proceeds of that fee come back inside the beltway and they are then redistributed through the economy in a politically-motivated, and deeply inefficient fashion. Does that raise the price of energy? Of course it does. But that’s not because cap & trade systems inherently raise the price of energy – it’s because that’s what you get if you don’t allow markets to trade! If I buy a stock for $10, the economy hasn’t been penalized by $10 – I’m out 10 bucks, but the person I bought the stock from is up 10 bucks. Net net, we’re even. This is how cap & trade is supposed to work, and just because it is possible to design a busted system doesn’t mean all systems are busted.

    A vastly better C&T system is possible, and there are lots of ways to do so. (For my preference, see here.) But the unifying feature is that a proper system allows bilateral transactions – just like in the stock market – so that carbon sources pay carbon sinks without any beltway interference. The only way that such a system would lead to an overall increase in energy costs is if the total supply of sinks is less than the total supply of sources – which is a function on the one hand of the size (and rate of reduction) in the cap, and on the other hand in the potential to squeeze more efficiency out of our economy. (Or, to use Skip Laitner’s phraseology, “the depth of our strategic efficiency reserve”.) All of my experience says that reservoir is particularly deep, and people may quibble.

    But in any event, it is decidedly non-zero, which goes to the heart of my initial post. If we want to write a policy that will drive up energy costs in the name of CO2 control, it’s quite possible to do so. But that doesn’t mean that there is a link between the two.

  5. Rich Sweeney said

    david,
    it’s funny to be called juvenile by someone who just yesterday wrote that the “Eco:nomics conference can blow [him]” (which was funny, btw). and i wasn’t trying to suggest that all people who criticize economists are acolytes of joe room. i was referring specifically to joe romm’s acolytes (those people scare me).

    sean,

    thanks a lot for your comment. i’m scrambling to meet a deadline right now but will give your rebuttal some serious thought later tonight.

  6. Rich Sweeney said

    btw, sean, did the DOE really give you $2 Billion??????????

  7. Rich, you can tell me to blow you. Just don’t call me a Joe Romm acolyte!

  8. OK, digging out the post, it seems I lied — Sean got $1.5 billion. See here:

    http://gristmill.grist.org/story/2007/11/16/82350/806

    That’s why he’s replying to your post from a Gulfstream IV, chomping on a stogie.

  9. I believe David misspoke. We have raised $500M of private equity to pursue projects that meet our mission to profitably reduce greenhouse gas emissions, which has been billed in the media as a $1.5 – 2B portfolio, recognizing that in normal markets (e.g., those other than the one we are in right now), you ought to be able to lever $500M of equity into that level of total value. He may also be referring to the fact that when my father and I total up all the projects we have done over our respective careers (and in prior ventures) to profitably reduce CO2 emissions, we have to date already deployed $2B in this space.

    That said, there is more than a little veritas in David’s typo, as the headquarters of the US financial services sector seems to be relocating from the Hudson to the Potomac, and we are awaiting word on applications for DOE loan guarantees that – at least theoretically – would put us well on a path towards the remaining couple billion we need.

    In any event, when I lament the fact that policy and economic theory so deeply misunderstands the reality of climate policy and it’s economic consequences, it is a lament with more than a little bit of underlying practical experience.

  10. Mark Shapiro said

    Perhaps Sean is simply confusing price with cost (price x quantity). As cap and trade increases the price of fossil fuels, consumers reduce demand with efficiency and conservation, and thus lower their energy cost. Consumers learn more about Sean’s valuable cogeneration and CHP service (and thousands of other efficiencies), his business expands, providing jobs for former coal miners. Savings from efficiency increase wealth, and the dead losses from pollution are reduced.

    Evidence at EDF http://www.edf.org/page.cfm?tagID=33427 and McKinsey http://www.mckinsey.com/mgi/publications/Carbon_Productivity/index.asp and at Rocky Mountain Institute http://www.RMI.org

    Stranded capital is a problem. That’s why we should not build any more coal plants.

    And Rich, don’t be scared by Joe’s acolytes. Most of us are gentle as lambs! (Joe is trying to slow down a big set of disasters. He gets frustrated and excited.)

  11. Carlos Ferreira said

    I hope you’re not forgetting about the price elasticity of demand in the short-run. As a producer of electricity is forced to buy permits, his marginal cost of production will increase. In the short-run, where constraints apply, producers pass on to consumers a proportion of this increase, proportional to the price elasticity of demand. Ideally, the price of permits will increase up to the point where the marginal cost of a unit of energy produced + the cost of the permits needed to produce it equals the marginal cost of producing the same energy by a renewable source – in the long-run this would lead to substitution of the source. Now, in the short-run, the company will keep on producing as long as there is demand for the energy produced.
    There are, with current constraints in place, two outcomes: consumers maintain current utility at a higher price OR consumers reduce their current utility in order to maintain current expensiture.
    I also prefer looking at the long-run and forget about the short-run and spot prices, which are messy. But they are where we live in.
    As for what to do with the cash from the permit trading, I have a theory as good as everyone else’s.

  12. Mark,

    I am making no such confusion. The act of trading a commodity does not suddenly raise the cost of that commodity. My company today is privately held and has not standard basis for valuation. But our investors have, to date spent something on the order of $10M in us to cover our overhead and project development costs. Suppose I went public tomorrow and sold the company for $100M. Is society therefore $90M worse off? Of course not. Our investors are a bit richer and investors are (hopefully temporarily) a bit poorer.

    There is no reason why a carbon market cannot work the same way, but only if you allow trading without beltway distortion. That is the key point, even as it is absent from every GHG bill we are considering. Take a couple numbers: a coal plant emits about 2000 lbs of CO2 per MWh. A natural gas plant can get as low as 900 lbs/MWh. A host of renewable and efficiency measures can get to zero. The grid average is 1300.

    So let’s say we want to impose a cap that has the initial effect of lowering the average power sector emissions to 1000 lbs/MWh, or a 23% overall reduction. Clearly, that will raise the costs to the coal plants, but – if the trading system is properly set up – it will lower the cost to the renewable, efficiency and gas plants by an equivalent amount. On an aggregate basis, there has been no change. A wealth transfer, to be sure, but not an increase in overall societal energy costs, any more than the wealth transfer created by taking companies public leads to an overall increase in total societal wealth.

    It is this distinction between wealth transfers and total wealth that has been consistently misrepresented and misunderstood in the GHG conversation (furthered in no small part by those who are on the losing end of that wealth transfer, and have self-interested reasons in maintaining that confusion.)

  13. Max Epstein said

    Sean, I tried to address this on grist but obviously we got sorta frozen. But first a new point, I think you’re mixing up costs and prices.

    “Clearly, that will raise the costs to the coal plants, but – if the trading system is properly set up – it will lower the cost to the renewable, efficiency and gas plants by an equivalent amount. On an aggregate basis, there has been no change. A wealth transfer, to be sure, but not an increase in overall societal energy costs…”

    In the EU ETS, by allocating all the allowances for free (which does NOT preclude trading), they explicitly compensated (in fact way over compensated) energy-producing power plants. There was, like in your example, no net aggregate cost increase to producing power. Prices still went up, as you know. This is because of the fundamental point that all the economists here I think are trying to point out – by adding a new factor of production (a necessary right to emit carbon), you are increasing the marginal cost of production, regardless of the cleverness of your scheme to distribute them throughout the economy or among the relevant actors. Marginal costs drive prices, and so prices would rise.

    But the other point I’d like to reiterate is just that, if you acknowledge that carbon prices will raise the price of “carbon intensive goods,” and you acknowledge that KWh’s from the grid will continue to be “carbon intensive goods” (even if all NEW energy added were clean) in the short run, how would KWh’s from the grid not see a price increase from the carbon price? Would the marginal fuel in every organized market in the country at every hour not continue to be gas or coal? So how would prices not rise? Unless you want to argue that the uniform price auctions in the organized wholesale markets are inefficient, but I’m pretty sure from your previous writing that you don’t believe that…

  14. Matthew said

    Sean’s last point is pivotal and seems to be typically overlooked, even by super-smart economologists on the intertubes.

    The late, great Shimon Awerbuch successfully demonstrated the value of mean-variance portfolio management in the power sector over ten years ago (you can and should look up his work, if you’ve not already). Just because the price of power from coal will, in fact, go up substantially under a cap – after all, the goal is less carbon, right? – that does not mean the the cost of power to the consumer will go up. Real-live markets like the way that higher-PRICED but fixed-COST resources (renewables, efficiency) tend to mitigate price risk among resources that aren’t fixed cost (coal, gas, with or without a cap). That’s because their profits soar when variable-priced resources rise above their their fixed-price resources at the margins; that hedge has real, measurable market value and utilities profit from it (see Spain, wind, 2008-2009), but I don’t see many economists, at RFF or anywhere else for that matter, integrating mean-variance portfolio theory into their models. Is it lazy? Is it just too avant-garde? Or do they spend too much time watching Cramer and Stewart? You be the judge.

    Further, as we learned from the McKinsey cost curves, under a cap there are substantial resources on the left side of the curve that “coal consumers” (i.e., utilities) will suddenly find much more attractive, primarily caulk, lighting and insulation, but also, in some markets, wind, geothermal, hydro etc., and, yes natural gas. The fact is the left side of the curve exists due to market failure that can, should and will be fixed by policy. I think no one would argue that a utility can build a new coal plant at a per KWh cost lower than demand-side resources – because they can’t. It’s not possible, not in the U.S. anyway, where 30-40 percent of our power is used to melt moths. Funny thing is, you don’t need a cap to fix this problem, you need sectoral policies like decoupling, building codes, etc., that gets you a heckofalotta carbon without trading so much as a burp’s worth of CO2.

    I’ve long wondered why the broader field of economists don’t seem to, you know, check out actual market economies when it comes to power, price risk, efficiency etc. But perhaps that’s because I’m just an idiot.

    Fun reading you guys argue, long time lurker, first time trash talker.

  15. [...] Sweeney then picked it up at Common Tragedies, and the conversation in the comments on both posts has been good. The substance of what I wanted [...]

  16. Hank Roberts said

    In part IV I see:
    ” the central test of a good carbon policy is whether or not it encourages investment in carbon-reducing technologies. ”

    I dunno about this. You’re assuming the old market idea still works, or can be made to work again. Encouraging investment is what drove the collapse, eh?

    Nine of ten companies venture capital invests in are expected to fail to produce the desired return — and are destroyed because they won’t yield fast enough for the VC, I recall. How many of those might survive and do well with a different expectation for short term profit? Lower bonuses of course, and lower commissions on the transactions.

    I’d think the “the central test of a good carbon policy is whether or not it encourages … carbon-reducing success” and whether it allocates the money to the future success versus to the short term profit.

  17. Hank,

    Whether or not you believe in markets is largely beside the point. Changing our economy to reduce our carbon emissions to the level required will require massive capital reallocation, which in turn means that there better be an incentive to reallocate that capital which is, after all overwhelmingly in private hands, even after the recent increase in federal participation in the financial sector. If we are not going to incent that private capital to redeploy itself, then we are massive dependent on a government that has both the scale and the wisdom to do that reallocation for us. I, for one, don’t think that either is possible. But I’m quite certain that if you give people a financial incentive to act in a certain way, they will act. That’s why I say that the test of good CO2 policy is to incentivize carbon-reducing capital.

  18. Matthew,

    Thanks – I am familiar with Shimon, but didn’t know he has passed away. He and I spoke at length several years ago about various things that we were both publishing along these lines. And I’m with you on the massive disconnect between the theory and practice of economics!

  19. Max,

    We’re talking past each other. Arguing that Kyoto somehow proves that it is not possible to do carbon policy that doesn’t raise the price of energy is tantamount to arguing that Hugo Chavez proves that it isn’t possible to have democracy without kleto-petro-states. And this has nothing to do with any discussion of wholesale markets.

    Throughout this discussion are a series of discussions about how people think carbon markets will be structured, and I’d encourage you all to look closely at those assumptions and ask how many are innate to carbon pricing and how many are simply features of those (largely crappy) carbon pricing models that we have tried to date.

    In an ideal carbon market, all tons of CO2 will face the same price. Anything short of that creates inefficiency and opportunities for regulatory arbitrage. There isn’t a single CO2 pricing regime that comes close to passing that test. But that doesn’t mean that inefficient capital and regulatory arbitrage are innate features to carbon markets! (As one recent example from Kyoto, see the recent German reports showing that feed in tariffs haven’t led to any CO2 reduction because they weren’t synchronized with their cap; every ton reduced from a solar panel created an opportunity for one more ton of emissions from the coal fleet.)

    As a practical matter, no one argues that it is actually possible to price every ton equivalently. (In the extreme case, no one is talking about taxing my dog’s exhalation.) But that doesn’t mean that we cannot allocate much more equally than we have – in every market I’m aware of, free emissions rights have been given to previous sources, following the old political saw that “losers cry louder than winners cheer”. But there are much better ways to do this – this is the crux of the output-based standard idea I linked to above, where every power plant gets an allocated right only up to a target ton/MWh and must either buy or sell their excess/surplus accordingly. As I noted above, smart people could come up with other forms, but the key point is that if sources are transferring wealth to sinks, it is quite possible to end up both with no net increase in energy costs and create an incentive for low carbon fuels. (Your comment that “KWh’s from the grid will continue to be “carbon intensive goods”” would appear to miss the differential pricing innate in two goods with differential carbon signatures. If the use of the lower-carbon kWh is leading to a net reduction relative to the average, it could well have a price advantage. Why stipulate an architecture where it does not?)

    I’ll close with another framing to try and clarify the larger point. Suppose that a country collects $X per year in income taxes from it’s citizens through a flat 10% income tax. Suppose further that they propose changing to a graduated tax structure, reducing to 0% on the bottom half of income earners and increasing to 20% on the top half, but set those break points so that the net income to the treasury is still $X. Clearly, there is no incremental cost to society from this structure. Equally clearly, those on the upper end of the scale will oppose such a structure and doubtless bring in no shortage of economic theory to argue why this disincentivizes wealth creation, trickle-down, etc. (I’m not taking a side in that debate – simply pointing out where the politics inevitably goes – you could just as easily make this argument with a regressive shift in tax rates.) Thus, if this hypothetical country were to make that shift, the politics would create such noise that the equivalence of $X = $X would be rapidly lost by those with the most to lose.

    This is exactly what is currently happening with the carbon conversation. A big part of the reason we don’t have anything resembling economically efficient carbon policies is because the conversation never rises above wealth transfer, and confuses many – including economists – who fail to appreciate the difference between specific wealth-transfers and general changes in overall societal wealth. Will carbon pricing make inefficient coal-combustion more expensive? For God’s sake, I hope so. If it doesn’t, it won’t be doing the one thing it ought to do. But that in no way means that overall energy costs will go up. Society wins when we consume our resources more efficiently, even if those in the mining sectors do not.

  20. Max Epstein said

    Sean, we may in fact be talking past each other so I’d just note one argument of mine I want to make sure is clear. I do not argue at all that Kyoto is anywhere near optimal or represents an upper bound of potential efficiency on carbon prices. I only brought it up to make my point about differentiating between prices and costs. Kyoto, for all its flaws, did not raise net costs for power plants because the (close to) 100% free allocation overcompensated for the cost increases. But this absence of net cost increases did not lead to an absence of net price increases, because prices still rose. Rather, the difference between costs to producers and prices was in windfall profits for producers. I believe your proposed system would substitute windfall profits for clean energy producers instead of coal plants in Europe, but in the short term the point is that net cost savings are still pocketed by someone’s shareholders while prices rise. There’s no way arguing around that anything that makes coal and gas more expensive will make electricity more expensive in every organized market (which is about half the country) in the SHORT RUN given the way these markets set prices, which is actually a matter of several years.

  21. Max Epstein said

    *”short run” is a matter of several years while these fuels remain the marginal fuels for most markets and hours, just to be clear. the “is actually a matter of several years” does not refer to “the way these markets set prices.” I should be more careful with my sentence structure.

  22. Max,

    Point largely taken, but I’d add one caveat. If shareholders pocket the gain from CO2 “windfalls” then do they also pocket the pain from CO2 payments? As a practical matter, answering the question requires an ability to predict the future and is unanswerable with any great degree of precision. But it bears noting that to the degree that shareholders bear the pain/gain of CO2 policies then energy consumers do not. (e.g., if a 10% reduction in margin is absorbed by shareholders, then prices are by definition unchanged.) This point is critical, as you cannot simultaneously argue that carbon-emitting businesses should be penalized and that doing so will raise prices (nor the inverse in the event of CO2 payments.) It’s a point I often make to the environmental community when they claim that we ought to protect lower income folks from CO2 price increases and simultaneously that we should ensure that energy companies bear the costs of CO2 release.

    In reality of course, businesses will pass those costs along where they can (as limited by markets and by law) and keep those gains where they can from the same pressure. And the history of every market is that entrepreneurs enter the field convinced they will keep all the gain and in the long run end up giving up much of it to the consumer – and society marches on. This starts to get wildly off topic with respect to short-term prices, I realize. But even in the short-term, the gain/pain of CO2 release at the level of a specific company will be borne partially by shareholders and partially by consumers. Thus, to argue that the aggregate impact will be to increase total energy costs is to presume that you know not only who the winners and losers will be but also the degree to which each will be able to absorb those costs and gains between their constituents.

    Which gets to my point. I don’t claim to be able to answer those questions, but I have a really hard time not making the default assumption that in a market where sources and sinks are treated equally, such that all marginal units of CO2 emissions have the same (absolute) value, the pressures between shareholders and customers on both sides of the ledger will be the same and net to zero. Can I make a case where they would net positive? Of course. And I can also make one where they net negative. I can also think of a whole host of regulatory models that would preferentially bias us one way or the other, and my great frustration with those out there today is that they are all set up to bias towards net costs. But it doesn’t have to be that way, and we cheapen the conversation by assuming that it does.

  23. Max Epstein said

    Sean, perhaps there’s some confusion here about how exactly prices are set for electricity in organized markets. (I continue to refer to organized markets because as far as I can tell from your writings you agree this is the way the industry needs to go. Non-organized markets may be regulated to soften short-term friction, but at the cost of long-run efficiency). A power plant bidding into PJM, NE-ISO, etc, does not bid the price of power it hopes to receive. If power plants bid the prices they hoped to receive, then they would have an incentive to bid the highest price they thought the market would bear. Occasionally low-cost power plants would guess (bid) too high, not be dispatched, and generators with higher actual marginal costs would be dispatched instead. The auction system in place is designed to avoid such inefficiencies and achieve “economic dispatch” – dispatching cheapest marginal-cost-generators first, then others successively in terms of next-lowest marginal costs.

    The way this is accomplished is by dispatching generators in the order of lowest-bids first, then those with higher bids, etc. However–and this is the key point– all generators dispatched at each hour are not paid what they bid, but are paid the highest bid of any generator that had to be dispatched to meet demand. This “marginal generator” sets the market clearing price for which all generators are paid. This incentivizes each generator to bid its marginal cost. If it bids above its marginal cost, it may not be dispatched at some hour even when price>marginal cost, and so it forgoes short-run profit. If it bids below its marginal cost, it may be dispatched even when price<marginal cost, and so it will lost money providing that power. So generators will always bid their marginal cost of supplying power. This is not just economic theory, this is how real-world US electricity markets operate today, with the exception of where there are market power issues (not unheard of but not the dominant feature of these markets).

    Nothing about carbon pricing, even optimum carbon pricing or your output-based standard, will change this incentive structure in organized markets’ uniform price auctions. Generators will continue to bid marginal cost. In the short run (which would actually last several years to 1-2 decades) the marginal generators setting the clearing prices at each hour will continue to be fossil based, and so their marginal-cost bids will be higher than they are today with a carbon price. In the short-run, prices will rise. Now the carbon cost will not raise costs for wind/nuclear/CHP, so the extra profits I spoke of will drive investment in clean energy, and in the long run maybe the new equilibrium price settles below todays prices. But that’s a long time coming, and policy makers should be wary of claims that energy price increases will be fleeting or nonexistent under even optimum carbon policy.

  24. Max,

    I’m quite aware of how those markets work. The reason I say that it’s not all that relevant is because the vast majority of capital allocation decisions today are external to those markets, whether they are from utilities making investments subject to regulatory approval to rate-base their capital or industrials making investments based on avoided retail rates. In an economically idealized world, all transactions would be via OTC trades on our ISOs/RTOs. In actuality, the vast majority are bilateral deals external to those markets. (Indeed, one of the great failings of the organized markets is precisely this lack of participation. In natural gas markets, it is an open secret that you can get better deals by doing bilateral trades outside of the Henry Hub index – and thus you take an inherent value hit when you index your gas price to the Hub – but it’s not such a huge sacrifice because most trades are on the NYMEX or other public index. In power markets, it is the reverse, with market participants only using the auction price as set in PJM/ISO-NE/etc. to top up when they cannot procure from bilateral deals.)

    This is all rather sideways to the conversation thread here, except to note that presuming that those market mechanisms will be the sole (or even dominant) way for carbon pricing to affect capital allocation decisions doesn’t make any sense – tantamount to arguing that the economics of air travel are based only on USAir’s fares as published on their website. It is a crude approximation for the market, but doesn’t capture the majority of the decisions.

    You’re quite right to suggest that I’m a pro-market guy, and I would really like to see those markets used more. But trust me: as a guy who has ample opportunity to use those markets, they are merely a backstop, useful only when you can’t get a better bilateral deal. The result of this is that they are – as you (inadvertently?) point out, only really good as an indicator of marginal cost, and lousy at incentivizing capital investment. And since the whole purpose of a carbon pricing model is to reallocate capital towards lower-carbon generators, they really aren’t of much value therein. Which I suppose makes it oddly fortunate that they are not playing a bigger role in today’s capital allocation decisions.

    But in any event, that really has virtually nothing to do with carbon pricing. Duke doesn’t make a decision to build a new coal plant based on RTO pricing any more than an industrial makes a decision to invest in more efficient variable-speed-drives based on same. (And post-Lehman, fewer and fewer people are even willing to enter into those contracts that do exist on those markets.)

    All a sidetrack though. In an ideal world, those markets would shape capital allocation. Unfortunately, this world ain’t ideal.

  25. Max Epstein said

    My impression Sean, and I could be wrong, was that PJM, ISO-NE, and NE-ISO operated pretty comprehensive power markets (including their day-ahead auctions, not just real-time spot trades), while CAISO, ERCOT and MISO relied more on bilateral trading, though with ERCOT and MISO moving more towards the eastern model. And of course I’m leaving out the Southeast, SouthWest (SPP), and Northwest, where there are not organized markets and so pretty exclusively bilateral (although I believe SPP is also looking at organizing to become regional balancing authority).

    You’re certainly right that even well-functioning organized markets can have trouble deploying capital. First, however, I’m pretty optimistic that evolving capacity markets will prove effective at providing the “missing money” to incentivize adequate capital investment, and think (but haven’t read enough yet) initial implementation of PJM and ISO-NE’s at least have been generally deemed successful. And second, a large portion of the country’s population has their retail rates indirectly but significantly tied to the wholesale power prices in these markets. So whatever their potential failings with capital investment, effects of carbon pricing on their wholesale prices can’t be ignored.

    One last point on marginal costs and capital allocation – carbon pricing doesn’t just reallocate capital, it must increase capital investment because plenty of coal plants could hum along just fine for quite a while if we weren’t worried about carbon. Since we worried about carbon though, the clean stuff has to get built. So given that average power costs are virtually always above marginal costs of power, wouldn’t your plan (and any carbon price) increase prices just by necessitating so much new investment, even if the compliance cost of the carbon allowance obligations netted to zero, and that net-zero effect of cost passed through to a net-zero effect on price from the carbon permits themselves?

  26. Max,

    The issue is one that I think the theory of electricity markets has done a very poor job of capturing. Wholesale power trading has only the most indirect impact on retail rates which – throughout the region – are set through processes that are heavily politicized. (Indeed, even where utilities have a pass-through tariff for wholesale fluctuations as you note, they still have differential capital recovery rates in various tariffs that can insulate some customers – especially big industrials – from the full cost of power.) Thus we end up with a situation where there are massive opportunities for capacity additions – whether through on-site generation or DR – that are made based on economic signals that are poorly connected the underlying market need.

    Meanwhile, on the upstream side, there are still many states that are part of wholesale markets but remain wholly or partially regulated (WV, IN, etc.) such that the GenCos operate under a set of economic incentives to deploy capital that have virtually no bearing on wholesale spot prices. The regulated markets are fine for what they are – and to be sure, have done a fantastic job at rationalizing dispatch of existing assets – but have largely failed to incentivize new investment, and the proof of that is in the pudding: 10+ years into dereg, we still have steadily dwindling system reserve margins. The credit crunch has made this worse still, as the only “markets” with long term price certainty are the regulated gencos (through rate-payer guarantees) and end-user efficiency measures (through retail rate displacement). But the former is predisposed to building uneconomic generation and the latter is – in most cases – not exposed to the full price of power because of the politicalization of rate cases. (Note that this latter point has been the fundamental failure of market restructuring, inasmuch as by keeping the regulatory constraint on the “last mile” of wire, it has kept the best options for cost mitigation out of any direct way to participate in markets. Some markets – ISO-NE most notably – have taken good steps to fix, but they have a long way to go, and ultimately cannot unpack all that baggage so long as the DISCO remains regulated.)

    Perhaps the best proof of all this is simply by looking at the capacity additions that the system has made over the last decade. As far as I can tell, the three biggest sources of new capacity during that period were central-station natural gas (about 200 GW), load-sited CHP (about 45 GW) and wind (something like 10 GW). Of those three, the gas is the only one that was set up to chase wholesale power prices and markets have “learned” that this game isn’t winnable, for exactly the reasons you note: the market gives you marginal prices, and equity takes it on the chin. As a result, construction of new gas assets has essentially stopped. The CHP has almost all been displacing retail, isolated from wholesale for the reasons noted above. And the wind is basically chasing tax incentives, almost fully divorced from market forces. (Indeed, wind rather uniquely remains pretty hostile to markets in many cases, since it is so dependent on subsidized transmission.) So we basically have a system wherein (a) we aren’t building the capacity we need and (b) the capacity that is being built is being built largely external to the structured markets. That doesn’t mean that markets haven’t played a role – but they have yet to prove their ability to meet capacity needs. (And to be clear, I use the word “markets” in a specific, lower-case “m” sense. I’m not critiquing Markets generally, but making an observation on those partial markets we have right now.)

  27. Max,

    Re your final point, my simple answer is that there is a real danger in economic over-think. I don’t disagree with any of your specific assertions re: coal and carbon prices. But step back and look at the forest: The average coal plant in this country was built in something like 1960 and is running today only because it was grandfathered out of CAA compliance. Setting aside any discussion of the Clean Air Act’s flaws, that basically means that those plants are selling a product that society doesn’t want, but allowed to sell the product because of regulatory arbitrage. Absent grandfathering, those plants (speaking about the broad average, and noting that there has been essentially no net increase in coal capacity since 1990) would either be shut down or much more expensive to run because of continuing capital investments and increasing parasitic loads. In other words, in any functioning market those plants would have been shut down years ago and replaced with something that better met society’s desires. The fact that a new gas plant has to meet environmental standards that are in excess of an operating coal plant has kept many a new gas plant from being built – including many other technologies that have inherently lower costs than coal due to higher efficiencies, use of opportunity fuels, etc.

    So the question then arises whether society would be worse off if this capital was stranded and a bunch of new construction had to take it’s place. Which on it’s face is a question that would force you to sit in the corner with an Idiot Hat in any other industry. Was the massive investment in fiber optic cable in telecoms bad for society because we had to spend all that capital? (It did idle copper wires, after all.) How about the retooling of our auto industry when leaded gasoline was phased out? Or any other Schumpeterian wave of creative destruction. The problem with the power industry is it’s stasis. Change is how markets work. The lack of change in the power industry is the cause of it’s problems – can you name any other industry that hasn’t increased it’s ability to convert raw material into finished goods in 50 years? (Delivered fuel efficiency in the power sector is 33% today, same as it was in 1957. Thomas Edison’s first plant was 50% efficient, lest anyone think that 1957 represented some technological high water mark.)

    So yeah, I’m with you. A functioning carbon market would make dumb-ass, inefficient coal plants of the type that you only build if you have insulation from competitive pressures and environmental regulations more expensive to run, and probably shut a few of them down. But when that happens, society will reap massive economic benefit, not pain.

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