A Primer on Allowance Distribution in Waxman-Markey
Posted by jab12004 on June 19, 2009
For the last month I’ve been spending a lot of time studying and modeling various allocation schemes for carbon allowances. This kind of a big topic, so I’m going to aim this post at talking about Waxman-Markey and what its distribution plan might mean. The current version of Waxman-Markey allocates 35% of permits to “electricity consumers” through Local Distribution Companies (LDCs). LDCs are highly regulated entities that take power from high-voltage transmission lines, and distribute it in a usable form to Industrial, Commercial or Residential customers. The details of how LDCs function aren’t that important, since the legislation lays out how the money should be used:
Emission allowances distributed to an electricity local distribution company under this subsection shall be used exclusively for the benefit of retail rate payers of such electricity local distribution (p575).
To the extent an electricity local distribution company uses the value of emission allowances distributed under this subsection to provide rebates, it shall, to the maximum extent practicable, provide such rebates with regard to the fixed portion of rate payers’ bills or as a fixed credit or rebate on electricity bills (p576).
To understand this, a little background on how electricity bills work is necessary. Unfortunately, every state has a different system, so forgive me if I misrepresent your state. The basic concept is that electricity bills have a fixed portion, and a variable portion. The fixed portion covers capital costs like transmission lines and maintenance etc. The variable part covers the cost of generating electricity like fuel costs and other variable operating costs.
The legislation above stipulates that as much as possible, the allowance revenue should go to subsidize the fixed portion of a bill instead of the variable cost. This is meant to allow the variable price of electricity to increase with carbon policy (and hence decrease consumption), but not increase the overall burden on consumers.
The reason why one might want the variable cost portion of a bill to increase is that it allows for a more efficient carbon policy. As consumers face higher costs, they will reduce their consumption and emissions. If consumers don’t face this higher variable cost, consumption will stay high, and emissions reductions under a cap and trade policy will have to come from other sectors of the economy. This is a less efficient overall outcome since the lower hanging fruit of reduced electricity consumption cannot be taken advantage of, and other less efficitn mitigation is necessary. This also results in a higher emissions allowance price.
The legislators seem to be somewhat aware of this, and hence the bill stipulates that money should go to reduce the fixed portion of a bill. In practice, this isn’t exactly what will happen. First off, residential consumers (around one third of consumption) probably aren’t sophisticated enough to think on the margin in electricity consumption decisions. I study energy and I just look my bill total, not the individual components. Industrial and Commercial customers, however, spend a lot more money on electricity and it is reasonable to assume that they would take higher variable costs into consideration.
The second important part is “to the maximum extent practicable.” This is tricky since in practice very few LDCs fully separate the fixed and variable portions of their bill. Instead, LDCs usually have some small fixed portion, but end up recovering a large portion of their fixed costs through the variable section of the bill. Other states hardly differentiate at all. In order to appropriately apply the allowance value to the full fixed portion of the bill, massive electricity billing reform would be needed.
If you have made it this far, you might be asking why this is important. I come at this issue from the income distribution perspective, and these small pieces of legislative language and assumptions about consumer behavior have huge impacts on who bears the cost of carbon policy. (In an effort not to write an essay for a post, I’ll touch on that next time.)
From the larger policy perspective, it looks like LDC allocation will be a part of Waxman-Markey as a compromise of sorts, but it doesn’t seem that the full effects of this policy have been fully analyzed. The bottom line is that LDC allocation is a less efficient mechanism for climate policy, and will force other sectors to abate more emissions to compensate. If we are ok with that as a compromise, so be it, but policy makers should at the very least know what they are compromising on.