Common Tragedies

Thoughts on Environmental Economics

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.

9 Responses to “A Primer on Allowance Distribution in Waxman-Markey”

  1. Max Epstein said

    Josh, your characterization that “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” is common in reporting on this bill, but for the life of me I don’t see it in the language. The sticking point here, as I read it, isn’t the “to the maximum extent practicable [use allowance value for fixed-price rebates],” its the first part of the second passage you quoted:

    “To the extent an electricity local distribution company uses the value of emission allowances distributed under this subsection to provide rebates, it shall…”

    Nothing that I have found in the bill mandates that any kind of rebates are used at all (and “to the extent” pretty clearly acknowledges a lack of mandate). The only true mandate is that allowance value be used for ratepayer benefit. But most utilities (LDC’s) own generation assets, and about 30 states and half the load in the country haven’t restructured the retail electricity industry, meaning the utilities/LDC’s own virtually all generation.

    Since generators have a carbon allowance obligation under W-M (its not all upstream on first-seller of fuel), and utilities will pass along in increased rates the cost of any allowances purchased, free allowances could be clearly used “for ratepayer benefit” by just detracting from the number of allowances utilities would otherwise have to buy for their generators. Rebates may come in for any leftover allowances, but except for some (likely NW) utilities that own lots of very clean generation and have lots of retail sales (allowance distribution is 50% by historical emissions and 50% by retail sales, if I remember correctly), this will not be an issue at all for most utilities.

    Ultimately, the carbon compliance obligation will get passed along through variable rate increases, and allocated allowances will most likely just mitigate these price increases. W-M gives a purely rhetorical nod to the efficiency (albeit with the empirical consumer behavior caveats you note) of lump-sum rebates, but ultimately doesn’t make it enforceable because no congressman wants to be blamed for “higher prices.” But state regulators face the same pressures, and forgoing the rebates in favor of rate-increase-mitigation costs the national economy (through higher permit prices), while no additional economic harm occurs at the state level (unless I’m missing something). Seems to me like another collective action problem, where state regulators will have no rational incentive to stray from the political pressures to mitigate price increases, which when done broadly will cost all of us substantially by inefficiently allocating pollution rights and raising permit prices like you noted.

  2. Josh Blonz said

    Max,

    You bring up some interesting points.

    The fact that LDCs own the generation assets doesn’t really affect the eventual outcome. What is more important is the desire and ability of LDCs to pass on the rebates as fixed or variable costs as you have indicated. I would agree that “To the maximum extent possible” seems easy to avoid, and I’m sure in practice it will be to some extent. The reality is that legislators thought enough of the concept to write it into the bill. Waxman-Markey is currently not in its final form, and it is issues such as these that need to be better understood as it moves forward. My perspective on the legislation comes from the incidence angle of these measures, where truly understanding how LDC allowances function can have huge distributional effects.

  3. Max Epstein said

    Josh, sorry, I must not have been clear. I am not arguing about how airtight “to the maximum extent possible/practicable” is, I’m arguing its irrelevant. Because it only applies “To the extent an electricity local distribution company uses the value of emission allowances distributed under this subsection to provide rebates…” which will likely be not at all, because its not necessary to satisfy the “for ratepayer benefit” mandate.

    In a free market, sure ownership of generation assets would be irrelevant, but you have to think of the context of the rate-cases presided over by the PUC’s. If you’re allocated 800 allowances (as an LDC) but need 1000 (for the generation assets for your vertically integrated utility that the same PUC presides over), you could

    1:
    a) sell all 800 allowances, put the money in bank account x
    b) buy 1000 allowances, raise (variable) prices by the cost of 1000 allowances
    c) empty bank account x for lump sum rebates off the fixed-cost portion of the bill

    OR you could
    2: Purchase 200 allowances and pass through a rate increase based on only those 200 purchased, as opposed to the full 1000 needed (because 800 were allocated).

    Obviously nationally it would be more efficient for all PUC’s to choose option 1 instead of 2, but there’s no reason to expect that they will– its certainly not mandated by W-M– and in fact good reason to suspect option 2 will be more prevalent. This is because of the political pressure against “raising prices/rates,” and that it avoids the waste of selling 800 (or whatever) allowances just to buy them back, plus more. Or PUC’s could find some way of valuing allocated allowances to credit towards rebates without selling them, but that would open up messy debates over how to value them (market price changes over time). Again, it would be simpler to use option 2 and just let allocated allowances mitigate allowance purchases and so variable-price rate increases, which is probably what will happen here.

  4. […] the past few days Josh Blonz at Common Tragedies had a couple of posts (here and here) about the permit allocation issues in the Waxman-Markey bill, and yesterday Tim Haab […]

  5. O said

    Couple of municipal utility directors commented recently that they probably wouldn’t give a lump-sum rebate to customers; they see it as more reasonable to reduce retail electricity prices. So no price signal to consume less–and yes, consumers will pay more for other goods. …I sit back and think about this and I guess this means LDC’s do intend to address the increase in the variable portion of the consumer’s electricity bill? But I’ll hopefully get to that below.

    I’ve heard from senate staffers on this issue: frankly, everyone is confused. The gist of what I hear simply concerns the likelihood of electricity consumers not getting something back (rebate, credit)…

    In regard to this point, I haven’t gone through all 50 states, but (differences in enforcement aside) I thought the fact that LDCs are “price” regulated ensures separate accounting books between the distribution and generation side–even in the same utility–and therefore (bad apples aside), it’s not likely LDCs would both issue a rebate or credit within the fixed portion and also increase collection from consumers in the variable portion (which includes taxes). –The reason I couple these two actions by LDCs (fixed-portion rebates and variable-portion cost increases) is to highlight what is and is not allowed within Waxman-Markey itself.

    Sec. 783, for example, mentions LDCs and giving benefits back to ratepayers (note that it does not have to be rebates, and while I don’t believe it’s explicit, it does mention “fixed”), but it also mentions two other related points: 1) EPA is tasked with developing the specific implementation guidelines, and 2) if an LDC gives a rebate, it can’t be based solely on the quantity of electricity delivered–which I believe is aimed at utilities that both generate and distribute.

    I bring all this up because of the last paragraph in Max Epstein’s second reply, ending with “…variable-price rate increases.” Part of what I’m still working on is how likely that is, so if anyone had any info on that it would be greatly appreciated. It seems to be the case that if 1) LDCs are not given water-tight language, and 2) appropriated state-regulated (along with EPA enforcement), they would prefer to just not give rebates or credits associated with the fixed portion and instead address customer price increases in the variable portion.

    Whether investor-owned, a municipal utility, or a co-op — I’m fairly sure that all 50 states require separate distribution and generation accounts. But whatever the EPA guidelines might be, I’m wondering if it’s possible for municipal utilities and co-ops to slip under the both the state’s PUC radar and their own boards when it comes to getting rebates and credits back to customers?

    Finally, I would just like to commend anyone writing on this. It’s a very important topic, and I’m surprised to see so little comment on it.

  6. Max Epstein said

    “O,” good point that EPA is ultimately tasked with developing implementing guidelines for this. However, I fear that even if EPA issued the most “watertight” regulations here to maximize efficiency by mandating lump-sum rebates–which is hardly a given– I think they would immediately be sued (and lose) by some state AG. The argument would be that the state’s PUC ruling to mitigate variable rate price increases satisfies the clear requirements of the statute, so if EPA regulations don’t allow it they would be acting beyond their statutory mandate. After all, EPA is a “creature of statute,” tasked with implementing laws not making them. And if I remember the language correctly the bill does not go out of its way to issue particularly broad discretionary power, which would be necessary to disallow something the original bill text would clearly condone.

  7. Shimpei said

    Hi Josh, have a question for you. Since most utility companies own their electricity generating power plant, do they need to comply both RES and cap and trade? I mean if a utility company buy REC from wind farm, it still needs to buy allowance for cap and trade. This seems pretty tough situation for them unless they produce their own renewable electricity. I know that RES is really small once all deduction accounted, but still is this the real consequence or I make a stupid mistake somewhere?

  8. Josh Blonz said

    Everyone’s points are well taken, and to be honest, I’m not that far down in the weeds to know state level information of LDCs and PUCs. My general feeling is that full fixed rebates do not seem that likely anywhere in the country. Most electricity companies that do have fixed charges still recover some of their fixed costs through the variable portion of their bill. This makes fixed rebates more difficult even if they are desired. It is also important to keep in mind that regulated regions with average cost of service will pass along the subsidy in the variable portion of the bill no matter what the legislation says.

    As to Shimpei’s point. Having both a cap-and-trade program and a RES is seen by many as conflicting and economically inefficient. At the end of the day, both have different goals, and they don’t necessarily overlap. If both pass together, generators (or wherever the point of compliance is) will be responsible for both credits to the best of my knowledge.

  9. average cost of electricity bill…

    For the last month Ive been spending a lot of time studying and modeling various allocation schemes […]…

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