Rethinking Cost Containment

1
Rethinking Cost Containment
2
Volatility

• Big difference between price trajectories from a
  perfect foresight model and volatility around the
  mean.
• Models do not address volatility and annual
  averages can hide major economic impact issues.
• According to Celebi Graves of the Brattle
  Group, volatility increases
• investment risk
• raises the cost of capital
• creates incentive to defer investments

Compared to a carbon policy regime with more
predictable carbon prices, we estimate that CO2
price volatility under current policy proposal
could delay investment in low-carbon and carbon
abatement technologies for 10 years or more
3
Developer Needs

• As a project developer I want to make the case
  that regulatory risk is one of the biggest
  concerns as we consider merchant CCS projects,
  even greater than technological challenges.
• The quantity of capital required will force
  developers to be cautious that the long term
  price signal is sufficient to ensure a return of
  and on the billions deployed.
• Allowing carbon prices to go infinitely high in a
  given year will amplify this risk and not
  encourage investment, reducing emission
  reductions and increasing their cost.
• Long-term stability is a priority, much more
  important than high prices in any given year.
• The position of project developers is different
  that the interests of traders, who find profit
  opportunities in unbounded volatility.

4
Humbling Examples

• United States SO2 market
• Price range of 1600 to 60 in 4 years
• European Union Carbon market
• Price range of 0 to 33 Euro in 2 years
• South Coast Air Quality Management District
  (SCAQMD) RECLAIM NOx
• Price range of 10 to 50 in 2 months

http//www.caiso.com/docs/2001/02/05/2001020510182
026927.pdf
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Correlation to Natural Gas Power

• Natural Gas Electricity are already notoriously
  volatile due to storage challenges.

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Correlation to Natural Gas Power

• Given the role of natural gas in electricity
  generation, carbon prices will be tied to both
  electricity and natural gas prices, with
  implications for retail heat and electricity
  prices. Factors that move natural gas will move
  carbon and vice-versa.

7
Policy Durability

• The example of RECLAIM and the California Power
  Crisis or power price increases in Illinois last
  year illustrate how government may sometimes feel
  compelled to act when energy prices rise above
  what is considered to be a politically acceptable
  threshold.
• Outcomes are unpredictable and build enormous
  risk that the policy will not survive to achieve
  its goals. This is in no one's interest.
• In the event of a politically unacceptable
  economic impact, a price cap allows careful
  consideration of the issues without a crisis.

8
Conventional Wisdom

• Safety valves limit upside for investors in
  emission reduction projects and thus limit
  emission reduction investments.
• Classic Rent Control Argument
• Under rent control a landlord is limited in the
  rent that can be charged, as a means to keep
  housing affordable.
• The unintended consequence is that housing become
  scarce, since there is little investment to
  maintain or create new rental stock due to the
  limitation on investment returns.
• Price caps, if set thoughtfully, can have
  benefits without constricting supply

http//www.ses.wsu.edu/People/faculty/rosenman/dis
t301/POLICY.htm
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Need not "Bust the Cap"

• Modeling will calculate a projected price
  required to encourage sufficient emission
  reductions to meet the cap.
• A price cap above that price should allow the
  achievement of goals without exceeding the cap.
• In the event of short term triggering of the
  price cap, the policy can be revisited in a
  controlled manner. In this situation, there is an
  exchange of very small short term emissions
  impact for certainty of the policy.
• A safety valve can utilize many different tools
  which allow temporary allowance injection under a
  rigorous schedule. These allowances can be
  additive to cap or borrowed from the future.
• Borrowing has limits on price dampening unless
  drawn from the distant future.
• Proactive approach, warning then action........
• Safe-guards include utilization of staged
  responses and a limited duration to price control
  periods

10
Successful models

• Price caps can be consistent with encouraging
  investment.
• Ideal example is the RPS markets where
  alternative compliance payments are common. The
  growth in wind development illustrates how
  successful complementary policies such as PTC and
  accelerated depreciation can work with financial
  incentives such as RECs in the presence of a
  price cap.
• Effectively NOx and SO2 markets have technologies
  (SCR FGD) that capped prices.

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One Approach

• Define measures taken in each zone

Allowance Cost
Allowed Volatility Band
Modeled Price Expectation
Price Cap
Policy Zone A
Allowed Volatility Band
Policy Zone A
Price Floor
Te - Expiration of price cap
Time
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One Approach

• Define measures taken in each zone

Allowance Cost
Allowed Volatility Band
Modeled Price Expectation
Price Cap
Policy Zone A
Allowed Volatility Band
Policy Zone A
Price Floor
Te - Expiration of price cap
Time
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Suggestion

• Convene a sub-group to craft a safety valve
  approach that works for the Midwest.
• Keep all approaches on the table.