Carbon cap and trade: pros, cons, and cautionary tales for Canada’s government

The world does not have much experience with carbon cap and trade schemes. The European ETS has only been in operation since 2006 and early experience has been generally negative. Price fluctuations in carbon permits have allowed coal-based power generators to make big profits. This means they actually increased their power output and hence their carbon emissions—exactly the opposite of the ETS’s intent.

Some have said this is because of the free carbon permits that were handed out to emitting companies before trading began in the ETS. To guard against this flaw, carbon allowances under the Regional Greenhouse Gas Initiative (RGGI), a newer scheme from the U.S. northeast, are sold at auction.

In my view, the RGGI approach is much better than the ETS approach of handing emission permits out for free. Cap and trade is politically acceptable precisely because rules can be tweaked so as to keep carbon prices low. For example, the initial version of the Lieberman-Warner climate change bill contained an “off-ramp” provision that would shield emitting companies from excessively high carbon prices. Low carbon prices, as the ETS has proved, are not a disincentive to emitting companies. Therefore, by selling permits at auction you at least can raise money for carbon-reduction projects.

Since September, RGGI has raised over US$144 million through the sale of allowances; see factsheet.

Of course, some projects are better than others, and the fixation on renewable energy illustrates that there’s no guarantee that the more deserving projects will get the funding (see article). But at least there’s a chance.

Paradoxically, it is likely that natural gas–based power generators who operate in deregulated power systems will oppose cap and trade. This might seem contrary to what you’d expect, since gas-fired generation emits less GHGs per kilowatt-hour than coal, which means gas generators would pay less of a carbon penalty.

The lower emission intensity of gas versus coal is why Ken Lay, the late chief of Enron, wanted George W. Bush to sign on to the Kyoto Treaty. Enron’s business, before the company mutated into a giant smoke-and-mirrors operation, was natural gas. Lay assumed high carbon prices would drive a shift from coal to natural gas in U.S. power generation (see article).

The problem is, gas-based generators already pay a fuel price penalty. Since 2001, natural gas has been expensive relative to coal, which has driven up the cost of gas-fired generation relative to coal-fired generation. In competitive power markets that aren’t carbon constrained, this already puts gas at a disadvantage.

A carbon penalty could, in theory, overcome the disadvantage of gas relative to coal. From the point of view of emission reductions, that’s the whole idea of cap and trade. But in practice the cost of carbon would have to be high enough to overcome the Dark Green Spread (i.e., the difference between the price of coal-plus-power-plus-carbon and gas-plus-power-plus-carbon).

And that mythical carbon price is much higher than the political mood will bear. I repeat: cap and trade is popular because it allows policymakers to keep carbon prices low. As in, so low that the price of carbon fails to overcome coal’s price advantage over natural gas. Coal is simply cheaper than gas. This makes coal-fired power more competitive in deregulated power markets.

This is why Indeck Corp., which operates a gas-fired plant in New York, is suing the State of New York for participating in RGGI (see article). According to Indeck, RGGI is an unconstitutional tax grab. This is not over taxes, it’s about removing a source of competitive disadvantage for gas-based generators.

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