Preliminary Oral Comments of New York State Attorney General Eliot Spitzer on the Allocation of Carbon Dioxide Allowances Pursuant to the Regional Greenhouse Gas Initiative Cap-and-Trade Program

May 2, 2006. The comments below were delivered in Hartford, CT, by New York State Assistant Attorney General J. Jared Snyder.

In general, the Attorney General’s office supports the carbon dioxide emission reduction program embodied in the Regional Greenhouse Gas Initiative (RGGI) model rule. Global warming is undoubtedly the most significant environmental problem facing America today and the RGGI cap-and-trade program is a good first step to reducing emissions from power plants, one of the two main sources of CO2 emissions in the northeastern states.

Let us be perfectly clear on one point however: while it is a good first step, it is by no means sufficient. Unless it is superceded by an effective federal program, significant additional reductions in the regional cap will be needed. The science is clear that eventual reductions in worldwide carbon dioxide emissions of about 80% are needed to stabilize the climate. Because the United States is, and long has been, the world’s largest source of carbon dioxide emissions, and power plants are the largest source of emissions within the United States, reductions of at least that magnitude in US power plant emissions will ultimately be necessary. RGGI is a good first step in that direction.

Now that the RGGI states have agreed to implement a carbon dioxide cap-and- trade program, the states must decide how to initially distribute the carbon dioxide allowances. Generators will need to have enough allowances to match the amount of their CO2 emissions, in a ratio of one allowance per ton of CO2 emitted. Among the options are: distributing the allowances to generators free-of-charge based on historic emissions, distributing the allowances free-of-charge based on electricity generation output, and auctioning the allowances to generators and using the auction revenue for some public purpose. The remainder of these comments at this time focus on the selection of an allocation methodology. In further written comments, our office will address a number of other issues relating to the RGGI design.

The importance of the allocation methodology transcends this limited emission reduction program. As the federal acid rain experience demonstrates, the allocation methodologies chosen now may well develop their own propulsion and provide the default choice for future reduction programs as well. In addition, considering the need for additional reductions in the future, it is essential that the allocation methodology minimize the burdens of the program to the public at large in order to build public support for the further reductions that will be needed in the future, both at the state and federal levels.

The state memorandum of agreement requires that at least 25% of the allowances must be sold to generators through an auction or similar mechanism for the public benefit. It is our view that the public benefit allocation should be expanded from the 25% minimum to 100% of the allowances.

We believe that three principles should guide the selection of an allocation methodology. The first goal is to minimize the impact on consumers’ electricity bills. Second, the allocation methodology should provide an incentive for development and implementation of clean sources of energy and energy efficiency. Third, the states should select an approach to allocation of allowances that ensures that CO2 emitters bear at least some of the cost of the harm caused by their emissions but borne by society at large, otherwise known as the externalities of their pollution.

Principles of economics and the modeling undertaken by the working group demonstrate that all of these goals are served by developing a mechanism whereby the allowances are auctioned to generators with all proceeds used for energy efficiency improvements and direct ratepayer or resident rebates.

Free Allocation vs. Auction of Allowances

Free allocation of allowances to CO2 generators will not lead to lower electricity prices to consumers. The price of electricity will rise to the same extent under RGGI whether the allowances are given to the generators for free or auctioned for the benefit of the public. The reason is a matter of fundamental economics.

In New York and other RGGI states, electric power is bought and sold on wholesale spot markets (the NYISO, ISO-NE, and PJM). Load serving entities, such as utilities and competitive energy service providers, purchase power from generators at a price set by the market. Generators offer power into the market at a price which represents their marginal cost (which includes all variable and fixed costs). The independent system operator matches generator offers with demand bid into the market, from least to most expensive power offered. When the demand is satisfied, the price at which it is satisfied, the “market clearing price,” is paid to all generators who have offered power at or below that price.

A generator will include in its variable costs, and thus in its offering price, the current market value of the CO2 allowances it uses to cover its emissions, regardless of how it originally obtained those allowances. This is because, in offering power into the market, a generator has to decide whether it is more profitable to produce electric power and expend the necessary CO2 allowances to do so, or not to produce electricity and instead sell its allowances to others. If it decides to offer power, it is foregoing the opportunity to sell the allowances in favor of consuming the allowances. This “opportunity cost,” which is the market price of the allowances, is a variable cost that will be included in generators’ marginal cost (i.e., the marginal bid price for the electricity they generate). The opportunity cost represents the cost to the generator of deciding to produce the power and use up allowances. The same opportunity costs will be included in the generator’s bid regardless of how the allowances were originally dispensed.

The price of electric power is ultimately passed on to the consumer, whether in the form of a direct pass-through on the bill (such as most New York electric customers get) or indirectly through recalculations down the road when fixed rate services are revisited by ratemaking agencies or when bilateral contracts are renegotiated or otherwise adjusted. Since the opportunity cost will be included in the generator’s bid price regardless of how the allowances were originally dispensed, giving the allowances for free to the generators will not lower the ultimate price paid by the consumer. It will simply provide a windfall to generators, who will be able to keep or sell the allowances received as needed. An auction would not provide such a windfall, but instead would generate revenue for public purposes, including reduction of electricity bills.

Cost studies for RGGI and other CO2 cap-and-trade programs confirm that the electricity price impact of the CO2 policy is the same whether under a historic allocation or under an auctioned allocation. However, the allocation methodology will have a significant impact on who benefits from the value of the allowances. For example, Resources for the Future (RFF) found that “due to electricity deregulation in the northeast, allowance value is reflected in electricity price to an equal degree for auction and historic approaches to distribution,” and generators would actually make more money under a CO2 policy with free allocation of CO2 allowances than they would in the absence of a CO2 policy altogether. In contrast, the value of allowances in an auction approach (i.e., the auction revenues) would benefit the public if used for rebates and energy efficiency improvements.

In the UK, where CO2 allowances were originally distributed at no charge based on historic emissions, it is anticipated that power generators will make increased revenue of approximately $500 million per year. Importantly, the Environmental Audit Committee of the UK House of Commons has concluded that auctions should be considered in future due to the massive windfalls generators have received.

Auction Revenues

As mentioned above, distributing allowances by auction eliminates the windfall to the emitters and allows the proceeds to be used to defray the increased prices. Through mechanisms such as rebates, credits and offsets, some portion of the proceeds can be returned directly to ratepayers who would otherwise bear the increased cost of electricity. In addition, auction proceeds can be used to fund energy efficiency programs directed at reducing consumers’ electricity usage. In this way, the effect of increased electricity prices on consumers’ bills will be tempered, if not eliminated completely. Furthermore, by reducing demand for power generation, improvements in energy efficiency will suppress both wholesale energy prices and the cost of allowances.

New York’s existing energy efficiency program has been a tremendous success, but there is still potential for further efficiency gains. Through 2004, NYSERDA’s energy efficiency and clean energy programs have reduced annual electricity use by 1,400 gigawatt-hours, reduced energy bills by $195 million annually, created 4,200 jobs per year, and reduced annual carbon dioxide emissions by 1,000,000 tons. By 2022, NYSERDA estimates that the potential energy savings from additional cost-effective energy efficiency improvements could be as high as 27,244 gigawatt-hours per year. Auction revenues could be used to help realize the full potential of energy efficiency in New York.

Allocating allowances by auction also promotes the development of cleaner sources of energy, because they will not have to bear the cost of acquiring allowances. This will give renewable energy and efficient generators modest advantage over higher emitting generators but that is unlikely to balance the significant existing indirect advantage the higher emitting generators have in the form of currently allowed pollution (of both CO2 and other pollutants) – basically free waste disposal.

Internalizing Externalities

The RGGI modeling demonstrates that the financial interests of most generators will be served by providing them with allowances free-of-charge, rather than requiring them to pay for their allowances. But no system of environmental regulation is without costs to the regulated industry and it makes economic sense to require the generators to internalize the true societal and environmental costs of their emissions.

Since higher emitting plants cause greater societal and environmental harm, it is appropriate for them to have to pay for the greater number of allowances they need to cover their higher CO2 emissions. If, as a result, some of higher-emitting plants are ultimately replaced by cleaner, more efficient sources of energy, then the program will be working as it should.

Summary

We strongly urge the RGGI states to provide for all allowances to be auctioned or, in other words, allocated to the public. We will submit additional comments on the allocation of funds received by the sale of the allowances, the sale mechanism, and other RGGI design issues.

Thank you again for considering the views of the Attorney General’s office on this important issue.

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