RGGI: How Not to Design a Carbon Market

The Regional Greenhouse Gas Initiative marked the start of operations Friday, trading 70 futures and options contracts on the Chicago Climate Futures Exchange. The contracts, which represent 70,000 emissions credits, were the first traded in the U.S. under a regulated cap-and-trade scheme. Many believe RGGI, which comprises 10 Northeastern and Mid-Atlantic states, will set the tone for a future federal emissions reduction scheme that is likely to be implemented under the next presidential administration.

Let’s hope not.

While investor interest in the pre-sale - RGGI opens officially on January 1, 2009 - is heartening, the market itself suffers from serious design flaws. Most of these are related to political compromise that will sink the market before it has to chance to make a significant difference. If the design flaws evident in RGGI are replicated on the federal level, we should give up hope for a thriving carbon market in the U.S. in the short- to mid-term.

Emissions credits in RGGI are limited to the power sector, binding generators to cumulative emissions of 188 million tons per year from 2009 to 2014. This number is set to decrease by 2.5 percent annually between 2015 and 2018, at which point climatologists expect most of the RGGI states to have sloughed off into the Atlantic. The emissions caps are set at higher-than-historic levels, meaning power generators will be allowed to emit more, though probably at a slower rate, than what was previously planned. Slowing emissions in the natural gas-dominated Northeastern power sector won’t be difficult, and an emissions credit surplus problem will probably emerge within the first few months of trading and last beyond 2014. The contracts ended their first day of action at $5.58 per short ton, far below the level required to illict credible behavior change. Trading yesterday wasn’t too thrilling either, with a meager trading volume of 4 contracts sending prices for December 2009 deliver down to $5.56. The spread out to December 2012 is still below $6.00, meaning traders don’t expect market conditions to become more competitive anytime in the near future.

And this is exactly what the power producers want. Electricity prices among RGGI states are some of the highest in the country, with New York and Massachusetts regularly topping out above $0.15/kWh. Because of retail choice, wheeling and common carrier requirements in the PJM Interconnection, NYISO, and and the Mass ISO, RGGI power producers often steep price competition from coal burners in West Virginia and hydroelectric producers in Quebec. The power producers within RGGI lobbied hard for relaxed emissions requirements - more stringent caps would have forced them to alter the fundamentals underlying their retail rates, which are negotiated annually with state-level public utility and public service commissions. By keeping caps high and requirements low, the cap-and-trade scheme will have little impact on the planning decisions of power producers. This defeats the purpose of emissions reduction.

The regularly cited figure for incentivizing behavior change is €35 per metric ton (U.S. emissions credits are traded on the short ton, equivalent to 907 kg - another market design flaw). Credits on the EU market trade around €24 per metric ton, below the line, but inclusive of emissions in both the power and industrial sectors. Because of the retail rate restrictions and public service obligations regulators place on power producers, including the industrial sector in the reduction scheme necessarily places pressure on power producers to make creative, often risky decisions, like building out renewable capacity. Fortunately, EU countries offer policy support for these projects. While not perfect, the integration of policy across both incentives and mandates makes conforming to emissions reduction regimes less painful.

Perhaps American power producers wouldn’t balk at carbon regulation if government bodies set about getting the incentives right. Whether this involves extending the production and investment tax credits, introducing a federal RPS or REFIT program, tax breaks, or merely directing subsidies to emitting companies for technological development and process innovation (kind of like how the government gives money away to oil companies), remains to be seen. To ask entrenched sectors like power, construction, or the industrials to cut emissions without support is ludicrious and leads to markets as potentially disfunctional as RGGI.