The Limits of Cap and Trade

This blog is my pragmatic view of environmental issues and, to be honest, goes way down in the weeds because most environmental issues are not simple. Spoiler alert this one is the worst yet.

The reason for this blog post is to document the possibility of a “bad thing” in New York that has a reasonable chance of occurring in late August and September of 2018 and possibly as soon as late this summer. I am worried about compliance and a potential threat to electric system operations with the Cross State Air Pollution Rule (CSAPR) NOx Ozone Season trading program. If the feces get entangled in the impeller remember you heard it here before it happened so you will know that the agencies were told that their plans were risky. Unfortunately in order to describe the “bad thing” you likely need some background information that may put you to sleep.

Before proceeding a disclaimer. Before retirement from the electric generating industry, I was actively analyzing air quality regulations that could affect company operations. The opinions expressed in this post do not reflect the position of any of my previous employers or any other company I have been associated with, these comments are mine alone.

Background

First off, you off to know about trading programs. EPA does a good job describing the fundamentals of cap and trade. What you need to know about this pollution control approach is that there are two components: the cap and tradable allowances for the pollutant covered. The cap sets a limit on the total regional emissions that must be met over a trading season such as a year or during the ozone season from May through September. The cap is set at a level such that the pollutant of interest will be reduced to levels that are supposed to improve air quality to the appropriate standard. Setting the cap level correctly is critically important: too high and the environmental objectives won’t get met and too low and the market mechanism won’t work. It is necessary to measure the emissions accurately and transparently because for every ton of pollution emitted affected sources have to surrender an allowance. EPA’s Acid Rain program is the poster child for a successful cap and trade program because greater than required reductions occurred, earlier than expected and with much lower costs than projected.

The key to cap and trade success is that sources that can implement the most cost-effective controls can install those controls, limit their emissions to less than their allocations and trade their excess allowances to sources with more expensive options. The result is that the cap is met in the most cost-effective manner. My particular concern with cap and trade programs in general, and this one in particular, is that in order for it to be successful somebody has to be able to over-control. The problem is if the cap is set so low that there are no options for sources to over control then there are no chances for generating excess allowances so no one has anything to trade. In the worst case affected sources will only run until they have no more allowances and then they will have to shut down.

Environmental NGOs have argued that cap and trade programs do not guarantee that all the sources reduce their emissions so they claim that it is not fair because some sources will not lower emissions and local air quality will not improve everywhere. However, there are national ambient air quality standards that cannot be exceeded for any pollutant that has a pronounced local impact so no sources should be over an emissions limit that causes those problems. Also the pollutants covered in cap and trade programs are related to regional problems such as acid rain and ozone where the local effects are small. Nonetheless, due to a court settlement, the CSAPR rules include a limitation on state emissions to limit interstate trading to prevent this, in my opinion, non-existent problem.

Updates to the CSAPR were proposed in 2015 and finalized in 2016 that included changes to address this problem. The feature that the CSAPR update rule added for this concern is called the compliance assurance mechanism. In addition to the cap a second level was set to limit interstate transfers. For each state in the trading program, the state’s allowance cap budget plus the newly defined variability limit constitutes that state’s assurance level. Each state’s assurance levels takes into account the inherent variability in the state’s baseline emissions from year to year. The intent is that emissions in states can exceed the assurance level due to natural variability (e.g., hot weather making units run more) but including this means that sources in states cannot rely on out-of-state allowances for routine compliance. In 2017, or any later year, if a state’s total emissions are greater than the sum of the state’s budget and variability limit the assurance provisions are triggered. In this case EPA’s rationale is that the state is using more allowances than necessary for inherent variability and is therefore relying on interstate transfers for compliance. When this provision is triggered, EPA determines which facilities exceeded their individual assurance level and requires them to surrender additional allowances equal to three times the excess over the assurance level.

Because the ozone limit has been racheted down over the years there still are many areas that do not attain the current national ambient air quality standard for ozone. The CSAPR NOX Ozone Season trading program is specifically designed to reduce interstate ozone transport that contributes to that problem. Note, that this is the fifth round of NOx reduction programs for New York. As a result, the easy, cheap and quick NOx control options have already been implemented. It is recognized that pollution control costs increase exponentially as the efficiency increases so any further reductions will be expensive and probably cannot be implemented quickly.

Because the cap level is so important I need to explain how EPA determines the cap size. I could easily double the length of this post and surely put to sleep anyone who has read this far if I were to explain in detail how EPA set this cap. Instead and briefly, they use the production cost model Integrated Planning Model (IPM) to analyze the impacts of air quality policies. This is a massive model that purports to estimate how the entire United States utility sector will react to changes in air quality regulations. In order to do that they have to model not only generator operations, fuel costs and control equipment strategies, but also the transmission system. However, the transmission component has been critically flawed when it comes to New York. In particular, the largest load center in the state, New York City, is mostly on islands, there are limits to the transmission available and consequently there are limits to how much electricity can be transmitted to the City. In order to model the entire United States IPM over-simplifies the New York transmission grid. As a result, EPA IPM modeling projects that the least cost solution is to simply generate power elsewhere and significantly under-estimates the amount of power that has to be generated in the City and Long Island, the resulting emissions necessary to keep the lights on, and sets a cap too low to accommodate the New York City constraint.

The New York allocations from EPA in the draft CSAPR update rule had the same flaw as previous programs because of this short-coming. I was responsible for some comments on the draft and we had some success. The final rule changed the New York allocation for a different reason and raised the final allocation.  In 2016 the New York NOx Ozone Season budget was 10,157 allowances. Even with additional allowances, the final CSAPR 2017 NOx Ozone Season Budget is only 5,135 allowances which is close to a 50% reduction. The 2016 NOx actual ozone season emissions in New York were 6,521 tons which is a 64% reduction from the start of the last New York NOx Ozone Season program in 2008. On the face of it then if Ozone Season emissions in 2017 are the same as 2016, then there will be a 20% shortfall of 1,386 tons.

There is another complication. EPA allows banking, i.e. unused allowances are carried forward and can be used in later years. However, the final regulation for the CSAPR update rule included a reduction in the allowance banks. New York affected sources argued, in vain, that because we had already made significant reductions due to other state initiatives that it would be unfair to discount the banked allowances that were earned as a result of those control investments. EPA calculated that there was a bank of 350,000 allowances in the affected states at the end of 2016. EPA argued that the size of the bank would have precluded additional reduction investments until the bank was reduced considerably so they promulgated a reduction to the total of aggregated variability limits times 1.5. The resulting across the board three to one reduction with no consideration of individual interim state actions was a major hit to NY compliance strategies. If historical emissions remain constant, the affected New York sources only have a bank of 3,060 allowances to cover the shortfall of 1,386 tons.

The EPA allocations are to the state and each state has the right to determine how those allowances are allocated to the affected sources. In order to account for new sources the New York Department of Environmental Conservation sets aside 5% of the total allocation for any new sources that come on line during the year. Previously, any unused allowances eventually were returned to the affected sources. Unfortunately, the Cuomo Administration also had plans for the New York allocations. After the “success” of a new and outside the legislature branch revenue stream from the auction of CO2 allowances for the Regional Greenhouse Gas Initiative, the Administration got wind of these allowances and immediately thought they could do the same thing. However, auctioning this kind of allowance is a whole different ball game and they did not try to auction all the allowances. Instead they siphoned off 10% of the allowances to the Energy Efficiency and Renewable Energy Technology (EERET) account and required that any unused new source set-aside allowances would also go to EERET. So instead of the affected sources getting the full allocation of 5,135 allowances they were only allocated 4,362 allowances. Affected sources in New York begged the State to give them the right of first refusal to buy the allowances that were skimmed off but the language in the rule specified sale on the “open market”. Consequently the State refused to incorporate that request into the sale and, to add insult to injury, specified that all the allowances had to be purchased in one batch. The NY 2017 allowances went to Louisiana and the 2018 allowances went to Texas where because of the size of those state budgets they are a fraction of the variability limit so they will most likely be used there. As best as I can tell the sale of those allowances must have netted over $280,000 for the 2017 EERET allowances.

The final consideration in this tale of an obscure air quality compliance issue is the size of the allowance bank. Academics and environmental NGOs cannot abide large margins between allowances and emissions and, in the case of the RGGI allowance margin, are arguing that the margin should be very small. Their rationale is that if allowances are scarce for those sources that need them to run then they will have to buy them at higher costs which in the case of the RGGI will increase the cost of carbon and eventually influence behavior. On the pragmatic side of affected source compliance however, there are advantages to a comfortable allowance margin. Without delving even deeper into the mire of allowance compliance, there can be regulatory and financial implications in the event that there is an allowance monitoring error that increases emissions discovered after the compliance reconciliation deadline and the affected source does not have enough allowances in its account to cover the difference. Environmental staff associated with emissions monitoring generally recommend keeping at least a 5% buffer in the allowance bank for that contingency. Furthermore EPA acknowledges that there is inherent variability in year to year emissions as specified in their CSAPR variability limit of 21% so companies that provide power to the public like to have banks available to cover operational variations. In my opinion an allowance bank of under 5% is very risky and I would recommend a minimum of 25% to cover operational and monitoring contingencies. The key point is that except in rare instances this issue has only been a theoretical problem at most companies for almost all cap and trade programs.

After I completed the draft of this post I found a recent report on the CSAPR Ozone Season allowance market that may be of interest.

The “Bad Thing”

My congratulations if you have made it this far.

My particular concern is New York compliance with the CSAPR NOx Ozone Season limit. To date no New York cap and trade program has had to deal with a constrained market and I vaguely recall only one instance of a constrained market in any cap and trade program.

Because there is only one update of emissions during the ozone season (at the end of July when the May and June data are submitted), facilities will not necessarily know whether the state has triggered the state’s assurance level with its requirement to surrender additional allowances at the end of the Ozone Season. The result is that facilities will be reluctant to exceed their assurance levels because they will not know whether they only need allowances to cover just the excess or three times the excess because the state exceeded the assurance level cap. There is another aspect to this issue that should not be ignored. Electric generating companies have very strong compliance policies and are very reluctant to even give the perception that they have exceeded their emission limits. It is possible company policies will limit emissions to the assurance level and no higher.

My scenario for a bad thing is that New York will be unable to meaningfully further reduce NOx emissions in the near term. If the next couple of summers are warm that will exhaust the current allowance bank to de minimus levels. The ultimate problem with a cap and trade program is that if allowances are not available then the only compliance option is to not run. There is little question in my mind that CSAPR allowances will be available somewhere but that may not be enough to prevent localized operational disruption due to allowance compliance uncertainties. The cumulative effect of the EPA constraints on interstate trading, the uncertainty of the status of emissions relative to the compliance assurance mechanism, and the lower than appropriate cap on NY emissions exacerbated by the Cuomo administration’s unwillingness to give NY affected sources the opportunity to purchase the allowances taken by the State means that New York State affected sources could easily be in uncharted territory. It is not clear how they will react but risking a compliance penalty is not in their best interests.

So my perfect storm worst case scenario is two warm summers that pushes the state close to the compliance assurance limit and reduces the NY allowance bank for one or more affected-source companies to low levels after the June emissions data are known in early August (it takes a month for the data to get reported). Companies with the small number of allowances available find they cannot purchase enough allowances on the market to cover their emissions and possible CAM penalties or find that the costs are so high they don’t think they can recover the cost of purchasing allowances so they get to the point where they simply have to tell the system operator that their units cannot run. This will precipitate a controversy at best and, in an order of magnitude less likely worst case, could even threaten grid reliability. I don’t think the last possibility is very likely but I do think that bringing system reliability into danger because of the regulatory decisions by EPA and NYS that ignored industry recommendations in this instance is possible.