Emissions Trading in the Presence of Price-Regulated Polluting Firms: How Costly Are Free Allowances?

Author:Lanz, Bruno
Position:Report - Statistical data

    Emissions trading programs have become a centerpiece of environmental policy in Europe and the United States. In a competitive setting with full information, the creation of a market for emissions permits works to equalize marginal abatement costs across sources and minimizes aggregate compliance costs (Dales, 1968; Montgomery, 1972). (1) An appealing feature of emissions trading is the independence of permit market outcomes and the initial allocation of permits (Hahn and Stavins, 2011). This enables separating efficiency (or cost-effectiveness) from equity considerations, creating the flexibility to secure political support for such policies. Free allowances or the revenue from auctioned permits can be used to relieve participating firms from their compliance costs and offset profit losses (Hepburn et al., 2012; Goulder et al., 2010), or to address unintended distributional outcomes (Stavins, 2008). The independence property also means that the central design question of emissions trading regulation, namely whether to auction or give away emissions permits for free, does not affect the aggregate cost of the policy.

    This paper challenges this view by investigating the extent to which the presence of price-regulated firms affects the outcome of alternative permit allocations rules. (2) Our analysis is motivated by two observable features of present-day economies. First, in many industrialized countries a large share of greenhouse gas emissions stems from electricity generation. Second, despite the ongoing liberalization of electricity markets in many countries, the electricity sector remains highly regulated, with electricity prices determined by some form of cost-of-service regulation. For example, in the United States about 30% of economy-wide carbon dioxide (C[O.sub.2]) emissions in 2011 stemmed from electricity generation (U.S. Environmental Protection Agency, 2014) and around 60% of electricity was generated by producers that were subject to cost-of-service regulation (Energy Information Administration, 2012).

    Combining stylized partial equilibrium analysis with numerical general equilibrium simulations, this paper shows that these two observations taken together have important implications for the design of emissions trading policies. The reason is that price-regulated firms need to adjust output prices with the value of free allowances. If emissions permits are instead auctioned (or if an emissions tax is used), the cost of buying emissions permits is fully reflected in the output price of price-regulated firms. Because an auction also generates an income effect for households, the impact of free permits relative to an auction depends on income and substitution effects for the good produced by the regulated firm. We show that when income effects associated with revenues from the auction dominate, distributing free permits induces higher output by price-regualted firms as compared to an auction. In turn, with free permits, emissions from price-regulated firms will be higher than under an auction, and abatement will have to shift to other (i.e., non-electric) sectors in the economy, potentially undermining cost-effectiveness. (3)

    To get a sense about the likely order of magnitude of efficiency costs and distributional impacts of alternative designs for emissions trading regulation, we develop a numerical general equilibrium model for the U.S. economy. The model is based on standard neoclassical optimizing behavior of firms and households, but it integrates a number of features that are essential for being able to provide an empirical analysis of the likely economic impacts.

    First, to characterize abatement opportunities in the electricity sector, we use data on all 16,891 electricity generators active in 2006 published by the Energy Information Agency (EIA) (2007a). Generators are owned by a set of operators, and we identify 319 operators subject to cost-of-service regulation (EIA, 2007b). Regulated operators are treated as cost-minimizers charging average costs, whereas generators owned by non-regulated operators trade on imperfectly competitive regional wholesale markets. (4) By providing a structural "bottom-up" representation of abatement options in the electricity sector, we avoid using overly simplistic aggregate production functions typically employed in aggregated economy-wide general equilibrium models for electricity generation (Paltsev et al., 2005; Goulder et al., 2010). On the one hand, it enables us to capture some of the complexity of the market structure of the U.S. electricity sector. On the other hand, and relevant for studying the impact of a carbon pricing policy, substitution among different types of electricity technologies is modeled at the generator-level and is based on detailed data for generation costs, fuel switching possibilities, and time-varying (diurnal and seasonal) demand for electricity (see Lanz and Rausch, 2011).

    Second, we embed the operator-level representation of electricity generation into a static general equilibrium model of the U.S. economy calibrated based on a set of regional Social Accounting Matrices for 2006. The sub-national detail of the model allows us to capture region-specific detail of energy use and production of various industries and final consumption sectors, and also how electricity demand by private and industrial consumers might change in response to a carbon pricing policy. Moreover, it characterizes abatement possibilities in non-electricity sectors and allows us to evaluate the equilibrium price for tradable emissions permits and economy-wide welfare costs of alternative initial allocations of emissions permits.

    Third, to illustrate the distributional impacts of alternative policy design, we build on previous work by Rutherford and Tarr (2008) and Rausch et al. (2011) and integrate "real" households as individual agents in the model. In particular, we include all 15,588 respondents from the Consumer Expenditure Survey (CEX), a representative sample of the U.S. population (Bureau of Labor Statistics (BLS), bls2006), as individual households in the model. Using an economy-wide model with heterogeneous consumers allows us to measure impacts both on the uses- and source-side of income, i.e. how do consumers spend and earn their income. (5)

    In our quantitative analysis, we consider two alternative bases to determine the quantity of free permits allocated to price-regulated firms, namely historic emissions (i.e., grandfathering) or historic output. (6) As free allowances distributed to price-regulated firms effectively work as a subsidy of electricity rates, allocating permits based on benchmark emissions mitigates electricity price increases of the most C[O.sub.2]-intensive operators. While this can partially smooth price differentials across operators, it is likely to magnify distortions associated with free allowances. In contrast, using benchmark output as a basis for allowance allocation provides an intermediate case, as it equalizes the subsidy rate across regulated operators and thus partially preserves the link between emissions intensity and output prices.

    Besides the aforementioned literature that is focused on the choice between auctioning and free allowances, this paper is germane to a number of studies that have investigated the implications of price-regulation for emissions trading policies. Theoretical work by Bohi and Burtraw (1992), Coggins and Smith (1993) and Fullerton et al. (1997) show that cost-of-service regulation can induce inefficient abatement behavior, potentially increasing the welfare costs of a cap-and-trade policy. Paul et al. (2010) and Burtraw et al. (2009) investigate the impacts of various assumptions about allowance allocation in the context of cap-and-trade policies in a numerical simulation model of the U.S. electricity sector that incorporates regional detail about cost-of-service regulation. While they find, in line with this paper, that distributing free allowances to regulated electricity producers substantially increase the equilibrium carbon price, looking at the electricity sector alone prevents addressing the broader policy-design question raised by the present paper. A related paper by Rausch et al. (2010) uses a general equilibrium model to investigate the welfare impacts of subsidized electricity prices, but assumes that the entire electricity produced in the U.S. is subject to price regulation. Our contribution relative to Rausch et al. (2010) is to identify the drivers of welfare impacts in a model capturing heterogeneity in the electricity markets both within and across regions, as well as across households.

    The structure of the paper is as follows. Section 2 employs a stylized partial equilibrium model to illustrate the fundamental implications of alternative allowance distribution in the presence of price-regulated firms. Section 3 provides some background about U.S. electricity markets, price regulation, and C[O.sub.2] emissions. Section 4 describes the numerical model used to quantify the economic impacts of alternative allowance allocation designs. Section 5 lays out the policy scenarios, reports our quantitative results, and discusses our findings and assumptions. Section 6 concludes.


    Our theoretical analysis builds on Fisher (2001) and Bohringer and Lange (2005) who study alternative allowance allocation rules in a one-sector partial equilibrium setting. In the present paper, we extend their analysis to consider the equilibrium outcome when the supply-side of the market is controlled by a price-regulated monopoly, and show how the outcome with free allowances differs from the social optimum. The analytical expressions we obtain provide the basic intuition for the results derived from numerical general equilibrium analysis reported in Section 5.

    Consider a good X whose production entails total emissions E...

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