Market Power with Tradable Performance-Based C[O.sub.2] Emission Standards in the Electricity Sector.

• Author: Chen, Yihsu
• Position: Report - Statistical table

1. INTRODUCTION

   While market-based policy is a generic label for various types of environmental standards that take advantage of incentives in polluting industries, it typically refers to price and quantity instruments. The price instrument, commonly known as a "tax," acts as a cost adder that penalizes polluting industries by internalizing pollution damage. The second type (known as cap-and-trade or C&T) regulates the pollution quantity, in which a regulatory body first allocates property rights of emitting pollutions, i.e., permits or allowances, to affected facilities by either auctioning, grandfathering, technology- or fuel-based updating, or other approaches. These facilities need to demonstrate their compliance by surrendering sufficient allowances to cover their emissions at the end of each compliance cycle, e.g., the annual cap for S[O.sub.2] and summer months for N[O.sub.x] The allowances can be traded freely in secondary markets such as the SO, trading program under the Clean Air Act (CAA), the European Union Emission Trading System (EU ETS), C[O.sub.2] trading, and renewable energy credit (REC) trading under several state-level renewable portfolio standards (RPS).

   Economists have long advocated market-based approaches on the grounds of economic efficiency. A tax and C&T are fundamentally different since the level of an emissions tax is pre-set by an authority and exogenous to the product market. By contrast, permit prices fluctuate constantly reflecting market participants' expectations concerning demand and supply conditions. Comparison of the tax and the C&T has, therefore, received considerable attention following early work by Weitzman (1974). Mansur (2013) shows that, in contrast to a tax, the polluters' decisions under a tradable permits system would affect the permit price, which might actually increase a strategic firm's output, thereby leading to a lower deadweight loss relative to a tax system. Green (2008) examines market risks faced by generators under the tax and permits systems with the finding that a tax increases (decreases) the volatility for a fossil-fuel (nuclear) plant. Chen and Tseng (2011) conclude that price volatility under C&T would induce early adoption of clean technology compared to a tax. While the efficiency properties of these two types of policies are well known through years of research, the newly introduced the U.S. federal Clean Power Plan (CPP) brings a new dimension.

   CPP was introduced by the U.S. Environmental Protection Agency to cut C[O.sub.2] emissions from existing fossil-fuel power plants by 30% below 2005 levels by 2030. While the proposal establishes a state-specific target with various building blocks that lay out possible reduction strategies, it leaves states and the power sector with considerable flexibility in attaining their targets. More specifically, a state can decide to adopt either 1) a default performance-based standard under which tons of C[O.sub.2] emissions per MWh of electricity generated is measured or 2) an equivalent mass-based standard, such as in a C&T regime based on GDP growth projections. Furthermore, those states will form an alliance that allows them to trade under either a "mass-based" or a "performance-based" standard. The performance-based standard essentially is an intensity standard, which limits the average emission rate allowed for a system, a market or a state. The tradable performance-based credits under the CPP are called emission rate credits (ERCs) with a physical unit of $/MWh. Each generating unit owned by a firm when subject to the policy might incur an emission cost or earn an emission revenue. In particular, given a state-level policy rate of [E.sup.policy], for a generating unit with an emission rate of E, producing 1 MWh of energy will be equivalent to generating [mathematical expression not reproducible] amount of ERCs credits, either positive or negative. When a state opts for implementing this tradable performance-based standard, it will comply with policy by collecting a non-negative net ERC. (1)

   Economic theory suggests that the two approaches would provide incentives that might alter a firm's production decisions in a very different way (Bushnell et al., 2014). In particular, similar to an RPS, a "performance-based" standard involves cross-subsidies from high-emitting sources to low-emitting sources (Tanaka and Chen, 2013; Siddiqui et al., 2016). In the case where a generating unit's emission rate is greater than the performance standard, it will need to pay a cost to cover its emissions, thereby effectively elevating its marginal cost of production. On the other hand, when a generator's emission rate is less than the performance standard, the negative cost becomes a subsidy that lowers its production cost, thereby making the generator more competitive. (2) As such units are the typically price-setting marginal units during peak periods, the policy would likely lower the power price, thereby inflating energy consumption in those periods (Bushneil et al., 2014).

   One emerging issue that has received little attention is the possibility of strategic behavior under the tradable performance-based standard as well as its repercussions for the product market. The distribution of economic rent or welfare analysis also needs further attention when comparing performance- with mass-based standards. In particular, while the government collects all the proceedings from auctioning off mass-based tradable permits, the tradable performance-based standard is inherently revenue neutral since it involves transfers of economic rent from high-emitting to low-emitting units. (3) This paper analyzes the efficiency properties of the CPP tradable performance-based standard under imperfect competition and compares it to the traditional mass-based policies. We focus on a short-run analysis within the partial equilibrium framework so that investment in new generation by existing firms, new entry, and interactions with other sectors are not considered. Moreover, while states are allowed to decide their choice of instruments under the CPP, we assume in our analysis that states opt for the same instrument, either performance- or mass-based policy, and are subject to a regional permit trading agreement. Currently, the enforcement of the plan is halted by Supreme Court until a lower court rules in the lawsuit against the plan (Hurley and Volcovici, 2016). President Trump also signed an executive order on March 28, 2017 mandating the EPA to review the plan (Davenport and Rubin, 2017). While the nation remains divided with regard to the CPP, states within a regional electricity market will have an economic incentive to form an alliance, such as the Regional Greenhouse Gas Initiative, by subjecting themselves to a regional emission trading program with either a performance- or a mass-based standard in order to lower their compliance cost, see, for example, Southwest Power Pool (Herman, 2015). Moreover, strategic choice of instruments under the CPP is studied by Bushneil et al. (2014), who conclude that adoption of inefficient performance-based standards is a dominant strategy for states from both a consumer's and a generator's perspective.

   The paper proceeds as follows. Stylized duopoly models considering a performance-based policy are developed to produce representative theories. However, welfare comparison is challenging due to differences in total CO, emissions. Therefore, more structured models that are generalized to more than two firms and account for the fact that firms might own multiple facilities with different emission intensities and compete in a transmission-constrained network are developed to reflect more realistic market conditions while holding total CO, emissions constant across scenarios. (4) Several scenarios are considered in the numerical examples, differing by their assumptions concerning 1) types of tradable permit markets (e.g., mass- or performance-based standard) and 2) whether firms possess market power in the power and the permit markets. If firms are allowed to exercise market power in the permit market, then a Stackelberg type of leader-follower formulation is considered where a leader could fully and correctly anticipate reactions by followers, including follower producers, system operator, and consumers. The impact of the adopted policy is shaped by the nature of the portfolio of generation assets owned by this dominant firm, i.e., relatively clean or dirty. Consequently, our analysis could be used to frame policy measures for the PJM Interconnection or California, where the dominant producers are likely to have relatively dirty or clean portfolios, respectively.

   Depending on market structure, we follow Hobbs (2001) and Chen et al. (2006) in formulating the problem as either a mixed linear complementarity problem (MLCP) or a mathematical program with equilibrium constraints (MPEC). When formulating the Stackelberg leader-follower problem as an MPEC, the problem is challenging to solve because of 1) complementarity conditions representing followers' first-order conditions so that constraint qualification is violated and 2) bilinear terms in leader's objective function. We overcome these difficulties by replacing complementarity conditions and bilinear terms with disjunctive constraints and binary expansion, respectively, to turn the problem into a mixed integer linear program (MILP) (Gabriel and Leuthold, 2010). While this transformation might be at the expense of precision of the solution, the mixed integer algorithm guarantees convergence and enables inferring the solution quality through the duality gap.

   The general conclusion from the stylized analysis indicates that the outcomes of the Cournot duopoly lie between that of the perfect competition and Stackelberg ones when a performance-based allowance market is considered. That is, the power price is highest under Stackelberg followed by...