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Lessons Are Learned From First U.S. Carbon Auction

October 16, 2008

In late September, the Regional Greenhouse Gas Initiative (RGGI), a coalition of ten Northeastern and Mid-Atlantic states, held the nation’s first auction of government-issued carbon dioxide allowances. The auction was the first opportunity for regulated entities and investors to purchase credits that can be used to comply with a mandatory cap on carbon dioxide emissions from power plants that goes into effect on January 1, 2009. Allowances for emitting over 12.5 million tons of carbon dioxide were sold at a clearing price of $3.07 per ton. The closing price was significantly lower than the price of allowances in the European Union Emission Trading System (EU-ETS), which are currently trading at around $32 per ton.

The inaugural RGGI auction, which culminated over five years of planning, showed some notable successes. Demand for allowances exceeded the available supply, resulting in allowances selling for 60 percent above the $1.86 reserve price. Despite its initial success, the auction results were met with some criticism. Some commentators, for example, believe that emission allowances were over allocated, and as a result, the auction price was too low to encourage utilities to move away from high carbon dioxide emitting technologies to cleaner alternatives such as wind, solar, or biofuels. Another concern is how RGGI will address potential emission leakage to jurisdictions outside its coverage.

Two other regional greenhouse gas trading systems (the Western Climate Initiative and the Midwestern Regional Greenhouse Gas Reduction Accords) are currently under development, and as reported elsewhere in this edition of Environmental News, Congress is also floating new cap-and-trade legislation. These developments highlight the difficult task of integrating fundamentally different emission trading frameworks and potential federal preemption.

RGGI Auction

RGGI is the nation’s only mandatory and operational cap-and-trade system for reducing carbon dioxide emissions. RGGI is designed to stabilize regional carbon dioxide emissions from coal- and natural gas-fired power plants at estimated current levels (188 million short tons of carbon dioxide per year) between 2009 and 2014, and then reduce those emissions 2.5 percent per year between 2014 and 2018. Each participating state is responsible for distributing emission allowances, either through auctions or free allocations, to regulated entities equal to that state’s proportion of the regional cap. The vast majority of allowances are being auctioned rather than allocated for free. Power plants subject to RGGI must obtain allowances (either through the auction, allowances, secondary market trades, or offsets) equal to their emissions for each compliance period. Facilities with insufficient allowances will face potential state-level enforcement.

Allowances (i.e. the right to emit one ton of carbon dioxide) were auction in 1,000 ton lots. A total of 59 participants from the energy, financial, and environmental sector submitted bids for over 51 million allowances – an amount four times greater than the available supply. The auction used an internet-based, sealed-bid format with the clearing price based on the highest losing bid. Allowances sold for $3.07 per ton, or 60 percent higher than the $1.86 per ton reserve price and on par with brokers’ estimates[1] and the Chicago Climate Futures Exchange RGGI Futures Dec09 closing price of $3.95 on September 25, 2008. The auction generated over $38 million in proceeds that participating states can use to invest in energy efficiency, renewable technology, or programs designed to benefit energy consumers.

Four states (New York, New Jersey, New Hampshire, and Vermont) did not participate in the first auction due to incomplete state-level regulations. RGGI has announced, however, that all ten member states have committed to participating in the next auction scheduled for December 17, 2008. Approximately 31.5 million allowances will be available in the uniform-price, sealed-bid auction. The reserve price is again set at $1.85 per ton. Applications to bid in the December auction are due by October 30, 2008.

Over Allocation

RGGI’s goal for the first two compliance periods (2009-2011 and 2012-2014) is to stabilize (i.e. stop the growth of) carbon dioxide emissions. Although the 2009-2014 cap is set at 188 million tons per year, EPA data indicates that emissions from participating states fell to 164.5 million tons in 2006, and suggests that 2007 emissions will be approximately 172.4 million tons. In other words, the current allowance supply appears to exceed demand.

Market observers suggest that the over-allocation of emission allowances will depress bids and limit the ability of RGGI to establish effective price signals for deploying emission reduction technology or renewable alternatives. For example, the $3.07 clearing price is likely below the price necessary to make natural gas more attractive than coal. Similarly, underground carbon sequestration becomes cost-effective when carbon dioxide costs $25 per ton, and nuclear becomes cost-effective when carbon dioxide prices exceed $45 per ton.

Low clearing prices may also impact the development of offset markets. Regulated entities may use offsets from approved project types (for example, afforestation, landfill gas capture, and end-use efficiency) to cover up to 3.3 percent of their compliance obligations. Offset projects located in RGGI states are prioritized, while projects outside RGGI’s jurisdiction receive half-credit. However, if allowance prices exceed $7.00 per ton, then regulated entities may rely on offsets to cover up to 5-20 percent of their compliance obligation, and offset allowances from projects located outside RGGI’s jurisdiction will receive one-to-one credit. In other words, carbon dioxide prices exceeding $7.00 per ton would likely increase demand for offset projects and spur innovation and economies of scale in the offset sector. The $3.07 clearing price, however, is far below that level. While WCI has proposed a significantly larger offset limit (49 percent), it may not spur short-term offset market development because WCI compliance obligations do not go into effect until January 2012.

RGGI has indicated that it will not revisit allowance allocations for the first compliance period (2009-2011), so over-allocation (as well as constrained credit markets) may continue to send bearish signals for upcoming auctions.

Leakage

RGGI and other regional trading systems also face significant potential leakage issues. In the absence of uniform federal standards, the three emerging regional trading systems (RGGI, WCI, and MRGGRA) have the potential to shift greenhouse gas emitting activities to regions with less stringent or no caps. Leakage calls into question the ability of sub-federal systems to achieve their emission reduction targets. This issue is particularly relevant to RGGI because it does not cap emissions attributable to electricity imported from facilities located outside its jurisdiction. Indeed, some RGGI member states participate in a regional electricity transmission organization (PJM), and commentators have suggested that resulting leakage to non-capped jurisdictions “could offset 60-90% of RGGI’s emission reductions.” RGGI recommends addressing leakage issues by prioritizing energy efficiency measures, and considering other measures such as emission performance standards or load-based (rather than the current generation-based) caps if leakage significantly impedes compliance with emission targets.

Integration and Preemption

RGGI is one of three regional greenhouse gas cap-and-trade systems under development in North America, and it is unclear the extent to which these emerging markets will integrate. In the absence of uniform federal emission reduction obligations, efficient integration between these systems is necessary to maximize opportunities for reducing emissions at the lowest cost by expanding markets and increasing liquidity.

Finally, Congress will likely consider federal cap-and-trade legislation in 2009, which raises the issue of whether RGGI and other regional emission trading systems will be preempted, and if not, how they will integrate into a federal system. Looming over the entire debate, of course, is recent market turmoil which may stifle political will to impose measures at the federal, regional, or state level that would increase energy prices and place additional strain on a fragile economy.

Conclusion

Despite the success of the opening auction, RGGI remains an experiment. Whether or exactly how it will succeed remains to be seen. It is, however, the only game in town, and one that policymakers, businesses, investors, and consumers will continue to closely follow. The next RGGI auction is set for December 17, 2008.

For more information on emerging carbon markets, please contact any member of Marten Law Group’s Climate Change and Sustainability practice group.

[1] PointCarbon: Carbon Market North America. Vol. 3, Issue 19. (September 24, 2008).

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