Cap-and-Trade & Efficiency: A Match Not Made in Heaven

By: Brenden Millstein

There is a lot of talk about carbon cap-and-trade, and energy efficiency. Carbon cap-and-trade is hailed as a market mechanism for reducing carbon dioxide emissions. Nine States in the Northeast and California all have statewide cap-and-trade systems operating. Energy efficiency is one of the most profitable investments most companies can make at all, reliably providing returns in excess of 30%. Efficiency is also a great way to reduce energy consumption and hence carbon emissions as well. So what happens when you combined a carbon cap-and-trade with energy efficiency?

Surprisingly, the answer is that while efficiency still provides great economic returns to those who do it, it stops reducing carbon emissions. Here’s why:

In a carbon cap-and-trade, the government requires every power plant to purchase one allowance for every ton of CO2 it emits. There is a set and limited number of allowances (hence the term cap), and power plants need to acquire one allowance for each ton of CO2 they emit and can sell the allowances they do not use (hence the term trade). There are hundreds of potential iterations on this – the government could require utilities instead of power plants to buy the permits, the government could give a certain percent of permits away, certain plants could be exempt because they have effective lobbyists, etc. – but in short power plants buy allowances for each ton of CO2 they emit and the supply is limited.

Under a cap-and-trade system, efficiency creates a bizarre feedback loop:

  1. If you reduce the demand for power through energy efficiency, fewer power plants will run.
  2. If fewer power plants run, there will be less demand for carbon allowances.
  3. When there is less demand for the same amount of supply (the supply is fixed by the cap), the price per allowance will fall. Here’s where the anti-magic happens:
  4. As the price for carbon allowances fall, dirtier power plants are able to buy more allowances.
  5. Now that dirtier power plants have more allowances, they run a little bit more.
  6. How much more? Exactly enough to make up the difference in carbon savings you received from energy efficiency.

So energy efficiency saves money by reducing the amount of energy consumed total, but it also enables dirtier power plants to deliver that power by reducing the cost of carbon allowances. Weird right? Right.

For economists and/or people who like pictures out there, here are a few pictures showing illustrating the problem:

CCTE_1

Figure 1: Supply of CO2 as a function of cost per ton.

As shown in Figure 1 above, in a cap-and-trade the supply of CO2 is set by the cap and does not change as a function of price. The demand for allowances, however, is set by the market and hence does change based on price as shown in Figure 2 below:

CCTE_2

Figure 2: Demand for allowances varies as a function of price.

Where the supply and demand meet determines the price per ton, as shown in Figure 3:

CCTE_3

Figure 3: When demand and supply are equal, the price per allowance is determined.

The number of available allowances, the supply, is fixed in a cap-and-trade. The demand is set by the market, however, and when the demand and supply are in equilibrium then the price per allowance is set. If you do a lot of energy efficiency, however, the overall demand for power falls. This in turn reduces the demand for carbon allowances since power plants are operating less, as shown in Figure 4.

 

CCTE_4

Figure 4. New and lower demand for allowances after energy efficiency reduces the demand for power.

 

This changes where the system operates and reduces the price per ton, shown in Figure 5.

CCTE_5

Figure 5. New operating point after energy efficiency.

 

As shown in Figure 6 below, the cost for one allowances is lower after energy efficiency reduces the demand for power.

CCTE_6

Figure 6. Price per allowance before and after efficiency.

And herein lies the problem: as shown in Figure 7 below, although the cost is lower the amount of carbon dioxide that is emitted remains exactly the same.

CCTE_7

Figure 7. Lower cost, same emissions.

 This result is a little counter-intuitive: as soon as a cap and trade is set up, energy efficiency in that region stops reducing carbon dioxide emissions. In fact, the only way to reduce carbon dioxide emissions is to reduce the cap.

This does not mean, however, that energy efficiency is useless. For one, it still saves consumers money, so it’s awesome. Secondly, reducing the cost of compliance with the cap and trade provides a huge economic value: in the nine Northeastern States that have cap and trade, more than 30 million allowances are sold every quarter. Reducing the cost per allowance by just fifty cents through energy efficiency would save more than $50,000,000 per year.

The above is not an entirely fair comparison; States could use the money raised through the cap and trade to reduce income taxes by the same amount, or reinvest the money in education, or simply pay it back to every citizen in that State, so the potential economics get extremely complicated. Using energy efficiency to reduce the cost of compliance, however, is still a good thing.

And if you want a chance to lower the cap, which would reduce emissions, then energy efficiency in fact may be required to make reducing the cap economically feasible.

In short summary, once a carbon cap-and-trade system is launched, energy efficiency no longer directly reduces carbon dioxide emissions. It still saves consumers and businesses money, it still helps strengthen our electric grid, and it is vital for reducing the cost of complying with the cap-and-trade system. In a cap-and-trade system, efficiency is a huge economic boon, even though its environmental benefits are less direct than might be expected.

3 Responses to Cap-and-Trade & Efficiency: A Match Not Made in Heaven

  1. I’m not sure if efficiency and cap-and-trade are as incompatible as you suggest. Sure, if a little less power is used, perhaps there are more allowances to trade around in a given period. However, in a well-designed cap-and-trade system, that cap should not be fixed forever. Most systems are designed with a cap that lowers over time. If efficiency measures are introduced, less power is used, and carbon allowance prices drop, regulators should theoretically respond to this signal by lowering the carbon cap.

    Reply
    • Yes, this is a great point and excitingly, this is also what the RGGI administrators did. RGGI — the Regional Greenhouse Gas Initiative — is the carbon cap-and-trade that’s been operating in nine Northeastern States since December of 2008. The region’s carbon emissions dropped 40% below the cap. Some of this was due to efficiency, probably much more of it was due to the recession and several large industrials moving overseas, but the important thing is that the regulators did respond by lowering the cap. Prices are still very low, and the cap is literally 40% lower than it was in 2008.

      Reply
  2. Nicely summarized, couldn’t have said it better myself. I would also mention that energy efficiency is what makes cap and trade systems politically feasible by keeping costs in check. Whenever opponents ask how a region is ever going to meet the cap, energy efficiency is the answer.

    Reply

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