Additional topic 1 - Cost containment

Our Response to:

"Design Elements of a Mandatory
Market-Based Greenhouse Gas Regulatory System"

Issued by Sen. Pete V. Domenici and Sen. Jeff Bingaman
February 2006

Additional Topic #1
Download Additional Topic #1 [1] (pdf)
Download Cost Containment Chart [2] (pdf)

Cost containment: A function of the whole package

The Center and most of the over 30 large corporations surveyed by the Center believe that, rather than focusing on any one design element in isolation, any bill must be evaluated as a whole, especially in minimizing the costs to covered entities and the economy.  The issue is raised by a design question not specifically mentioned in the White Paper: the concept of a “safety valve.”  Under a safety valve provision, exemplified by the recommendation of the National Commission on Energy Policy (NCEP), covered entities would be allowed to pay the implementing agency a specified amount per ton of GHG instead of submitting emissions allowances, thus capping the cost per ton at the specified “safety valve” level.  In fact, a safety valve is only one tool for providing cost containment.  Moreover, it is one that could limit environmental effectiveness of the program and present complications for linking to other trading programs (as discussed in response to Question 3).  A GHG cap-and-trade program can be designed to minimize costs using a variety of other approaches:

• selection of moderate targets and timetable;
• advanced notice of policy;
• banking of allowances and offsets;
• borrowing of allowances;
• staggering compliance deadlines;
• extending compliance deadlines;
• providing consumer dividends (payments made to energy consumers to compensate them for any increased energy costs);
• providing relief for individual emitters;
• inclusion of offsets;
• linkage with other trading systems; and
• complementary policies that drive energy efficiency and technological innovation

Additionally, low price caps act as a tax.  Taxes have been shown to be fairly ineffective in the short term at eliciting significant results. (See attached chart on cost containment mechanisms.)

The companies surveyed by us hold a wide range of opinions about the policy benefits of a safety valve, though most say that a safety valve may be politically necessary. Of companies that favor a safety valve, or at least think it might be politically necessary, several note that $7/ton of CO₂ (the initial level recommended by NCEP) is too low to achieve significant emissions reductions or to drive market-based transition to a wide range of low-carbon technologies. If a safety valve is used, it should be set high enough to encourage meaningful change. For instance, integrated gasification combined cycle (IGCC) coal or supercritical pulverized coal electric power generation combined with carbon capture and sequestration (CCS) may only become economically viable on a self-sustaining basis (without continued government subsidy) with CO₂ values at or above $25-35 per ton. This does not necessarily mean the safety valve should be set immediately at $25-$35 per ton. Rather, the starting point and growth curve of the safety valve must be such that the net present value of paying it will be more than what companies project will be that of investment in IGCC-CCS.

One company notes that mere inclusion of some reasonable cost limit may be more important for getting legislation enacted than the limit’s specific level. The presence of a safety valve, even at a high dollar level, could undercut assertions that GHG regulation will bring about the “end of the economy,” since it would remove from consideration the modeling results that posit extreme cases of unlimited cost. Another company notes that, when GHG regulation is viewed as inevitable and may affect upstream energy producers, financial structuring for large new oil and gas production projects may not be possible without a price cap, since otherwise these projects would involve a large unknown liability that constrains equity value and cash flows.

A few companies opposea safety valve altogether because of its distortionary effect on the market, or only favor a safety valve with a sunset clause. Companies express concern that a safety valve would complicate linkage between the U.S. carbon trading market and the cap-and-trade programs of other countries, which likely would increase the cost of U.S. reductions and reduce the economic efficiency of the system. Some companies point out that the market, left to develop without interference, will develop a range of financial products and services that provide cost certainty to firms but are less distortionary than safety valves. Under a mature carbon emissions trading market with adequate certainty about cap levels beyond the short term, financial services firms will offer hedging products such as forward call options that allow companies to lock in a maximum cost.