A question I hear frequently (in wonk circles anyway): If the U.S. implements a declining cap on CO2, why does it also need a national Renewable Portfolio Standard?

(For non-wonks, some basic background: a declining cap on CO2 emissions would, theoretically, force electric utilities to find low-carbon alternatives. An RPS would dictate that utilities generate some percentage of their power — usually around 20 percent by 2020 — from renewable sources. The idea behind the question is, if the cap already requires reducing emissions, why prescribe how utilities go about it? Why not leave them alone to determine the most cost-effective reductions? Is the RPS not redundant?)

Economist Michael Giberson proposes one answer: greens want to meddle and tell people how to live, and a pure market-based policy like cap-and-trade doesn’t allow them to do so. After all, maybe utilities will reduce CO2 without building out a lot of renewables … and moralistic greens can’t have that, can they? Says Giberson, “the further ambitions of these regulation proponents sound like a bad mix of industrial policy and meddlesome preferences.” Damn those meddling greens!

Rich Sweeney over at Common Tragedies asked the same question a while back, and while he didn’t offer an answer, I suspect it would be roughly similar to Giberson’s. TNR‘s Brad Plumer also asked the question and got a few answers, though he says he’s not convinced.

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As it happens, I think Giberson has it exactly wrong. The problem is not that “regulation proponents” like meddling for meddling’s sake. The problem is that academic economists (and the wonks who love them) have an idealized view of the market and market-based policies. They seem to believe that unpriced carbon pollution is the only externality (or “market failure”) in an otherwise more-or-less free, open, competitive energy market. Incorporate the social cost of carbon pollution into the price of energy and you’re done. Indeed, why any policies beyond a price on carbon?

The answer is that unpriced carbon is not the only market failure. In fact, there are dozens, hundreds of such failures. If you sought to address them all with a carbon price — a fairly blunt tool — you’d need a very, very high price, and that’s not going to happen. A politically realistic price on carbon, likely to be low at least for the first decade or two, will not address or overcome most of those failures. The idea behind “complementary policies,” or policies outside the carbon price, is to address some of those failures and thereby make the road smoother (cheaper, more efficient) for the declining cap. I plan to write more on this soon, but for now I recommend this report from the Carnegie Mellon Electricity Industry Center: “Cap and Trade is Not Enough: Improving US Climate Policy” (PDF). See also Holmes Hummel, “The Essential Role of Complementary Policies in Climate Policy Design” (PPT).

For now, it’s worth addressing the more specific question: why this complementary policy? Why an RPS?

There are three basic answers.

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The first is short and simple: utilities.

In half of U.S. states, utilities are regulated monopolies. They are not operating in a “market,” not in the conventional sense. They do not face pressure from competitors; there’s no threat of going out of business. The necessary skill is not innovation or efficiency but Regulator Management. Utilities pitch regulators on what they need to do, what it’s going to cost, and what rates they need to charge to cover it, and regulators approve. And the relationships between regulators and utilites, particularly in the coal-heavy South, are notoriously cozy. It’s a real good ol’ boys network.

Add to this the fact that utility rate design is based on commodity sales — utilities make money based on deploying capital and selling electricity. So to make more money, they deploy more capital and sell more electricity. It is thus in their interest to deploy big, central power plants rather than fashioning a mix of efficiency measures and small-scale, distributed generation. (This is why there’s so much buzz around “decoupling.” Decoupling revenue from sales will, the theory goes, balance these incentives.)

I once asked a high-ranking Obama administration official this question: As the cap looms, how can you stop utilities from defaulting to the highest cost, most capital-intensive options (think coal with sequestration and nuclear)? All they have to do is convince regulators that clean-coal and nukes are the “only” options and their rate of return is guaranteed. Isn’t that the path of least resistance for them? Based on their history and habits and business model and relationships with regulators, isn’t that what we can expect? It’s not like they’ll face competition from others using lower cost options like cogeneration, solar thermal, wind, etc.

“That,” the official said, “is why we need the RPS.” In short: we need an RPS precisely because utilities can not be trusted to travel the most cost-effective path to the 80 percent reductions in CO2 emissions needed by 2050. There is no “market” forcing that discipline on them. Ideally, the solution would be to make utilities into energy service providers and expose them to actual competitive pressure, but since that’s basically impossible in current political circumstances, you’re forced into these Rube Goldberg policy mechanisms.

The second reason for the RPS is that existing coal-fired plants will have to be phased out sooner or later to meet long-term CO2 targets. Even if everything else in the U.S. economy were carbon neutral, existing coal alone would put the country over its 2050 target.

However, existing coal plants are paid off, fully amortized, and grandfathered under the Clean Air Act. They are mints, cranking out free money (and pollution). It would take a gargantuan carbon price, on the order of $1000 a ton, to make existing coal uneconomic. You could wait, I suppose, until carbon hit that price, but that’s a long time to delay the process of ramping up renewables. The alternative is to start gradually scaling up renewables, and scaling back coal, now. That way existing coal can be phased out smoothly, over several decades.

The third answer is: yes, it’s industrial policy, a conscious bid to establish a presence in a competitive global market that everyone knows will be booming in coming decades. What the hell is wrong with industrial policy? (This, obviously, requires a longer defense, and this post is already too long. But suffice to say, the current economic dogma that industrial policy is always and everywhere to be shunned needs serious re-examination.)

In a perfect world we wouldn’t need an RPS — we’d only need the cap. But we live in a fallen world, wherein markets are shaped by historical, political, and psychosocial contingencies; a price on carbon leaves many flaws in existing energy markets untouched. It will help change incentives at the margins, but its progress can be greatly eased with the help of complementary policies targeted directly at some of those market distortions.