This post is reprinted from Climate Progress.

As the U.S. makes significant progress towards enacting a cap-and-trade system to control greenhouse gas emissions, some are worried that the new Waxman-Markey bill (W-M or H.R. 2454) may enable polluting utilities to reap windfall profits. We disagree. The allowance allocation provisions of this bill have been thoughtfully crafted to avoid a repeat of Europe’s experience. There certainly are issues and challenges remaining with the legislation, but windfall profits arising from allowance allocations isn’t one of them.

So begins an exclusive analysis of Waxman-Markey for Climate Progress by two of the country’s leading experts on the electric utility industry and energy economics, Peter S. Fox-Penner and Marc Chupka. The debate over the large amount of allowances given to utilities is certainly heated (see “Greenpeace’s indefensible attack on the House clean energy bill perpetuates myths about the European carbon trading system“). But very few are expert on the economics of regulated electric utilities — including me. That’s why I asked for this analysis from two former colleagues from the Clinton Energy Department. Fox-Penner is an internationally recognized authority on electric power industry issues, whose forthcoming book is The Future of Power (Island Press). He held the position of Principal Deputy Assistant Secretary for Energy Efficiency and Renewable Energy right before I did. Chupka is an economist with two decades of public and private sector experience analyzing the market impacts of both domestic and international energy and environmental policy. He was Acting Assistant Secretary for Policy when I was at DOE. This analysis examines the likely impact of the allowance allocation to utilities and includes an extended Q&A at the end.

The key to W-M’s success in this area is that it is careful to give the overwhelming majority of free utility allowances to the electric or gas retail distribution company, not the generator or the entity that sells wholesale gas or power itself. Whether or not you have electric or gas deregulation in your state, you still receive your power or gas deliveries from a regulated distribution company. If you are served by a rural electric co-op they are your distributor, and similarly for a government-owned utility like LADWP. All distributors are either state-regulated, customer-owned, or government-owned.

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While you may not know it, every monthly power or gas bill that customers pay separates the cost of delivering gas or power from making or buying the energy itself. State regulators, city managers, or coop management boards — who have full access to the accounts of distributors – set distribution charges so as to manage the profits earned by the distributor. This is a key point. Unlike some other parts of the utility industry, distributor profits are strictly controlled.

W-M specifies that the bulk of free allowances given to utilities can be given only to a gas or electric distributor — not to a standalone retailer or generator. Furthermore, the law says that “the allowances distributed to an electric or gas local distribution company … shall be used exclusively for the benefit of retail ratepayers of such…company.” Each state regulator or manager of a coop or municipal utility must conduct a proceeding to determine how the value of allowances will be treated – for example some of the proceeds might help fund energy efficiency if the regulators decide that represented benefits to retail customers. But, W-M does not allow the size of individual customer rebates to reflect that customer’s metered energy consumption.

With these provisions, it will be awfully hard for any utility to harvest a windfall from the free allocations — especially a shareholder-owned utility. Yes, the free allowances given to the distribution utility will be worth a lot. But the law is pretty clear that the benefits of receiving the free allowance go to the utility’s customers, not their shareholders.

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As folks who’ve been involved in utility regulation for a long, long time, we see this as pretty straightforward and transparent. State regulators will all know the number of allowances each utility gets and their value. [See the Q and A below for more on this] They will see the accounts books of utilities (as they do today). To give ratepayers the value of the allowances, they will probably do one of two things:

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  1. Have the distributor sell the allowances in the secondary market and use the revenues to lower distribution bills to their customer dollar for dollar; or
  2. If the distributor also supplies power, which most do these days, use the allowances as currency to pay for power.

Either way, profits are unchanged. For those who want to delve more deeply into the details of ratemaking for the free allocation, at the bottom of this post we include some Q and A on some of the fine print. But the important takeaway is that material windfalls are about as likely as the Washington Nationals winning the pennant this year.

If you’re wondering about natural gas utilities, pretty much the same process and rules apply. Natural gas allocations are easier to figure out than electric utilities because it is easy to calculate the precise amount of CO2 created by the customers of any gas distributor. This amount is used to set an allocation of free allowances to the regulated gas distributor. As with electric distributors, the value of the free allowances must be given entirely to gas customers via the same kind of uniform rebates or credits given to electric customers

Preserving the Price Signal with Free Allowances

It is important not to confuse this absence of windfall profits with the “price signal” issue, as in: “Doesn’t giving away allowances blunt the very carbon price signal we are trying to send with a cap and trade system?”

Free allocations can blunt the price signal along the value chain, but here again W-M includes protections against this happening.

When cap and trade kicks in, one thing will certainly happen — wholesale power and gas prices will begin to increase in proportion to the carbon content of the power source and the (actual or estimated) price of allowances. Coal-fired generation produces roughly one ton of CO2 per Megawatt-hour (MWh); allowances priced at $20/ton will raise coal-fired power prices in the wholesale marketplace by about $20/MWh. This wholesale marketplace is where utilities and deregulated generators respond to economic signals to dispatch their plants, sell power to each other on either a short or long term basis, and it is also the market utility managers and regulators look to when they set utility rates or decide what type of plant to build.

Everyone trading in this market already has a lot of experience with including the cost of emissions permits in their power prices. In most of the country all coal-based power includes the cost of sulfur dioxide permits in just the same way it will include carbon prices. Regardless of how any power generator gets their allowances — including for free — they will offer their power in the wholesale market at a price that will cover all of their costs, which include the market price of allowances consumed in generating the power. It’s economically correct (an opportunity cost is just as valid as an out-of-pocket cost), it’s good business for them, and best of all, it makes sure that the price signal is sent downstream to the market regardless of how allowances are allocated.

So far so good. What about the prices seen by individual power customers? Doesn’t giving out the allowances to power distributors for free undo the very price signal that will help consumers get away from high-carbon fuels, invest in energy efficiency, and so on?

Here’s where W-M got it right. It forbids distributors from giving customers the value of the free allowances as a “per unit price rebate.” So retail customers will still have to pay a price for power and natural gas that includes a carbon price signal. The free allowance value must be given to them as a lump sum rebate.

Continuing the example above, suppose that a utility was 100% dependent on coal, so its own power price went up $20 per MWh, which is the same as 2 cents/kWh. This utility will pass on its cost increase dollar for dollar (if it doesn’t then its own profits will go down.) The average customer of this utility uses 1000 kWh a month, so they’ll pay 2 cents/kWh x 1000 kWh = $20 more a month. They see the price signal because every additional kWh they use costs them 2 cents more and every kWh they save will lower their bill an added 2 cents.

This customer will get a monthly credit on the distribution portion of their bill of, say, $10, offsetting about half their overall bill increase. But it receives this credit (or rebate) no matter how many or how few kWh they use — that’s the rule in W-M. The credit or rebate doesn’t change the customer’s incentive to switch to lower-carbon power or (better yet) reduce their power use. In fact, if customers saved enough power they could be better off under the W-M bill, since the rebate will be based on the average customer’s power carbon footprint. If they are well below the average for that utility, they might actually come out ahead. Moreover, since energy consumption and expenditure is related to household income, the uniform rebates represent a progressive approach to consumer cost mitigation.

All in all, W-M got it right on windfall profits and price signals. Other parts of the bill might pose efficiency or equity concerns, but these parts shouldn’t.

Q and A

1. Your examples assume that all companies are independent. What if a deregulated generation company also owns a regulated wires company? Don’t the shareholders of the overall holding company get windfall profits?

No. When regulated wires companies are owned by larger holding companies, they are always required to keep separate accounts for the regulated wires company only. The allowances go to this company and can be used only for its customers. Transferring the value of the allowances to another part of the holding company would violate the W-M law.

2. State regulators, municipal power managers, and co-op managers already have a lot to do. How do we know they’ll get it right? Didn’t they often fail to regulate holding companies properly in the past?

Mistakes are always possible, but this is about as straightforward and transparent as anything in utility regulation. The profits of utilities are easily observed, allowance allocations and prices will be public, and the law is very clear on this point. Regulators and coop & public power managers will have little incentive to allow manipulation of the ratepayer benefit standard.

2. In your example, the per-customer rebate is $10 per month. If the fixed distribution charge is $20 per month, a rebate is possible. What if the real numbers are reversed, and there isn’t enough money in the fixed part of the distribution bill to give a credit?

The credit or rebate can be larger than the fixed distribution charges, and offset some of the generation or commodity gas charges. After all, the total customer rebates only reflect the total value of allowances given to the distribution company — so they are not affected even if the allowance value is higher than the overall fixed distribution charges that they are entitled to charge for providing distribution services. But, it will not affect the marginal cost of consuming additional energy or the marginal savings from conservation. In addition, a credit can be spread across many months or years. If necessary, the distribution company can literally give the money back to customers via a refund check.

3. How will free allowances actually be allocated to distribution companies?

Out of the available total amount of free allowances, they will be allocated pro-rata based on the estimated baseline emissions of CO2. For electric utilities, baseline emissions will be estimated as the average of 2006-2008 CO2, or any other consecutive three year period between 1999-2008 chosen by the utility. This allocation formula also targets the consumer benefits to those regions that experience the highest cost increases, such as the South East and Midwest, which is not only politically necessary but also equitable in our view.

Of course, we expect utilities to choose the three year period with the highest CO2 emissions to boost their percentage of the allowed auctions. While this may set off rivalry for the free permits, it doesn’t change the emissions limits, which is what’s important.

4. Isn’t it impossible to trace actual power flows from generators to individuals, and therefore its impossible to allocate free allowances accurately?

We can model power flows with more than enough accuracy today to ensure that allowance allocations among distribution companies are reasonably accurate and fair – that is, they will approximately reflect the underlying amount of CO2 allowance costs incurred in the wholesale power markets. They won’t be perfect, but they’ll be more than “close enough for government work.”

5. Even if your analysis is right, won’t free allowances prevent a fall in the stock market value of coal-based utilities and coal-based generators – and isn’t this a different kind of windfall?

The impact of allowance prices and allocations on individual companies’ value is very complicated, but in general we would expect the market values of the most coal-intensive utilities or generators to be lower under W-M than they would be absent CO2 legislation. However, the decline in stock market value under W-M will be smaller than what would be expected to occur under an otherwise identical bill with 100% auctioning. In both cases they are likely to go down. In our view, going down by less isn’t exactly what we call a windfall. Similarly, low-carbon power sources will be worth more after this legislation passes than before – but this is inevitable. It would be true regardless of how allowances are allocated.

Author Biographies

Peter Fox-Penner is a consulting executive and internationally recognized authority on energy and electric power industry issues; his forthcoming book is The Future of Power (Island Press) He is a Principal and chairman emeritus of The Brattle Group, a leading international economic consulting firm and serves on the advisory boards of Enviance, Inc. and Daylight Technologies. He was a senior official in the U.S. Department of Energy and the White House Office of Science and Technology Policy and helped found and lead the Environmental Alliance and Environment 2004. For more information about Peter, click here.

Marc Chupka is a principal at The Brattle Group with over two decades of public and private sector experience analyzing the market impacts of both domestic and international energy and environmental policy. He formerly served as the Acting Assistant Secretary for Policy and International Affairs at the U.S. Department of Energy, and was the Associate Director for Air, Energy and Transportation at the White House Office for Environmental Policy. For more information about Marc, click here.