April 2018 EMISSIONS TRADING AND ELECTRICITY SECTOR REGULATION A conceptual framework for understanding interactions between carbon prices and electricity prices April 2018, Berlin, Germany International Carbon Action Partnership Secretariat William Acworth, Mariza Montes de Oca, and Carlotta Piantieri International Institute for Sustainable Development Frdric Gagnon-Lebrun, Philip Gass, and Yanick Touchette ko-Institut Felix Christian Matthes April 2018 Acknowledgements ICAP would like to express its gratitude to the German Ministry for Environment, Nature Conservation, and Nuclear Safety BMU for funding this work. The discussion paper has benefited from debates with ICAP members as well as comments from Californian Air Resources Board staff, Will Space of Massachusetts Department of Environmental Protection, Bill Drumheller of Washington Department of Ecology and Johannes Enzmann of the European Commission. We are also grateful for support from Anatole Boute from the Chinese University Hong Kong and Kristian Wilkening from the German Development Agency GIZ. Workshops with policy makers, power sector representatives and experts in Tokyo, Lisbon and Hangzhou also helped shape the report. All mistakes or errors are the sole responsibility of the authors. Cite as Acworth, W., Montes de Oca, M., Gagnon-Lebrun, F., Gass. P., Matthes, F., Piantieri, C., Touchette, Y. 2018. Emissions Trading and Electricity Sector Regulation. Berlin ICAP. Disclaimer The ideas expressed in this report do not necessarily represent the views of ICAP or its members, or their endorsement of any approach described herein. April 2018 Table of Contents 1. Introduction 1 2. The electric power sector . 4 2.1. The electricity grid 4 2.2. Electricity markets 4 2.3. Electricity tariffs 7 3. Allowance prices and electricity prices 9 3.1. Low-carbon production clean dispatch 10 3.2. Low-carbon consumption 11 3.3. Low-carbon investment 11 3.4. High-carbon decommissioning 12 3.5. Allocation and compensation effects 12 4. Emissions trading and electricity sector regulation 15 4.1. Retail price regulation 15 4.2. Wholesale price regulation 16 4.3. Planned investments/disinvestment . 19 4.4. System with regulated/planned production. 20 5. Options to strengthen the allowance price signal 23 5.1. Consignment auctions 23 5.2. Coverage of indirect emissions 23 5.3. Climate oriented dispatch 24 5.4. Carbon investment board 25 5.5. Pricing committee . 26 5.6. Consumption charge 27 6. Companion Policies . 28 6.1. Types of companion policies 28 6.2. Options for dealing with companion polices 29 7. Conclusions 33 Appendix A Empirical evidence of cost pass-through from the EU ETS 34 References . 35 April 2018 Glossary Ancillary services Services related to the stability of an electrical system; e.g., generation of reserve capacity, regulation of voltage. Average cost pricing Setting prices according to average costs. Base load The minimum level of electricity required over a fixed period e.g. 24 hours. Base load plant A baseload plant refers to a power plant that is planned to run continually except for maintenance and scheduled or unscheduled outages. Bidding To make an offer of; to propose. Specifically To offer to pay a certain price, as for a thing put up at auction, or to take a certain price, as for work to be done under a contract. Bundled service Including a variety of services in combination. Electricity supplier might combine generation, transmission, distribution, and related customer service and support functions as a combined service. Capacity The maximum power that can be produced by a generating resource at specified times under specified conditions measured in MW. Carbon cost The cost resulting from CO2 emissions when carbon is priced. Central planning Planning characterized by state allocation of resources in association with production goals to meet targeted growth rates. Consignment auctions A consignment auction is a mechanism through which recipients of free allowances are required to offer their allowances for auctioning, but in exchange receive the revenues of such sales. Cost-of service regulation A of regulation that determines prices based on the costs of serving different customers and producing different services. Cost-plus pricing When a firm adds a given percentage mark-up to average cost. Cost pass-through Cost pass-through is the mechanism through which the CO2allowance price is reflected in electricity prices and/or in prices of electricity-intensive goods. April 2018 Demand-based pricing Prices set according to customers’ willingness to pay. Depreciation Reduction in the value of an asset overtime. Depreciation is not a cash outlay, but an accounting tool for allocating cost over the service life of the physical asset. Dispatch The sequence in which the generating sources are called upon to generate power to serve fluctuating loads. Distribution The transport of electricity to the point of final consumption, such as homes and businesses. Economic dispatch Start-up, shutdown and allocation of load to individual generating units to effect the most economical production of electricity for customers. Double-coverage Double-coverage refers to the situation where two allowances are generated for one unit of carbon emissions; once for direct emissions and again for indirect emissions. They are typically allocated to two different installations in different sectors. Investor owned utilities IOUs A privately-owned utility organized as a corporation for the purpose of providing electric power service and earning a profit for its stockholders. Fixed costs Production expenses that are independent of the level of output; e.g., administrative overhead, loan repayments. Grid A system of interconnected power lines and generators that is managed to meet the requirements of customers connected to the grid at various points. Independent system operator ISO An independent system operator ISO maintains balance of the grid system by controlling the dispatch of plants and ensuring that loads match system resources. Load The amount of electricity delivered to or required by a power system at a given point. Marginal cost The cost of providing the next unit of output. Monopoly Exclusive control of a market by a single provider, supplier or seller. April 2018 Opportunity cost The value of the next best alternative foregone when a choice is made. Public utility Enterprise providing essential public services, such as electricity, gas, telephone, water, and sewer under legally established monopoly conditions. Public utilities Board/Commission Public institutions with the primary objective of ensuring reasonable costs for consumers, alongside objectives such as reliability and quality of electricity service. Peak load Peak load refers to the maximum electrical load demand in a period of time. On a daily basis, peak loads normally occur at midmorning and in the early evening. Peak load plant A peak load plant is normally operated to provide electricity during maximum load periods. Peak load plants might also be called on when renewable generation is low. Shadow-price The estimated price for a good or service for which no market exists. Where markets are not present but carbon costs are considered relevant, a shadow carbon price can guide supply generation, dispatch, investment, and demand decisions. State-owned enterprise SOE An organization that produces goods or services for sale to its clientele and that is organized in the of a corporation or other business association and is owned by a government. Stranded investment or stranded asset When changes in public policy have a significant impact on the cash flows that can be obtained from productive assets, those assets are less valuable than before the policy change. In electricity markets, this might result in generation facilities, owned by existing utility companies, that produce electricity at above-market marginal prices. Tariff A rate, charge or condition approved by regulatory agency for a regulated utility. Transmission Transmission refers to the process of transporting electricity in bulk from one point to another in the power system, rather than to individual customers. Unbundled utility services Disaggregating components of a previously vertically integrated network. For example, separating electricity service into its basic components generation, transmission distribution, and retail and offering each component for sale. April 2018 Variable costs The total costs incurred to produce electricity, excluding fixed costs which are incurred regardless of whether the resource is operating. Variable costs typically include fuel, maintenance and labor. Vertical integration It refers to the arrangement whereby a utility owns the generating plants, transmission system, and distribution lines used to provide all aspects of electricity service. Wholesale power market Purchase of electricity from generators for the purpose of reselling it to others, who then sell to retail customers. Source Berg et al.2005; Burtraw and McCormack 2016; NWPPA, n.d.Emissions trading and electricity sector regulation 1 International Carbon Action Partnership 1. Introduction An emissions trading system ETS is a market-based mechanism that is applied to achieve emissions targets at least cost. By fixing a quantity of emissions the cap, requiring that companies surrender one allowance for each unit of emissions generated and making the allowance tradable, a carbon market is created through which an allowance price emerges. For producers, the allowance price is treated as a marginal cost in operation decisions and is a commodity that needs to be reflected in investment appraisals. It encourages them to optimize their operations with a view on the system-wide emissions constraint, render their goods less emissions-intensive or to make low-carbon investments. For consumers, carbon-intensive goods become more expensive, encouraging a switch to low-carbon alternatives or to change consumption patterns e.g., energy efficiency. The relative change in prices creates incentives to invest in low-carbon assets and to develop new products, processes and technologies that use carbon more efficiently. At the same time, high-carbon assets become less competitive, which could lead to an accelerated decommissioning of these assets. When declining emission caps are set also for future periods, an ETS serves not only as an economic carbon pricing mechanism but also as an inational instrument; that there will be less scope for emissions-intensive activities in our future economies. This can provide visibility and accountability on the longer-term pathways for time horizons that potentially go beyond the periods that are most relevant for decision-making on long-lived assets. The long term signal will be strongest where the ETS is embedded within a credible, long-term policy architecture that reduces uncertainty for participants. For an ETS to achieve emission reductions at least cost, markets ideally must function freely and transmit uni and non-distorted price signals to all decision makers in the economy. That is, the cost of emission allowances allowance costs can be freely reflected in the price of carbon-intensive goods and economic entities are free to adjust their economic operations and investment decisions Boute and Zhang, 2017. The ability of the covered entities to pass through some of the costs of CO2 allowances to consumers is also fundamental for recouping the costs of long-term low carbon investments and enhancing the credibility of future reduction targets Hintermann, 2014.1 This is the case for liberalized electricity markets where customers are free to choose their electricity supplier; there is unbundling of supply, generation, and networks ensuring competition in wholesale and retail markets; generators are free to supply the market and independent regulators are assigned to monitor the market and regulate the natural monopolies networks to ensure non-discriminatory and unimpeded access to the networks. Matthes 2017; Ecofys, 2016. Under these conditions, a liquid allowance market, where price 1 Throughout this paper, the term cost pass-through refers to the mechanism through which the allowance price is reflected in power prices and/or in carbon-intensive goods. Emissions trading and electricity sector regulation 2 International Carbon Action Partnership discovery is facilitated through allowance auctions and where there are no distortions from free allocation2, will drive cost effective emission reductions. In practice, different s of electricity sector regulation interact with real-world ETSs in ways that may prevent or change how participants respond to the allowance price. At one end of the regulation spectrum, vertically integrated and in some cases non-profit driven monopolies deliver all services of the electricity sector, from generation to electricity retailing and power prices and/or investment decisions are subject to regulatory oversight. In partially liberalized markets, regulators fix power prices with multiple policy objectives in mind e.g., affordability and reliability and impose output, investment and technology requirements on firms’ industrial activities Boute and Zhang, 2017. More flexible s of power sector regulation might include market conditions with maximum or minimum prices for certain consumers or perance standards for power producers. Even in partially liberalized markets, access to the grid is regulated through tariffs, and planning such as renewable energy targets and portfolio standards can influence the role for and strength of the allowance price signal. The interaction of market-based carbon pricing mechanisms with sectoral regulation is particularly pertinent for the electricity sector. Firstly, the electricity sector3 is a major source of emissions, globally responsible for 45 percent of CO2 emissions in 2015, with 72 percent of global electricity emissions generated from coal combustion IEA, 2017. Secondly, reducing emissions from the power sector is generally cheaper than in other sectors. Thirdly, a clean power sector will play a key role in decarbonizing the heat and transport sectors. For these reasons, large emission reductions are required both at a domestic level for cost effective attainment of Nationally Determined Contribution NDC goals for many countries and at a global level to achieve net zero emissions by the mid part of this century. Indeed, ETS as a cost-effective instrument for emissions control is now being implemented or considered in China, South Korea, Mexico, Chile, Colombia, Vietnam, Turkey, Thailand, and the Ukraine, in addition to established systems in North America, Asia-Pacific and Europe ICAP, 2018. In this paper, we develop a conceptual framework to analyze the interact