The Power of Carbon July 2008

8/9/2019 The Power of Carbon July 2008

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Carbon Market Analyst

The Power o Carbon

TO THE POINT CONTENT

UPCOMING REPORTS

POINT CARBON RESEARCH All rights reserved 2008 Point Carbon

RESEARCH

North America

2 Executive summary

3 What uture carbon constrained

economy?

4 Carbon and Power10 Carbon and Transportation Fuels

13 Conclusions

14 Contacts

Pre-emptive strike: The Future o

Regional Carbon Trading Programs

in the US

RECs and the Carbon Market

North American Oset Supply

The US will most likely be operating in a carbon-constrainedeconomy in the near uture as both presidential candidatesavor a greenhouse gas cap-and-trade system to reduce

domestic emissions.

Implications o such a system includude increases in the priceo electricity and transportation uels, as the emitters and uelproviders must account or the cost o carbon associated with

their product.

Increases in electricity prices will be more drastic in coal-heavy regions. This is especially true or deregulated powermarkets where the uel on the margin determines the

electricity price.

In regulated power markets, public ofcials will have acertain degree o control over the carbon-induced powerprice increase, as they may limit the degree to which ossil uelred generators can pass the cost o carbon on to consumers

in the orm o higher rates.

In the transportation sector, carbon caps will make biouelsmore price-competitive with their ossil-derived counterparts.Our analysis looks at an expanded scope o regulation in the

transportation sector that may exist in uture cap-and-trade

proposals.

I uels are regulated according to their liecycle carbon

emissions, certain types o biouels will become morecompetitive and the proft margins o the most energy-intensive ossil uel producers would narrow.

July 18, 2008


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Carbon Market Analyst North America

2 All rights reserved 2008 Point Carbon

CMA July 18, 2008

In this issue o Carbon Market Analyst North America, we take a look at the implications o impending carbon constraints

on energy commodities: electricity and transportation uels.

Current legislative proposals or combating climate change in the US include a greenhouse gas cap-and-trade system

that would include emissions rom the power and transportation sectors. We use the most recent such proposal, the

Lieberman-Warner bill, to exempliy a uture carbon trading regime in the US and explore its implications or the power

and transportation sectors.

Cap-and-trades most immediate eect in the power sector is to alter the price dierential among uels used to produce

electricity. The price o natural gas and oil will go up because reners will have to submit allowances or those uels

carbon emissions. Coal-red power generators will have to submit allowances or the emissions associated with their

coal combustion. The cost dierential between coal and natural gas in power generation will narrow ollowing this

inclusion o a carbon price, which will incentivize uel-switching rom coal to natural gas on the margin.

Increases in electricity prices will be more drastic in coal-heavy regions. This is especially true or deregulated power

markets where the uel on the margin determines the electricity price. In regulated power markets, public ocials

could have some control over the retail power price increase, as they may limit the degree to which ossil uel-red

generators can pass the cost o carbon on to consumers in the orm o higher rates.

In the transportation sector, reners and processors o ossil uels would have to pay or the emissions that will occur

when the uel is burned. In a carbon-constrained economy modeled ater the Lieberman-Warner bill, ossil uel prices

would rise while all biouels would become more competitive.

Policymakers are increasingly aware o the dierentiated environmental eects o energy crops, meaning that the

way biouels are regulated may change in uture cap-and-trade proposals. Such a change could involve expanding

the compliance burden in a cap-and-trade system to reners and importers o all uels, requiring them to surrender

allowances or the liecycle emissions o their products.

Under that regulatory scenario, the relative prices o uels would be dierentiated beyond the ossil uel - biouel

divide. Some types o biouels would become more competitive relative to others, acilitating an overall reduction in

average uel carbon intensity.

Executive summary

Setting the sceneWith both US presidential candidates

in avor o addressing the problem o

climate change by implementing a

cap-and-trade system to reduce US

greenhouse gas emissions, a carbon-

constrained US economy is likely in

the near uture.

Businesses in all sectors are

bracing themselves or what this

means to their bottom line, and

consumers wonder how it will aect

their pocketbook. Setting a cap on

greenhouse gases and monetizing

each ton emitted makes carbon a

commodity a commodity or which

there will be a complex market once

the rules o trading are set.

The price o carbon will have direct

and signicant eects on the price o

other commodities, particularly those

in sectors that are the largest sources

o emissions: power generation and

transportation uels.

Overall in the US, burning the uels

needed or electricity generation

and transportation causes nearly

three-ourths o the countrys total

emissions. Putting a price on these

emissions will raise the price o uels

with which we tank our cars and

infuence the economics o energy

markets, avoring less carbon-

intensive electricity generation.

In this Carbon Market Analyst North

America, we explore the impact

o potential US carbon emissions

regulation on electricity prices and

the relative costs o transportation

uels, showing what the market or

these commodities could look like

in a uture carbon-constrained US

economy.

Setting a cap ongreenhouse gasemissions makes

carbon a commodity


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CMA July 18, 2008

Both presidentialcandidates would be

likely to sign a successorbill into law

What uture carbon-constrained economy?

Several proposals to implement a

cap-and-trade system have been

introduced in the US Congress,

each with diering reduction

timelines, points o regulation, and

allocation structures. We base our

calculations on the proposal that

made it the arthest toward actual

implementation, the Lieberman-

Warner Climate Security Act that was

briefy debated on the Senate foor in

June 2008.

Although this bill ailed to pass a cloturevote, it is the best available indication

o what policy might be adopted

under the next administration: several

o its components will be included

in a successor bill on cap-and-trade,

which both presidential candidates

would be likely to sign into law.

The Climate Security Act would

impose a limit on over 80

percent o US carbon emissions,

including electricity generation

and transportation. While the bill

regulates these emissions rom coal-

red power plants directly, it covers

the emissions associated with other

uels (natural gas and transport uels

such as gasoline) urther upstream,

at the renery or uel import level

(see Textbox 2).

This means that while coal-burningpower plants must surrender

allowances (or carbon emission

permits) or each ton o carbon

dioxide equivalent (CO2e) they emit,

emissions rom cars and natural

gas-red generation are accounted

or by the provider o that uel the

reners and processors must submit

an allowance or every ton o CO2e

that will be emitted when that uel is

burned.

The compliance obligation on the part

o emitters and uel providers changes

the current cost ratios in marketsor power and uels, as generating

electricity by burning coal becomes

relatively more expensive compared

to lower-carbon sources - just as

gasoline or diesel becomes more

expensive relative to lower-carbon

uels like ethanol or biodiesel.

Assuming a possible near-term cost

o carbon derived rom analyses o

the Lieberman-Warner bill, we showsome o the eects o this cost on

regional electricity prices as well as

uel price spreads.

The timerame we look at represents

the initial years o the proposed US

carbon market, during which the

The US Environmental Protection Agency (EPA) published a detailed

analysis o the Lieberman-Warner bill in March 2008, including projected

per-ton prices o carbon given various policy and uel cost scenarios. The

agency came up with a range o carbon price estimates over the 2012-2050

period covered by the bill, based on Computable Generalized Equilibrium

models.

These models, with acronyms IGEM and ADAGE, orecast expected

allowance prices based on economic activity, uel prices, technology

development, carbon oset availability, and several other actors. Using

dierent scenarios containing a mix o these parameters, the EPA models

revealed possible carbon price curves throughout the 2012-2050 period.

Textbox 1: The price o carbon in 2012

The initial price estimates or the start o the bills cap-and-trade program

in 2012 were $24.20 per ton CO2e in the low estimate and $33.40 on thehigh end we take the average, $28.80, as a central carbon price estimate

in 2012.

This price ts within the range o another component o the Lieberman-

Warner bill, a so-called cost-containment auction through which the EPA

administrator would sell allowances borrowed rom the period ater 2030

to emitters during the early years o the program. According to the bill,

regulators should sell the allowances in this auction at a price between $22

and $30 initially.

0

10

20

30

40

50

60

70

80

90

100

2010 2012 2014 2016 2018 2020 2022 2024 2026

Year

Price

('05

$/ton)

EPA - LW IGEM

EPA - LW ADAGE

Source: EPA 2008


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CMA July 18, 2008

obligation to surrender emissions

allowances or emissions will have

just entered into orce (2012-2015).

The price we use as representativeor the cost o a ton o CO2e at

that time ($28.8) is derived rom

US government analyses o the

Lieberman-Warner bill (see Textbox

1).

Carbon and Power

The eect o a $28.80 per ton

carbon price on 2012 electricity

costs will vary by region, depending

on the respective states generation

mix, transmission grid, and whether

its power market is regulated orderegulated.

Fuel mix

A regions uel mix is the primary

actor determining the extent to which

carbon costs add to power prices.

Conventional power generation

rom coal is more greenhouse gas

intensive than any other type o

ossil-ueled generation, so the cost

o producing power under carbon

constraints increases more or coal-

heavy producers than or thoseburning other ossil uels.

As shown in Table 1, the cost o

electricity rom coal would increase

by over 30 percent i emissions are

accounted or and passed through

to the consumer, while the cost o

generating power rom oil and natural

gas would increase only 11 and 9

percent, respectively.

Coal makes up adierent percentage

o the generation mix ineach state

The prices shown in the table are

actual exchange-traded uel utures

rom late June 2008 or typical plant

eciencies, representing the carbon-

added scenario under one set o

conditions. The adjusted uel cost or

each plant will change depending on

actual uel prices in 2012.

The US gets roughly hal its electricity

rom coal, but coal makes up a

dierent percentage o the generation

mix in each state.Pacic Northwest,

or instance, is supplied largely by

hydroelectric power, dampening

the carbon-induced power price

increase in that region. West Virginia

and Kentucky, however, get over 90

percent o their power rom coal,

ampliying the eect o carbon costs

on energy prices.

Caliornias in-state power generation

is nearly 50 percent natural gas, which

emits roughly hal the carbon per unit

o energy as coal. However, the state

imports 20 percent o its electricityrom coal-heavy neighbors like Utah

and Nevada, whose generation mix is

among the most carbon-intensive in

the nation.

In states where power comes

mainly rom ossil uels, wholesale

electricity costs will increase under

a carbon-capped economy. But

that power price increase will not

be uniorm: the spread between

current power prices and those

adjusted to include the additional

cost rom carbon is largest where

the generation mix is most coal-

heavy.

Spread varies by season

Figure 1 illustrates this dierence

in power price spread or two

existing power markets the

more coal-heavy PJM region

in the eastern mid-Atlantic andNew Englands more natural gas-

dependent power market.

The bottom curves represent real

traded orward prices or peak

power in these regions, while

the top lines represent that same

generation with the carbon prices

increased cost o uel included in

the price.

The width o the bands,

representing the spread between

electricity prices and their carbon-

adjusted equivalent, is narrower

in New England than in the PJM

region. This is because coal is on

the margin more oten in PJM

(Figure 1a), while lower-carbon

Generating electricityby burning coal be-

comes more expensive

Source: EIA, Nymex

Generation type Carbon intensity

(lbs CO2e /MMBtu)

Typical heat

rate (Btu/kWh)

Fuel cost

($/MWh)

$/MWh increase

due to CO2 cap

Carbon adjusted uel

cost ($/MWh)

gas 115 8000 104 10 114

oil 174 12300 208 27 235

coal 210 10800 65 28 93

Table 1

The increase in

power prices willnot be uniorm


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CMA July 18, 2008

Figure 1: Dierent spreads or dierent generation mixes - The cost dierential between electricity with carbon constraints and

without is larger where coal is more oten on the margin

80

100

120

140

160

180

Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09

$/mwh

$/mwh

$/mwh

$/mwh

PJM On Peak with CO2e PJM OnPeak

80

100

120

140

160

180

Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09

$/mwh

$/mwh

$/mwh

$/mwh

ISO-NE OnPeak with CO2e ISO-NE OnPeak

natural gas is almost always the uel

on the margin in New England.

Though it is less visible on the graph,

both bands representing the cost

spread are slightly narrower during

peak demand seasons, especially in

summer when gas is more requently

on the margin. The cost dierential

between PJMs power prices and

carbon-adjusted power prices is only

$20-$21 per MWh in the hot months

o July and August, when natural gas

red plants are running to power air

conditioning units across the region.

The so-called shoulder months

o March and April, on the other

hand, would see a price dierential

between $22 and $23 per MWh.

Average demand or electricity islower during these months, as homes

and industries require less power or

heating or cooling overall. Thereore

ewer natural gas-red peaking

plants are run and the uel mix in both

regions is more coal-heavy.

The same dierential would develop

regionally, between the eastern,

gas-heavier portion o PJM and the

western, coal-heavier parts.

Provisions limit impact onelectricity prices

But the eect o uel carbon intensity

on the cost o producing electricity is

not the only thing that aects what

consumers see on their utility bills.

The Lieberman-Warner bill aims to

lessen the need or power rms to

pass on their higher generation costs

to consumers. It provides so-called

transition assistance to ossil uel-

red power generators, in the orm

o ree emission allowances.

The administrator o the US

Environmental Protection Agency

(who would run much o the US

carbon trading program) would

distribute a certain percentage o

the countrys emissions permits to

ossil-red acilities or ree, rather

than requiring companies to buy

them rom the government. The

number o allowances generatorswould receive is proportional to their

carbon intensity.

The Lieberman-Warner cap-and-trade

design decreases the total amount

o transition assistance distributed

over the years, such that by 2030,

generators do not receive any ree

allowances at all. At the bills required

start o carbon trading in 2012,

however, ossil uel-red generators

would get a ull 18 percent o the

total US allowance budget rom

the government. This accounts or40 percent o the emissions rom

ossil ueled generators expected

emissions in that year, leaving 60

percent to be purchased.

How regional regulators allow

generators to pass on the cost o

these allowances in their electricity

rates will determine the cap-and-

trade programs eect on retail

The power price

spread is lowerin hotter months,

when gas is more re-quently on the margin

Source: NyMex, PJM, ISO-NE


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CMA July 18, 2008

power prices. Thereore, state public

utility commissions and other energy

regulators have some degree o

control over the power price eectso ederal carbon legislation.

Regulated power markets

In states where energy markets are

regulated, public utility commissions

(PUCs) determine the rates

companies are allowed to charge

or their power. They could allow

generators to recover the cost o

their allowances entirely, or limit the

carbon cost pass-through to the

amount o allowances that actually

had to be purchased.

To illustrate the eect o PUC

decisions on this point, gures 3 and

4 show two potential impacts on

electricity prices in regulated states.

In the scenario illustrated by gure 3,

PUCs would allow ull cost recovery

(total carbon cost pass-through) or

power generators having to comply

with Lieberman-Warners carbon

caps by purchasing allowances or

Figure 2: How much do emitters get or ree? Transition assistance to electric

power generators would cover about 40 percent o their emissions

US allowance budget in 2012: 5.8 billion tons

Expected US emissions from fossil fuels

in 2012: 2.6 billion tons

18% Allowances covered by transition

assistance: 1.04 billion

40%

60%

Carbon constraints play out dierently

depending on where they are applied.

Policy makers generally distinguish

between downstream regulation,

which aects the entity that actually

emits the carbon into the atmosphere,

and upstream regulation, which holds

entities closer to the source o ossil

uel responsible or the emissions it

will cause when burned.

Europes emissions trading program

covers only electricity and industry,

so it caps actual emissions rom

those sectors. Installations (power

plants and industrial acilities) must

surrender an allowance or each ton

o CO2 emitted. But when the trading

system covers the transportation

sector as the Lieberman-Warner bill

does, some upstream regulation is

required because the government

cannot track emissions rom (and

require allowances or) every single

car or truck.

Proposals to include transportation

under a cap thereore regulate the

uel production chain by requiring that

producers, reners, or distributors

o a uel surrender allowances or

its carbon content. The Lieberman-

Warner bill regulates processors or

reners or all uels except coal.

For the power sector, this means that

coal-burning power generators must

pay or their emissions, while plants

that burn oil or natural gas are covered

indirectly through higher uel prices:

the reners and processors who had

to surrender allowances or the uels

emissions will presumably recover

those costs by charging more.

Regardless o uel type, the carbon

cost eventually reaches ratepayers,

as generators pass down the added

cost o allowances or the increased

cost o uel to their customers in the

orm o higher electricity rates.

Textbox 2: Point o regulation - Who gets hit with the cost o carbon?

their emissions. The incremental

cost o electricity is calculated rom

the states average emissions rate,

under the assumption that assets in

regulated markets are able to recover

their costs.

In the gure 4 scenario, PUCs

recognize that nearly hal o the

allowances needed to cover thosecosts were given out to generators

or ree, so they only allow power

companies to pass on the cost o

emissions permits they had to buy

(60 percent).

We determined each states individual

allocation rebate rom transition

assistance again based on its

percentage o ossil uels and their

respective carbon intensity and

subtracted its monetary equivalent

in terms o incremental electricitycost to get the net retail price o

power accounting or a limited pass-

through.

Fossil uel-red gen-erators would get 18percent o the US

allowance budget or ree


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CMA July 18, 2008

Figure 3: A ull carbon cost pass-through Carbon price increases in regulatedelectricity markets, assuming ull cost recovery rom generators at $28.80/ton carbon price

10 15 $/MWh

> 25 $/MWh

20 25 $/MWh

15 20 $/MWh

< 5 $/MWh

5 10 $/MWh

The gures show that i regulators

restrict the ability o utilities to pass

on the cost o the carbon or which

they were compensated through

transition assistance, there is a muchlower price impact on ratepayers.

The two gures represent bookends in

a range o possible scenarios, as it is

uncertain what degree o carbon cost

pass-through ocials will consider

air. Regulators decisions will be most

infuential in regions highly dependent

on ossil uels. Non-emitting power

sources like hydroelectric dams and

nuclear power plants will receive no

transition assistance allowances,

but will also not be required to buy

emission permits or which they couldpass costs through to ratepayers.

Hydro-heavy pacic northwest states

o Idaho, Oregon and Washington

would experience no great increase

in power prices in either scenario, as

most o their power generators willnot have to purchase allowances or

ace higher uel costs under carbon

caps. The wholesale power price

increases in those states would be $2,

$6, and $4.70 per MWh, respectively,

whereas limiting carbon cost pass-

through would change those increases

to $1.80, $5.20, and $4.40.

In contrast, the increase in power

prices in Kentucky and West Virginia in

the east, as well as Utah and Colorado

in the west, will depend strongly on

the degree to which coal-red power

plants are allowed to recover costs o

emission allowance rom ratepayers.

The wholesale power price increase

under our scenario would amount

to $26.90 per MWh in Kentucky and

$27.80 in Utah, whereas limiting the

degree o carbon cost pass-through

would conne retail power price

increases to $16.60 and $16.80 in

those states.

Regulators may be infuenced by

evidence rom Europes carbon

market, which indicates that utilities

made so-called windall prots by

passing the cost o carbon on to

their customers through increasedrates even though all their emission

allowances were given out or ree.

European power rms justiy the cost

pass-through, arguing that keeping

allowances rather than selling them

represents oregone revenue. To

avoid this situation o power rms

passing on costs they did not incur,

public ocials in the US could lean

toward a rate-setting scenario that

resembles gure 4.

Note that our depiction o power

price increases by state is an

oversimplication, as all regional

power grids are connected through

transmission lines. In actual power

markets, the colors would be

< 5 $/MWh

5 10 $/MWh

5 10 $/MWh

15 20 $/MWh

20 25 $/MWh

> 25 $/MWh

Figure 4: Limited carbon cost pass-through Price increase in regulated electricitymarkets assuming cost pass-through is limited to 60 percent o allowances at $28.80/toncarbon price

Regulators deci-sions will be most

infuential in regionshighly dependent on os-sil uels

No great price in-crease or regions

with hydro and otherrenewables


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CMA July 18, 2008

blurred according to which system

operator, transmission grid, and

power market the respective areaalls under power prices do not

change at state borders, but at utility

service areas.

Other infuences on retail power prices

not shown here include potential

additional transition assistance to rural

electric cooperatives (such a provision

is included in the Lieberman-Warner

bill) as well as some orm o overall

nancial assistance to low-income

electricity ratepayers, to compensate

them or a general power price

increase.

Deregulated power markets

Prices in deregulated electricity

markets are set by the uel on the

margin, meaning the last (most

expensive to run) unit o power used

to meet demand. The price bid by

the generator supplying this last unit

o power sets the price paid to all

generators in the market.

Figure 5 illustrates the dynamics

o carbon costs with marginal

pricing. Gas is on the margin in atypical electricity stack (gure

5a) where the location o the load

curve determines the price o power.

The boxes on top o the original

coal and gas prices in gures 5b

and 5c represent the added cost o

producing power rom these uels

under carbon caps.

Under these carbon-capped

conditions, the last, most costly-

to-run coal plant that would be

dispatched beore resorting to gas

(the one arthest to the right onthe stack) actually becomes more

expensive to run than the cheapest

gas plant. This incentivizes coal-to-

gas uel-switching (gure 5c).

Fuel switching results in overall

emission reductions rom the power

sector because gas is used to provide

the same amount o electricity that

would have come rom coal.

ShortRunMarginalCost$/MWh

Gas

Capacity in MW

Hydro/Wind/Renewables

NuclearCoal

Peakers

Load curve

Figure 5a: Typical dispatch order without carbon caps

SRMC$/MWh

Gas

Capacity in MW


Nuclear

Peakers

Priceincrease

Emissions

Coal

SRMC$/MWh

Gas

Capacity in MW


Nuclear Coal

Peakers

Pricedecrease

Emissions

Figure 5b: Adding the cost o carbon The boxes on ossil-red plants represent powerprice increase incurred by accounting or CO2 emissions.

Figure 5c: Carbon-induced uel-switch The least-ecient coal plant becomes moreexpensive to run than the most ecient gas plant, changing their respective dispatch order.


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CMA July 18, 2008

Fuel switching re-sults in overall CO2

emission reductions romthe power sector

Figure 6: Carbons retail price impact in deregulated markets

10 15 $/MWh

> 25 $/MWh

20 25 $/MWh

15 20 $/MWh

< 5 $/MWh

5 10 $/MWh

At the uel prices shown here, the

carbon price required to achieve

such uel-switching or genericcoal and natural gas plants is $66

per ton, assuming US coal and

gas plants average emissions per

MWh are roughly 0.98 and 0.39

tons, respectively. Thus our per

ton carbon price o $28.80 would

not be enough to induce much

uel switching on the margin in

these regions.

This is merely a scenario, as

uel prices change daily and

the switching price is highly

dependent on the underlying uel.

Were the price o natural gas to

all $2 below the levels used in our

Table 1 calculations, all other uels

remaining constant, the switching

price would be around $40 per ton

CO2e.

Figure 6 shows how marginalpricing under carbon caps

could play out in the major US

deregulated electricity markets.

Unlike their counterparts in

regulated regions, PUCs in

states with deregulated markets

ollow wholesale orward power

prices closely when setting retail

electricity rates. Wholesale and

retail impacts are thus equivalent

in deregulated states.

The Caliornia, New England

and Texas power markets havethe lowest average marginal

emissions rates (0.5 tons CO2 per

MWh) o the deregulated markets,

as natural gas is the marginal

uel o choice in those regions.

Their power prices will thereore

increase the least (about $15 per

MWh) under a carbon price o

$28.80.

New York and the eastern PJM

region have slightly higher marginal

emissions rates, making their price

increase under carbon caps more

signicant.

Deregulated markets in the

Midwestern US will see the highest

power price increases under this

scenario, as coal is more likely to be

the uel type on the margin there:

the average marginal emissions rate

or the western part o PJM and

the region served by the Midwest

Independent System Operator is

over 0.75 tons per mWh, translating

into a price impact o around $22 per

MWh.

Conclusions or power

Implementing a greenhouse gas

cap-and-trade program will alter the

price dierential among uels used

to produce electricity. The price

o natural gas and oil will go up

because reners will have to submit

allowances or those uels carbon

emissions, and will thereore charge

buyers more or these uels.

The price o coal as a uel will remain

unaected by the carbon cap, but

coal-red power generators will

have to submit allowances or the

emissions associated with their

coal combustion, while other ossil

generation will not.

The cost dierential between coal

and natural gas in power generation

will narrow ollowing this inclusion o

a carbon price, which will incentivize

uel-switching rom coal to natural

gas on the margin. This incentive is

highest at peak times, when natural

gas makes up a greater percentage

o generation. Power price increases

under carbon constraints will be

generally higher or o-peak than or

peak generation.

Increases in electricity prices will be

more drastic in coal-heavy regions.This is especially true or deregulated

power markets where the uel on

the margin determines the electricity

price.

In regulated power markets, public

ocials will have a certain degree

o control over the carbon-induced

power price increase, as they may

Source: ISO-NE, ERCOT, MISO, PJM

Wholesale and retailpower price impacts

are equivalent in deregu-lated states


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CMA July 18, 2008

The eect o a capis similar to a carbon

tax rom the consumersperspective

limit the degree to which ossil uel

red generators can pass the cost o

carbon on to consumers in the ormo higher rates.

The eect o such limitation is again

most drastic in states where coal

makes up a high percentage o the

resource mix, as those areas will

receive more government-issued

allowances to cover their emissions.

Carbon and transportationuels

Just as carbon costs change relativeuel prices in the power sector, they

alter the relative price o uels used

in passenger vehicles. This section

o the report looks at how such

alterations would occur under the

Lieberman-Warner bill, and discusses

additional measures that could

infuence consumers choice at the

pump. We conne ourselves to uels

that can be substituted, and thereore

do not include electric power used in

hybrid or plug-in vehicles, although

it is commonly considered an

alternative uel.

The direct eect: biouels over ossiluels

The Lieberman-Warner bill names

importers and reners o petroleum-

based liquid or gaseous uel as

the entities which must surrender

allowances or the emissions that

will be released into the atmosphere

when that uel is burned. Those

entities will pass on the cost o those

permits in the orm o higher gasoline

or diesel prices, making the eect o

the cap similar to a carbon tax rom

the consumers perspective: the

costs o petroleum-based vehicle uel

would increase relative to its carbon

content.

Reners and importers o non-

petroleum-based uel, however,

would not have to submit allowances.

This gives an automatic advantage

to biouels like ethanol, or which

consumers would see no carbon-

induced price increase. Biouel

prices would thereore become thatmuch more competitive relative to

the conventional uels.

Assuming that reners o petroleum-

based uel will pass on the entire

cost o allowances, we can assess

the carbon-induced price increaseor some conventional uels. Figure

7 illustrates this carbon adder or

conventional gasoline and diesel,

using EPA estimates o the amount

o CO2 these products will emit

when burned.

The actual carbon adder may be

smaller, as reners or importers may

allow the cost o emissions permits

to eat into their prot margin to a

certain extent, rather than passing

it on to consumers entirely. The ull

carbon adder is $0.26 per gallon orgasoline and $0.29 or diesel and

zero or ethanol, as biouel reners

have no compliance obligation.

For the uel prices used in this

scenario (spot prices rom June

2008), the gure illustrates that

adding the $28.80-per-ton carbon

cost to petroleum-based uels can

alter their relative prices enough

to tip the scales on ethanol versus

gasoline. Without the added cost o

carbon, Brazilian sugarcane ethanol

is a ew cents per gallon moreexpensive than gasoline or our given

set o prices, when adjusted to its

gasoline energy-equivalent. Including

the cost o carbon makes gasoline

more expensive.

O course, the degree to which the

scales are tipped among uel types

depends primarily on the underlying

uel price when gas and diesel are

-

0.50

1.00

1.50

2.00

2.50

3.00

3.50

4.00

4.50

Conventional Gasoline Conventional Diesel Brazilian ethanol with

import tariff

Midwest corn ethanol

$/gallon

Cost ($/gallon) Carbon price impact

Figure 7: Fuel prices with carbon constraints.

The uel prices used are August 2008 uel prices rom Nymex in June 2008, adjusted or dieringenergy content by volume. The grey boxes represent what reners would pay or the allowancesneeded to cover the amount o CO2 their uels will emit when burned at a per ton carbon price o$28.80

Source: Nymex, EIA uel emissions coefcients available online at http://www.eia.doe.gov/oia/1605/coefcients.html


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CMA July 18, 2008

A carbon price couldtips the scales onethanol vs. gasoline

cheap, an extra $0.25 per gallon

is more signicant, while current

skyrocketing gas prices render thesame price increase a less infuential

actor.

Though biouels are advantaged by

the Lieberman-Warner plan under

any uel price scenario, their relative

competitiveness is heavily altered

through other policy measures.

The production o US corn ethanol

is subsidized, while the price o

Brazilian ethanol is infuenced by a

$0.54/gallon import tari.

Even without carbon caps, Brazilian

ethanol is actually cheaper thanconventional gasoline i the tari is

excluded rom the price, due partially

to sugarcanes less energy-intensive

distillation process. However, supply

constraints and lack o ethanol

inrastructure in the US also aect

the penetration o this uel in the

market.

Eliminating the tari would thus

make Brazilian ethanol even

more competitive relative to the

domestically-produced variety.

Presumptive US presidentialcandidate John McCain has declared

he would remove the current tari

on sugarcane ethanol as president,

making this scenario a possibility.

The rationale behind promoting

biouels in this way is directly

related to climate change mitigation.

Reners and importers are required tosurrender allowances or emissions

rom ossil uels and not rom

biouels because the latter generally

emit less carbon. Petroleum is stored

plant energy that would remain

underground i humans did not dig

it up, so emissions rom burning it

are additional to those o the earths

natural carbon cycle.

The plants out o which biouels aremade (corn, sugarcane, or other crops)

instead removed carbon dioxide rom

the atmosphere as they grew, such

that burning them as uel results in

an even net carbon balance.

Not all biouels are created equal

The net carbon balance, however,

is not the same or all biouels. The

amount o greenhouse gas emissions

associated with the respective

biouels liecycle diers greatly

depending on what type o crop is

used and what happens at the arm

and the renery.

For example, growing corn involves

ossil uel use in tractors, harvesters,

and reneries. Most crops also use

ertilizer, o which a major component

(nitrous oxide, N2O) is itsel a

greenhouse gas.

Earlier in a biouel crops liecycle, the

issue o land use change comes intoplay. I orests, which are one o the

earths main CO2 sinks, are cleared

to make way or energy crops, there

is a net carbon increase.

Massive palm oil plantations in

Southest Asia, or instance, are grown

on land that was originally tropical

rainorest. Lost carbon sink capacity

rom the associated deorestation

would be part o the uels liecycle

emissions.

The Lieberman-Warner bills binary

distinction between ossil and non-

ossil uels does not refect this

liecycle accounting, partially because

greenhouse gas emissions o various

uels are hard to quantiy.

However, policies currently being

implemented at the state level

actually measure liecycle uel

emissions and can serve as a model

We use in this analysis liecycle estimates rom the University o Caliornia

commissioned Caliornia regulators to implement their low carbon uel

standard (LCFS), which aims to limit the average emissions o the states

uel mix.

The metric used or the LCFS targets is average uel carbon intensity

(AFCI), dened as grams CO2-equivalent per megajoule o uel, or emissions

per unit o energy contained in the uel.

We use this metric in our calculations to show how various biouels would

are price-wise, i allowances were required or their liecycle carbon

emissions (gure 8). Grams per megajoule are converted to tons per gallon,

and discounted or the lower heating value o biouels.

Cellulosic ethanol rom cover crops such as switchgrass have extremelylow (sometimes negative) AFCI values, as their growth reduces topsoil

loss, sequestering more carbon in the soil than is emitted when burned.

An important limitation to the model is the measure o land use change

and its contribution to greenhouse gas emissions. The model accounts or

CO2 emissions resulting rom converting pastureland to cropland at rates

necessary to produce corn-based ethanol in the US.

Most models o liecycle carbon emissions ail to account or land use

change beyond this, as net emissions impacts o deorestation or other

land conversion are not extremely dicult to quantiy accurately.

Textbox 3: Methodology or liecycle greenhouse gas emissions


12/14



CMA July 18, 2008

Fuel price spreads under liecycleaccounting

Altering the compliance obligation or

uel reners in this way would have

a signicant eect on relative price

dierences between and among

various biouels. I all uel reners had

to surrender allowances according to

their average uel carbon intensity

(AFCI, see Textbox 3), we would see

signicant deviation in prices among

uel types. Fuels whose production

and rening is less greenhouse

gas intensive would become more

competitive the higher the carbon

price.

This is illustrated in gure 8, which

depicts the price spread between

conventional gasoline and other uels

i liecycle emissions are taken into

account.

As the gure shows, higher carbon

prices generally make biouels more

competitive compared to gasoline.The

(1.00)

(0.50)

-

0.50

1.00

1.50

2.00

- 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85 90 95 100

$/ton CO2e

Gasoline-b

iofuelin$/gallon

Brazilian ethanolBrazilian ethanol with import tariffUS corn ethanol coal-fired refineryCellulosic ethanol - prairie grassUS corn ethanol stover-fired refinery

Renewable

fuelfavored

Gasoline

favored

or such accounting in cap-and-

trade. Caliornias low carbon uel

standard (LCFS) aims to reduce thestates average uel greenhouse

gas intensity (emissions per unit o

energy) over a given time period.

The Lieberman-Warner bill calls

or a national version o this LCFS

overseen by the EPA, so tools or

measuring liecycle emissions

could be in place.

Policymakers are also becoming

increasingly attuned to the

signicance o liecycle accounting

or biouels, as the global

controversy over energy crops and

their possible role in ood price

increases gains media attention.

Though this issue is not directly

related to climate change, US

decision makers are calling or a

re-think on energy crops and their

implications.

In climate terms, such a re-think

may entail a cap-and-trade program

in which reners and importers o

all uels are required to surrender

allowances or the uels liecycle

carbon emissions.

exception is corn ethanol produced

in coal-red reneries. Burning the

coal in that rening process is parto the liecycle emissions o the uel

as the allowances reners would

be required to surrender get more

expensive, so does the cost o the

ethanol end product. Corn ethanol

rened mills red with the corns own

stover (husks) has lower liecycle

emissions, as using this byproduct

cancels out emissions that would

have occurred using ossil uels.

The slope o each line reveals the

uels relative AFCI. Cellulosic ethanol

made rom prairie grass, which

sequesters carbon in the soil and

thereore has nearly negative AFCI,

is initially more expensive than corn

ethanol compared to conventional

gasoline. But it catches up with corn

ethanol when carbon costs around

$52 per ton. Its competitiveness

increases more rapidly than that o

corn ethanol under carbon constraints:

while cellulosic costs the same as

gasoline when carbon hits $70 per

ton, corn ethanol would not become

price-competitive with gasoline until

carbon costs $90 per ton.

Figure 8: Fuel spreads by liecycle carbon intensityThe x axis represents carbon prices, while the y axis represents the cost dierential between gasoline and the respective biouel. Where the lines are abovezero, the biouel is cheaper than conventional gasoline.

Source: www.ethanolmarket.com, Senate testimony by US National Bioenergy Center Director Michael Pacheco on cellulosic ethanol costs, June 2006

Policymakers areaware o liecycle

accounting


13/14



CMA July 18, 2008

The current US administrations

priority o making cellulosic ethanol

more cost-competitive, as statedin President Bushs 2007 State o

the Union speech, would thereore

become realized aster in a carbon-

constrained economy that accounts

or uels liecycle greenhouse gas

emissions.

Though it is not shown in the graph,

assessing liecycle uel greenhouse

gas intensity allows dierentiation

among ossil uels as well. Some

ossil uels require a lot o energy

to produce and thereore take a

double hit under carbon constraints,

i the emissions caused by their

production are accounted or:

bitumen-rich tar sands in western

Canada, or example, are rened

into oil using ltration and heating

processes that require vast amounts

o energy, which in turn is supplied

by burning ossil-uels.

The higher liecycle emissionsinherent to gasoline or diesel

made rom tar sands-derived oil

may render those products more

expensive relative to gasoline or

diesel whose oil inputs came rom

less energy-intensive sources. This

would reduce the prot margin rom

producing those uels.

Conclusions or transportationuels

When reners and processorsmust pay or the emissions that will

occur when their uel is burned, uel

prices rise. In a carbon-constrained

economy modeled ater the

Lieberman-Warner bill, ossil uel

prices would rise while all biouels

would become more competitive

because they are assumed to be

less greenhouse gas intensive.

Policymakers are increasingly aware

o the complexity o environmental

eects o energy crops, so thatthe way biouels are regulated may

change in uture cap-and-trade

proposals. Such a change could

involve expanding the compliance

burden to reners and importers o

all uels, requiring them to surrender

allowances or the liecycle emissions

o their products.

Under that regulatory scenario,

uel prices would be dierentiated

beyond the ossil uel - biouel

divide. Some types o biouels would

become more competitive relative

to others, and the prot margins o

the most energy-intensive ossil uel

producers would narrow.

General conclusions

Comparing the cap-and-trade

programs eect on the power and

transportation sectors, it becomes

clear that carbon constraints will have

a more immediate eect on emission

reductions in the power sector than

in transportation.

This is largely due to the nature o

uel use in each sector. Even relatively

minor increases in the cost o uel

brought on by carbon constraints

can aect the electric power sector

in a signicant way by providing the

incentive to use a lower-emitting

power plant.

Drivers, on the other hand, have

ew low-carbon uel options readily

available. Petroleum-based uels

power nearly all motor vehicles in

the US -- and as liecycle emission

analyses have shown, the biouelalternatives are not always much

better in terms o their climate

change impact.

Furthermore, supply and technological

constraints limit the ability to switch

easily rom one uel to another. As

we have shown, a $28.80 per ton

carbon price would only raise the per-

gallon cost o conventional uels by

ractions o a dollar -- given the lack

o alternative transportation uels,consumers are relatively insensitive

to such a minor price change.

This dierence in cap-and-trades

eect on the two sectors suggests

that other policies may be needed to

cut greenhouse gases rom vehicle

use. Some o the most eective

measures to that end include a low

carbon uel standard to incentivize

cuts in average uel greenhouse gas

intensity.

More ar-reaching measures involve

cutting vehicle use itsel, throughlong-term inrastructural shits as

well as new settlement patterns

that reduce vehicle miles traveled.

These include an expansion o

public transportation and urban

zoning policies geared toward

cutting the length o commutes.

But in the decades it takes or such

comprehensive changes to occur,

the most immediate eect o carbon

caps will be to alter the current price

ratio o those liquid transportation

uels already on the market.

Cellulosic ethanolcould become

competitive


14/14

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CMA July 18, 2008

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The Power of Carbon July 2008