Navigating the path to the low-carbon future

Navigating the path to the low-carbon future
Aug 17, 2021
7 MIN. READ
How can stakeholders and regulators manage the risks of carbon emission reductions while maintaining acceptable cost boundaries?

Regulators in many states and localities have attempted to decarbonize the economy through a combination of specific policies (e.g., efficiency mandates) and cross-cutting programs (e.g., cap-and-trade). While regulators are familiar with individual programs in isolation, they often have faced difficulty designing a balanced portfolio of abatement measures that accounts for possible interactive effects.

Well-designed complementary measures can smooth out and moderate carbon prices; poorly calibrated programs can produce price fluctuations and muddy market signals. How can stakeholders and regulators understand these risks to achieve emission reductions within acceptable cost boundaries?

Incentivizing carbon reductions

Programs that aim to lower carbon have taken three main forms.

1. A carbon tax. Carbon taxes are a predetermined tax on every ton of carbon emitted during a certain period. They provide concrete signals to the market but do not enforce a given emissions outcome.

2. Cap-and-trade. This sets a limit on the total amount of carbon emitted in a certain period. Entities bid for the right to pollute, creating a market signal for necessary levels of abatement. The emissions outcome is more certain, but prices may fluctuate.

3. Complementary measures. Also referred to as policy actions, these measures aim to generate investment in a particular type of abatement activity (e.g., electrification) based on the judgment of policymakers.

Complementary measures can play a vital role in reassuring new investments in lower-emitting technology (and signaling the intent of that investment). However, it can be difficult to calibrate these targets to achieve carbon reduction goals and change market dynamics. Without acknowledging this dissonance, complementary measures can pose a detriment to cross-cutting policies like cap-and-trade.

Following the emissions trail

While most state programs focused on capping carbon emissions are couched in the electric sector, national electric generation only accounts for under a third of total emissions. Therefore, a program aimed at economy-wide reductions should extend beyond electricity generation and move the needle on transportation or other end-use emissions.

With a relatively lower emission reduction cost, cap-and-trade alone may put a burden on the generation sector disproportionate to its emissions share. Electrification of other sectors to reduce emissions would increase that burden but may open opportunities for new utility investment. Regulators and sources affected by these portfolios must understand and quantify these interactions to prevent costly policy decisions that may undermine the goal of emission reductions.

Focusing on a sustainable long-term plan

The high cost of reductions in the transportation sector limits the ability to drive abatement, particularly in the near term. For instance, the imposition of a hypothetical carbon tax of $10/ton would cause gasoline prices to rise only $0.10/gallon—and therefore, less likely to affect customer behavior. Thus, incentivizing meaningful changes in consumer behavior within the transportation sector requires more tailored policy tools.

Most transportation entities are price takers, which means fuel providers pass costs on to customers. With little incentive, save the price of carbon penalties, the transportation sector may buy up a larger share of available allowances in a particular market. This, in turn, could drive up the carbon price and cause deeper reductions in other sectors to meet economic goals. In this scenario, the industrial or energy sectors would compete at a relatively higher price to purchase carbon allowances and potentially implement more aggressive measures to cut emissions.

Properly calibrated complementary measures can:

  • Reduce carbon emissions in the short- term
  • Create a long-term signal for continued investment in infrastructure and research
  • Help maintain prices in the cap-and-trade market to allow more time for budget tightening
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Using California’s programs as an example, Figure 2 shows that the imposition of a 20% low carbon fuel standard (LCFS) reduces transportation sector emissions significantly. In turn, this reduces the pressure and cost of abatement from other sectors and reduces the demand for allowances. Such an imposition lowers California’s projected market-clearing allowance price by $19/metric ton CO2e (CO2 equivalent), relative to a 10% LCFS mandate.

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Striking a balance with dynamic programs

Complementary measures have also played a major role in the power sector in the form of policies such as energy efficiency mandates and renewable portfolio standards (RPS). Failing to make these targets dynamic may leave stakeholders blind to the evolving linkages between sectors.

Ultimately, poorly handled complementary measures lead to a fragmented policy framework that results in a disproportionate reliance on one measure.

Figure 3 displays the need to walk the line between doing too much and too little. California’s 2030 decarbonization target requires deep cuts in the power sector, achieved through greater penetration of renewable resources.

Therefore, the RPS is a complementary measure that works in addition to cap-and-trade to achieve these reductions. Setting too low a target (e.g., a 33% RPS level) results in no change in market-clearing carbon allowance prices since the carbon price is sufficient to incent renewable penetration equivalent to a 50% RPS level.

On the other hand, the imposition of a 60% RPS level in 2030 would drop allowance prices by $10/metric ton. A 60% RPS forces the market to reduce power sector emissions further and faster than economics would dictate. The increased abatement reduces the burden on reductions from other sectors and lowers the carbon price. The cost of incremental renewable commitments is still passed on to customers, potentially increasing the program’s total cost. A balanced program that takes advantage of changing dynamics is crucial to cost-effectively meet carbon reduction goals.

The need for a holistic view

Programs that encourage decarbonization are not a panacea for an entire country. The benefits of any proposals or policies targeting the deep decarbonization of large swaths of the economy must be balanced with the individual attributes and goals of the region or sector implementing the policies.

Electrification of residential heating loads is one example of how a policy with unconsidered factors has the potential for significant unintended consequences. While the electrification of residential heating loads would displace direct-use natural gas by consumers, any changes to net emissions would need to account for factors such as the local electric grid emission levels and the relative performance and efficiency of the replacement electric heating unit.

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The colder the climate, the lower the grid emissions required to result in a net reduction in CO2 emissions. In addition, in colder climates, heat pump efficiency declines substantially on the coldest days, leading to increases in peak period electricity demand, and potential costly increases in the electricity capacity and transmission grid.

Additionally, while reductions in natural gas use could present savings opportunities on future gas distribution infrastructure requirements, any incremental demands placed on the electric system require consideration. If the system is unable to accommodate significant increases in winter demand, there may be a need to develop new generating capacity, thus increasing the cost of the emissions savings.

Developing policies catered to the needs and goals of a particular actor ensure the pursuit of the most cost-efficient program.

Designing an optimal decarbonization strategy

Components of carbon policy portfolios (already underway in some states and provinces; envisioned in others) affect other components, as well as the success of the overall program.

Meeting targets in one sector can influence market-clearing allowance prices that affect all sectors, resulting in significant risk to all market participants, regardless of their own abatement potential. Thus, stakeholders must understand compliance not only in relation to their respective sectors and others in their sphere but how compliance in other sectors may affect their own as well. Regulators, meanwhile, must deliberately balance these measures to meet emission reduction requirements.

Designing a harmonized set of carbon-reducing policies and programs depends on the quality of cooperation among stakeholders and regulators. To strike the right balance, they must commit to incorporating perspectives across the energy landscape with integrated analysis at the company level of potential outcomes. New policies and programs shouldn’t “shake things up,” but instead should balance costs and benefits with existing efforts; should update those efforts to welcome new efforts, technologies, and changes to the market; and should consider the cost implications of the different elements of the emissions reductions strategy.

Meet the author
  1. Philip Sheehy, Director, Transportation and Energy

    Philip is committed to identifying cost-effective solutions to meet the challenge of decarbonization, with over 15 years of experience navigating the technical, economic, and regulatory challenges associated with decarbonizing transportation fuels.  View bio