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Electricity Markets Not Ready to Fight Climate Change

May 27, 2014
Carbon dioxide (CO2) emissions can be reduced more effectively if there are appropriate incentives and well-functioning markets.

As the climate change debate rages on, the role of the electricity markets is often forgotten. Carbon dioxide (CO2) emissions can be reduced more effectively if there are appropriate incentives and well-functioning markets. This is explained in our recent white paper, “Markets Matter: Expect a Bumpy Ride on the Road to Reduced CO2 Emissions.”

In June 2014, the Environmental Protection Agency (EPA) is expected to release proposed guidelines for reducing CO2 emissions from existing electric generation. This proposal will face significant scrutiny from the electric utility industry, environmental groups, state and federal government agencies, members of Congress, and many others. While we can only speculate on the substance of the proposal, we already know that it will face two significant impediments. First, limitations on EPA’s statutory authority prevent the agency from considering options that economists view as the most efficient, such as a carbon tax. Second, and more vexing, are the complex and problematic electricity market structures throughout much of the country.

There are a host of different market and regulatory regimes throughout the country that vary at both the wholesale and retail level. At the retail level, some states have undergone retail restructuring, and as a result, the utilities no longer own generation. The generation in these states is primarily owned by for-profit companies that sell energy at market prices and are neither under traditional utility ownership nor subject to state price regulation. How can states reduce CO2 emissions when they have little regulatory authority over the markets and the for-profit generation owners? It won’t be as simple as regulating generation owned by utilities.

At the wholesale level, many states are located within the boundaries of regional transmission organizations (RTOs). The greatest barriers to development of new and lower CO2 resources will be for states located in those RTOs that rely on mandatory capacity markets to incent new investment.

The mandatory capacity markets are already floundering over existing challenges, with what seems like a never-ending stream of complaints and modifications being addressed at the Federal Energy Regulatory Commission (FERC). The problem is compounded when states have adopted retail choice in regions that rely on RTO-run capacity markets.

Significant questions have been raised by many market participants about whether these markets are actually impeding the development of an optimal mix of supply and demand-side resources. Restrictions to state-sponsored support of new supply from minimum offer price rules place further impediments to optimizing the array of generation, demand response, and efficiency resources.

If EPA guidelines motivate substantial changes to the industry, these capacity markets will be severely stressed by the added complexity of maintaining reliability while shifting to a lower CO2 emission portfolio. FERC will remain a battleground, with intense pressure from merchant generation owners seeking to maintain high capacity payments at odds with state-backed policies to achieve emission reductions and minimize customer costs.

Given EPA’s limited flexibility in developing guidelines and the problems with mandatory capacity markets, we can’t expect the ideal, economically-efficient outcomes that some might suggest are possible. To counter these problems, the states themselves must be given a high degree of flexibility to achieve these reductions within their specific regulatory and market structures.

CO2 emission reductions are possible. But they will be more difficult and more costly — and have unintended long-term consequences — in the absence of much-needed electric market reform.

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