Corporate Environmental Policy Market-Based GHG Reduction Policies Frank Harris, PhD Manager – Corporate Climate Policy Southern California Edison Presentation to Southern California Alliance of Publicly Owned Treatment Works October 22, 2009

Page: 1 Corporate Environmental Policy  A “market-based” solution, such as a cap-and-trade program enables regulated entities to pursue the lowest cost compliance option. Entities able to reduce emissions at relatively low cost will “sell” abatement to higher cost entities. Total social cost of abatement is minimized under optimal conditions.  Emissions allowances can be auctioned or allocated directly into the market. A well designed allocation process will not influence future environmental choices.  Imposing command and control regulations on entities also obligated under a cap-and-trade program will increase the overall cost of reducing emissions. However, the cost of allowances in the cap-and-trade market can be expected to fall.  An ideal cap-and-trade program would broadly include all emitting sectors. Transaction costs may cause some sectors to be excluded.  Offsets are reductions provided by entities outside of the cap-and-trade program. Reductions obtained via offsets that are “in the money” would also be selected if the entities were covered under the cap-and-trade program. Today’s Discussion

Page: 2 Corporate Environmental Policy Market based policies utilize price signals to efficiently achieve a regulatory goal. Public policies to reduce GHG emissions are inherently based on governmental mandates. Market-based policies create “price signals” and then allow individual regulated entities the flexibility to respond to these signals on a decentralized basis. Commonly referenced market-based policies include:  Emissions taxes  Tradable emission allowances Including certain complementary policy instruments: Offsets: Allowances created outside the directly regulated sectors Safety Valves: Supplementary allowances sold at a given “trigger” price Price floors: Government is buyer of last resort of allowances at a special floor price SCOPE OF MARKET-BASED POLICIES

Page: 3 Corporate Environmental Policy In a cap-and-trade program, abatement occurs where it is most efficient, not by direct mandate.  Equiproportional Abatement A mandate requiring all regulated entities to reduce emissions by the same proportion, regardless of cost.  Equimarginal Abatement The result of a market-based program in which the marginal cost of abatement is identical across all regulated entities.  When equimarginality is achieved, the total cost of reducing emissions is minimized  A cap-and-trade program is more likely to minimize total abatement cost if it includes all emitting entities  A cap-and-trade program works best when there are a variety of technical solutions available No central agency can possibly know of all possible compliance solutions. Entities that cannot reduce directly will benefit from the abatement of other capped entities. ABATEMENT UNDER CAP-AND-TRADE

Page: 4 Corporate Environmental Policy Equiproportional Abatement May Seem Fair... $/ton Marginal Cost of Abatement Company A 50% 100% Pollution Abated (Tons) $/ton Marginal Cost of Abatement Company B 50% 100% Pollution Abated (Tons) In this example, all companies are required to cut their emissions in half. But since the cost of abatement is not the same for each company, total abatement costs are not minimized.

Page: 5 Corporate Environmental Policy... But equiproportional abatement is not economically efficient. $/ton Marginal Cost of Abatement Company A 50% 100% Pollution Abated (Tons) $/ton Marginal Cost of Abatement Company B 50%100% Pollution Abated (Tons) Level of Equalized Marginal Cost Increased Abatement Costs Reduced Abatement Costs Economic efficiency requires the equalization of the marginal cost of abatement. In a cap-and-trade market, company A is encouraged to abate more while Company B abates a corresponding amount less.

Page: 6 Corporate Environmental Policy An emissions tax can equalize the marginal abatement cost, but cannot ensure a specific level of abatement. $/ton Marginal Cost of Abatement Company A $/ton Marginal Cost of Abatement Company B Per Ton Tax Paid Tax Paid Abatement Undertaken “Residual” Pollution Abatement Undertaken “Residual” Pollution 100% All companies see the same per-ton tax and, therefore, they undertake emissions abatement to the same level of marginal abatement costs. EMISSIONS TAX

Page: 7 Corporate Environmental Policy By distributing allowances equal to the cap, CARB ensures that the AB-32 emission target is met Emissions 2005 Emissions Potential Intermediate Points of Regulation 2020 Allowed Emissions Remain at Capped Level Until 2050 Target is Enforced “Business as Usual” Emissions Forecast Cap = 1990 Emissions The “ramp rate” ?? 2050 Baseline for 2050 Cap 80% Below 1990

Page: 8 Corporate Environmental Policy  Allowance allocation should not compromise the integrity of the carbon price. Allocations should not change as a result of future incremental production. Customer benefits from allocation should not be realized through reduced volumetric costs.  Allocating allowances should create a different financial result than that obtained by allocating auction revenue rights. The monetized value of direct allocation should equal the realized auction revenue from an ARR structure. CARB may be unable to distribute auction proceeds without legislative approval. ALLOCATION BASICS The allocation method has a direct impact on the cost of a cap-and-trade program to the regulated entities.

Page: 9 Corporate Environmental Policy Direct abatement behavior is a function of relative marginal abatement costs and is independent of the allocation method. P = $/ton Additional Abatement Costs Undertaken Company A Initial Allocation The market clearing allowance price will be the same for both firms. Decremental Abatement Costs Avoided Initial Allocation Company B Abated Pollution (Tons) Abated Pollution (Tons) Independent of allocation method, entities with lower abatement costs will undertake additional abatement and sell their unneeded allowances to those companies with higher abatement costs. ABATEMENT AND ALLOCATION P* P = $/ton

Page: 10 Corporate Environmental Policy PG&E, SEMPRA and LADWP favor an allocation scheme based on historical production.  PG&E and SEMPRA favor a direct allocation based on historical electricity sales. PG&E supports a 15% carve out to fund new technology.  LADWP favors a direct allocation based on historical emissions. Suggests that a sales based allocation amounts to a direct transfer from POU to IOU ratepayers.  SCE favors an allocation, or the allocation of auction revenue rights, in a manner that minimizes economic harm. ALLOCATION PREFERENCES CARB may face legal or political restrictions on its ability to distribute auction proceeds.

Page: 11 Corporate Environmental Policy RATEPAYER ECONOMIC HARM Price Before ILLUSTRATIVE PURPOSES ONLY Price $/MWh MWh Ratepayer Harm Price After Price Increase = M.E.R P GHG Ratepayers suffer economic harm as electricity costs increase to fund allowance auctions. Allocating to LSEs on behalf of their ratepayers can mitigate the ratepayer harm. To maintain the environmental integrity of the carbon price, this economic value must not be provided to ratepayers on a volumetric basis.

Page: 12 Corporate Environmental Policy Generators incur economic harm when the electricity market does not allow full recovery of allowance auction expenses. Marginal Emissions Rate ILLUSTRATIVE PURPOSES ONLY Emissions Rate (mton/MWh) MWhNuclear Renewables Natural Gas Marginal Unit Coal Additional Profit Harm GENERATOR ECONOMIC HARM Generators with emissions rates equal to or less than that of the marginal unit incur no economic harm and thus need no direct allocation. Higher emitting units cannot pass all of their emissions costs to their buyers and incur economic harm as a result. Wholesale electricity prices will increase by the emissions rate of the marginal unit times the allowance price.

Page: 13 Corporate Environmental Policy Emissions offsets allow regulated entities to utilize emission reductions achieved outside the regulated sector. Baseline Sector Emissions Offsets Cap Level Controlled Sector Emission reductions in uncapped sectors effectively increase the number of allowances in the capped sector, although total emissions are unaffected. Offsets are ideally suited to GHG emissions because these emissions quickly disperse in the atmosphere. Restrictions on offsets will increase the cost of compliance EMISSIONS OFFSETS BAU Reduction from BAU creates “Offsets” usable as allowances in the capped sector. Uncontrolled Sector

Page: 14 Corporate Environmental Policy Emissions offsets provide an opportunity for regulated entities to indirectly reduce emissions at a lower cost than direct reductions. $/ton Allowances Issued Tons Emitted Total Allowances Issued Offsets “Supply” Curve “Demand” For Emissions (Willingness to pay for allowances or offsets) Offsets Purchased Allowances Price w/o Offsets Allowance/ Offset Price w/ Offsets THE ECONOMICS OF OFFSETS Baseline Emissions Direct Abatement

Page: 15 Corporate Environmental Policy Imposing command and control regulations on sectors covered by a cap-and-trade program effectively imposes constraints on the set of possible abatement options. $/ton Tons Emitted Total Allowances Issued Restricted demand Unrestricted demand for emission reductions Unrestricted allowance price Allowance price with direct mandates CAP-AND-TRADE AND COMMAND-AND-CONTROL Imposing direct mandates on capped sectors will cause the abatement demand curve to shift inward to match the amount of abatement achieved through direct mandates. Abatement due to direct measures

Page: 16 Corporate Environmental Policy The economic burden of a cap-and-trade program may vary across industries.  The economic burden of the GHG regulation will not necessarily be borne simply by the business at the point of regulation Much like a sales tax does that not simply affect the business whose sales are directly taxed: This is a question of tax “incidence”  The burden of the regulation will be determined primarily by two factors: The manner in which the government distributes allowances or auction revenue The ability of regulated entities to pass along to their consumers the higher costs of their products. This will depend mainly on the price elasticity of demand for their products (availability of substitutes, etc.) DISTRIBUTIONAL IMPACTS

Page: 17 Corporate Environmental Policy  A “market-based” solution, such as a cap-and-trade program enables regulated entities to pursue the lowest cost compliance option. Entities able to reduce emissions at relatively low cost will “sell” abatement to higher cost entities. Total social cost of abatement is minimized under optimal conditions.  Emissions allowances can be auctioned or allocated directly into the market. A well designed allocation process will not influence future environmental choices.  Imposing command and control regulations on entities also obligated under a cap-and-trade program will increase the overall cost of reducing emissions. However, the cost of allowances in the cap-and-trade market can be expected to fall.  An ideal cap-and-trade program would broadly include all emitting sectors. Transaction costs may cause some sectors to be excluded.  Offsets are reductions provided by entities outside of the cap-and-trade program. Reductions obtained via offsets that are “in the money” would also be selected if the entities are covered under the cap-and-trade program. Summary

Corporate Environmental Policy QUESTIONS? Frank Harris, PhD Manager – Corporate Climate Policy Southern California Edison