On the meaning of existence

Here at the EI blog, we don’t shy away from addressing the deep questions in energy and environmental economics. With this week’s blog, we tackle the very meaning of existence (with respect to power plants regulated under proposed greenhouse gas emissions standards).

thinkSource (Rodin) ; Source (power plant)

The graph below helps set the stage by summarizing the increasing role of natural gas fueled power plants in the power sector.  The bars indicate EIA projections of new investment in electricity generating capacity (by fuel type) in the United States through 2040. After 2020, the EIA projects that natural gas will account for over 70 percent of new investment.

fig_mt-31Source: AEO2014 Reference case from 2013 to 2040

Importantly, these EIA reference case projections do not reflect recently proposed greenhouse gas standards for power plants.  Whereas new source performance standards are not expected to materially affect new investment decisions, the proposed Clean Power Plan, a centerpiece of Obama’s climate change policy agenda, could heighten the role of new investment in natural gas fired generation.

The extent to which new gas capacity investment is affected by these standards depends in part on the meaning of “existence.” The Clean Power Plan sets emissions standards for existing sources.  Digging into the Regulatory Impact Analysis, an existing source is defined as:

“A fossil fuel-fired electricity generating unit that was in operation or had commenced construction as of January 8, 2014.” 

This means that a natural gas plant that breaks ground today and starts generating electricity (and emissions) in 2015 will not actually “exist” in the eyes of the EPA for the purpose of administering these existing source standards.  This non-existence factor has potentially significant implications for future investments in new natural gas capacity.

New investments under existing source standards

To think intuitively about how the proposed emissions standards for existing sources could affect the decision to invest in new natural gas generation, let’s review some basic mechanics of the rule.

Under the proposed Clean Power Plan, the EPA has defined state-specific emissions standards in terms of a ratio that can be summarized approximately as the CO2 emissions from sources covered by the rule divided by the sum of electricity generated at covered sources plus energy saved via demand-side efficiency improvements:

rate

Note that electricity and emissions generated at a “new” fossil plant do not factor directly into the rate calculation above.[1]  In fact, investing in new, relatively clean natural gas generation will reduce the emissions intensity of a state’s electricity generation if it displaces production at more emissions intensive plants.  By excluding new fossil generation from the rate-based standards that define compliance, the effect of new gas investment on emissions intensity is not fully captured.

The punch-line: The rate-based standard defined above lowers the incentive to invest in new, relatively clean natural gas plants as a means of reducing emissions (versus a standard that covers both new and incumbent sources).

Things get more interesting when you consider that, under the proposed Clean Power Plan, states have the ability to convert their rate-based standard into a mass-based cap on emissions from existing sources. In this scenario, any electricity produced at a new source will not count against the emissions cap.  In contrast to the rate-based standard, excluding new capacity from a mass-based standard exaggerates incentives to invest in new natural gas generation because it allows a state to move electricity generation – and emissions – out from under the emissions cap.

An existential problem worth worrying about?

It is relatively straightforward to think about how a rate-based (or mass-based) standard could distort investments in new gas generation under the proposed rule. It is not so straightforward to assess the extent to which these incentives might actually affect real-world investment decisions.

Enter Dream Team Bushnell/Holland/Hughes/Knittel (aka BHHK)

In a recent – and impressive! – working paper, BHHK analyze, among other things, the potential effects of the Clean Power Plan (CPP) on power sector operations in the Western United States.

The authors develop a model of electricity production that they calibrate using data from the western interconnection and the emissions standards proposed in the CPP. They use the model to simulate investment in new combined cycle gas turbines under alternative policy scenarios. The results are striking.

In a scenario in which all states adopt a mass-based standard, excluding new fossil capacity investments from the regulation almost doubles the amount of new natural gas capacity due to the distorting investment incentive discussed above.  Conversely, under a rate-based scheme, new investment is reduced by 20 percent when new gas capacity is excluded (versus included) from the regulation.

Perhaps more concerning, these distortions are greatly exacerbated under a highly plausible scenario in which some states adopt a rate-based standard while others convert to a mass-based target.  In this scenario, new investment will occur in the rate-based regions if it is included under the CPP, but shifts dramatically to mass-based regions if excluded from the rule.

Should we redefine the meaning of existing?

What can be done to mitigate the extent to which the proposed policy distorts investment incentives?  Here is where things get murky for someone without a law degree.

Take, for example, the Clean Power Plan scenario most preferred by many economists in which all states adopt a mass-based standard.  In this case, it is clearly preferable to bring both new and existing sources under the regulation in order to eliminate the incentive to over-invest in new, uncapped natural gas capacity.  This could be achieved explicitly by redefining “existing” to mean any plant that physically exists.  Or it could be achieved implicitly by requiring states to offset any emissions from new sources at “existing” sources.

This seems like a simple fix. But there is much ambiguity and nuance surrounding EPA’s ability to expand the scope of existing source standards (implicitly or explicitly). Different legal scholars seem to have different opinions about what is/is not possible under the auspices of the Clean Air Act.

Presumably, the rationale for keeping new source regulations distinctly separate from existing source standards is to avoid redundancy and unnecessary overlap in regulatory requirements. In this case, subjecting new sources to both new and existing source standards is not redundant. New source standards ensure any new plants that are built will meet mandated performance standards. But the level and location of this new capacity investment will depend on how these investments are factored into compliance with existing source standards. These are long-lived investments, so getting the incentives right (or wrong!) will have lasting implications.

[1] The indirect effect of new investment on the emissions rate used to determine compliance will depend on the relative emissions intensity of any “existing” generation that is displaced by the new capacity.

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One Response to On the meaning of existence

  1. An analysis performed by OnLocation, Inc., (http://onlocationinc.com) supports Ms. Fowlie’s conclusion that “these distortions are greatly exacerbated under a highly plausible scenario in which some states adopt a rate-based standard while others convert to a mass-based target. In this scenario, new [natural gas] investment will occur in the rate-based regions if it is included under the CPP… “

    Our analysis used an OnLocation version of the National Energy Modeling System (NEMS) that allows the user to create a mix of regional CO2 policies, some rate-based and others mass-based, as may occur under the EPA’s proposed Clean Power Plan. In one scenario performed by OnLocation, we set all regions to be mass-based except one region where we imposed a target emissions rate that would favor new natural gas combined cycle (NGCC) generation. We assumed that all fossil generation, including new natural gas generation, could be used to meet the requirements of the CO2 policy. We also assumed that emissions credit trading was not allowed between the rate-based region and the mass-based regions, but electricity trading was allowed as in a business-as-usual case.

    The results of this scenario were striking. The rate-based region built large amounts of new NGCC capacity, resulting in excess generation that was exported to neighboring mass-based regions. The rate-based region benefitted from the excess natural gas generation, which improved its ability to meet the target emissions rate and reduced the need to retire more carbon-intensive sources such as coal generation. Conversely, the mass-based regions benefitted by importing clean generation that could be used to reduce generation from more carbon-intensive sources. However, the resulting emissions from the rate-based region increased rather than decreased as originally intended, and the resulting net CO2 emissions across all regions were higher than in similar scenarios where all regions were treated the same, either mass-based or rate-based.

    While there may be safeguards that can be built into the final regulation, it is important to note that unintended consequences, such as increased emissions, can occur when states are free to create programs with very different policy incentives.

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