Flexible Global Carbon Pricing: A Backward-Compatible Upgrade for the Kyoto Protocol

The Kyoto Protocol’s approach of assigning emission targets, or “caps,” promises certainty that it cannot deliver, because it exacerbates problems with international cooperation and commitment. Global carbon pricing addresses these problems and, with less risk and more reward, can generate and sustain stronger policies. This paper proposes a system, “flexible global carbon pricing,” designed to replace the Kyoto Protocol. It provides backward-compatibility with the Kyoto Protocol by allowing un-modified cap and trade as one form of national carbon pricing. Instead of many national “caps,” the proposal sets a global target price for carbon and specifies a pair of incentives. A Pricing Incentive rewards nations that set their carbon price higher than the global target and penalizes nations that underachieve. These rewards and penalties sum to zero by design. The strength of the Pricing Incentive is adjusted automatically so that the global average carbon price converges to the global target price. A Clean Development Incentive (CDI), free from the gaming problems that plague the U.N.’s Clean Development Mechanism, encourages full participation by low-emission countries. An example, based on a $20 price target, causes transfers from the United States of only seven cents per capita per day. Nevertheless, India’s CDI receipts cover its compliance costs. The example shows that low costs can be guaranteed.Kyoto protocol,cap and trade,flexible global carbon pricing,international cooperation

International Climate Games: From Caps to Cooperation

Greenhouse gas abatement is a public good, so climate policy is a public-goods game and suffers from the free-rider incentives that make the outcome of such games notoriously uncooperative. Adopting an international agreement can change the nature of the game, reducing or exacerbating the uncooperative tendencies of the players. We analyze alternative international agreements as variations of the public-goods game, and examine the incentives for cooperation under each alternative. The addition of cap-and-trade rules to the basic public-goods game is found to polarize the free-rider incentives of that game, encouraging those who would abate the most to target even higher abatement levels and those who would abate the least to target lower, and even negative, abatement levels. Such polarization between developed and developing countries is familiar from both the Kyoto and Copenhagen climate summits. Since cap-and-trade rules decrease cooperation by developing countries, developed countries are led to reject the game’s outcome and in the process prevent agreement on a set of quantity targets. To break this deadlock and shift the equilibrium toward cooperation, a modification of the public-goods game based on price rather than quantities is needed. This involves a global price target and equity transfers via a Green Fund that rewards adoption of and compliance with such a target. The Nash equilibrium of one such game is analyzed for a group of three countries similar to the United States, China and India.global warming, climate change, climate treaty, cap and trade, carbon tax, carbon price, public goods

Why We Need to Stick with Uniform-Price Auctions in Electricity Markets

Wholesale electricity markets are commonly organized around a spot energy market. Buyers and suppliers submit bids and offers for each hour and the market is cleared at the price that balances supply and demand. Buyers with bids above the clearing price pay that price, and suppliers with offers below the clearing price are paid that same price. This uniform-price auction, which occurs both daily and throughout the day, is complemented by forward energy markets. In practice, between 80 and 95 percent of wholesale electricity is traded in forward energy markets, often a month, or a year, and sometimes many years ahead of the spot market. However, because forward prices reflect spot prices, in the long run, the spot market determines the total cost of energy. It also plays a critical role in the least-cost scheduling and dispatch of resources, and provides an essential price signal both for short-run performance and long-run investment incentives. Arguments that the uniform-price auction yields electricity prices that are systematically too high are incorrect. However, insufficiently hedged spot prices will result in energy costs that fluctuate above and below the long-run average more than regulated prices and more than is socially optimal. Tampering with the spot price would cause inefficiency and raise long-term costs. The proper way to dampen the impact of spot price fluctuations is with long-term hedging. Although re-regulation can provide a hedge, there are less costly approaches.Auctions, electricity auctions, uniform-price auctions

A Capacity Market that Makes Sense

We argue that a capacity market is needed in most restructured electricity markets, and present a design that avoids the many problems found in the early capacity markets. The proposed locational capacity market pays suppliers based on their demonstrated ability to supply energy or reserves in shortage hours—hours in which there is a shortage of operating reserves. Thus, only supply that contributes to reliability is rewarded. The capacity price responds to market conditions. When capacity is scarce the capacity price is high; when capacity is plentiful the capacity price is low or zero. Market power in the capacity market is addressed by setting the capacity price based on actual capacity, rather than bid capacity, so generators cannot increase the capacity price by withholding supply. Ex post peak energy rents (the short-run energy profits of a benchmark peaking unit) are subtracted from the capacity price. Thus, a supplier does not have an incentive to create real-time shortages—the high shortage price resulting from a shortage is subtracted from the capacity price, so there is no net gain from the high price. By defining a capacity product closely tied to reliability and directly addressing market power both in the capacity market and in the spot energy market, the proposed design results in a market participants can trust to encourage efficient behavior both in the short run and long run.Auctions, Electricity Auctions, Capacity Auctions, Market Design

The Convergence of Market Designs for Adequate Generating Capacity

This paper compares market designs intended to solve the resource adequacy (RA) problem, and finds that, in spite of rivalrous claims, the most advanced designs have nearly converged. The original dichotomy between approaches based on long-term energy contracts and those based on short-term capacity markets spawned two design tracks. Long-term contracts led to call-option obligations which provide market-power control and the ability to strengthen performance incentives, but this approach fails to replace the missing money at the root of the adequacy problem. Hogan’s energy-only market fills this gap. On the other track, the short-term capacity markets (ICAP) spawned long-term capacity market designs. In 2004, ISO New England proposed a short-term market with hedged performance incentives essentially based on high spot prices. In 2005 we developed for New England a forward capacity market with load obligated to purchase a target level of capacity covered by an energy call option. The two tracks have now converged on two conclusions: (1) High real-time energy prices should provide performance incentives. (2) High energy prices should be hedged with call options. We argue that two more conclusions are needed: (3) Capacity targets rather than high and volatile spot prices should guide investment, and (4) long-term physically based options should be purchased in a forward market for capacity. The result will be that adequacy is maintained, performance incentives are restored, market power and risks are reduced from present levels, and prices are hedged down to a level below the present price cap.Auctions, electricity auctions, uniform-price auctions

Price is a Better Climate Commitment

Developing countries justifiably reject meaningful emission targets. This prevents the Kyoto Protocol from establishing a global price for greenhouse gas emissions, and leaves almost all new emissions unpriced. This paper proposes a new pair of commitments—a commitment to a binding carbon-price target and to a Green Fund financed by a form of carbon pricing. The result is global carbon pricing that neither requires developing countries to accept emission caps nor requires industrial countries to accept carbon taxes. The cost of complying with these commitments is subject to far less risk than the cost of an emissions cap, and the combined cost of a $30/ton price target and the Green Fund is only 23 cents per person per day for the United States and is negative for India. The combined advantages should significantly increase the chance that developing countries will commit to a substantial carbon price, and this should increase the chance of cap and trade passing the U.S. Senate.Climate change, carbon pricing, cap and trade, carbon auctions

Global Carbon Pricing: A Better Climate Commitment

Developing countries reject meaningful emission targets (recent intensity caps are no exception), while many industrialized countries insist that developing countries accept them. This impasse has prevented the Kyoto Protocol from establishing a global price for greenhouse gas emissions. This paper presents a solution to this dilemma—allow countries to commit to a binding global carbon-price target. This commitment could be met by cap and trade, a carbon tax, or any combination. This would allow developing countries to accept the same carbon price as the most advanced countries instead of accepting a cap that is as low as U.S. emissions in the 1800s. And it would allow the U.S. and the E.U. to keep their cap and trade schemes. The paper defines a carbon-price target, and shows how compliance could be induced using both carrots and sticks. We also demonstrate that carbon pricing can be guaranteed to be inexpensive under a carbon-price target. A Green Fund is suggested that reinforces rather than subverts cooperation on global carbon pricing. The combined cost of a $30/ton price target and the Green Fund is only 23 cents per person per day for the United States and is negative for India. Together, these advantages should greatly increase the chance that developing countries will commit to a substantial carbon price, and this should increase the chance of cap and trade passing the U.S. Senate. Such a policy would also reduce the world oil price. For China and the United States, this savings might well cover the full cost of the proposed initial climate agreement.Climate change, carbon pricing, cap and trade, carbon auctions

Forward Reliability Markets: Less Risk, Less Market Power, More Efficiency

A forward reliability market is presented. The market coordinates new entry through the forward procurement of reliability options—physical capacity bundled with a financial option to supply energy above a strike price. The market assures adequate generating resources and prices capacity from the bids of competitive new entry in an annual auction. Efficient performance incentives are maintained from a load-following obligation to supply energy above the strike price. The capacity payment fully hedges load from high spot prices, and reduces supplier risk as well. Market power is reduced in the spot market, since suppliers enter the spot market with a nearly balanced position in times of scarcity. Market power in the reliability market is addressed by not allowing existing supply to impact the capacity price. The approach, which has been adopted in New England and Colombia, is readily adapted to either a thermal or a hydro system.Auctions, electricity auctions, capacity auctions, reliability auctions

Colombia Firm Energy Market

A firm energy market for Colombia is presented. Firm energy—the ability to provide energy in a dry period—is the product needed for reliability in Colombia’s hydro-dominated electricity market. The firm energy market coordinates investment in new resources to assure that sufficient firm energy is available in dry periods. Load procures in an annual auction enough firm energy to cover its needs. The firm energy product includes both a financial call option and the physical capability to supply firm energy. The call option protects load from high spot prices and improves the performance of the spot market during scarcity. The market provides strong performance incentives through the spot energy price. Market power is addressed directly: existing resources cannot impact the firm energy price. Since load is hedged from high spot prices, the market can rely on high prices to balance supply and demand during dry periods, rather than rationing.Auctions

Simulation of the Colombian Firm Energy Market

We present a simulation analysis of the proposed Colombian firm energy market. The main purpose of the simulation is to assess the risk to suppliers of participation in the market. We also are able to consider variations in the market design, and assess the impact of alternative auction parameters. Three simulation models are developed and analyzed. The first model (Model 1) uses historical price data from October 1995 through May 2006 to assess the performance risk of hypothetical thermal and hydro generating units. The second model (Model 2) uses historical price and operating data to assess performance risk of the actual generating units in Colombia over the same period. This analysis allows us to assess company risk. The third model (Model 3) differs from the other models in that it explicitly models the firm energy auction and investments going forward. Thus, the model is able to assess how the distribution of firm energy purchases differs from the firm energy target, and how this distribution depends on the firm energy demand curve. Model 3 also studies the investment decisions of suppliers, the impact of lumpy investments, and the impact of a higher scarcity price. Taken together, the simulation results demonstrate the risk reducing benefits of the firm energy market. Provided there is competitive new entry in response to load growth, the firm energy market should work well at coordinating investment in new supply, while minimizing supplier and consumer risks.Auctions