Carbon Market Analyst

North America

The Power of Carbon

RESEARCH July 18, 2008

TO THE POINT CONTENT

The US will most likely be operating in a carbon-constrained 2 Executive summary
economy in the near future as both presidential candidates 3 What future carbon constrained
favor a greenhouse gas cap-and-trade system to reduce
domestic emissions. economy?
4 Carbon and Power
Implications of such a system includude increases in the price
of electricity and transportation fuels, as the emitters and fuel 10 Carbon and Transportation Fuels
providers must account for the cost of carbon associated with 13 Conclusions
their product.
14 Contacts
Increases in electricity prices will be more drastic in coal-
heavy regions. This is especially true for deregulated power
markets where the fuel on the margin determines the
electricity price.
In regulated power markets, public officials will have a
certain degree of control over the carbon-induced power
price increase, as they may limit the degree to which fossil fuel
fired generators can pass the cost of carbon on to consumers
in the form of higher rates.
In the transportation sector, carbon caps will make biofuels UPCOMING REPORTS
more price-competitive with their fossil-derived counterparts.
Our analysis looks at an expanded scope of regulation in the
transportation sector that may exist in future cap-and-trade • Pre-emptive strike: The Future of
proposals. Regional Carbon Trading Programs
in the US
If fuels are regulated according to their lifecycle carbon • RECs and the Carbon Market
emissions, certain types of biofuels will become more • North American Offset Supply
competitive and the profit margins of the most energy-
intensive fossil fuel producers would narrow.

POINT CARBON RESEARCH All rights reserved © 2008 Point Carbon

Carbon Market Analyst North America CMA July 18, 2008

Executive summary
In this issue of Carbon Market Analyst North America, we take a look at the implications of impending carbon constraints
on energy commodities: electricity and transportation fuels.
Current legislative proposals for combating climate change in the US include a greenhouse gas cap-and-trade system
that would include emissions from the power and transportation sectors. We use the most recent such proposal, the
Lieberman-Warner bill, to exemplify a future carbon trading regime in the US and explore its implications for the power
and transportation sectors.
Cap-and-trade’s most immediate effect in the power sector is to alter the price differential among fuels used to produce
electricity. The price of natural gas and oil will go up because refiners will have to submit allowances for those fuels’
carbon emissions. Coal-fired power generators will have to submit allowances for the emissions associated with their
coal combustion. The cost differential between coal and natural gas in power generation will narrow following this
inclusion of a carbon price, which will incentivize “fuel-switching” from coal to natural gas on the margin.
Increases in electricity prices will be more drastic in coal-heavy regions. This is especially true for deregulated power
markets where the fuel on the margin determines the electricity price. In regulated power markets, public officials
could have some control over the retail power price increase, as they may limit the degree to which fossil fuel-fired
generators can pass the cost of carbon on to consumers in the form of higher rates.
In the transportation sector, refiners and processors of fossil fuels would have to pay for the emissions that will occur
when the fuel is burned. In a carbon-constrained economy modeled after the Lieberman-Warner bill, fossil fuel prices
would rise while all biofuels would become more competitive.
Policymakers are increasingly aware of the differentiated environmental effects of energy crops, meaning that the
way biofuels are regulated may change in future cap-and-trade proposals. Such a change could involve expanding
the compliance burden in a cap-and-trade system to refiners and importers of all fuels, requiring them to surrender
allowances for the lifecycle emissions of their products.
Under that regulatory scenario, the relative prices of fuels would be differentiated beyond the fossil fuel - biofuel
divide. Some types of biofuels would become more competitive relative to others, facilitating an overall reduction in
average fuel carbon intensity.

Setting the scene there will be a complex market once

With both US presidential candidates
in favor of addressing the problem of
climate change by implementing a
cap-and-trade system to reduce US
greenhouse gas emissions, a carbon-
constrained US economy is likely in
the near future.
Businesses in all sectors are
bracing themselves for what this
means to their bottom line, and
consumers wonder how it will affect
their pocketbook. Setting a cap on
greenhouse gases and monetizing
each ton emitted makes carbon a
commodity – a commodity for which
the rules of trading are set.
Setting a cap on
greenhouse gas
emissions makes
carbon a commodity
The price of carbon will have direct
and significant effects on the price of
other commodities, particularly those
in sectors that are the largest sources
of emissions: power generation and
transportation fuels.
Overall in the US, burning the fuels
needed for electricity generation
and transportation causes nearly
three-fourths of the country’s total
emissions. Putting a price on these
emissions will raise the price of fuels
with which we tank our cars and
influence the economics of energy
markets, favoring less carbon-
intensive electricity generation.
In this Carbon Market Analyst North
America, we explore the impact
of potential US carbon emissions
regulation on electricity prices and
the relative costs of transportation
fuels, showing what the market for
these commodities could look like
in a future carbon-constrained US
economy.

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Carbon Market Analyst North America
What future carbon-
constrained economy?
Several proposals to implement a
cap-and-trade system have been
introduced in the US Congress,
each with differing reduction
timelines, points of regulation, and
allocation structures. We base our
calculations on the proposal that
made it the farthest toward actual
implementation, the Lieberman-
Warner Climate Security Act that was
briefly debated on the Senate floor in
June 2008.
Although this bill failed to pass a cloture
vote, it is the best available indication
of what policy might be adopted
under the next administration: several
of its components will be included
in a successor bill on cap-and-trade,
which both presidential candidates
would be likely to sign into law.
Both presidential
candidates would be
likely to sign a successor
bill into law
The Climate Security Act would
impose a limit on over 80
percent of US carbon emissions,
including electricity generation
and transportation. While the bill
regulates these emissions from coal-
fired power plants directly, it covers
the emissions associated with other
fuels (natural gas and transport fuels
such as gasoline) further upstream,
at the refinery or fuel import level
(see Textbox 2).
This means that while coal-burning
power plants must surrender
allowances (or carbon emission
permits) for each ton of carbon
dioxide equivalent (CO2e) they emit,
emissions from cars and natural
gas-fired generation are accounted
for by the provider of that fuel – the
refiners and processors must submit
an allowance for every ton of CO2e
that will be emitted when that fuel is
burned.
3 All rights reserved © 2008
CMA July 18, 2008
The compliance obligation on the part Assuming a possible near-term cost
of emitters and fuel providers changes of carbon derived from analyses of
the current cost ratios in markets the Lieberman-Warner bill, we show
for power and fuels, as generating some of the effects of this cost on
electricity by burning coal becomes regional electricity prices as well as
relatively more expensive compared fuel price spreads.
to lower-carbon sources - just as
gasoline or diesel becomes more The timeframe we look at represents
expensive relative to lower-carbon the initial years of the proposed US
fuels like ethanol or biodiesel. carbon market, during which the
Textbox 1: The price of carbon in 2012
The US Environmental Protection Agency (EPA) published a detailed
analysis of the Lieberman-Warner bill in March 2008, including projected
per-ton prices of carbon given various policy and fuel cost scenarios. The
agency came up with a range of carbon price estimates over the 2012-2050
period covered by the bill, based on Computable Generalized Equilibrium
models.
These models, with acronyms IGEM and ADAGE, forecast expected
allowance prices based on economic activity, fuel prices, technology
development, carbon offset availability, and several other factors. Using
different scenarios containing a mix of these parameters, the EPA models
revealed possible carbon price curves throughout the 2012-2050 period.
100
90
80
EPA - LW IGEM
70
EPA - LW ADAGE
Price ('05 $/ton)
60
50
40
30
20
10
0
2010 2012 2014 2016 2018 202 0 202 2 2024 2026 2 028 2 030
Year
Source: EPA 2008
The initial price estimates for the start of the bill’s cap-and-trade program
in 2012 were $24.20 per ton CO2e in the low estimate and $33.40 on the
high end – we take the average, $28.80, as a central carbon price estimate
in 2012.
This price fits within the range of another component of the Lieberman-
Warner bill, a so-called cost-containment auction through which the EPA
administrator would sell allowances ‘borrowed’ from the period after 2030
to emitters during the early years of the program. According to the bill,
regulators should sell the allowances in this auction at a price between $22
and $30 initially.
Point Carbon
Carbon Market Analyst North America
obligation to surrender emissions
allowances for emissions will have
just entered into force (2012-2015).
The price we use as representative
for the cost of a ton of CO2e at
that time ($28.8) is derived from
US government analyses of the
Lieberman-Warner bill (see Textbox
1).
Carbon and Power
The effect of a $28.80 per ton
carbon price on 2012 electricity
costs will vary by region, depending
on the respective states’ generation
mix, transmission grid, and whether
its power market is regulated or
deregulated.
Fuel mix
A region’s fuel mix is the primary
factor determining the extent to which
carbon costs add to power prices.
Conventional power generation
from coal is more greenhouse gas
intensive than any other type of
fossil-fueled generation, so the cost
of producing power under carbon
constraints increases more for coal-
heavy producers than for those
burning other fossil fuels.
As shown in Table 1, the cost of
electricity from coal would increase
by over 30 percent if emissions are
accounted for and passed through
to the consumer, while the cost of
generating power from oil and natural
gas would increase only 11 and 9
percent, respectively.
Table 1
Generation type Carbon intensity
(lbs CO2e /MMBtu)
gas 115
oil 174
coal 210
Source: EIA, Nymex
4 All rights reserved © 2008
The prices shown in the table are
actual exchange-traded fuel futures
from late June 2008 for typical plant
efficiencies, representing the “carbon-
added” scenario under one set of
conditions. The adjusted fuel cost for
each plant will change depending on
actual fuel prices in 2012.
Generating electricity
by burning coal be-
comes more expensive
The US gets roughly half its electricity
from coal, but coal makes up a
different percentage of the generation
mix in each state.Pacific Northwest,
for instance, is supplied largely by
hydroelectric power, dampening
the carbon-induced power price
increase in that region. West Virginia
and Kentucky, however, get over 90
percent of their power from coal,
amplifying the effect of carbon costs
on energy prices.
California’s in-state power generation
is nearly 50 percent natural gas, which
emits roughly half the carbon per unit
of energy as coal. However, the state
imports 20 percent of its electricity
from coal-heavy neighbors like Utah
and Nevada, whose generation mix is
among the most carbon-intensive in
the nation.
Coal makes up a
different percentage
of the generation mix in
each state
Typical heat Fuel cost
rate (Btu/kWh) ($/MWh)
8000 104
12300 208
10800 65
CMA July 18, 2008
In states where power comes
mainly from fossil fuels, wholesale
electricity costs will increase under
a carbon-capped economy. But
that power price increase will not
be uniform: the “spread” between
current power prices and those
adjusted to include the additional
cost from carbon is largest where
the generation mix is most coal-
heavy.
Spread varies by season
Figure 1 illustrates this difference
in power price spread for two
existing power markets – the
more coal-heavy PJM region
in the eastern mid-Atlantic and
New England’s more natural gas-
dependent power market.
The bottom curves represent real
traded forward prices for peak
power in these regions, while
the top lines represent that same
generation with the carbon price’s
increased cost of fuel included in
the price.
The increase in
power prices will
not be uniform
The width of the bands,
representing the spread between
electricity prices and their carbon-
adjusted equivalent, is narrower
in New England than in the PJM
region. This is because coal is on
the margin more often in PJM
(Figure 1a), while lower-carbon
$/MWh increase Carbon adjusted fuel
due to CO2 cap cost ($/MWh)
10 114
27 235
28 93
Point Carbon
Carbon Market Analyst North America
Figure 1: Different spreads for different generation mixes - The cost differential between electricity with carbon constraints and
without is larger where coal is more often on the margin
180
160
140
$/mwh
120
100
80
Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09
PJM On Peak with CO2e
Source: NyMex, PJM, ISO-NE
natural gas is almost always the fuel
on the margin in New England.
Though it is less visible on the graph,
both bands representing the cost
spread are slightly narrower during
peak demand seasons, especially in
summer when gas is more frequently
on the margin. The cost differential
between PJM’s power prices and
carbon-adjusted power prices is only
$20-$21 per MWh in the hot months
of July and August, when natural gas
fired plants are running to power air
conditioning units across the region.
The so-called shoulder months
of March and April, on the other
hand, would see a price differential
between $22 and $23 per MWh.
Average demand for electricity is
lower during these months, as homes
and industries require less power for
heating or cooling overall. Therefore
fewer natural gas-fired peaking
plants are run and the fuel mix in both
regions is more coal-heavy.
The same differential would develop
regionally, between the eastern,
5 All rights reserved © 2008
180
160
140
$/mwh
120
100
80
Jul-08
PJM OnPeak
gas-heavier portion of PJM and the
western, coal-heavier parts.
Provisions limit impact on
electricity prices
But the effect of fuel carbon intensity
on the cost of producing electricity is
not the only thing that affects what
consumers see on their utility bills.
The Lieberman-Warner bill aims to
lessen the need for power firms to
pass on their higher generation costs
to consumers. It provides so-called
transition assistance to fossil fuel-
fired power generators, in the form
of free emission allowances.
The power price
spread is lower
in hotter months,
when gas is more fre-
quently on the margin
The administrator of the US
Environmental Protection Agency
(who would run much of the US
carbon trading program) would
CMA July 18, 2008
Oct-08 Jan-09 Apr-09 Jul-09 Oct-09
ISO-NE OnPeak with CO2e ISO-NE OnPeak
distribute a certain percentage of
the country’s emissions permits to
fossil-fired facilities for free, rather
than requiring companies to buy
them from the government. The
number of allowances generators
would receive is proportional to their
carbon intensity.
The Lieberman-Warner cap-and-trade
design decreases the total amount
of transition assistance distributed
over the years, such that by 2030,
generators do not receive any free
allowances at all. At the bill’s required
start of carbon trading in 2012,
however, fossil fuel-fired generators
would get a full 18 percent of the
total US allowance budget from
the government. This accounts for
40 percent of the emissions from
fossil fueled generators expected
emissions in that year, leaving 60
percent to be purchased.
How regional regulators allow
generators to pass on the cost of
these allowances in their electricity
rates will determine the cap-and-
trade program’s effect on retail
Point Carbon
Carbon Market Analyst North America CMA July 18, 2008

power prices. Therefore, state public

utility commissions and other energy
regulators have some degree of
control over the power price effects
of federal carbon legislation.
Regulated power markets
In states where energy markets are
regulated, public utility commissions
(PUCs) determine the rates
companies are allowed to charge
for their power. They could allow
generators to recover the cost of
their allowances entirely, or limit the
carbon cost “pass-through” to the
amount of allowances that actually
had to be purchased.
To illustrate the effect of PUC
decisions on this point, figures 3 and
4 show two potential impacts on
electricity prices in regulated states.
Fossil fuel-fired gen-
erators would get 18
percent of the US
allowance budget for free
In the scenario illustrated by figure 3,
PUCs would allow full cost recovery
(total carbon cost pass-through) for
power generators having to comply
with Lieberman-Warner’s carbon
caps by purchasing allowances for
Figure 2: How much do emitters get for free? “Transition assistance” to electric
power generators would cover about 40 percent of their emissions
US allowance budget in 2012: 5.8 billion tons
60% Expected US emissions from fossil fuels
in 2012: 2.6 billion tons
18% 40% Allowances covered by transition
assistance: 1.04 billion
their emissions. The incremental emissions permits they had to buy
cost of electricity is calculated from (60 percent).
the states’ average emissions rate,
under the assumption that assets in We determined each state’s individual
“allocation rebate” from transition
regulated markets are able to recover
their costs. assistance – again based on its
percentage of fossil fuels and their
In the figure 4 scenario, PUCs respective carbon intensity – and
recognize that nearly half of the subtracted its monetary equivalent
allowances needed to cover those in terms of incremental electricity
costs were given out to generators cost to get the net retail price of
for free, so they only allow power power accounting for a limited pass-
companies to pass on the cost of through.

Textbox 2: Point of regulation - Who gets hit with the cost of carbon?
Carbon constraints play out differently
depending on where they are applied.
Policy makers generally distinguish
between downstream regulation,
which affects the entity that actually
emits the carbon into the atmosphere,
and upstream regulation, which holds
entities closer to the source of fossil
fuel responsible for the emissions it
will cause when burned.
Europe’s emissions trading program
covers only electricity and industry,
so it caps actual emissions from
those sectors. Installations (power
plants and industrial facilities) must
surrender an allowance for each ton
of CO2 emitted. But when the trading
system covers the transportation
sector as the Lieberman-Warner bill
does, some upstream regulation is
required because the government
cannot track emissions from (and
require allowances for) every single
car or truck.
Proposals to include transportation
under a cap therefore regulate the
fuel production chain by requiring that
producers, refiners, or distributors
of a fuel surrender allowances for
its carbon content. The Lieberman-
Warner bill regulates processors or
refiners for all fuels except coal.
For the power sector, this means that
coal-burning power generators must
pay for their emissions, while plants
that burn oil or natural gas are covered
indirectly through higher fuel prices:
the refiners and processors who had
to surrender allowances for the fuels’
emissions will presumably recover
those costs by charging more.
Regardless of fuel type, the carbon
cost eventually reaches ratepayers,
as generators pass down the added
cost of allowances or the increased
cost of fuel to their customers in the
form of higher electricity rates.

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Carbon Market Analyst North America CMA July 18, 2008

The figures show that if regulators

restrict the ability of utilities to pass Figure 3: A full carbon cost pass-through Carbon price increases in regulated
on the cost of the carbon for which electricity markets, assuming full cost recovery from generators at $28.80/ton carbon price
they were compensated through
transition assistance, there is a much
< 5 $/MWh
lower price impact on ratepayers.
5 – 10 $/MWh

10 – 15 $/MWh
The two figures represent bookends in 15 – 20 $/MWh
a range of possible scenarios, as it is 20 – 25 $/MWh
uncertain what degree of “carbon cost > 25 $/MWh
pass-through” officials will consider
fair. Regulators’ decisions will be most
influential in regions highly dependent
on fossil fuels. Non-emitting power
sources like hydroelectric dams and
nuclear power plants will receive no
transition assistance allowances,
but will also not be required to buy
emission permits for which they could
pass costs through to ratepayers.
Figure 4: Limited carbon cost pass-through Price increase in regulated electricity
No great price in- markets assuming cost pass-through is limited to 60 percent of allowances at $28.80/ton
crease for regions carbon price
with hydro and other < 5 $/MWh

renewables 5 – 10 $/MWh

5 – 10 $/MWh

15 – 20 $/MWh

Hydro-heavy pacific northwest states 20 – 25 $/MWh

of Idaho, Oregon and Washington > 25 $/MWh

would experience no great increase

in power prices in either scenario, as
most of their power generators will
not have to purchase allowances or
face higher fuel costs under carbon
caps. The wholesale power price
increases in those states would be $2,
$6, and $4.70 per MWh, respectively,
whereas limiting carbon cost pass-
through would change those increases
those states. public officials in the US could lean
to $1.80, $5.20, and $4.40.
toward a rate-setting scenario that
Regulators may be influenced by
In contrast, the increase in power resembles figure 4.
evidence from Europe’s carbon
prices in Kentucky and West Virginia in
market, which indicates that utilities
the east, as well as Utah and Colorado
made so-called windfall profits by
Regulators’ deci-
in the west, will depend strongly on sions will be most
passing the cost of carbon on to
the degree to which coal-fired power
plants are allowed to recover costs of
their customers through increased influential in regions
rates even though all their emission highly dependent on fos-
emission allowance from ratepayers.
allowances were given out for free.
sil fuels
The wholesale power price increase
European power firms justify the cost
under our scenario would amount Note that our depiction of power
pass-through, arguing that keeping
to $26.90 per MWh in Kentucky and price increases by state is an
allowances rather than selling them
$27.80 in Utah, whereas limiting the oversimplification, as all regional
represents foregone revenue. To
degree of carbon cost pass-through power grids are connected through
avoid this situation of power firms
would confine retail power price transmission lines. In actual power
passing on costs they did not incur,
increases to $16.60 and $16.80 in markets, the colors would be

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Carbon Market Analyst North America CMA July 18, 2008

blurred according to which system

operator, transmission grid, and Figure 5a: Typical dispatch order without carbon caps
power market the respective area
falls under – power prices do not
change at state borders, but at utility

Short Run Marginal Cost $/MWh

service areas. Load curve

Other influences on retail power prices Peakers

not shown here include potential
additional transition assistance to rural
electric cooperatives (such a provision
is included in the Lieberman-Warner
bill) as well as some form of overall Gas
financial assistance to low-income Nuclear
electricity ratepayers, to compensate Coal
Hydro/Wind/Renewables
them for a general power price
increase. Capacity in MW

Deregulated power markets

Figure 5b: Adding the cost of carbon The boxes on fossil-fired plants represent power
Prices in deregulated electricity price increase incurred by accounting for CO2 emissions.
markets are set by the fuel on the
SRMC
margin, meaning the last (most
$/MWh
expensive to run) unit of power used
to meet demand. The price bid by
the generator supplying this last unit Peakers
of power sets the price paid to all
generators in the market.
Price
Figure 5 illustrates the dynamics increase
of carbon costs with marginal Gas
Emissions
pricing. Gas is on the margin in a
typical electricity “stack” (figure Coal
Nuclear
5a) where the location of the load
curve determines the price of power. Hydro/Wind/Renewables
The boxes on top of the original
Capacity in MW
coal and gas prices in figures 5b
and 5c represent the added cost of
producing power from these fuels Figure 5c: Carbon-induced fuel-switch The least-efficient coal plant becomes more
under carbon caps. expensive to run than the most efficient gas plant, changing their respective dispatch order.

Under these carbon-capped SRMC

conditions, the last, most costly- $/MWh
to-run coal plant that would be
dispatched before resorting to gas
Peakers
(the one farthest to the right on
the stack) actually becomes more
expensive to run than the cheapest Price
gas plant. This incentivizes coal-to- decrease
gas “fuel-switching” (figure 5c). Gas
Emissions
Fuel switching results in overall
emission reductions from the power Nuclear Coal
sector because gas is used to provide Hydro/Wind/Renewables
the same amount of electricity that
would have come from coal. Capacity in MW

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Carbon Market Analyst North America
At the fuel prices shown here, the
carbon price required to achieve
such fuel-switching for generic
coal and natural gas plants is $66
per ton, assuming US coal and
gas plants’ average emissions per
MWh are roughly 0.98 and 0.39
tons, respectively. Thus our per
ton carbon price of $28.80 would
not be enough to induce much
fuel switching on the margin in
these regions.
Fuel switching re-
sults in overall CO2
emission reductions from
the power sector
This is merely a scenario, as
fuel prices change daily and
the switching price is highly
dependent on the underlying fuel.
Were the price of natural gas to
fall $2 below the levels used in our
Table 1 calculations, all other fuels
remaining constant, the switching
price would be around $40 per ton
CO2e.
Figure 6 shows how marginal
pricing under carbon caps
could play out in the major US
deregulated electricity markets.
Unlike their counterparts in
regulated regions, PUCs in
states with deregulated markets
follow wholesale forward power
prices closely when setting retail
electricity rates. Wholesale and
retail impacts are thus equivalent
in deregulated states.
The California, New England
and Texas power markets have
the lowest average marginal
emissions rates (0.5 tons CO2 per
MWh) of the deregulated markets,
as natural gas is the marginal
fuel of choice in those regions.
Their power prices will therefore
increase the least (about $15 per
MWh) under a carbon price of
$28.80.
9 All rights reserved © 2008
Figure 6: Carbon’s retail price impact in deregulated markets
Source: ISO-NE, ERCOT, MISO, PJM
New York and the eastern PJM
region have slightly higher marginal
emissions rates, making their price
increase under carbon caps more
significant.
Wholesale and retail
power price impacts
are equivalent in deregu-
lated states
Deregulated markets in the
Midwestern US will see the highest
power price increases under this
scenario, as coal is more likely to be
the fuel type on the margin there:
the average marginal emissions rate
for the western part of PJM and
the region served by the Midwest
Independent System Operator is
over 0.75 tons per mWh, translating
into a price impact of around $22 per
MWh.
Conclusions for power
Implementing a greenhouse gas
cap-and-trade program will alter the
price differential among fuels used
to produce electricity. The price
of natural gas and oil will go up
because refiners will have to submit
allowances for those fuels’ carbon
CMA July 18, 2008
< 5 $/MWh
5 – 10 $/MWh
10 – 15 $/MWh
15 – 20 $/MWh
20 – 25 $/MWh
> 25 $/MWh
emissions, and will therefore charge
buyers more for these fuels.
The price of coal as a fuel will remain
unaffected by the carbon cap, but
coal-fired power generators will
have to submit allowances for the
emissions associated with their
coal combustion, while other fossil
generation will not.
The cost differential between coal
and natural gas in power generation
will narrow following this inclusion of
a carbon price, which will incentivize
“fuel-switching” from coal to natural
gas on the margin. This incentive is
highest at peak times, when natural
gas makes up a greater percentage
of generation. Power price increases
under carbon constraints will be
generally higher for off-peak than for
peak generation.
Increases in electricity prices will be
more drastic in coal-heavy regions.
This is especially true for deregulated
power markets where the fuel on
the margin determines the electricity
price.
In regulated power markets, public
officials will have a certain degree
of control over the carbon-induced
power price increase, as they may
Point Carbon
Carbon Market Analyst North America
limit the degree to which fossil fuel
fired generators can pass the cost of
carbon on to consumers in the form
of higher rates.
The effect of such limitation is again
most drastic in states where coal
makes up a high percentage of the
resource mix, as those areas will
receive more government-issued
allowances to cover their emissions.
$/gallon
Carbon and transportation
fuels
Just as carbon costs change relative
fuel prices in the power sector, they
alter the relative price of fuels used
in passenger vehicles. This section
of the report looks at how such
alterations would occur under the
Lieberman-Warner bill, and discusses
additional measures that could
influence consumers’ choice at the
Source: Nymex, EIA fuel emissions coefficients available online at http://www.eia.doe.gov/oiaf/1605/coefficients.html
pump. We confine ourselves to fuels
that can be substituted, and therefore
do not include electric power used in
hybrid or plug-in vehicles, although
it is commonly considered an
“alternative fuel.”
The direct effect: biofuels over fossil
fuels
The Lieberman-Warner bill names
importers and refiners of “petroleum-
based liquid or gaseous fuel” as
the entities which must surrender
allowances for the emissions that
will be released into the atmosphere
when that fuel is burned. Those
entities will pass on the cost of those
permits in the form of higher gasoline
or diesel prices, making the effect of
the cap similar to a carbon tax from
the consumer’s perspective: the
costs of petroleum-based vehicle fuel
would increase relative to its carbon
content.
Refiners and importers of non-
petroleum-based fuel, however,
would not have to submit allowances.
This gives an automatic advantage
10
Figure 7: Fuel prices with carbon constraints.
The fuel prices used are August 2008 fuel prices from Nymex in June 2008, adjusted for differing
energy content by volume. The grey boxes represent what refiners would pay for the allowances
needed
5.00
to cover the amount of CO2 their fuels will emit when burned at a per ton carbon price of
$28.80
4.50
4.00
3.50
3.00
2.50
2.00
1.50
1.00
0.50
-
Conventional Gasoline
to biofuels like ethanol, for which
consumers would see no carbon-
induced price increase. Biofuel
prices would therefore become that
much more competitive relative to
the conventional fuels.
The effect of a cap
is similar to a carbon
tax from the consumer’s
perspective
Assuming that refiners of petroleum-
based fuel will pass on the entire
cost of allowances, we can assess
the carbon-induced price increase
for some conventional fuels. Figure
7 illustrates this “carbon adder” for
conventional gasoline and diesel,
using EPA estimates of the amount
of CO2 these products will emit
when burned.
The actual carbon adder may be
smaller, as refiners or importers may
allow the cost of emissions permits
CMA July 18, 2008
Conventional Diesel Brazilian ethanol with Midwest corn ethanol
import tariff
Cost ($/gallon) Carbon price impact
to eat into their profit margin to a
certain extent, rather than passing
it on to consumers entirely. The full
carbon adder is $0.26 per gallon for
gasoline and $0.29 for diesel – and
zero for ethanol, as biofuel refiners
have no compliance obligation.
For the fuel prices used in this
scenario (spot prices from June
2008), the figure illustrates that
adding the $28.80-per-ton carbon
cost to petroleum-based fuels can
alter their relative prices enough
to tip the scales on ethanol versus
gasoline. Without the added cost of
carbon, Brazilian sugarcane ethanol
is a few cents per gallon more
expensive than gasoline for our given
set of prices, when adjusted to its
gasoline energy-equivalent. Including
the cost of carbon makes gasoline
more expensive.
Of course, the degree to which the
scales are tipped among fuel types
depends primarily on the underlying
fuel price – when gas and diesel are
All rights reserved © 2008 Point Carbon
Carbon Market Analyst North America
cheap, an extra $0.25 per gallon
is more significant, while current
skyrocketing gas prices render the
same price increase a less influential
factor.
Though biofuels are advantaged by
the Lieberman-Warner plan under
any fuel price scenario, their relative
competitiveness is heavily altered
through other policy measures.
The production of US corn ethanol
is subsidized, while the price of
Brazilian ethanol is influenced by a
$0.54/gallon import tariff.
Even without carbon caps, Brazilian
ethanol is actually cheaper than
conventional gasoline if the tariff is
excluded from the price, due partially
to sugarcane’s less energy-intensive
distillation process. However, supply
constraints and lack of ethanol
infrastructure in the US also affect
the penetration of this fuel in the
market.
Eliminating the tariff would thus
make Brazilian ethanol even
more competitive relative to the
domestically-produced variety.
Presumptive US presidential
candidate John McCain has declared
he would remove the current tariff
on sugarcane ethanol as president,
making this scenario a possibility.
A carbon price could
tips the scales on
ethanol vs. gasoline
The rationale behind “promoting”
biofuels in this way is directly
related to climate change mitigation.
Refiners and importers are required to
surrender allowances for emissions
from fossil fuels and not from
biofuels because the latter generally
emit less carbon. Petroleum is stored
plant energy that would remain
underground if humans did not dig
it up, so emissions from burning it
are additional to those of the earth’s
natural carbon cycle.
11
CMA July 18, 2008
Textbox 3: Methodology for lifecycle greenhouse gas emissions
We use in this analysis lifecycle estimates from the University of California
commissioned California regulators to implement their low carbon fuel
standard (LCFS), which aims to limit the average emissions of the state’s
fuel mix.
The metric used for the LCFS targets is “average fuel carbon intensity”
(AFCI), defined as grams CO2-equivalent per megajoule of fuel, or emissions
per unit of energy contained in the fuel.
We use this metric in our calculations to show how various biofuels would
fare price-wise, if allowances were required for their lifecycle carbon
emissions (figure 8). Grams per megajoule are converted to tons per gallon,
and discounted for the lower heating value of biofuels.
Cellulosic ethanol from cover crops such as switchgrass have extremely
low (sometimes negative) AFCI values, as their growth reduces topsoil
loss, sequestering more carbon in the soil than is emitted when burned.
An important limitation to the model is the measure of land use change
and its contribution to greenhouse gas emissions. The model accounts for
CO2 emissions resulting from converting pastureland to cropland at rates
necessary to produce corn-based ethanol in the US.
Most models of lifecycle carbon emissions fail to account for land use
change beyond this, as net emissions impacts of deforestation or other
land conversion are not extremely difficult to quantify accurately.
The plants out of which biofuels are issue of land use change comes into
made (corn, sugarcane, or other crops) play. If forests, which are one of the
instead removed carbon dioxide from earth’s main CO2 ‘sinks,’ are cleared
the atmosphere as they grew, such to make way for energy crops, there
that burning them as fuel results in is a net carbon increase.
an even net carbon balance.
Massive palm oil plantations in
Not all biofuels are created equal Southest Asia, for instance, are grown
The net carbon balance, however,
on land that was originally tropical
rainforest. Lost carbon sink capacity
is not the same for all biofuels. The
from the associated deforestation
amount of greenhouse gas emissions
would be part of the fuel’s lifecycle
associated with the respective
emissions.
biofuel’s lifecycle differs greatly
depending on what type of crop is The Lieberman-Warner bill’s binary
used and what happens at the farm distinction between fossil and non-
and the refinery. fossil fuels does not reflect this
lifecycle accounting, partially because
For example, growing corn involves
greenhouse gas emissions of various
fossil fuel use in tractors, harvesters,
fuels are hard to quantify.
and refineries. Most crops also use
fertilizer, of which a major component However, policies currently being
(nitrous oxide, N2O) is itself a implemented at the state level
greenhouse gas. actually measure lifecycle fuel
emissions and can serve as a model
Earlier in a biofuel crop’s lifecycle, the
All rights reserved © 2008 Point Carbon
Carbon Market Analyst North America CMA July 18, 2008

for such accounting in cap-and- Fuel price spreads under lifecycle exception is corn ethanol produced
trade. California’s low carbon fuel accounting in coal-fired refineries. Burning the
standard (LCFS) aims to reduce the coal in that refining process is part
Altering the compliance obligation for
state’s average fuel greenhouse of the lifecycle emissions of the fuel
fuel refiners in this way would have
gas intensity (emissions per unit of – as the allowances refiners would
a significant effect on relative price
energy) over a given time period. be required to surrender get more
differences between and among
The Lieberman-Warner bill calls expensive, so does the cost of the
various biofuels. If all fuel refiners had
for a national version of this LCFS ethanol end product. Corn ethanol
to surrender allowances according to
overseen by the EPA, so tools for refined mills fired with the corn’s own
their average fuel carbon intensity
measuring lifecycle emissions stover (husks) has lower lifecycle
(AFCI, see Textbox 3), we would see
could be in place. emissions, as using this byproduct
significant deviation in prices among
cancels out emissions that would
Policymakers are also becoming fuel types. Fuels whose production
have occurred using fossil fuels.
increasingly attuned to the and refining is less greenhouse
significance of lifecycle accounting gas intensive would become more The slope of each line reveals the
for biofuels, as the global competitive the higher the carbon fuel’s relative AFCI. Cellulosic ethanol
controversy over energy crops and price. made from prairie grass, which
their possible role in food price sequesters carbon in the soil and
increases gains media attention. Policymakers are therefore has nearly negative AFCI,
Though this issue is not directly aware of lifecycle is initially more expensive than corn
related to climate change, US accounting ethanol compared to conventional
decision makers are calling for a gasoline. But it catches up with corn
re-think on energy crops and their ethanol when carbon costs around
This is illustrated in figure 8, which
implications. $52 per ton. Its competitiveness
depicts the price spread between
increases more rapidly than that of
In climate terms, such a re-think conventional gasoline and other fuels
corn ethanol under carbon constraints:
may entail a cap-and-trade program if lifecycle emissions are taken into
while cellulosic costs the same as
in which refiners and importers of account.
gasoline when carbon hits $70 per
all fuels are required to surrender
As the figure shows, higher carbon ton, corn ethanol would not become
allowances for the fuels’ lifecycle
prices generally make biofuels more price-competitive with gasoline until
carbon emissions.
competitive compared to gasoline.The carbon costs $90 per ton.

Figure 8: Fuel spreads by lifecycle carbon intensity

The x axis represents carbon prices, while the y axis represents the cost differential between gasoline and the respective biofuel. Where the lines are above
zero, the biofuel is cheaper than conventional gasoline.
2.00

1.50 Brazilian ethanol

Brazilian ethanol with import tariff
Gasoline - biofuel in $/gallon

US corn ethanol coal-fired refinery

1.00 Cellulosic ethanol - prairie grass
Renewable
fuel favored

US corn ethanol stover-fired refinery

0.50

-
- 5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85 90 95 100
Gasoline
favored

(0.50)

(1.00)
$/ton CO2e

Source: www.ethanolmarket.com, Senate testimony by US National Bioenergy Center Director Michael Pacheco on cellulosic ethanol costs, June 2006

12 All rights reserved © 2008 Point Carbon

Carbon Market Analyst North America
The current US administration’s
priority of making cellulosic ethanol
more cost-competitive, as stated
in President Bush’s 2007 State of
the Union speech, would therefore
become realized faster in a carbon-
constrained economy that accounts
for fuels’ lifecycle greenhouse gas
emissions.
Cellulosic ethanol
could become
competitive
Though it is not shown in the graph,
assessing lifecycle fuel greenhouse
gas intensity allows differentiation
among fossil fuels as well. Some
fossil fuels require a lot of energy
to produce and therefore take a
double hit under carbon constraints,
if the emissions caused by their
production are accounted for:
bitumen-rich tar sands in western
Canada, for example, are refined
into oil using filtration and heating
processes that require vast amounts
of energy, which in turn is supplied
by burning fossil-fuels.
The higher lifecycle emissions
inherent to gasoline or diesel
made from tar sands-derived oil
may render those products more
expensive relative to gasoline or
diesel whose oil inputs came from
less energy-intensive sources. This
would reduce the profit margin from
producing those fuels.
Conclusions for transportation
fuels
When refiners and processors
must pay for the emissions that will
occur when their fuel is burned, fuel
prices rise. In a carbon-constrained
economy modeled after the
Lieberman-Warner bill, fossil fuel
prices would rise while all biofuels
would become more competitive
because they are assumed to be
less greenhouse gas intensive.
13
CMA July 18, 2008
Policymakers are increasingly aware gallon cost of conventional fuels by
of the complexity of environmental fractions of a dollar -- given the lack
effects of energy crops, so that of alternative transportation fuels,
the way biofuels are regulated may consumers are relatively insensitive
change in future cap-and-trade to such a minor price change.
proposals. Such a change could
This difference in cap-and-trade’s
involve expanding the compliance
effect on the two sectors suggests
burden to refiners and importers of
that other policies may be needed to
all fuels, requiring them to surrender
cut greenhouse gases from vehicle
allowances for the lifecycle emissions
of their products.
use. Some of the most effective
measures to that end include a low
Under that regulatory scenario, carbon fuel standard to incentivize
fuel prices would be differentiated cuts in average fuel greenhouse gas
beyond the fossil fuel - biofuel intensity.
divide. Some types of biofuels would
More far-reaching measures involve
become more competitive relative
cutting vehicle use itself, through
to others, and the profit margins of
long-term infrastructural shifts as
the most energy-intensive fossil fuel
well as new settlement patterns
producers would narrow.
that reduce “vehicle miles traveled.”
These include an expansion of
public transportation and urban
General conclusions zoning policies geared toward
Comparing the cap-and-trade cutting the length of commutes.
program’s effect on the power and But in the decades it takes for such
transportation sectors, it becomes comprehensive changes to occur,
clear that carbon constraints will have the most immediate effect of carbon
a more immediate effect on emission caps will be to alter the current price
reductions in the power sector than ratio of those liquid transportation
in transportation. fuels already on the market.
This is largely due to the nature of
fuel use in each sector. Even relatively
minor increases in the cost of fuel –
brought on by carbon constraints –
can affect the electric power sector
in a significant way by providing the
incentive to use a lower-emitting
power plant.
Drivers, on the other hand, have
few low-carbon fuel options readily
available. Petroleum-based fuels
power nearly all motor vehicles in
the US -- and as lifecycle emission
analyses have shown, the biofuel
alternatives are not always much
better in terms of their climate
change impact.
Furthermore, supply and technological
constraints limit the ability to switch
easily from one fuel to another. As
we have shown, a $28.80 per ton
carbon price would only raise the per-
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