(April 19, 2010) The carbon prices outlined in this news article are consistent with the idea that high-emitting power generation and industrial facility operators will pay whatever it costs to operate existing plants through the end of their normal, pre-carbon tax, expected lives. If we assume no early plant retirements, the marginal cost of complying with the WCI 2020 target ranges between $30 and $80/TCO2e.

In many cases, however, the least cost compliance strategy will be the early write down of power plants and industrial facilities.

Most of the US’s top-10 power utilities (on a sales volume basis) operate existing facilities that deliver less than US$8/TCO2e in returns (share value plus dividends) to shareholders, annually. But it will cost at least $34/TCO2e to cut emissions in these low value plants. So their least cost compliance option is to retire existing plants ahead of the currently planned end of their operating lives.

If it costs, say, $13 per TCO2e reduced to shut-down already aged coal-fired power plants (up to $8/TCO2e reduced to write off the plants’ current market value and $5/TCO2e reduced to finance decommissioning costs, amortizing capital expenditures over the 20 years of emissions—the minimum estimated operating lives of replacement, lower-or-zero-emitting power supply), and to generate a return on the new supply, we have to secure the equivalent of an additional $3 to $5/TCO2e reduced ($2 – $8/MWh) increase in the price of power, then the marginal cost of carbon does not exceed US$21/TCO2e between now and 2030.

The above theoretical write-off and replacement cost estimates are actually HIGH relative to many of the 10 largest power companies operating coal-fired generation capacity in the US at this time. You can verify this statement by reviewing large US power utility annual and environmental reports.

Then let’s look at what write off costs should be at the complete other end of the power industry spectrum. For example, PG&E is one of—if not THE—least carbon intensive power suppliers in the US. So the cost of writing off PG&E’s fossil-fired plants and power purchase agreements (PPAs) should give us a signal as to the maximum price carbon should hit in a rationally regulated and operating carbon market. (You can sownload PG&E’s annual report here).

If you assume you can buy the whole company—all of its assets and power supply contracts—for a 25% premium above the current share value, and add in the cost of retiring all of the company’s long-term debt, we face a one-time cost of $36 billion. Only 8% of the power PG&E supplies originates at coal-burning plants and 39% originates at gas-burning plants. These sources currently combine to discharge just under 29 MM TCO2e/year. The rest of the power that PG&E supplies comes form nuclear, hydro and low impact renewable sources.

To over-simplify, let’s just assume that all of PG&E’s production assets and PPAs have the same book value (generate the same contribution to earnings)/MWh of output. If we were to buy and then write off PG&E’s carbon-emitting assets, amortizing that cost over 20 years (the operating lives of the assets I build to replace the high-GHG supply), we get a cost per tCO2e reduced of US$29.48/TCO2e. This estimate is likely high, given the assumptions I made to keep the analysis simple.

In a rational world, the highly efficient PG&E gas-fired assets are among the last assets that would be retired in the US to achieve any given GHG target. But if these assets were written off TODAY, the cost of that relative young and efficient plant write-off is well under US$30/TCO2e.

This means that under any rational GHG regulatory context, the real cost of carbon in the US should be well under US$30/TCO2e, well beyond 2030.

When I look at the annual reports of AEP, Southern Electric, Arizona Public Service, Constellation, the Edisons and other utilities that operate sizeable fleets of older, high-emitting plants, even after considering replacement costs, I have a very difficult time forecasting carbon prices in excess of US$17/TCO2e through 2020, unless we proceed down an irrational and unnecessarily inefficient regulatory path. Of course, it is always possible that WCI is estimating the price of irrational regulation!

Any price of carbon exceeding $30/TCO2e (in 2010 $s) over the next 20 years will derive exclusively from politically-motivated and inefficient carbon quota allocations and/or tax measures, combined with market incumbents’ use of the quota regime to block new market entrants, slow down innovation rates and to artificially inflate carbon and electricity prices.

Note that all market participants in the US SO2 and EU ETS CO2 market do currently use the new market power derived from their free emission quota allocations—combined with mandates that oblige new market entrants to buy quota at market prices—to erect substantial barriers to new entrants and to maintain artificially high power prices given the decommissioning costs and replacement value of their operating power production assets. Over 80% of the “turnover” of emission certificates in these markets is in the form of “swaps”, because no entity that holds perpetually bankable SO2 or carbon quota actually sells it, in perpetuity, to a third party unless they are under extreme financial distress. On the ground, we call these quota swaps “leases”.  In a properly regulated exchange-based market, the market value of swaps would be reported at a $0 market value, not the marked-to-market price that is currently reported in the US SO2 and EU ETS CO2 markets at this time.

This low US compliance cost finding should be of major concern to the government of BC, because below $30/TCO2e, costing real reduction opportunities in BC’s reported GHG inventory are few and far between. So BC’s inclusion in the WCI marketplace eventually translates into BC electricity rate-payers exporting WCI carbon taxes to California rate-payers.

The reason the marginal cost of reducing GHGs in BC is so high is that every energy intensive sector operating in BC is already much more efficient than its California counterpart. The WCI-agreed regulatory strategy rewards regions with low cost reduction opportunities (the regions with the largest stocks of old plant and equipment) at the expense of regions that are already more efficient producers of energy and carbon-intensive goods and services.

Aldyen Donnelly, April 19, 2010