by Gregory J. Casas, Johyn S. Rainey and Jeffrey J. Nichols
By 2012, the United States may have in place a program to decrease the domestic emission of greenhouse gases. Legislation establishing such a program may likely be enacted within the next 12 to 18 months. Indeed, the Lieberman-Warner bill, titled “America’s Climate Security Act of 2007,” has just been approved by a subcommittee of the Senate’s Environment and Public Works Committee and will likely be on the Senate floor for debate by the end of the year.
Under the Lieberman Warner bill, the Environmental Protection Agency must create and implement a program to cap and reduce certain emissions to 1990 levels in 2020, dropping emissions to 65 percent of 1990 levels by 2050. The key to achieving these reductions under the Lieberman Warner bill is a cap and trade program. Other proposed greenhouse gas legislation also relies upon similar cap and trade programs. Understanding how a cap and trade program would function and how it would impact the costs of production, therefore, is essential for long-term planning.
Under a cap and trade program, emitters of greenhouse gases, referred to as “covered facilities,” must have sufficient carbon credits to emit greenhouse gases regulated under the program. Carbon credits are measured in terms of metric tons of carbon dioxide equivalent. If the facility emits more than its credits, it will be fined, assuming the emitter is unable to purchase credits from some other source. Under the Lieberman Warner bill, electricity generators that currently emit more than 10,000 metric tons of carbon dioxide equivalent per year will be a “covered facility” and will be subject to a cap on their emissions.
The number of carbon credits any covered facility will be initially allocated has yet to be determined. How the credits will be distributed is somewhat clearer.
Most of the bills pending before Congress, including the Lieberman Warner bill, provide that carbon credits, in the form of emission allowances, will be allocated for free by the federal government to covered facilities. Over time, however, the free allocation will be phased out and covered facilities will have to purchase carbon credits at annual auctions.
In addition to obtaining the carbon credits either allocated or auctioned by the government, a covered facility in need of additional credits will be able to purchase another covered facility’s unused credits, as well as credits in the form of emissions offsets, which are generated through emissions reduction projects. The creation of carbon credits offsets for purchase through emissions reduction programs is similar to the Clean Development Mechanisms (CDM) or Joint Implementation (JI) Programs allowed under the Kyoto Protocol.
Purchasing carbon credits, whether through a government auction or private sales under a mandatory cap and trade program, may be expensive. Currently, carbon credits offsets from CDM and JI projects are trading at approximately $30.00 to $35.00 per metric ton. When a U.S. emissions reduction program comes on-line, and assuming it recognizes carbon credits from international projects, which would allow U.S. companies to purchase these credits and use them in order to meet the U.S. caps, this price may increase dramatically because of the increased demand by U.S. covered facilities. Also, while voluntary carbon credits are currently available in the U.S. for approximately $7.00 per metric ton, these voluntary credits are unregulated and likely may not qualify as certified credits under the definition of what constitutes a certified allowance or offset under a U.S. program. As a result, the price for true carbon credits originating from U.S.-based emission reduction programs will likely increase dramatically once a U.S. cap and trade program is in effect.
The new “clean spark spread”
The impact of the cost of having to purchase carbon credits must be factored into the costs of production and will impact a covered facility’s operational choices. For example, the main factors electric generators currently consider are the cost of the natural gas, coal or fuel oil used to run their generators and the price for which the power can be sold to determine the spark spread. With a cap and trade system, electric generators must subtract the cost of the carbon credits from the spark spread calculations. The new “clean spark spread” incorporates this factor.
Just as the regular spark spread varies depending upon the price of coal or natural gas, the clean spark spread will vary even more dramatically because of the addition of this third dimension. Further, the value of carbon credits will rise or fall in relation to natural gas and coal prices. For example, if natural gas prices are high and coal prices are low, electric generators may wish to turn to the cheaper coal-fired plants to generate electricity. Coal-fired plants will require more carbon credits to run because burning coal emits more greenhouse gases than burning natural gas. An increase in the firing of coal-fired plants will increase the demand for carbon credits, and their price will increase as a result.
While the price of coal versus natural gas might make it more economical to run the coal-fired generators, the higher cost of carbon credits to cover the firing of the coal might make it more expensive to fire the coal generators once the cost of the credits are factored into the spark spread. As a result, natural gas, even when it is considered expensive in comparison to coal, still might be the fuel of choice when viewed in terms of the clean spark spread.
An electric generator’s spark spread may not have to be completely beholden to the cost of carbon credits on the open market. Generators might be able to increase the clean spark spread, regardless of the cost of fuels or credits, if they participate in emissions reduction projects, such as biogas programs. Typically, these programs use methane captured from manure management programs in feed lots and dairy production facilities. Power generators could participate in manure management programs to capture the methane, clean it, enrich it so that it can burn in an efficient manner and use this methane as a way to run some or all of its generation capacity. By capturing the methane in a manure management program, the electric generator would create carbon credits that it could apply to its own operations. Because the credits would come from the manure management program that the electric generator owned or in which it was an investor, the generator might obtain these credits for free or at a reduced cost. These “free” or relatively inexpensive carbon credits would increase the clean spark spread. Electric generators may also be able to engage in waste heat recovery programs and other internal emissions reduction projects in order to reduce emissions and create credits that can be used to counter the emissions generated during power generation. Credits created through these types of programs could also be used to increase the clean spark spread, regardless of whether the generator is burning coal or natural gas.
In light of the current potential regulatory environment and the impact new legislation will likely have on the costs of producing electricity, electric generators should begin to plan on ways to account for the cost of carbon credits in the spark spread calculations. Generators should also evaluate the local area to determine whether off-take of gas from manure management programs is possible, evaluate whether participation in some other type of emissions reduction projects, such as waste heat recovery, is feasible, or consider investing in new processes or equipment that will result in the most efficient method for generating electricity. By planning ahead, electric generators can protect against a large negative clean spark spread come 2012.
Authors
Gregory J. Casas, John S. “Chip” Rainey and Jeffrey J. Nichols are active members of Greenberg Traurig’s carbon credit practice group. Casas’ experience includes litigating power plant disputes and greenhouse gas emissions trading under the EU ETS and the Kyoto Protocol. Rainey has experience in structured finance transactions and agreements for trading environmental credits in the EU. Nichols represents clients in the energy, banking, hedge fund and venture capital industries, and power plants with their industrial contracts for O&M of natural gas and coal-fired plants.