Resource shuffling continues in California's carbon market

One of the biggest problems facing climate policymakers is leakage, which happens when policy causes emissions to go down in one location but up in another. The canonical example is a factory that shuts down due to government policy and opens up just across the border. 

Here in California, where the state has a cap-and-trade policy, the problem is even tricker. California is the only state that prices greenhouse gas emissions, yet it is also part of a physically interconnected electricity system that stretches from the Pacific Coast to the Rocky Mountains. As a result of California's carbon market, power companies have an incentive to swap electricity contracts such that out-of-state entities hold the high-emitting contracts, and in-state entities hold the low-emitting contracts.

This practice is called resource shuffling. Because these kinds of financial transactions can occur without affecting the physical operation of the grid and don't require expensive investment in new infrastructure, they pose a difficult challenge for climate policymakers. Simply put, resource shuffling is cheap and easy for power companies to execute, but difficult to regulate. When it occurs, pollution reductions reported in California don't reflect actual reductions in greenhouse gas emissions.

A greener Los Angeles

Today, the Los Angeles Department of Water and Power announced the latest in a series of large transactions in which California utilities divest their interests in out-of-state coal-fired power plants. By mid 2016, LADWP intends to sell its 477 MW interest in the 2250 MW Navajo Generating Station to the Salt River Project, a municipal Arizona electric utility serving Phoenix and other communities. 

 Photo credit:  Alex Proimos  / flickr

Photo credit: Alex Proimos / flickr

According to LADWP, this transaction is a big win for the climate. The utility's President proudly cites the deal as early compliance with two of California's climate laws—SB 1368 and AB 32—that seek to limit greenhouse gas emissions. But since LADWP will replace the lost power deliveries with other resources, hasn't the utility just entered into an agreement to resource shuffle? 

By any common sense definition, the answer would be yes. Under California law, however, the answer is no. 

California's carbon market regulations theoretically prohibit resource shuffling, but in practice, a number of safe harbors exempt almost all kinds of transactions from the ban. One safe harbor offers an explicit exemption for utilities that want to divest from their legacy coal-fired power contracts. So there's no legal question here: even though LADWP will replace its coal-fired imports with cleaner alternatives (reducing in-state emissions) and Salt River Project will consume the same coal power outside of California's cap-and-trade system (increasing out-of-state emissions), the transaction fits squarely into many of the exemptions the California Air Resources Board granted to electric utilities.

It may cause leakage, but it's perfectly legal. 

A silver lining?

To be fair, there are some legitimate benefits to the transaction. For one, LADWP cites the ability to use transmission rights now freed up because the city no longer needs coal power from the Navajo Generating Station. If LADWP replaces the power with new renewables that couldn't have been built before due to transmission constraints, perhaps there will be positive consequences for the global atmosphere. 

In addition, LADWP suggests that Salt River Project will also close one of the three 750 MW units at the Navajo facility, eliminating additional pollution. This is good news, of course, but I'm skeptical that LADWP's sale is the cause of this shutdown—after all, LADWP is selling less capacity than Salt River Project would lose if it shut down an entire power unit. It's much more likely that EPA's air quality or mercury regulations are forcing Salt River Project to either install expensive pollution controls or reduce production. 

To the extent LADWP's sale helps make it possible to close a unit, perhaps the utility deserves some credit. But credit is also due to the environmental regulators and NGOs who have spent years pushing for this outcome. Any argument that there isn't leakage because one of the plant's generating units will be closed suggests that federal environmental law isn't the cause. But according to Bloomberg New Energy Finance, the EPA's mercury pollution rule is causing many coal plants to shut down. If that's the case here, then the emissions reductions from the partial closure would likely have happened without LADWP's sale. 

Countdown to 2020

At the end of the day, there's a whole lot of leakage going on in California's carbon market. By my count, this is the fourth of the state's six major legacy coal power contracts that have left the carbon market via resource shuffling—contracts my colleague Dave Weiskopf and I identified in a July 2013 paper as at risk of resource shuffling under the regulator's then-proposed safe harbor exemptions

As a result of leakage, carbon market prices are artificially depressed, reducing the signal to investors to reduce emissions as well as the revenue collected by the state. But this didn't have to be the case. California had several options to encourage utilities like LADWP to exit their coal contracts without undermining the carbon market. Under one approach, the state could have made utilities financially responsible for leakage. Under another, the regulator could have ratcheted the market cap down when leakage occurs. Neither approach was simple, but either would have preserved the carbon market's integrity without unduly complicating electricity markets. 

Resource shuffling is tough issue to regulate, but California's approach—see no leakage, hear no leakage, speak no leakage—isn't setting the right tone for a state that wants to establish credible long term emissions reductions. Let's hope state climate policymakers are ready to get serious soon. Leakage aside, we'll need much more than coal power divestment to get to any post-2020 emissions targets.