Wharton's Jose Miguel Abito on how Clean Power Plan rules could spark investment and efficiency.

Implementing the EPA’s Clean Power Plan initially creates higher costs to electricity generators that have to pay offsets for carbon dioxide emissions. Over time, however, the state-implemented federal regulations end up raising investment incentives to increase capacity. That new capacity tends to be built with “the best-available technology in terms of emissions and efficiency,” which leads to lower wholesale electricity prices in the long run, according to Wharton economics and public policy professor Jose Miguel Abito, who has co-authored a new policy paper on the subject. He explains how it all works in this Knowledge at Wharton interview.

An edited transcript of the conversation follows:

Knowledge at Wharton: Mike, tell us about the Clean Power Plan (CPP), put forth by the Environmental Protection Agency. It’s designed to limit the carbon dioxide emissions from fossil fuel plants, such as coal-fired and natural gas plants, by setting a price for those emissions. One big question: Is it better to do that from a federal level or a state level — which would be most efficient? You have co-written written a policy paper on this subject, titled “The Economic Costs and Benefits of Implementing the Clean Power Plan” for the Penn Wharton Public Policy initiative.

Jose Miguel (Mike) Abito: In this project, what we look at is the Clean Power Plan (CPP), which is a landmark policy of the Obama Administration to address CO2 (carbon dioxide) emissions. We are zeroing in on this issue: Although the Clean Power Plan is based on the federal level law, by virtue of being under the Clean Air Act, implementation of the Clean Power Plan is actually at the state level. So, you have different jurisdictions coming up with different rules or different ways to implement the policy, and that may actually create inefficiencies…. This is what we’re studying in this paper.

Knowledge at Wharton: What were some of the conclusions?

Abito: What’s interesting here is with emissions — we’re looking at emissions coming from power plants producing electricity. So, we focus on PJM, the Pennsylvania, New Jersey, Maryland interconnection, which is basically a grid that covers — or a wholesale market that covers — 13 states. And so, firms who own power plants produce across these 13 states, and then they sell the electricity they produce in a single market, PJM, and then they get a single price.

What we recognize is the following insight: There is a CO2 permit market for each state, or 13 markets, and they can’t trade [permits] among each other. That really sounds like a very inefficient scenario. However, when a firm that owns plants — let’s say in Pennsylvania and Delaware – they’re going to look at the CO2 price in Pennsylvania and compare it with the CO2 price in Delaware and somehow decide, “where should I produce based on these CO2 prices?” So even though seemingly these are disconnected markets, the fact is that firms that participate in the single market for electricity actually make decisions that take into account the distribution of CO2 prices across states, and that somehow implicitly coordinates these separate markets. We found in our research that actually alleviates or completely mitigates some of the inefficiencies of these separate markets.

Knowledge at Wharton: So, a power company, regardless of what state they reside in and what the CO2 rules are for that state, can easily — being part of this grid you’re describing — produce that electricity in one of the other states that’s part of that grid.

Abito:  Exactly.

Knowledge at Wharton:  And so, they’re indifferent to the regulation, except to the extent that they are going to produce it where there are the least costs (in terms of CO2 price, all else equal)?

Abito: Where costs are cheapest, exactly. Suppose you have two plants producing electricity at exactly the same cost and the only difference is that the CO2 price in Pennsylvania is more than in Delaware — then of course, I’m going to move my production to Delaware.

The problem with that is you’re pretty much limited with how much you can re-allocate, because the reason why probably prices in Pennsylvania are more expensive is because a lot of production is being done in Pennsylvania. You have big plants in Pennsylvania as opposed to small plants in Delaware. So, you can’t really move a majority of output from Pennsylvania to Delaware even though it’s cheaper in Delaware.

So here, what we identify as the main mechanism in the paper is actually investment, and that has consequences in terms of what’s going to happen to electricity prices.

Knowledge at Wharton: So, was the purpose of the paper to show that while dealing with federal and state regulations can be complicated, in fact, the way that the market is set up kind of bypasses all of that?

Abito:  In a way, it kind of has that message. We’re coming from the premise that having states coordinate and having a single market, and having a consensus on how to design a single market is a difficult proposition. You can think about it with a bigger picture. Imagine — we’re all hoping for a global CO2 market.

But in order to have that, you have to have China, the U.S., each of these countries actually have to agree on the details of this market.

It could take a while, even forever. The point of the paper is that, okay, wait a minute, we don’t need to really aim for that. The fact that somehow we are talking about CO2 emissions, which are coming from certain activities, as long as these activities are coordinated [in some way] across these different entities, then we can actually do something.

Knowledge at Wharton:  So it’s kind of a hopeful message … that you can actually apply some restrictions that will help keep carbon out of the atmosphere and you don’t need to have it coordinated internationally or even across the U.S. These regions are already set up on grids that cooperate and coordinate….

Abito: Exactly. Although we’re focusing on the PJM, there are a bunch of regional markets in the U.S. As you said, they’re actually still somehow interconnected.

Knowledge at Wharton: What surprised you when you started looking at this? Did you come to the conclusion that you thought you would?

Abito: We understood the basic economics… Our primary focus was on electricity prices under state-by-state [implementation of CPP regulations], which is, having separate markets, versus regional implementation. The regional PJM, for example, behaves in effect as a single market versus many smaller, separate markets…. What surprised us a lot is that profits actually end up to be better in the state-by-state regulation case, as opposed to the regional case…. It’s only recently that we actually understood what was happening.

It’s counter intuitive, in the sense that with the state-by-state implementation, the CO2 regulation is more stringent as opposed to the regional case. Why do you end up with higher profits with state-by-state implementation?

But many of the power companies, with their current portfolio of plants, are barely making any money. The price they are getting in the market is almost exactly equal to their cost. And once you introduce the CPP, the costs are going to go up. But demand for electricity is, at least in the short-term, very inelastic in the sense that people are willing to pay almost any amount just to get that specific amount of electricity.

So, what’s going to happen is that when costs go up, prices are going to go up in the same proportion, and people are willing to pay for that. But higher prices create a very strong incentive for the companies to invest. And the fact that you’re investing in technologies that are cleaner and actually more efficient means that when you compare the existing plant’s cost versus the new investment … the reward from investing is actually much higher.

“The underlying assumption in our paper is that firms are profit-maximizing. We’re not coercing them to invest, we’re not forcing them to invest. It’s just that the reward from investing is actually much higher with a stricter law.”

Knowledge at Wharton: Does that mean these increased regulations provide an incentive to modernize?

Abito:  Exactly. At the end of the day, at some point in time, all of these coal plants are going to get retired. A stringent CPP, or what a state-by-state CPP does, is it basically makes it happen faster…. It’s going to give a really strong signal.

Knowledge at Wharton: It speeds up the retirement of these plants.

Abito: Exactly. And here, the underlying assumption in our paper is that firms are profit-maximizing. We’re not coercing them to invest, we’re not forcing them to invest. It’s just that the reward from investing is actually much higher with a stricter law.

Knowledge at Wharton: And when you’re producing electricity, it’s not like there are a thousand different markets you can go to, you’re wired into your location.

Abito: You can’t even store it, for example, once you produce it.

Knowledge at Wharton: You gave us one example of something you’ll be looking at next, what else will you be looking at?

Abito:  I worked with a bunch of co-authors in this paper. And … the moment that we got the results of the U.S. election, my co-author emailed: “What’s going to happen to the CPP?” So, a little bit of background: The final CPP was put in the federal register last year…. In February, 2016, the Supreme Court put a stay on it. So right now, whether this Clean Power Plan will actually push through depends on several things…. What’s going to happen to the composition of the Supreme Court? What’s going to happen to the EPA? One of my co-authors wondered about what’s going to happen to the project because if there’s no CPP, then why are we talking about this?

But the fact that we’re focusing on this separate market’s different jurisdictions, as opposed to, a coordinated way to regulate the emissions, actually says something about this environment where we don’t have CPP. So that’s something that our current project has something to say about, but we need to do more research. What do I mean specifically? Suppose the EPA abolishes the CPP. Although there’s no CPP, individual states can still decide to regulate themselves.

What if Pennsylvania and Delaware individually decide to regulate themselves? They might not be able to coordinate because they don’t have this umbrella of the Clean Power Plan, but they can, by themselves, take on these kinds of initiatives. In future research, we would like to see whether this kind of investment and re-allocation works in the same way in these kinds of environments. So it’s something that’s worth looking at for the next few months.