An Energy Efficiency Trading System

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					An Energy Efficiency Trading System
Lisa Margonelli

               he United States consumes en-         consumers to use more—not less—en-
               ergy so lavishly that the cost is     ergy. Consequently, they are now spend-
               equivalent to nearly 10 percent of    ing more money on fuel without being
         our GDP, reducing our competitive-          able to cut back.
         ness, constraining our foreign policy,         The government needs to make a
         and producing a fourth of the world’s       fundamental change in the way it ap-
         greenhouse gases. And because the U.S.      proaches energy policy—instead of
         economy is far more energy dependent        simply trying to ensure supply, it needs
         than the economies of other advanced        to begin reducing demand by spurring
         industrialized nations, American indus-     a revolution in energy efficiency. Set-
         try and families are far more vulnerable    ting tough energy standards for Amer-
         to natural catastrophes like hurricanes     ica’s biggest energy users, and mak-
         or political upheavals in oil- and gas-     ing energy efficiency tradable—much
         producing countries than industry and       the way we now trade oil and natural
         families in Europe and Japan. In the        gas—would quickly reduce our total en-
         coming decade that vulnerability will       ergy consumption while limiting carbon
         only increase, as more and more of our      emissions, stimulating productivity, and
         energy supply will be concentrated in       creating jobs. Higher taxes on gasoline
         politically unstable regions. Reducing      are political poison, but tougher energy
         the economic and environmental risks        standards have overwhelming support
         of excessive energy use therefore must      among both Democrats and Republi-
         become one of America’s most impor-         cans—well above 70 percent. Adding a
         tant national goals.                        market mechanism to trade efficiency
            Nearly a century of government ef-       gains would make energy efficiency
         forts to make energy abundant has led       standards more palatable to industries
         many Americans to see cheap energy as       that have resisted them in the past, at
         a virtual right, creating political rigor   the same time raising economic growth
         mortis with respect to energy policy.       and providing incentives for technologi-
         Higher energy taxes are unpopular, and      cal innovation.
         manufacturers have fought the imposi-
         tion of tighter energy standards for ap-    Rethinking the Old Supply-
         pliances and automobiles. So the gov-       Side Bargain
         ernment has abdicated responsibility for    The American way of using energy is
         reining in energy use to “market forces.”   based on a grand bargain dating back
         But low prices in the 1990s encouraged      to the 1930s, in which the government

An Energy Efficiency Trading System

       focused on energy supply rather than demand. The        them to carry more energy will be costly and time
       goal of American policy was to secure new cheap         consuming. Some isolated sections of the electrical
       supplies of energy by providing tax incentives and      grid are actually facing supply shortfalls within the
       other forms of government support for produc-           next two years. In these and other cases, reducing
       ers and by pursuing “oil diplomacy” internation-        demand would solve the bottleneck more quickly
                                 ally. Using military power    than increasing supply.
Efficiency is America’s           to protect shipping lanes        Reducing energy demand is both cheaper and
                                 and pipelines, and making     faster than is the alternative of securing new sup-
largest and most cost-           special deals with key pro-   plies by exploring new oil fields or building more
                                 ducers like Saudi Arabia,     power plants. Efficiency is America’s largest and
    effective potential          allowed the United States     most cost-effective potential energy resource, and
                                 to promise cheap energy       it has already provided three-quarters of our new
      energy resource.           to the world, while offer-    energy needs since 1970. There is much more ef-
                                 ing energy markets to our     ficiency to be found. Conservative estimates sug-
                                 trading partners. This ap-    gest that buildings and vehicles could halve their
       proach virtually sanctioned waste, with the result      energy use without radical changes in design and
       that more than 40 percent of the energy the United      construction. Emerging technologies, like sensors
       States uses is lost as waste heat.                      and supercomputing, nanotechnology, computa-
          Increasing competition for global oil and natural    tional fluid dynamics, and bioengineering hold the
       gas supplies, on the one hand, and declining U.S.       possibility of radically changing our relationship to
       reserves, on the other, mean that the old bargain is    energy and improving standards of living.
       no longer effective insurance against either price         Promoting efficiency, however, has been an un-
       spikes or the exercise of market power by the Or-       derutilized policy option. In fact, many current
       ganization of the Petroleum Exporting Countries         government policies do not reward conservation
       (OPEC). Despite some gains in efficiency in the          or, worse, encourage waste. The Internal Revenue
       1980s, the U.S. economy remains vulnerable to           Service, for example, creates a perverse incentive
       high oil prices. Any increase in gasoline prices acts   to waste energy by allowing commercial landlords
       as an almost instant regressive tax on American         to write off their energy costs every year. At the
       drivers, who rely on the automobile much more           same time, it requires building costs to be depre-
       than their counterparts in other advanced indus-        ciated on a 30-year schedule, effectively devaluing
       trialized economies. It also creates an increasing      investments in energy efficiency. Removing such
       fiscal burden for the American economy, driving          perverse incentives would help encourage greater
       up America’s international deficit. In the first two      efficiency but alone would not be enough to spur
       quarters of 2006, petroleum imports accounted for       the efficiency gains we need. Without positive gov-
       nearly a third of the U.S. trade deficit.                ernment incentives, it often does not make sense
          Despite higher prices, both oil and electricity      for individual purchasers to spend more on a more
       demand continues to grow fast. Overall U.S. elec-       efficient car or building, either because they can-
       trical demand is expected to grow by 19 percent by      not afford the higher initial investment or because
       2015, while new power generation will expand by         they are not sure they will see a return on their
       only 6 percent. To manage the gap, utilities will       investment given the volatility of energy costs. For
       have to consider reducing demand. Another barrier       example, under most scenarios, it is unrealistic for
       to meeting America’s expanding need for energy is       the purchaser of a hybrid car to expect the fuel cost
       that the domestic infrastructure for delivering oil     savings to exceed the higher purchase price. Thus,
       and electricity is old, and in some areas pipelines     relying on the market alone does not often yield
       and grids are operating near capacity. Expanding        greater efficiency because it does not take into ac-

                                                                                                                                                                                                                       Ten Big Ideas for a New America

               count the externalities of using energy—pollution,                                                                                                            iting electrical demand through efficiency for the
               greenhouse gases, road wear by heavy vehicles, en-                                                                                                            past 30 years. Residents now use 30 percent less
               ergy security costs, and tax breaks to the energy                                                                                                             electricity per capita than the country as a whole
               industry—which are borne by society as a whole,                                                                                                               and the state has avoided building many power
               but not by the individual purchaser.                                                                                                                          plants. This prevents the emission of an estimated
                  New research from the United States and Eu-                                                                                                                18 million tons of carbon, while allowing every
               rope suggests that improved efficiency brings with                                                                                                             Californian to spend $400 per year on things other
               it a multiplier value that far exceeds the fuel savings                                                                                                       than energy. The state program has stimulated the
               realized by the individual. To return to the meta-                                                                                                            rapid commercialization of such technologies as
               phor of the hybrid car: its real value may lie not in                                                                                                         compact fluorescent light bulbs and energy-saving
               the energy savings to the individual owner but in                                                                                                             refrigerators and air conditioners. New refrigera-
               the jobs it creates, the technology it stimulates, and                                                                                                        tors use just 25 percent as much energy as the old;
               the reallocation of capital from energy to invest-                                                                                                            even better, their prices have fallen by more than
               ment it encourages. Efficiency is a productivity-                                                                                                              half. The benefits don’t stop at California’s bor-
               enhancing tool, raising the return on capital and                                                                                                             ders: energy-saving appliances have proliferated
               increasing GDP output. Reducing energy demand                                                                                                                 everywhere from China to New York.
               has also lowered energy prices, notably oil prices
               during the mid-1980s; and forecasts suggest that                                                                                                              How to Trade Efficiency
               small drops in U.S. electricity use could precipitate                                                                                                         The United States needs to remodel its energy
               a dramatic fall in the price of natural gas.                                                                                                                  portfolio, abandoning incentives for wasted en-
                  One example of the benefits of energy standards                                                                                                             ergy and putting in place a framework to support
               can be found in California, which has been lim-                                                                                                               increasing energy efficiency. Like carbon cap-and-

Average Energy Use Per Unit (KWh/yr.) and Price (2002 US$)

                                                                           US Sales Weighted Average Energy Use
                                                             2200                                                                                                                                                                                                              $22
                                                                           Adj. Volume (ft3)
                                                             2000          Real Price
                                                             1800                                                                                                                                                                                                              $18
                                                                                                                                                                                                    1978 CA Standard
                                                             1600                                                                                                                                          1980 CA Standard
                                                             1400                                                                                          $1,272.03                                                                                                           $14
                                                                                                                                                                                                                              1987 CA Standard
                                                                                                                                                                                                                                 1990 NAECA Standard
                                                             1000                                                                                                                                 $893.58                                                                      $10
                                                                                                                                                                                                                                            1993 DOE

                                                              600                                                                                                                                               $576.11                                                        $6

                                                              400                                                                                                                                                                                   $462.99

                                                              200                                                                                                                                                                      2003 DOE Standard                       $2


















                                                                                                                                                        Year Manufactured or Priced

               Source: David Goldstein, Natural Resources Defense Council.

An Energy Efficiency Trading System

       ENERGY FLOW, 2005

                                                                                                      Exports 4.64
                      23.05                                                                      Otherg 2.18
               Natural Gas                                                                                                21.87
               18.76                                                             22.83
                                  Fossil Fuels
             Crude Oila             54.97                                                                                Commerciall
             10.84                            Domestic                        Natural Gash                                 17.97
                                              Production                         22.64         Fossil
                                                                Supply                         Fuelsj
                                                69.17           104.54                                Comsumptionk
         NGPLb 2.32                                                                            85.96
                                                                                                         99.89              Industriall
             Nuclear Electric Power 8.13                                                                                      31.98
             Renewable Energyc 6.06                                              40.44

                                            Imports 34.26                                                            Transportationl
                                                                            Nuclear Electric Power 8.13                  28.06
                 Petroleumd 28.87                                            Renewable Energyc 6.06

                                                 Adjustmentsf 1.11

                            Othere 5.39

       a Includes lease condensate.
       b Natural gas plant liquids.
       c Conventional hydroelectric power, wood, waste, ethanol blended into motor gasoline, geothermal, solar, and wind.
       d Crude oil and petroleum products. Includes imports into the Strategic Petroleum Reserve.
       e Natural gas, coal, coal coke, and electricity.
       f Stock changes, losses, gains, miscellaneous blending components, and unaccounted-for supply.
       g Coal, natural gas, coal coke, and electricity.
       h Includes supplemental gaseous fuels.
       i Petroleum products, including natural gas plant liquids.
       j Includes 0.04 quadrillion Btu of coal coke net imports.
       k Includes, in quadrillion Btu, 0.34 ethanol blended into motor gasoline, which is accounted for in both fossil fuels and renewable
        energy but counted only once in total consumption; and 0.08 electricity net imports.
       l Primary consumption, electricity retail sales, and electrical system energy losses, which are allocated to the end-use sectors in pro
        portion to each sector’s share of total electricity retail sales.

       Source: Annual Energy Review 2005, Energy Information Administration.

       Notes: Data are preliminary. Values are derived from source data prior to rounding for publication. Totals may not equal sum of com-
       ponents due to independent rounding.

                                                                              Ten Big Ideas for a New America

trade programs, the energy efficiency initiative          “price” of credits for the pickups and still sell extra
proposed here would combine setting national lim-        credits. Gradually, though, the cost of inefficiency
its on energy use with letting the market determine      would be integrated into the purchase price of the
who pays. By instituting efficiency standards that        pickup truck, changing the market.
increase over time, the government will be able to          Targets for vehicles will need to be set for at
guarantee that the country’s economy will become         least ten years in advance,
more efficient by at least 1–2 percent a year over the    requiring perhaps a one             Phasing in tough
next decade and beyond. As with carbon cap-and-          mpg improvement a year
trade programs, businesses that exceed their effi-        for the fi rst five years, and        energy standards
ciency targets can sell excess credits, while those      a two mpg a year improve-
that fail to meet them can buy credits from other        ment for the second five             for America’s
producers or the government. This differs from           years. The point of this
the policies of the 1970s, when government “com-         system is that it is flexible        biggest energy
mand-and-control” regulations essentially picked         but insures results. As the
which products would succeed. The key is to in-          standards go into effect,           users – and making
ternalize the true costs of energy inefficiency and       and the valuation of effi-
allow the market to work out which users should          ciency credits begins, the          energy efficiency
produce or consume efficiency gains.                      government will be able
   The place to begin implementing standards is          to influence the price of            tradable – would
with transportation and electricity—together these       efficiency credits by sell-
two sources account for 67 percent of the energy         ing them, which will give           quickly reduce total
the United States uses. Both vehicle manufacturers       the emerging market a
and utilities are source producers, able to employ       safety valve and prevent            energy consumption
a variety of strategies to reduce energy demand          prices from getting pro-
while being relatively easy to identify and regulate.    hibitively high.                    while limiting carbon
Once standards are in place and trading has begun,          Vehicle makers will be
standards could be extended to other markets, such       able to use many strategies         emissions.
as industry and buildings, and trading could be al-      to meet the standards—
lowed between categories.                                from buying credits to
   Corporate Average Fuel Economy (CAFE) stan-           changing marketing and sales practices, substituting
dards have allowed overall fleet efficiency to fall        more efficient components like air conditioners and
since the late 1980s because there are separate re-      tires, changing the way they finance and lease, as
quirements for cars and for light trucks, and none at    well as altering vehicle designs, materials, and power
all for heavy trucks. More effective standards should    trains. A study by the Congressional Budget Office
be set to include all vehicles in the fleet so that the   found that tradable credits would allow automakers
total amount of fuel used is reduced. Fleet efficiency    to increase the fuel economy of cars and trucks by
is calculated by multiplying the amount of gasoline      3.8 miles per gallon for 17 percent less cost.
consumed by each model car over its lifetime by the         As targets for standards, utilities have proven to
number of units sold, so that the targets apply to all   be powerful actors because they can use efficiency
the vehicles a company makes. If Ford produces a         investments to avoid buying peak power and build-
pickup that gets, say, 22 miles per gallon (mpg), the    ing power plants, both expensive undertakings. The
company would need to buy credits to bring it up         ability to promote more efficient appliances, build-
to the fleet target of 30 mpg. If, on the other hand,     ings, and transmission systems among their custom-
Ford also produces twice as many Escorts getting         ers gives utilities extraordinary leverage over con-
40 mpg as pickups, it would be able to cover the         sumer markets. Utility standards could be phased in

An Energy Efficiency Trading System

       U.S. ENERGY CONSUMPTION BY FUEL (1980–2030)

                    Petroleum      Natural Gas         Coal
                    Nuclear        Hydropower          Renewable/Other (excl. Hydro.)





             1980                  1990                              2004           2010                 2020                 2030

       Source: U.S. Department of Energy, Energy Information Administration.

       so that the first year might require half a percent of                   to invest in energy efficiency, could start collecting
       reduced demand a year; years two to four, 1 percent                     those improvements into credits to sell, providing
       a year; years five to seven, 2 percent; and years eight                  greater penetration of very high-efficiency build-
       to ten, 3 percent. In addition to reducing demand,                      ings. An American city considering a massive neigh-
       utilities also have the ability make their generation                   borhood-by-neighborhood efficiency program to
       facilities and transmission lines much more efficient,                   save as much as 20 percent of the region’s power
       and if those goals are added to the program, the tar-                   would be able to aggregate and sell credits.
       gets should be set accordingly.                                           While the vehicle and electrical credits would
          Utilities that beat their targets can aggregate                      not be immediately interchangeable, it is reason-
       their savings into bundles of efficiency—usually a                       able to expect to see outside players aggregating
       megawatt of demand—called white tags. European                          credits here too. Cascade Sierra Solutions, an Or-
       utilities have already begun trading white tags, and                    egon-based nonprofit, already has a program to
       Connecticut and Pennsylvania are now preparing                          help truckers install inexpensive kits to retrofit
       to do so. In the late 1990s, the energy service com-                    their long-haul trucks and save as much as 5,000
       pany Enron began experimenting with standard-                           gallons of fuel a year. United Parcel Service has
       izing and trading efficiency. Now a Georgia-based                        developed software that saves fuel by optimizing
       company called Sterling Planet is launching a sys-                      delivery routes, using information about package
       tem for verifying and trading white tags.                               weights and GPS route setting. Other companies
          Once these trading systems were in place, a num-                     might decide to use their leverage over employees
       ber of related secondary trading systems would be-                      or suppliers to acquire credits. Wal-Mart, for ex-
       come possible. For example, consumers could reduce                      ample, might provide scheduled van pools for em-
       their energy use and aggregate the savings to sell to                   ployees, and bundle and sell the commuter miles
       a utility much the way a producer of wind electric-                     saved. (These companies would also save money
       ity might sell back power. A mortgage company like                      by not providing employee parking spaces, and
       Fannie Mae, which already encourages homeowners                         see benefits from on-time employees and reduced

                                                                               Ten Big Ideas for a New America

road congestion.) Auto insurers might start offer-        the United States would save as much as $2 billion
ing low-cost insurance rewarding drivers who limit        in electrical costs and eliminate a million tons of
their miles, aggregating and selling the credits.         greenhouse gases, according to the Environmental
                                                          Protection Agency. This kind of market failure is
The Advantages of the Tradable                            best fi xed by a combination of standards and mar-
Efficiency Option                                          ketable efficiency because it discourages manufac-
Combining standards and tradable efficiency would          turers from cutting corners on energy efficiency,
have some clear advantages over the conventional Re-      while allowing the
publican and Democratic policy approaches for reduc-      market to decide          The ability to trade
ing energy use and greenhouse gas emissions. Unlike       which combina-
voluntary measures, this approach would ensure re-        tion of price and         efficiency gains
sults; but unlike taxes and the command-and-control       efficiency works
strategies often associated with liberal Democrats, it    best.                     would make energy
would not constrain the economy or hurt economic             Many Demo-
growth. While traditional Democratic and Republi-         crats favor raising       efficiency standards
can approaches to energy have led to policy gridlock,     energy taxes to en-
tradable efficiency offers a third way with wider and      courage consum-           more palatable to
deeper benefits—and fewer drawbacks—than the               ers to conserve.
commonly discussed alternatives.                          But this idea does        industries that have
   Republican solutions to energy issues tend to en-      not make either
courage energy supply while leaving demand man-           political or eco-         resisted them in
agement to the market or voluntary initiatives. But       nomic sense. A
without new incentives and penalties, neither in-         regressive tax on         the past.
dustries nor consumers are likely to become more          fuel will hurt not
efficient. In 1998, utilities in Texas voluntarily saved   only businesses
a modest 300 million kilowatt hours of electricity.       but also poorer working families and rural drivers
By 2003, under a utility efficiency standard signed        without access to public transportation while doing
by former Governor George W. Bush, they saved 5           little to reduce the amount of gasoline middle-class
billion kilowatt hours, greatly exceeding their tar-      consumers use. Although they complain vocifer-
gets. Although the efficiency programs were cost-          ously about fuel prices, American drivers do not
effective, the utilities were reluctant to adopt a new    use significantly less gas when prices are high. And
business model without being pushed.                      high fuel costs do not consistently inspire them to
   Market choices do not always favor efficiency,          buy fuel-efficient cars. Even in Europe, where taxes
either because manufacturers have other priori-           make gasoline very expensive, governments have
ties or because consumers lack information. Take          still found it necessary to institute voluntary fuel
cell phones, for example. Because consumers are           economy targets for automakers. A program that
focused on features, manufacturers save money by          combined fuel economy standards and tradable ef-
using inefficient chargers that draw 2–5 watts per         ficiency would produce much better results because
hour, even when they are not charging. Highly effi-        manufacturers would need to ensure that the fleet’s
cient chargers use just half a watt, and cost slightly    fuel consumption falls, thus making fuel-efficient
more, but who chooses a phone by the charger?             cars less expensive and fuel-inefficient ones more
Left to individual choice, consumers end up buy-          expensive. It might also lead to more transportation
ing power vampires whether they want to or not.           choices for many poor and rural families because
Imposing standards on the billion chargers (for           governments would have more incentive to provide
phones, computers, and other appliances) used in          public transportation for these populations.

An Energy Efficiency Trading System

          Limiting greenhouse gas emissions through a             powerful productivity-enhancing tool in the same
       cap-and-trade system is another favorite liberal idea.     vein as supply-chain management, just-in-time
       But it is not a substitute for an efficiency trading sys-   production, and financial instruments like deriva-
       tem and in fact would work best if it were combined        tives. Just as the potential for new technology to
       with one. One problem with carbon cap-and-trade            save energy is unknown, the potential uses of trad-
       proposals is that the initial value of carbon cred-        able efficiency may be much greater than we can
       its may be too low to change energy-use patterns.          grasp now. Failing to encourage efficiency, by con-
       Thus they tend to encourage responses that put             trast, may have a high opportunity cost for U.S.-
       the emphasis on carbon mitigation rather than on           based manufacturers because the European Union,
       energy reduction. This may encourage a different           Japan, South Korea, and China all have committed
       choice of energy—natural gas rather than coal—but          themselves to aggressive energy standards.
       not result in new technologies to reduce energy use
       in any significant way. When tradable efficiency is          An Opportunity for a New Grand Bargain
       combined with cap and trade, however, companies            Energy is an intensely politicized subject in the
       would be able to leverage both efficiency credits and       United States. Steep gasoline prices have led to the
       emissions credits to achieve their goals faster.           defeat of at least one president, while California’s
          One of the clear benefits of a standards-and-ef-         electricity crises caused the recall of one governor.
       ficiency trading system is that it will spur both tech-     The high political stakes of another crisis and pub-
       nological innovation and the diffusion of that tech-       lic anxiety about energy security make this a fertile
       nology more rapidly than other policy alternatives.        time to make a new grand bargain. The standoff
       Already there is evidence that combining standards         between liberals and conservatives on the topic
       with tradable credits can speed up the commercial-         of energy makes America vulnerable to a crisis of
       ization of cutting-edge technology. A fuel-cell gen-       cripplingly high prices. In the longer term, energy
       erator normally has a payback time of more than            prices will be volatile, and the costs of emitting
       three years, which most companies consider to be           carbon (whether explicit carbon credits or implicit
       too long to justify the investment. With tradable ef-      rising temperatures) will become very high.
       ficiency credits soon to be available in Connecticut,          Tradable efficiency, coupled with high stan-
       one large company found that the payback time for          dards, is a grand bargain that combines the secu-
       the fuel cell fell to just over two years, making it a     rity of regulation with the creativity of the market.
       much more feasible investment.                             This plan not only reduces U.S. exposure to high
          A standards-and-efficiency trading system has            energy costs, it offers considerable economic and
       other advantages as well. For one thing, it is busi-       environmental benefits. The objection to most de-
       ness friendly in that it gives businesses more ways        mand-side energy proposals is that they could be
       to meet their targets, encouraging both experi-            “forced downsizing,” but a market-based efficiency
       mentation and innovation. For another, it is market        program will stimulate productivity. Tradable ef-
       oriented in that it begins the process of reallocating     ficiency has the potential to remodel the American
       the price of inefficient energy use to the purchase         economy by harnessing emerging technologies and
       price of a product, thus changing buying patterns          new tools for managing information and finances
       by use of the market. Thirdly, energy service com-         to tackle one of our most intractable problems.
       panies, new industries, and even nonprofits like cit-          James Schlesinger, former secretary of energy,
       ies and states may begin to bundle efficiency, tak-         once said that the United States has two modes
       ing advantage of synergies between efficiency and           regarding energy: complacency and panic. Adopt-
       other economic and social goals. And finally, when          ing energy efficiency is a smart third mode, and it
       it is more thoroughly fi nancialized and packaged           would steadily lead us toward greater economic and
       as a credit, efficiency has the potential to become a                        security.
                                                                  environmental security.❖


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