How Will Changes to the Greenhouse Gas Protocol Affect Short-Term Markets?

Late last year, the Greenhouse Gas Protocol (GHGP) proposed revisions to its Scope 2 emissions accounting guidance. If put into place, these revisions could significantly change how companies voluntarily report their greenhouse gas emissions through the program.

One major effect of the proposed revision is an increase in the price of energy attribute credits (EACs) in a relatively small number of hours throughout the year. In a previous blog post, I discussed how the proposed requirements of “hourly matching” and “deliverability” can lead to these EAC price increases and, by extension, greater clean electricity deployment. While the origin of the high EAC prices is straightforward in theory, it is much more challenging to understand how price increases occur in practice and how they could affect the finances of clean energy developers.

Long-term contracts are major sources of revenue and derisking for clean energy developers. But it is not clear, at least to me, how the revisions to the GHGP affect long-term contracting for clean electricity. Instead, it seems likely that the increased prices for EACs will mainly be transmitted through short-term markets called “spot” markets. In these markets, individual EACs are sold by clean energy developers and purchased by companies seeking to claim the consumption of zero-carbon electricity. When these EACs are in short supply, such as when the wind isn’t blowing and the sun isn’t shining, companies may be willing to pay more for the EACs, providing more revenue for clean energy developers, especially those that can produce electricity in those times of shortage (such as through nuclear or geothermal generation).

However, these short-term markets may not be effective in providing a price signal to clean energy developers. Instead, the unpredictability and inflexibility of wind and solar generation will likely lead to volatile EAC prices. In addition, the many types of EACs—one for each hour of the year and for each of 10-plus regions, meaning well over 80,000 types of EACs in the United States—may lead to “thin markets,” further increasing price volatility. This price volatility can make it difficult for clean energy developers to anticipate the revenue they will receive from the sale of EACs on the spot market, to the detriment of project financing and investment.

You Can’t Control the Weather

Traditionally, the price of a good affects both the supply and demand for that good. The market for an EAC looks very different, however. High prices for EACs can’t make the wind blow any harder, nor the sun shine any brighter. For wind and solar, the current sources of the vast majority of EACs, the supply is fixed (“inelastic supply” in economics parlance). If there are enough EACs to satisfy all the demand in a given hour and region—and if electricity storage, which can shift EACs from one hour to another, is absent—the EAC price will be zero. Otherwise, the price will be equal to the highest price a company is willing to pay. In addition to this price volatility, the inelastic supply may force companies to go without EACs in some hours, either reducing their consumption of electricity or relinquishing their claim of consuming 100 percent clean electricity. The presence of sufficient quantities of storage may change this story, an interesting subject for future research.

Weather Forecasts Are Often Wrong

Weather, while predictable to some extent, is fundamentally chaotic. While generation from wind and solar is relatively predictable over the course of a year, the amount of generation in a given hour has a fundamental degree of uncertainty. So, not only is the supply of EACs from wind and solar in each hour unresponsive to prices, generators and companies don’t know for sure how much clean electricity will be available on the spot market at any given time.

This weather uncertainty is a recipe for volatile prices, since you can’t know for sure in any hour whether there will be sufficient EACs to satisfy demand, or too few. This unpredictability makes the revenue in any given hour hard to rely on, and all this uncertainty makes it harder for developers to plan their finances.

Markets work better with more participants, which makes it easier to arrive at a price for the good being traded. So-called “thick” markets have enough participants to ensure that credits can be easily bought and sold and have relatively stable prices. “Thin” markets, with fewer participants, make it harder for buyers and sellers to settle on a consistent price, leading to more price volatility. Among other things, thin markets can lead to more opportunities for price manipulation.

The proposed changes to the GHGP will replace a single EAC market with over 80,000 separate markets. Will these individual markets be thick or thin? On one hand, there may be more participation in these markets, because companies will no longer be able to claim 100 percent clean electricity from single long-term contracts and may turn to the spot market to be able to make these clean electricity claims. On the other hand, that is a lot of markets.

Markets like this can be successful. In some regions of the country, electricity is bought and sold every five minutes. This effectively creates thousands of separate markets for electricity, and these markets operate reasonably well (although certainly not without problems). However, EAC markets differ from electricity markets. For example, most everyone needs electricity, but participation in EAC markets is voluntary. How the EAC markets will operate is still an open question.

The Problem with Uncertainty

Investors don’t like uncertainty, a sentiment reflected in how they finance clean energy. The level of debt a clean energy project can take on is ultimately determined by the project’s ability to make its debt payments, and more revenue uncertainty increases the odds that a project could miss a payment. Somewhat schematically, more revenue uncertainty means that a project must rely on more equity financing, which makes the project cost more. And higher project costs mean less clean energy.

In most new projects these days, clean electricity generators embed EACs in long-term contracts that provide steady streams of revenue to the projects. If project revenues become more reliant on EAC spot markets, revenue uncertainty increases. This uncertainty is compounded by the fact the markets have fixed, uncertain supply and may be thin, leading to more uncertainty in the price signal.

In theory, introducing scarcity into EAC markets can raise the price of EACs and lead to greater deployment of clean electricity. But the real world of clean electricity development and EAC markets is not as simple as the theory. The GHGP’s proposed changes may drive companies to no longer acquire EACs via the traditional approach of long-term contracts. EAC spot markets present many challenges and uncertainties for companies and generators that rely on them instead of long-term contracts. These uncertainties must be managed if spot-market price signals are to be meaningful to developers. And, faced with all these uncertainties and complexities, companies may simply choose not to participate in the GHGP’s voluntary reporting program anymore, and no longer purchase EACs at all.

Like any major change in policy, these proposed revisions to the GHGP represent a bit of a leap into the unknown. All these uncertainties can be managed, potentially through new business models, and it does seem likely that these changes will provide an additional incentive to technologies like nuclear, geothermal, and storage. The question, as always, is whether the potential benefits outweigh the downsides of the new uncertainties. The GHGP has recognized the need for a transition period in the proposed guidance and has suggested exempting smaller companies from certain requirements. Will this flexibility be enough? Time will tell. The GHGP is accepting public comments on its Scope 2 revisions through January 31.