What’s the Worst That Could Happen?

[This post is co-authored with my three collaborators in cap-and-trade work for the California Air Resources Board:  Frank Wolak, Jim Bushell and Matt Zaragoza-Watkins.]

 

California’s year-and-a-half old cap-and-trade market for reducing greenhouse gases (GHGs) has drawn renewed interest over the last few weeks, since the EPA announced its initiative for limiting greenhouse gases from existing power plants.  California’s program is seen by many as a model of how state-level policies can lower GHGs without imposing undue costs on the economy.  This is heartening to supporters of the program who argued that by going first California could develop a market-based system for emissions reduction that could be a model for other regions and countries.

Of course, being on the “bleeding edge” of any movement means learning from risks and mistakes as well as from successes.  So far, California’s program has operated smoothly and is mostly viewed as a success, though the price has stuck pretty close to the effective price floor, $10-$11 for an “allowance” that covers one ton of CO2 emissions.  Some stakeholders, however, have expressed concerns with how the market will perform in the future, particularly after January 1, 2015 when emissions from transportation fuels, residential natural gas combustion and some other sources are added to the market.

The oil refining industry and some lawmakers have argued that the market could see volatile allowance prices, which would feed through to the price of gasoline and to other GHG-intensive products.  Another set of stakeholders have worried that certain market participants might be able to manipulate the price of allowances to their advantage.

The final report of the Market Simulation Group to the California Air Resources Board – released today by the Energy Institute and the Air Resources Board – examines these concerns.  The members of the MSG are Severin Borenstein, Jim Bushnell, and Frank Wolak working with Energy Institute graduate student Matt Zaragoza-Watkins.  In 2012, we were enlisted by the ARB to “stress test” the market design.

The report focuses on what might still go wrong in the market, not on the many thoughtful design features that have reduced or eliminated myriad other problems that could have otherwise occurred in such a complex market.   Our group recognizes the years of careful planning that have gone into creating the foundation for an efficient and robust market.  While we find that some risks remain, we conclude by recommending a couple of straightforward adjustments that could address those risks.  We believe that with these changes, California’s course for addressing climate change with a market mechanism will indeed be a model for other regions and countries.

 

CCD Carbon Price without flag (including caption) 2014.07.08 2The price of allowances in California’s cap-and-trade market since trading began. Graphic by Climate Policy Initiative with interactivity and updates at CalCarbonDash.org.

 

A Sidebar on Including Transportation Fuels in Cap and Trade

Before we get too far into the details of market rules and trading strategies, we want to note that our report has direct implications for the recent debate over whether or not to include gasoline in the cap-and-trade program starting on January 1, 2015, as is now prescribed by state law.  Our estimates imply that by far the most likely effect of including transport fuels in the program next January will be to raise California gasoline prices about 10 cents per gallon.[1]  That barely registers in the context of gasoline price gyrations.

To put that in context, the average Californian uses about 40 gallons of gasoline and diesel per month (directly in their own cars and indirectly through transportation of products they purchase), so this will raise their cost of living in California by about $4 per month.  That’s not nothing, but in the long list of +costs and benefits of living in California, it isn’t one of the major factors.  And unlike when crude oil price spikes drive up gasoline prices, the cap and trade revenue is going back to Californians through state expenditures of the funds.

Finally, the program has been designed around the 2015 expansion to include transport fuels.  Changing the program at this point to exclude fuels from cap-and-trade would be extremely disruptive to the market and could exacerbate the risk of volatile and high allowance prices.

 

WhatsTheWorst2California gasoline prices since 1995 (constant 2014 dollars).  Source: U.S. Energy Information Administration

 

Now Back to Our Study

Our report evaluates the possible outcomes of a competitive allowance market and the potential for non-competitive outcomes, such as market manipulation.  Importantly, we incorporate the uncertainty in economic growth, GHG intensity and other factors that would determine the “business as usual” path of emissions, which is the starting point for analyzing a GHG market.  Previous estimates have not accounted for this uncertainty.

We find that the most likely outcome is a competitive allowance market that yields a low allowance price.  But we also find real risks that allowance prices could rise to much higher levels due to combinations of low CO2 abatement, strong economic growth, and possible market manipulation.  Such disruptive price spikes that could create a backlash against cap-and-trade markets are reminiscent of the impact the California electricity crisis had in virtually stopping electric industry restructuring in the U.S.    Along with nearly all the people we’ve spoken with about the market, we would hate to see a disruption in California’s cap-and-trade program slow the pace of adopting market mechanisms to address climate change.

In response to these risks, the report recommends two changes to the market that would greatly reduce the probability of disruptive price spikes, which we explain below.  Any regulatory change in California requires a lengthy legal process, but we think the changes we propose are relatively straightforward.

 

Forecasting Long Run Supply/Demand Balance in the Cap-and-Trade Market

We first examine the likely supply/demand balance through 2020, the period for which the rules of the program have been set.  The most likely outcome in the overall market, we conclude, will be allowance prices at or just slightly above the price floor.  We also find, however, that in less likely, but plausible, scenarios in which the market tightens and the price starts to rise, there would probably be relatively little additional GHG abatement available.  Thus, if the California economy were to grow strongly and boost GHG emissions – not the most likely outcome, but certainly not unimaginable — we could see allowance prices jump to much higher levels, most likely in the later years of the program.

Our median estimates suggests that without changes to the program there is an 18% chance that prices would eventually rise high enough to trigger the Allowance Price Containment Reserve (APCR).  The APCR adds some additional allowances to the supply if the price exceeds a trigger level that increases from $40 in 2013 to $56 in 2020 (all adjusted for inflation to 2013 dollars).  The same estimates suggests a 6% chance of depleting all the allowances in the APCR, which would then allow prices to go much higher.[2]

Severin’s previous blog posts, in May and September of last year, addressed this risk of price volatility in the cap and trade market, and the need for a credible price ceiling.  The first recommendation in the report is for ARB to adopt a firm and credible price ceiling by standing ready to make additional allowances available at the ceiling price – which they could do by borrowing from post-2020 emissions, purchasing allowances from other GHG markets, or otherwise expanding supply at the ceiling price.

 

Scarcity and Market Manipulation Risks in the Short Run

The final report also expands the analysis to examine the competitive supply/demand balance in the market during the earlier “compliance periods” – 2013-2014 and 2015-2017 – within which participants will accumulate allowance obligations by emitting GHGs and then have to acquire enough emissions allowances to cover them. We find that for each of the earlier compliance periods, prices are very likely – over 80% probability in nearly all scenarios — to remain at or near the price floor.

But, as with the overall eight-year program analysis, we find that there are scenarios of strong economic growth — especially when paired with only modest reductions in emissions intensity — that could push up emissions.  In those cases, the market would be unlikely to demonstrate much price-responsive abatement over the short time available for such response.  The outcome could be substantial price spikes and potential disruption in the market.

Finally, we turn to the potential for anti-competitive behavior in the market.  We find a small but significant risk that some market participants could manipulate the price upwards by buying up more allowances than they need for a given compliance period and then “banking” some of them for use in future compliance periods, thereby creating an artificial shortage of allowances for compliance in the current period.  The report walks through in detail how this might be done and the difficulties a firm would face in carrying out such manipulation.  Banking is just saving and there are legitimate and important reasons for banking; the program needs a policy that undermines use of banking as part of a manipulation strategy.

In response to these risks of short-run shortages and market manipulation, we propose a change in market protocols.  Our second recommendation is to allow “vintage conversion”:  by paying a “conversion fee,” a firm would be permitted to use a later-year “vintage” allowance to meet a compliance obligation it faces in earlier years.[3]  We demonstrate that vintage conversion would greatly reduce the size of price spikes that could occur due to real or artificial short-run allowance shortages and it would undermine the incentive for participants to manipulate the market in order to create an artificial shortage.

California’s cap and trade market is working well so far and our analysis suggests there is a good chance that would continue without changes to the market.  But we also find real risks that the market could tighten and result in large increases in allowance prices.  Such increases would likely make the market politically unsustainable and, in any case, would damage the credibility of this cap and trade market, and probably others.  We urge the Air Resources Board to make the changes proposed in our report in order to greatly reduce or eliminate these risks.  Such changes would be very much in the spirit of pioneering a new path in environmental policy not just by celebrating the successes, but also by learning from the risks and possible failures.

A press release from the Energy Institute on the report can be found here

The final report can be found here as working paper #251

 

[1] Each gallon of California gasoline is counted as about 0.008 tons of GHG, so the current price around $12/ton translates to about $0.10 per gallon.

[2] To be clear, the 6% chance of exhausting the APCR is a subset of the 18% probability of triggering the APCR.

[3] The concept is very close to what is known as “borrowing” in the cap and trade literature.

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2 Responses to What’s the Worst That Could Happen?

  1. mcubedecon says:

    I much appreciate the approach in this analysis, focusing on the range of potential outcomes and the drivers of those outcomes. This is how most policy analysis should be done rather than choosing a single point forecast that most assuredly will be wrong.

    However, I have an important reservation: It is not possible to place probabilities on future events that are embedded with “deep uncertainty” (see for example: http://www.rand.org/pubs/research_briefs/RB9701.html). Assuming that past events driven by complex, changing underlying circumstances (more reflective of chaos than a Markov process) are a good predictor of future outcomes is not a proper representation for policy makers.

    This analysis progresses towards a more appropriate presentation that focuses on the vulnerabilities in the system, the consequences or risks with those vulnerabilities, and proposing solutions that might mitigate those risks. But I think being upfront about an inability to place quantitative probabilities would be more honest.

  2. Pingback: Cap-and-Trade’s Moment of Truth |

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