Californians Can Handle the Truth About Gas Prices

A few weeks ago, Jim blogged about the concerns that cap-and-trade will drive up gas prices in California.   In late June, those concerns resulted in a letter from Assemblymember Perea and 15 other Democrats asking the California Air Resources Board to delay this expansion of the cap-and-trade program to include transportation fuels from January 1, 2015 to January 1, 2018.  And a couple weeks ago, the ARB Chair, Mary Nichols, sent a reply explaining why ARB was not going to do that.

Meanwhile, the oil industry and some other groups opposed to fuels in the cap-and-trade program have been making inaccurate statements that the change will cause huge increases in gasoline prices.  The ARB and some other supporters of fuels under the cap have responded with their own inaccuracies, saying that including fuels in the program needn’t raise gas prices at all and suggesting that any increase is the fault of oil companies.

CarbonPieChart

There is a real policy debate here about how and when California should reduce its greenhouse gas emissions, 38% of which come from transportation.  I share Jim’s view that this is a moment of truth in which California needs to show it will really step up to reduce GHGs.  Unfortunately, that debate is being obscured by the battling spin over how much gas prices will go up when we expand cap-and-trade on January 1, 2015.

So here’s my attempt at de-spinning (I’m going to focus on gasoline, but the calculations are similar for diesel):

California’s gasoline blend sold at the pump is 90% gasoline and 10% ethanol, a ratio that is unlikely to change anytime soon.  Ethanol counts as zero carbon under cap-and-trade (long story, but not as silly as it sounds).  Pure gasoline emits about 0.009 tons of CO2e (the units of the cap-and-trade allowances) per gallon, so the gasoline blend you put in your car will make the seller responsible for about 0.008 (90% of 0.009) allowances per gallon.

The current price of an allowance is slightly less than $12/ton and the futures market predicts it will be about the same on January 1, 2015.  Our own analysis that I discussed a month ago also finds that the price of allowances will most likely remain in the $12-$15 range out to 2020.[1]  There is a small, but real, risk that allowance prices could go much higher a few years out, which we discuss in detail in our report. But if you want to know what gasoline price “shock” will hit consumers in January when gasoline comes under the cap and trade program, the relevant allowance price is about $12/ton.  That will increase the marginal cost of selling a gallon of gasoline by about 9-10 cents per gallon on January 1.

A large literature in economics has examined what happens to gasoline prices when the marginal cost of selling gas increases, looking at changes in the price of crude oil and changes in gas taxes.  The answer: those increases are passed through one-for-one to consumers, generally in a matter of days or maybe a week or two.

That’s why the almost certain outcome is that within a few days after January 1, 2015, the cap-and-trade program will cause the price of gasoline in California to increase by 9-10 cents, less than the drop in gas prices over the last few weeks.

GasPriceNonsenseSource: Energy Information Administration

 Average California gas price so far this year

(What’s that you say? You didn’t notice the drop? I’m not surprised.  With oil price fluctuations regularly pushing gasoline up or down 25 cents or more, an extra 10 cents one way or the other doesn’t catch the attention of most consumers.)

Before I move on to confront some of the spin, let’s consider that price increase in context.  A 10 cent increase will be about 2.5%.  Here are some things you could do to fully offset that additional cost:

  • Drive 70 mph instead of 72 mph on the freeway. That difference would improve your fuel economy by about 2.5%.  The savings are much larger if you actually drive the speed limit.
  • Buy a car that gets 31 MPG instead of 30 MPG. That will get you more than a 3% savings in fuel cost, more than offsetting the price increase.
  • Keep your tires properly inflated. The Department of Energy estimates that underinflated tires waste about 0.3% of gasoline for every 1 psi drop in pressure.

Instead of this simple reality, we are hearing misinformation coming from both sides:

 

wspa

What The Oil Industry is Claiming (and many others opposed to the program expansion are repeating):  The Western States Petroleum Association (WSPA) says at every opportunity that cap-and-trade will raise the price of gasoline by 16-76 (or 14-69) cents per gallon. Huh?  These ranges don’t even include the most likely effect of 10 cents.  The industry got to these much-scarier ranges in two ways, both of which are – to be charitable – not based on the current information.

First, they took a 2010 ARB study – from before the final details of the program were even set – that predicted a 4%-19% price increase back when gas prices were in the $3 range and just slapped it on the current price of $4.  That doesn’t make any sense because the cost of allowances doesn’t scale up and down with the price of gasoline.  But, in any case, the range was based on a range of possible allowance prices from 2010 analysis.  We know a lot more now than we knew in 2010.  For instance, we now know the current market price of allowances and the market’s prediction for the January price.  Those allowance prices imply gasoline prices will rise by 9-10 cents, below the bottom of the very wide range the oil industry asserts is possible.

Second, WSPA took a prediction from their own consultants’ 2012 report, which argued that allowances would cost $14-$70 and (doing the calculation slightly incorrectly) concluded that this would cause the emissions costs from gasoline to be 14-69 cents per gallon.[2]  More recent information suggests the best forecast for January is below this range, so the oil industry is just choosing to ignore more recent information.

On August 1, the oil industry doubled down on their assertions in a letter to ARB.  While making some valid points about ARB’s misguided claims (which I’ll discuss below), WSPA states that ARB’s 2010 numbers must be the best estimates out there because ARB hasn’t put out a new estimate. That seems less than genuine given that the oil industry is as familiar as anyone with the market price of allowances.  They can certainly do the calculation I’ve done above.[3]

The oil industry might respond that the high end of this range could conceivably happen years from now if no further changes to the program are made.  That’s true — as our report explains — but these figures are being used to argue for a 3-year delay in fuels under the cap, often using the WSPA range to discuss the price shock that might otherwise occur in January 2015.  The “shock’’ on January 1 will be about 10 cents.

The oil industry’s numbers are eye-catching — much more than the boringly realistic 10 cents a gallon impact — and they are getting traction. Media reports of expected increases include 15-40 cents, 17 cents or higher, 40 cents, 15 cents or more and 15 cents (surprisingly moderate for Fox News).  A few stories repeat claims that cap-and-trade could cause gas prices to spike by more than a dollar, though I haven’t seen that claim attributed or justified.  Even the letter from the Assemblymembers to ARB says of the immediate price jump at the pump on January 1, 2015: “an increase of about 15 cents is likely and a much larger jump is possible.”  Not true.

 

CARB

What the Air Resources Board is Claiming:  ARB officials and (others supporting the policy) seem to have decided that counterspin is a better strategy than straight talk.  They have repeatedly suggested that if gas prices rise in January, ARB policy would not be the cause:  Cap-and-trade just requires sellers to turn in allowances; whether they choose to pass along that cost to consumers is their decision, not ARB’s fault.  Really? Every economic analysis of cap and trade I have ever seen –left, right or center politically (and ARB’s own analysis) – recognizes that it will raise the cost of selling gasoline and that this increase will be passed along to consumers.  That isn’t due to some conspiracy.  It’s how markets work; when the marginal cost of selling a good goes up, firms raise their price.  The cap-and-trade program will cause gas prices to go up in January 2015 by about 10 cents per gallon.

An ARB spokesperson has also suggested that these costs somehow won’t or shouldn’t be passed along because oil companies have been buying allowances since 2012 and already have a lot of them.  What?!? That’s like saying you paid for your house long ago so now you should give it away for free when you move.  In reality, every allowance a fuel dealer uses to cover its compliance obligation from selling gasoline will be an allowance it can’t sell in the marketplace.  That’s a real cost.

In the letter to Assemblymember Perea and his colleagues and in other statements ARB argues that any impact from cap-and-trade should occur gradually, not a sudden jump on January 1.  But the cost effect of fuels under cap-and-trade will go from zero on December 31, 2014 to 10 cents on January 1, 2015.  Just like an increase in crude oil prices or raising a gas tax, the empirical evidence is that this will show up at the pump within days.

Bottom Line: Like Jim, I strongly support bringing fuels under cap-and-trade on January 1, 2015.  That’s been the plan for many years and the current arguments for delay contain no new information.  Robust debate is valuable, but that debate is undermined when the public is told either that this change won’t (or shouldn’t) cost them anything or that the cost will be many times higher than the most reasonable estimates.

One Final Note About Public Opinion: Many of the newspaper articles on the price increase and many of the advocates for delay are citing a poll by the Public Policy Institute of California.  They quote the PPIC report saying “A large majority of Californians (76%) favor this requirement [including transportation fuels in cap and trade], but support declines to 39 percent if the result is higher prices at the pump.”  Is that informative? When you look at the actual survey question (page 31, question 30), I’d say it’s pretty useless.  The question asks if you favor requiring oil companies to “produce transportation fuels with lower emissions?” and then “Do you still favor this state law if it means an increase in gasoline prices at the pump?”.  There is no specific increase mentioned; that’s left up to the imagination of the person answering.  I bet if they asked about a one cent increase, there would have been almost no change, and if it asked about a one dollar increase, support would plummet.  Too bad they didn’t ask about a 10 cent increase.  That would have been interesting.  But I have no idea how to interpret the results of the question that was actually asked.

 

 

[1] The California Legislative Analyst’s Office sent a letter to Assemblymember Perea last week that called our study the most credible of the studies they reviewed.  They used our estimates to say that gas prices would likely go up 13-20 cents by 2020.  They did not mention that the same reasoning implies the impact in 2015 will be about 9-10 cents per gallon, but that is what their analysis also implies.

[2] Actually, the report states this range for the year 2020, which is three years after the proposed delay of implementing fuels under the cap.

[3] Some in the oil industry continue to argue that transportation fuels under cap-and-trade will hurt sellers – it won’t because the cost will be fully passed through – and that sellers should receive some free allowances to cover this additional burden.  Free allowance allocation would just be equivalent to a cash gift to gasoline distributors; for the marginal cost reasons explained they would still raise gas prices. (In fact EU policy makers tried this and were “shocked’’ to see that the companies getting free EU-ETS allowances still raised their prices).

I tweet interesting energy news articles most days @EnergyClippings

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Identifying the Best Ways to Increase Energy Access

NPR ran a story a couple months ago about a seemingly clever device. It’s called the Soccket. The name – and the device – combines soccer with electricity.

SoccketThe Soccket – created by a US-based NGO and distributed around the developing world – allows kids to play soccer during the day and then use the kinetic energy from their balls to power a reading lamp at night. Seems great – helps kids study even if they don’t have electricity in their homes.

To the Soccket entrepreneur’s dismay, NPR’s story pointed out that the devices weren’t robust. The reporter also interviewed a woman whose grandson had been given a Socket, noting that, “for the $60 it cost a charity to provide her family with one Soccket ball, she said she could have had her home hooked up to the electric grid, and that could have provided light for her whole family for years to come.” While her home didn’t have electricity, the grid had already come to her village.

The debates about the Soccket are representative of broader discussions about the best ways to bring electricity to the more than one billion people in the world who live without it: Lots of good intentions, but very little data that could help inform decisions about how to best increase energy access.

The current discussions about energy access tend to focus on two mechanisms: grid extensions and off-grid solutions, like solar home systems, village-level microgrids or even the Soccket. Sometimes these approaches are pitted against one another.

For example, debates between the Breakthrough Institute and Sierra Club have gotten heated. The Sierra Club sees huge potential for growth in off-grid solutions, like solar home systems. They recently put out a report containing the graph below, which depicts the amount of money for grid extensions dwindling while spending on minigrids and solar home systems (SHS) expands.

sierra club chartThe Breakthrough Institute is critical of the report, and notes that solar home systems and similar devices are, “a vision of, at best, charity for the world’s poor, not the kind of economic development that results in longer lives, higher standards of living, and stronger and more inclusive socioeconomic institutions.

Recent data that several colleagues and I have collected in Western Kenya suggest that the distinction between on-grid and off-grid may be too stark. As part of a larger project, we geo-coded over 20,000 structures and noted whether or not they were electrified. Very few of them were: only 5% of the homes and 22% of the businesses.

Here’s the surprising thing, though. All of these structures were within 600 meters of existing transformers. A full half of the unconnected homes were within 200 meters of an existing connection. We are calling these homes and businesses “under-grid” as they’re not on the grid but “off grid” just doesn’t capture their proximity to the existing grid infrastructure.

Many unelectrified households (in green) surround a transformer (T). White circle demarcates 600 meter radius.

Many unelectrified households (in green) surround a transformer (T). White circle demarcates 600 meter radius.

How can this happen? We have several hypotheses that we’re testing rigorously in on-going work. One notable fact is that households must pay over $400 for a connection, a very high sum in a country where average per capita incomes are around $1700. Kenya Power and Light Company claims that its average cost of establishing a new connection is even higher and appears uninterested in lowering the connection charge.

We suspect that there’s a virtuous cycle to take advantage of, though. If KPLC lowered the charge or even offered households a way to finance the charge, paying back the fixed costs over time, more households would likely connect. In turn, with a greater density of new connections, the average cost per connection is likely to be lower.

Building out the grid in Western Kenya

Building out the grid in Western Kenya

How representative is the situation in Western Kenya? To really answer that, we need to collect more hard data about electricity demand and supply around the developing world. The Soccket is clever, but donors interested in helping kids study at night should know that there may be cheaper ways to achieve that goal.

While we are collecting more data, though, I would like to see the term “under-grid” introduced into the debate. Rhetoric can matter, especially in the absence of hard facts. Often, people on both sides of the solar-versus-grid-extensions debate talk about waiting for the grid to “reach” households. Even the term “extensions” suggests a technological challenge, but our results in Kenya suggest that economics – getting the connection charges right – may be the crucial barrier.

There is one aspect of the Kenyan experience that is likely to have general resonance. The country embarked on a massive grid extension program in 2006 focused on electrifying all the schools in the country. Similar ambitions in other countries will bring the grid close to most people. And, after all, while having electricity in your home is one important measure of development, electrified schools and health centers, which are usually close to where people live, are also important.

The cover of the Sierra Club report is pictured below. The man seems proud of his solar home system, which I suspect is why the Sierra Club chose the picture. Note that in the background of the picture, and presumably close to the solar owners’ home, there are grid electricity lines. In many parts of the developing world, those lines could carry electricity from large- scale renewable resources, so the grid does not have to be synonymous with dirty fossil-fuel power.

Sierra Club CoverAchieving energy access for the billion-plus people without pillaging the climate will be one of the toughest challenges of our time. As we do that, it’s important to make decisions with the best possible information.

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Will coal exports abroad offset hard-won carbon reductions at home?

When President Barack Obama took office in 2009, he set a goal of cutting U.S. greenhouse gas emissions by 17 percent of 2005 levels by 2020.  The graph below shows that we appear to be making progress towards meeting this target.  The solid black line tracks domestic GHG emissions in recent years. U.S. emissions have now fallen to their lowest point in two decades!

coablogfigDomestic greenhouse gas emissions (left axis) and electricity generation shares by fuel (right axis)

Sources:  US EPA GHG emissions inventory (emissions) and EIA monthly energy review (fuel shares)

Researchers have been busy digging into the data to explain this decline in domestic emissions– most of which has occurred in the power sector (a great example of recent work can be found here). Part of the explanation clearly lies with the shale gas boom – and limited opportunities to export natural gas.  The resulting fall in domestic natural gas prices over the 2008-2012 has led to a re-allocation of electricity production from coal to gas-fired generating plants. The broken blue line in the graph shows the increasing share of US electricity generated using natural gas; the broken brown line shows the decline of coal. Increased penetration of renewables has also played a role in reducing coal’s share of electricity production over this period.

The graph also shows that we have a ways to go before we hit President Obama’s 2020 emissions reduction target (denoted by the red line).[1]  Recently announced standards to limit carbon pollution from existing power plants, in conjunction with other environmental regulations such as the mercury rule, are expected to further reduce the share of electricity generated using coal in the years ahead.

In sum, a reduced reliance on coal in the domestic power sector has been – and will continue to be – an important driver of reductions in domestic greenhouse gas emissions. But what is happening to the coal that we’re no longer burning here at home?

Domestic coal consumption down, exports on the rise

Over the period 2000-2012, domestic coal consumption declined by 18 percent whereas domestic coal production declined by just over 5 percent. The graph below helps to illustrate how the rise in net exports makes up the difference.

coalfig2U.S. coal imports and exports

Source : Energy Information Administration

This upward trend in net exports is expected to continue apace, particularly if coal companies succeed in building new coal-export ports in the Northwest. It is estimated that ports under consideration in Oregon and Washington could eventually ship over 100 million tons of coal per year to Asia. These developments have environmentalists urgently questioning the extent to which increased energy exports will undermine carbon emissions reductions achieved within the U.S.

What effect do U.S. coal exports have on global GHG emissions?

To answer this question, we need to make assumptions about what patterns of global energy consumption would look like in a world with and without US coal exports. Not surprisingly, different assumptions can generate very different answers.

Consider, for example, a provocative report released earlier this year by the CO2 Scorecard Group.  This report – which attracted considerable attention in the energy/environment blogosphere- looks to estimate the extent to which increased coal exports have eroded domestic emissions reductions from the shale gas boom.  The authors begin by estimating the impact of the shale gas boom on domestic steam coal exports. They then multiply each exported ton by the EPA-reported average emissions rate of 1.8 metric tons of CO2 per short ton of steam coal consumed in the electric power sector. They conclude that, between 2007-2012, CO2 emissions from coal-to-gas fuel switching were more than offset by increased emissions associated with coal exports.[2]

Importantly, this approach assumes that domestic coal exports act to increase global energy consumption, versus displace coal or other energy sources. In other words, each ton of coal exported is assumed to be additional to – versus substituting for- energy that would otherwise be consumed. In fact, it seems much more likely that some fraction of the coal exported will crowd out other coal supplies. Particularly when you consider that China – with its seemingly insatiable appetite for coal- was the third largest destination for US coal exports in recent years. Only the Netherlands and the UK imported more U.S. coal in 2012.

With this in mind, Stanford economist and Energy Institute affiliate Frank Wolak puts forward a different view. Frank and co-authors have been analyzing the likely emissions impacts of expanding U.S. coal exports to Asia using an economic model of global coal markets. This research is finding that increasing domestic coal exports to China could reduce GHG emissions. The basic argument is as follows. Because China has very little natural gas-fired generation and highly inelastic demand for coal, U.S. exports of coal to China will substitute for other coal.  Selling U.S. coal to China could raise coal prices in the U.S. and Europe (a major importer of U.S. coal). In both of these regions there is flexible natural gas fired capacity capable of substituting for coal in the production of electricity. This fuel switching would reduce greenhouse gas emissions. Keep an eye on this site for a full report coming soon.

The bottom-line

Many are hoping that the current U.S. commitment to reducing domestic emissions will provide the moral authority needed to negotiate international commitments to reducing global greenhouse gas emissions next year in Paris.  If we really want to lead by example, it is important to understand and account for the emissions implications of both our energy consumption and production. The extent to which U.S. increased coal exports offset reductions in domestic GHG emissions will depend on parameters that are difficult to estimate, including the elasticity of supply for coal at home and abroad, the elasticity of supply of other energy sources (e.g. natural gas), and the own-price elasticity of demand for coal in China and elsewhere.  That said, economics research can and should shed some much needed light on the most likely emissions implications of US energy exports.

 

[1] This graph may misrepresent the true target. It is not clear if the official pledge refers to all GHG emissions. The pledge is to reduce emissions: “In the range of 17%, in conformity with anticipated U.S. energy and climate legislation..” The “legislation”  was Waxman-Markey which targeted energy-related emissions primarily.

[2] These numbers would look even worse if we account for the emissions generated in transporting the coal abroad. Based on Joe Shapiro’s excellent work on the emissions implications of trade, this could amount to roughly 0.16 tons CO2 per ton of coal exported. On the flip side, these numbers would look a little better if we account for the fact that coal plants in some importing countries out-perform the average US coal-fired power plant in terms of fuel efficiency and emissions intensity.

Author Comment

Many thank to Andrew Revkin for mentioning this post in his New York Times blog and drawing more attention to these issues.

The intended points of my post are: the impacts of domestic coal exports on global greenhouse gas emissions are difficult to tease apart but important to understand; different underlying assumptions can lead to different conclusions; and, new research in this area will help to shed more light on this controversial question.

This prompted a detailed response from CO2 Scorecard: http://co2scorecard.org/home/researchitem/30

Back-and-forth discussion of the strengths and limitations of different modeling approaches/assumptions can help us understand the true emissions impacts of US energy exports on global emissions. An important – and continuing – conversation to be having on this blog and elsewhere. Thanks for reading.

 

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What we don’t know about economic climate change impacts

A relatively recent econometric literature examines the impact of weather/climate on a variety of outcomes of economic interest. In order to provide an estimate of a climate impact you need two things: An estimate of how a sector responds to a change in weather/climate and projections of future climate. The latter comes out of Global Climate Models with global coverage. The response functions, however, are increasingly provided by econometric studies. These studies are based on statistical models explaining variation in observed outcomes (e.g. crime rates, mortality, electricity consumption) as a function of weather, while carefully accounting for the impact of other confounding factors.

I have written on the impact of weather on electricity consumption and rice yields. EI@Haas family member Wolfram Schlenker has written extensively on the impacts of weather on agricultural yields. Michael Greenstone has some fascinating work on heat mortality in the US and India. There is a recent explosion in the literature of the weather impacts on crime, conflict and labor productivity. These studies are important as they inform us about how sensitive these sectors are to higher temperatures. There is a lively discussion about what we can and cannot learn from these models.

While I get excited about these studies, I was not fully aware of how limited their coverage is in terms of sectors and geographical areas. Enter Solomon Hsiang. As many readers of this blog know, Tom Steyer (founder of Farallon Capital), Hank Paulsson (former treasury secretary and CEO of Goldman) and Michael Bloomberg (founder of Bloomberg and former mayor of NYC) recently released their “risky business” report, which studies the projected impacts of climate change on the US economy. They hired Solomon and coauthors to quantify the impacts of climate change on the US economy using econometrically estimated response functions for different sectors. Their background report is truly illuminating (and full of frightening, yet beautiful graphs). They scoured the literature for available response functions and incorporated them in their analysis. If they did not find high quality estimates for a sector, they did not include it in their study. Below is a schematic of what was and was not included in the analysis. The blue symbols are areas that were included:

Screenshot 2014-07-21 15.27.10

The grey symbols in the box of impacts are areas that were not included in the analysis because there aren’t any well-estimated response functions available. This is really worrisome. We are missing good estimates for some very important sectors: Water supply and demand, morbidity, extreme weather impacts, livestock, crops other than the big four etc. etc. And this is just for the United States!

Are these important issues we should be working on? Well, greetings from the state of California. If the current drought is any indication of what is to come by end of century, it would be useful to have a well estimated weather elasticity of water demand – maybe even by sector. Morbidity anyone? Does a damage only count if one drops dead? If you look at the projected impacts in this most excellent report, we see that it is high time we get to work. We have spent the vast majority of our time worrying about agriculture and written hundreds of papers estimating impacts for a very limited number of sectors, but largely ignored energy, productivity and storm damages. And more importantly, there are few to no studies for a significant number of other climate sensitive sectors.

To make that point a little bit more bluntly, look at the figure of total impacts by sector for the end of the century:

Screenshot 2014-07-21 15.32.17

What this indicates is that we expect relatively small and well estimated impacts for agriculture (green) and crime (red) (which is what the literature has focused on) and big yet uncertain impacts for labor (yellow), energy (orange) and coastal damages (blue) (which has been largely ignore by the econometric literature so far). What is even more worrisome are the sectors that do not appear on these graphs.

On the spectrum of econometric difficulty, these studies are not that hard to do. Even I work on them. Funders and researchers should make these a priority. The required weather data are easily accessible. All we need to do is identify the relevant outcomes and collect high quality data on them. Let’s get to work. If you’d like to collaborate, drop me a line. I’m ready.

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Cap-and-Trade’s Moment of Truth

With the looming expansion of its cap-and-trade program to transportation fuels like gasoline, California is fast approaching a significant moment of truth for its climate policy. This has some people nervous, and there are growing rumblings of proposals to delay, perhaps permanently, the expansion of the cap to transportation fuels. While many of the backers of these proposals profess continued support for AB 32 and its goals, such a stance (pro-AB 32, anti fuels under the cap) is not logically consistent.

California’s Global Warming Solutions Act (AB 32) was passed in 2006. As is so common with ambitious policy initiatives, AB 32 immediately generated a lot of excitement, while initiating a slow process that deferred much of the costs till later. It was a feel good moment, but now the time to pay part of the bill is nearly upon us.

Amongst the pro-AB 32 community, there has always been two competing narratives. The first, the “it’s all good!” narrative, has been that AB 32 would be nothing but positive for California’s environment and its economy. Since CO2 regulations are inevitable, according to this narrative, by moving first California can get a jump on other states and countries and gain a competitive advantage in a new carbon-controlled world. All of the new policies directed at reducing CO2 emissions would stimulate innovation and growth in new industries.

A second narrative, which is more persuasive to me and many other environmental economists, is that there are indeed some costs to imposing limits on carbon emissions, but that those costs are far outweighed by the risks of climate change and the pressing need to do something. There would obviously be growth in some industries (biofuels, solar panels) but there would also be (likely modest) costs imposed on many others. Those of us in this second camp have always been nervous about emphasizing economic benefits, since real change would require a continued commitment even when it’s not all good. An overemphasis on the economic benefits risks a collapse of support when the public is confronted with any bad news.

The first narrative was dominant for many years in California. Each step in this process has contained an element of trying to shield customers, either psychologically or literally, from the costs of the regulations, and therefore from the costs of their contribution to global greenhouse gasses. Part of the appeal of AB 32 programs like the renewable portfolio standard, and the low-carbon fuel standard, is that those programs emphasize subsidizing clean energy, rather than the costs they create for dirtier energy. As readers of this blog will know, cap-and-trade in its pure form puts a price on carbon. Indeed, that’s sort of the point. So far, however, the impact on consumers and business has been greatly muted by the extensive free allocation of allowances to almost every business currently under the cap.[1]

At each major decision point, there have been signs of second-thoughts, but the public mood was dominated by a sense it was necessary to continue along the path set in 2006. We are now approaching the most significant milestone to date for the program. Gasoline and other transportation fuels (and much natural gas usage) are set to go under the cap starting in January 2015. This will more than double the amount of CO2 emissions covered under the program.

This is a major milestone in many ways. Transportation fuels are one of the very few sources of CO2 emissions that will not be offset with the free allocation of allowances. Just about every serious person who has thought about this expects that the costs of the carbon that is contained in petroleum-based fuels will be reflected in retail prices.[2] While the suite of other policies rolled out under AB 32 will certainly have an impact on electricity, auto, and (yes) even gasoline prices, expanding the cap to transportation fuels will constitute the most explicit link of carbon-costs to consumer prices yet seen in California.

Chevron+Posts+Best+Quarterly+Earnings+Record+Svo93DoV961l

May 2, 2008 – Source: David McNew/Getty Images North America

This looming impact on transportation fuel prices has had a lot of people worried for quite some time, and the intensity is growing. In February Darrel Steinberg proposed taking fuels out from under the cap, and instead taxing them. More recently a Bill sponsored by Henry Perea would delay expanding the cap to fuels until 2018.  The fuels industry itself has periodically argued for either more allocations of allowances or some kind of alternative to the cap.

There are different motivations at play here, Steinberg cited concerns over uncertainty in environmental costs, but by offering a tax recognizes a role to be played by the fuels industry.  Perea appears mainly focused on the costs of gasoline, considering the 10-15 cents per gallon that the cap could add to fuels costs to be an unacceptable burden for drivers.

However if you were a believer in AB 32 in 2006, nothing has really changed.  If we want to make even a tiny dent in CO2 emissions we need to begin addressing transportation fuels, the largest single category of such emissions in California. We knew this in 2006 and it is still true today. There is also a logical disconnect to continued support for AB 32 and opposition to capping transportation fuels. If the sole concern is the costs imposed on drivers, policies like the low-carbon fuel standard are likely to have a greater impact than the cap.

blog_graph

One fact that is not widely appreciated is the critical role that transportation fuels have been given in the design of the cap-and-trade program. One of the best aspects of California’s market design has been the relatively tight price-collars (price floors and ceilings) it has placed on CO2 prices. But these price-collars depend upon the ability of the ARB to inject or withdraw allowances into the market to maintain a relatively stable price. In essence, fuels provide the slack that allows the cap-and-trade market to balance.

You can’t just pull fuels out of the cap and expect the rest of the system to work just fine without it. It wasn’t designed that way. As we wrote last week, the most likely outcome is that allowance prices would settle in close to the floor price. But if fuels are taken out, that floor price would be very vulnerable. The ARB maintains the integrity of the floor price through its ability to reduce the number of permits sold in its quarterly auctions. The problem is most all of the permits outside of transport are already spoken-for, having been freely allocated to various industries. It is very plausible that the remaining market could be left with excess allowances that would continue to be injected in to the market since they have already been allocated to the various remaining industries.

Taking fuels out from under the cap, and taxing them instead would reduce the uncertainty of carbon costs on fuels, but it would increase the uncertainty for everything else at the same time. That makes no sense. Fuels are important, but given their high visibility on street corners and in the news-media, policy discussions too often focus solely on fuel prices at the expense of other aspects of the economy.

If its uncertainty we are really worried about, then lets take steps to reduce that uncertainty by reinforcing, or even tightening the allowance price-collar mechanisms that are already in place. Adopting the recommendations in the Market Simulation Group report would be a good start on that. If we are really worried about any increase in gasoline prices, well, that is effectively saying that we are unwilling to take the steps California committed to in 2006.[3]

California’s experiment with climate policy has always been about trying to set a model for the rest of the country and world. It is also a learning experience.  Maybe one of the most important lessons we need to learn is whether the public, and our political leadership, can tolerate policies that are transparent in their impact on energy costs.  If not, then we will be left with a suite of less efficient, more feel-good policies that impose only hidden costs.

[1] Really close followers of the blog will note that the exogenous free allocation of permits benefits the firms that receive them but probably not their customers. However the bulk of allowances allocated in Calfornia have either been allocated through output-based updating, which can keep the CO2 price from filtering down, or given to regulated utilities whose regulators are requiring that the allowance value is passed on to consumers.

[2] Because of the way ethanol is treated under the cap, the 10% of our fuels that are biofuels will not carry a carbon cost. Neither will most of the emissions associated with refinery emissions, which will be offset by the allocation of allowances. Also because it is one of the few sources of emissions for which allowances have not been freely allocated, the auctioning of allowances associated with fuels will provide the bulk of the revenues generated by the cap-and-trade program.

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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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Open Sourcing Risky Business

A lot of the policy discussion, and many of our blog posts, focus on the difficult task of trying to slow climate change. It’s useful to remind ourselves of the difficulties associated with NOT slowing climate change.

Last week, Michael Bloomberg, Hank Paulson and Tom Steyer released their Risky Business report quantifying the costs of climate change for the US economy. The report relies heavily on modeling work by one of EI@Haas’ own, Solomon Hsiang. Sol is a professor at UC Berkeley’s Goldman School of Public Policy and was a visitor at the Energy Institute this past semester. He was the lead economic author on the technical report that generated all of the results for the Bloomberg et al. glossy.

rb2

Photo from Risky Business Report

The technical report is notable on several dimensions, both the results it presents and the methodologies the authors use. The press has picked up on the bi-partisan leaders of the project, their call to apply risk management thinking to climate change, and the impactful charts and figures documenting the regional effects of climate change.

I was intrigued by a component of the report that hasn’t gotten as much attention –its commitment to “open science.” There’s no hard and fast definition of that term, but the Open Science organization defines it as, “the idea that scientific knowledge of all kinds should be openly shared as early as is practical in the discovery process.”

I have been involved in lengthy discussions about open science with my colleagues. Here are some of the tradeoffs in the context of the Risky Business report.

Bartopen-1Underlying the report’s fabulous pictures is an elaborate computer simulation model. Sol and his co-authors spent many, many hours developing their model, which they are calling SEAGLAS (Spatial Empirical Global-to-Local Assessment System). Developing a model like SEAGLAS involves everything from digging into the literature to come up with the best inputs to the model (e.g., the projections for temperature changes, impact of weather on electricity consumption) to writing lines and lines of code to combine all the inputs to generate useful outputs.

The benefits to embracing open science in this case are pretty clear. If Sol and his co-authors make the code underlying SEAGLAS accessible, other researchers can check the code for errors, stress test it by using it to generate results different from the ones in the original report, write modules to expand it, and generally improve its usefulness.

But, there is a potential cost. Academics are rewarded (e.g., promoted to tenure or given raises) almost purely on the number of original scientific publications they produce. So, the inclination of some people who develop models like SEAGLAS is to keep them under lock and key while they publish papers. After all, what’s the purpose of investing a lot of time in a well-constructed model if other researchers can use it to do cool stuff before you can? It’s like a company shielding its intellectual property, just that the currency is academic publications rather than cash. The risk is that we will get fewer valuable models created in the first place if researchers are expected to immediately make them open.

Much like Elon Musk at Tesla, Sol and his co-authors seem to be opening up the model vault. The report explicitly says, “We will be making our data and tools available online at climateprospectus.rhg.com. We hope others build on and improve upon our work in the months and years ahead.”

Sol and his co-authors are certainly not the first climate modelers to make their code public, and, in fact, how truly public it is remains to be seen. Posting undocumented code is almost useless to other researchers – it can take as much or more time to dissect someone else’s code as to write your own. On the other hand, some modelers have made an industry out of teaching people about their models and go to great lengths to make it accessible.

I am optimistic that Sol and his co-authors will provide useful information at the link above. After all, they’ve already made an early, public commitment to do that in the Risky Business technical report.

And, in terms of the inputs to the model, Sol sent us an email explaining that, “We have developed a new Distributed Meta-Analysis System (DMAS) that continuously and dynamically integrates new empirical findings (that are crowd-sourced from researchers around the world).” This means the inputs will be kept current and should represent consensus estimates from other researchers.

We have a lot of work to do quantifying the impacts of climate change and identifying the best mitigation and adaptation strategies. With public-minded – not to mention superb – researchers like Sol, I’m optimistic about the progress we can make.

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