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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.

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.


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.



13 thoughts on “Cap-and-Trade’s Moment of Truth Leave a comment

  1. Using cap and trade to fighting global warming is an ancient and outdated technique put forth no later than the 1980s. Instead of trying to resurrect this antiquated method of reducing CO2 emissions, we should instead focus on creating renewable energy models that encourage and subsidize individuals and businesses who create solar, wind and geothermal electricity production which is something California has been doing for the past 20 years.

    Unfortunately these things take time and I know many feel we don’t have much more of that spare at this point as we may have already passed away of no return on our way to runaway global warming. And trade won’t change this, however.

  2. Please give us a rigorous and succinct explanation of how it was determined that human caused CO2 has a significant effect on temperature. Modeling cannot do that.

  3. I am really grateful that the State of California has elected to be the test laboratory for these policies. Really I am. Thank you.

    I live in Houston, Texas. In Texas, we don’t worry about the environment or environmental externalities. We view the environment as a force which is relentlessly trying to subdue, kill and consume us. Things which are trying to kill you do not merit worry or sympathy. We worry, instead, about jobs and economic growth and the negative externalities of not having jobs and economic growth. I pay 10 cents a kwh, all day long, all year long, for electricity. I paid 80 dollars a square foot for my house. We have low unemployment and economic growth. We don’t have crumbling schools and infrastructure. Jobs flow out of California and flow to Texas. It is useful, to the rest of us, that California is demonstrating the economic externalities imposed by green regulations before the Congress can be persuaded to impose these same policies on the rest of us. Yes, you say; temperatures will change and sea levels will rise one day; but we will build dikes or we will simply move somewhere else, in much the same way that Californians are moving away, today, from unemployment and blighted opportunities for economic growth.

    Thank you, California. Thank you.

  4. Great summary of the timing — theoretical and applied — for dialing back externalities. I’m always surprised to see politicians who promise to “do something” about climate change (or dirty groundwater, etc.) and THEN say it won’t cost anything. Cognitive dissonance 😦

    • Our elected representatives have been briefed on the AB32 scoping plan over the years and they have been told that fuel costs can go down on average as noted recently here:

      Click to access first_update_climate_change_scoping_plan.pdf

      B. Foster Resilient Economic Growth pg 27:

      “ The combination of California’s vehicle GHG and Zero Emission Vehicle (ZEV) standards and policies adopted under AB 32—including the Low Carbon Fuel Standard, SB 375, and Cap-and-Trade—will reduce per-capita fuel costs and GHG emissions from light-duty vehicles and fuel use by about 30 percent from current levels in 2020, and by about 50 percent in 2035 (see Figure 5). Additional measures to reduce emissions could further reduce fuel costs, as well.”

      Naturally the statement above ASSUMES a few items, but the politicians can use the statement to say it’s not my fault, kind of like having a get out of jail free card in Monopoly, when the assumptions don’t come true.

  5. This is crazy! Have not these well-paid ivory-tower academics heard that the new models predict no climate crisis and no need to tax CO2 and damage the economy of this state. Also, energy experts predict that CO2 emissions will begin to decline around 2035 – long before the benign effects of warming are reversed. See the studies of or the Exxon Mobil’s Energy Outlook 2014-2040. I spent my early career in the oil business – overseas and then in R&D in Houston. I gained great respect for Shell and Exxon scientists. Yes, they even recognize the end of the fossil fuel age.

    In an earlier piece on the worst, etc., academics were debating some fine points of Cap and Trade, and I thought: Do they not know what is going on in this state – outside their ivory tower. More than 10 million residents live below the poverty level! This is nothing but a tax which will hurt many people in this already expensive state. Another 50 cents and eventually more for a gallon of gasoline! CO2 taxes going to a bullet train to nowhere just to make people feel good while not even decreasing CO2 by 0.01%! All this nonsense is hurting the most vulnerable! Has California lost its way? We have seen the departure of so many industries – driven out by the high costs of everything, particularly regulations. Do we notice our crumbling infrastructure and declining public education? A state that has everything going for it is no longer going forward!

  6. Nice piece. One point of fact: California’s renewables programs rarely provide any subsidy for renewables, as you suggest. Rather, the large majority of wholesale contracts save ratepayers money because they are less than the comparable price of power from natural gas plants (the Market Price Referent benchmark). The large majority of wind and solar projects now getting contracts are way below the Market Price Referent and utilities consider anything even near the MPR a bad deal for ratepayers.

    • Tam,

      PG&E just read, for the 8th time, my E-7 rate scheduled Net meter with PV for my yearly True Up bill. I was entering some kWh data into an excel spreadsheet this morning and I came across the details of the Time of Delivery (TOD) factors that PG&E, SCE, and San Diego used to determine the value (their cost = the price the utility scale RE project owner receives) of the kWh’s coming from the various RE projects put in place via the must take PPA’s for the original 20%RES.

      Click to access 154753.PDF

      The contracts don’t provide a subsidy per say for the approved RE, but they defiantly provide additional cash flow (value) for the kWh delivered to the grid at different times of day. I don’t think the Natural gas generators get TOD factors for the energy they provide to the grid. The combination of the TOD factors and the strike price based on the MPR led the CPUC to say this a couple of years ago:
      “Figure 6 below shows the weighted average TOD-adjusted cost approved by the CPUC that year. From 2003 to 2011 the, contract costs have increased from 5.4 cents to 13.3 cents per kWh…. In order to meet the ambitious 20% and 33% RES targets, the IOU’s have to contract with new facilities, which require higher contract costs to recover the capital needed to develop the new facilities…”

      The recently brought on line concentrating solar facility had an average cost to PG&E closer to 17 cents a kWh for the output of this RE generation facility. The rational for the higher price was the energy storage capability of the facility.

      A few years back I attended a couple CEC meetings on residential electrical rates. The different service providers, public as well as the big three, have rather dramatically different Average prices as denoted on in Table B-7 Average Residential Electricity Rates (2010 Cents/kWh), updated forecast.

      Click to access CEC-200-2011-006-SD.pdf

      PG&E’s average E-1 Non Care price for a kWh is now $.20. With Tier 3 and 4 prices above $.30 kWh. Unfortunately, it appears that actual 2014 residential rates for PG&E are tracking towards the “Low Demand Scenario” noted above.

      I feel sorry for the poor analysts who have to come up with the kWh savings for various EE efforts as part of the energy audits that are occurring. To come up with an ROI for the various improvements they need some expected kWh costs in the future. Using a state wide average kWh cost estimate would be a poor choice.

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