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.
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. 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.
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.
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.
 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.
 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.