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Fixing a major flaw in cap-and-trade

While many Californians are spending August burning fossil fuels to travel to vacation destinations, the state legislature is negotiating with Gov. Brown over whether and how to extend the California’s cap-and-trade program to reduce carbon dioxide and other greenhouse gases (GHGs).   The program, which began in 2013, is currently scheduled to run through 2020, so the state is now pondering what comes after 2020.

The program requires major GHG sources to buy “allowances” to cover their emissions, and each year reduces the total number of allowances available, the “cap”.  The allowances are tradeable and their price is the incentive for firms to reduce emissions.  A high price makes emitters very motivated to cut back, while a low price indicates that they can get down to the cap with modest efforts.

Before committing to a post-2020 plan, however, policymakers must understand why the cap-and-trade program thus far has been a disappointment, yielding allowance prices at the administrative price floor and having little impact on total state GHG emissions.  California’s price is a little below $13/ton, which translates to about 13 cents per gallon at the gas pump and raises electricity prices by less than one cent per kilowatt-hour.

CapAndTradeExtensionFig1The low prices in the three major markets for GHGs mean little impact on behavior

And it’s not just California. The two other major cap-and-trade markets for greenhouse gases – the EU’s Emissions Trading System and the Regional Greenhouse Gas Initiative in the northeastern U.S. — have also seen very low prices (about $5/ton in both markets) and scant evidence that the markets have delivered the emissions reductions.  In fact the low prices in the EU-ETS and RGGI have persisted even after they have effectively lowered their emissions caps to try to goose up the prices.

In all of these markets, some political leaders have argued the outcomes demonstrate that other policies – such as increased auto fuel economy and requiring more electricity from renewable sources – have effectively reduced emissions without much help from a price on GHGs. That view is partially right, but a study that Jim Bushnell, Frank Wolak, Matt Zaragoza-Watkins and I released last Tuesday shows that a major predictor of variation in GHG emissions is the economy.  While emissions aren’t perfectly linked to economic output, more jobs and more output mean generating more electricity and burning more gasoline, diesel and natural gas, the largest drivers of GHG emissions.

CapAndTradeExtensionFig2Accurately predicting California’s GSP 10-15 years in the future is extremely difficult

Because it is extremely difficult to predict economic growth a decade or more in the future, there is huge uncertainty about how much GHGs an economy will spew out over long periods, even in the absence of any climate policies, what climate wonks call the “Business As Usual” (BAU) scenario.

If the economy grows more slowly than anticipated — as happened in all three cap-and-trade market areas after the goals of the programs were set – then BAU emissions will be low and reaching a prescribed reduction will be much easier than expected.  But if the economy suddenly takes off — as happened in the California’s boom of the late 1990s — emissions will be much more difficult to restrain.  Our study finds that the impact of variation in economic growth on emissions is much greater than any predictable response to a price on emissions, at least to a price that is within the bounds of political acceptability.

CapAndTradeExtensionFig3California emissions since 1990 have fluctuated with economic growth

Our finding has important implications for extending California’s program beyond 2020.     If the state’s economy grows slowly, we will have no problem and the price in a cap-and-trade market will be very low.  In that case, however, the program will do little to reduce GHGs, because BAU emissions will be below the cap.  But if the economy does well, the cap will be very constraining and allowance prices could skyrocket, leading to calls for raising the emissions cap or shutting down the cap-and-trade program entirely.

Our study shows that the probability of hitting a middle ground — where allowance prices are not so low as to be ineffective, but not so high as to trigger a political backlash — is very low.  It’s like trying to guess how many miles you will drive over the next decade without knowing what job you’ll have or where you will live.

So, can California’s cap-and-trade program be saved? Yes. But it will require moderating the view that there is one single emissions target that the state must hit. Instead, the program should be revised to have a price floor that is substantially higher than the current level, which is so low that it does not significantly change the behavior of emitters.   And the program should have a credible price ceiling at a level that won’t trigger a political crisis.  The current program has a small buffer of allowances that can be released at high prices, but would have still risked skyrocketing prices if California’s economy had experienced more robust growth.

The state would enforce the price ceiling and floor by changing the supply of allowances in order to keep the price within the acceptable range. California would refuse to sell additional allowances at a price below the floor. This is already state policy, but the floor is too low. California would also stand ready to sell any additional allowances that emitters need to meet their compliance obligation at the price ceiling.

Essentially, the floor and ceiling would be a recognition that if the cost of reducing emissions is low, we should do more reductions rather than just letting the price fall to zero, and if the cost is high, we should do less rather than letting the price of the program shoot up to unacceptable levels.

But should California’s cap-and-trade program be saved?  I think so.  My first choice would be to replace it with a tax on GHG emissions, setting a reliable price that would make it easier for businesses to plan and invest.  But cap-and-trade is already the law in California and with a credible price floor and ceiling it can still be an effective part of the state’s climate plan.

Putting a price on GHGs creates incentives for developing new technologies, and in the future might motivate large-scale switching from high-GHG to low-GHG energy sources as their relative costs change.  The magnitudes of these effects could be large, but they are extremely uncertain, which is why price ceilings and floors are so important in a cap-and-trade program.  With these adjustments, California can still demonstrate why market mechanisms should play a central role in fighting climate change while maintaining economic prosperity.

A shorter version of this post appeared in the Sacramento Bee August 14 (online Aug 11)

I’m still tweeting energy news articles and studies @BorensteinS

Severin Borenstein View All

Severin Borenstein is E.T. Grether Professor of Business Administration and Public Policy at the Haas School of Business. He has published extensively on the oil and gasoline industries, electricity markets and pricing greenhouse gases. His current research projects include the economics of renewable energy, economic policies for reducing greenhouse gases, and alternative models of retail electricity pricing. In 2012-13, he served on the Emissions Market Assessment Committee that advised the California Air Resources Board on the operation of California’s Cap and Trade market for greenhouse gases. Currently, he chairs the California Energy Commission's Petroleum Market Advisory Committee and is a member of the Bay Area Air Quality Management District's Advisory Council.

26 thoughts on “Fixing a major flaw in cap-and-trade Leave a comment

  1. Nice post. The tighter the price collar, the closer the system is to a tax. So instituting a collar and then gradually tighten it will eventually deliver what a tax would have delivered right away.
    Btw, that the price in the EU ETS did not increase despite “lowering the cap to goose up the price” is because the EU promised to re-inject the part of the cap that they did not auction at a later point, thereby leaving the total cap over time unchanged. Truly reducing the cap would certainly increase the price of EUAs. Having said that, I like the California system of retaining permits if the price floor is not hit, possibly forever. I think the EU should take note.

  2. Prof. Borenstein,
    Thanks for this lucid analysis. It’s an interesting time for Ca’s C&T experiment that happens to coincide with resolution AJR 43, now before the state senate after handily passing in the assembly. It calls on the US Congress to enact a federal revenue neutral carbon fee, dividend and border duty. The wording is almost precisely that recommended by Citizens’ Climate Lobby, which aims for passage of such a bill by Congress by the end of 2017.

    Your preference for a carbon tax is noted. (“My first choice would be to replace it with a tax on GHG emissions, setting a reliable price that would make it easier for businesses to plan and invest.”) Might the great state of California now be in a position to lead the way in DC by showing that in “the laboratory of democracy” our state level C&T program has shown a lacks of efficacy?

    After all, the global problem of global warming requires a global solution that only national programs can provide. There’s no more time for states to individually experiment. They should all pressure Congress to act on their behalf.

  3. Thanks for this post, Severin. I wonder if a carbon intensity target, expressed in GHG emissions per dollar of GSP, would be a better (or complementary) target than absolute emissions. On one hand it does internalize economic performance so reductions can be achieved regardless of activity. On the other hand, I see how hard it would be for entities to forecast how many permits to buy if they need to guess economic growth as part of their mitigation decisions.

  4. “But should California’s cap and trade program be saved? I think so. My first choice would be to replace it with a tax on GHG emissions, setting a reliable price that would make it easier for businesses to plan and invest.”

    C&T with price floor and ceiling is just a tax with some market driven float right? I’m with you on carbon tax. If BC can do it, why can’t California? We could even put the revenue towards dealing with the miserable state of housing and transportation in California.

  5. Your post leads to an interesting thought–can we get to the equivalence of a carbon tax by setting a very tight collar (e.g., $30 to $35/tonnne) while maintaining the flexibility of cap & trade? The important question of pulling off this trick is how well do we think that the ARB can manage the pool of allowances in the auction to maintain such a price collar? And what do we think will happen in the secondary market–will it become a safety valve that undermines the collar?

  6. Thanks for your work helping the state get this right, Severin. I largely agree. In discussing cost containment in California’s cap-and-trade program, i think it is worth pointing out that the state also has borrowing. I would quibble somewhat with the notion that the Allowance Price Containment Reserve is small. It stands at 141 million metric tons. My preference would be to increase the size of the reserve in the post-2020 time period by adding to it an amount equal to the amount of allowances in the bank on December 31, 2020. That said, it seems that there is little downside to putting in place a harder price ceiling, especially if it helps to smooth the path to finalizing legal authority for policies need to achieve deep emission reductions by 2030.

    The state’s economy is already doing quite well, as your graph indicates. Jobs are being produced at a 50% faster rate than the nation as a whole.

    (See, e.g.: http://www.ccsce.com/PDF/Numbers-June-2016-May-Jobs-Report.pdf)

    It will be interesting to see when 2015 and 2016 GHG figures are released the extent to which decoupling of emissions and growth has been achieved. The relationship will certainly be weaker than in the past.

  7. Sounds like your parting comment on carbon taxes might be the start of a longer post on how to switch from a flawed system… Don’t let tradition be a barrier to change (e.g., draft to voluntary military)

    • We must also be careful not to compare a flawed a cap-and-trade program with a perfect tax system. The debate often overlooks the complexity of the tax code with its exceptions, carve outs, and loopholes. To mix metaphors, the grass is not always greener and at some point we have to stop chasing our tail and get down to the hard work at hand of reducing emissions and helping others not increase emissions to compensate for our reductions.

  8. Thank you for this post. It is interesting that the original work leading to the conclusion that prices would likely be either near the floor or at the allowance price containment reserve was met with disapproval by the Air Resources Board. Disapproval to the point that the ARB chose not to renew the contract. As was brilliantly stated in a workshop presentation, I leave it to the audience to interpret as they will.

    In your current post, while you mention the direct measures, I suggest that you have not provided sufficient attention to the interplay between the direct measures and the market. These direct measures act to mute the value of the cap-and-trade price signal and as such, the direct measures hide the true cost of compliance. While I agree that it is ridiculously obvious (to anyone who does not cash a paycheck via the ARB) that a price floor/price cap should be implemented, such an instrument cannot address the far less obvious costs imposed due to the direct measures. Like the prices of CCAs, the cost of compliance with direct measures will also rise as the economy grows.

    While a price floor / price cap, implemented before it is needed, can help the State avoid the type of last minute, poorly planned policy outcomes we saw in the 2000 timeframe, this cannot address the incredibly high cost of compliance with the direct measures.

    • The paper does address the effect direct measures have on clearing out “moderately” priced abatement, making the cost curve even steeper when the carbon price is left as the only remaining incentive for the next unit of emission reduction, which is not addressed in this post. That’s not meant as a criticism of the post, which is very well done, but a reminder of another aspect of the underlying work that I found particularly enlightening. Thanks.

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