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

About Severin Borenstein

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.
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24 Responses to Fixing a major flaw in cap-and-trade

  1. Pingback: Fixing a major flaw in cap-and-trade - Berkeley-Haas Insights

  2. ferknm says:

    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.

    • Bard Ffen says:

      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.

  3. dzetland says:

    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)

    • Bard Ffen says:

      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.

  4. Chris Busch says:

    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.

  5. mcubedecon says:

    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. Dave M says:

    “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.

  7. Juan Pablo Carvallo says:

    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.

  8. Pingback: Carbon Tax vs Cap-and-Trade. This is boring by now. – Tools of our Tools

  9. peter joseph says:

    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.

  10. Beat Hintermann says:

    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.

  11. Pingback: Improving California’s Cap-And-Trade Program | Ethan Elkind

  12. Rashad Morris says:

    Much of this makes sense, including the posts of many of the commenters, up to the point where you and others indicate that a carbon tax represents a preferred / best option for reducing GHGs as opposed to a cap. If I’m understanding this correctly, what you’re suggesting Prof. Borenstein is that a legislature or the people (via ballot) should institute a tax sufficiently high that it exceeds the price elasticity of fossil fuels and therefore leads to actual emissions reductions. But you also say that enacting such a price is outside “the bounds of political acceptability.” To wit, you seem to suggest that we try to politically institute a carbon tax that is impossible to institute politically. Care to clarify? I don’t question your economic analysis, particularly regarding the role of larger economic drivers on emissions. But the seeming contradiction I’ve just highlighted in your post (and please do correct me if there is no contradiction, in fact) leads me to substantially question your political assessment as well as your substantive conclusion around caps versus taxes. Is this an instance where academic purity meets the real world and is found wanting? Indeed, it is the simplicity of a tax that makes it exceedingly easier for a legislative body to change / eliminate when it starts to actually bend emissions curves. One rationale I’ve heard in support of a cap and permit system is that such a system is substantially more difficult to dismantle once in place. . .

    • mcubedecon says:

      That’s a good point about the cap & trade program–it awards property rights to private parties who then have a vested interested in its continuance. One of the hypothesized reasons for the lack of activity in the most recent CCTP auction is that participants are uncertain about the permanence of their property rights.

      • Rashad Morris says:

        Precisely! A similar rationale applies to items purchased with carbon revenues. Psychology tells us that humans are strongly motivated by tangible incentives they can see and touch. And based on the theory of “loss aversion,” people are even more motivated will to keep those tangible things. This can be a very important consideration in the cost / benefit analysis of various carbon policies

  13. AM Narayanan says:

    Energy efficacy and environmental friendly public transport system, which may substantially result private vehicles off the road; and energy intensity reduction in commercial and domestic sectors may be factored into with necessary policy intervention and norms and targets for cities and suburbs. A techno-economic modelling study in this aspect may be worthwhile.

  14. Greg Rock says:

    A cap and trade with a tight collar, is basically as good as a self-adjusting tax tied to a cap. If I had my perfect policy I would take the later due to the predictable rate of escalation until the final goal is achieved. Still the two are far more similar than they are apart. However, my political assessment is that adding a regulatory limit will dissuade broad political support at the national level and in most states in the Union – so I believe a simple escalating tax, like I-732 in Washington which go to a vote of the people in November, with no targeted cap is more likely to spread across the nation – Note: national financial support needed for this important campaign in Washington.

    While both mechanisms can be designed properly to eliminate volatility which will tear up any market-place, I do worry that trade systems provide more opportunity for: gaming, broker profits, and special interest negotiating for grandfathered permits. These direct financial subsidies often end up going to established businesses (that shouldn’t be subsidized) creating a competitive disadvantage to new competitors who would typically have more efficient modern equipment. Tax structures can also create subsidies via tax rebates, which disrupt market forces, but they typically get applied to an entire sector not individual companies so less competitive disadvantages are created.

    I can see the argument that a C&T is more politically entrenched than a simple tax due to complexity but this doesn’t serve as a major motivator for me. I prefer simple, low-cost, and easy to administer mechanisms. The world is moving towards, not away from, climate action. There is absolutely the threat that a price could change too quickly or volatility swings wreak such havoc on the marketplace that there is public outrage and roll-back no matter how entrenched, but a well-designed pricing mechanism (either collared C&T or a predictable escalating tax) doesn’t have these challenges.

    The carbon tax in BC has been predictable, lead to reduced emissions, and they have enjoyed slightly stronger economic growth than the rest of in Canada. This policy is widely popular among both political parties 8 years after implementation, and is creating a positive political feedback. The discussion in BC isn’t about repealing the tax, it is about increasing it.

    I absolutely agree that economic variability will outweigh any near-term GHG trends from pricing mechanisms. That economic variability can be huge especially when set on the backdrop of the very extreme economic and energy demand volatility we have seen over the past decade. This is why it is important to compare BC reductions relative to the rest of Canada using a metric that isn’t influenced by other factors (like the de-carbonization of the rest of Canada’s electric supply, relative population growth, and the dramatic increase in natural gas production and exports in BC) I think petroleum consumption per capita is the most uniform metric to compare and it has decreased 16% per capita in BC while growing by 3% per capita in the rest of Canada over the same time period. This comparison largely eliminates the impacts of economic variability. A downside to this metric is that it focus primarily on transportation fuels which are typically the least elastic to price changes – still the impacts on petroleum consumption in BC have been a fantastic success story that has out-performed econometric modeling.

  15. Greg Rock says:

    I do want to caution readers against thinking that price elasticity leading to behavior changes are the only way a price on carbon reduces emissions – it is not.
    There are three main ways that a price reduces emissions.
    1. Price elasticity – the more expensive a product gets the less consumers use of it. People drive less, turn off lights more, turn down the heat more, to save the direct expenditure. i.e. higher prices lead to more conservation
    2. Cost Effectiveness – In the business world engineering economics, or life cycle cost analysis, is used to analyze new investments/remodels, and in the consumer world most purchases are influenced dramatically by the simple payback they deliver. Small changes in price, especially predictable price escalation, can have a dramatic effect on what investments are cost-effective for businesses and deliver an acceptable simple payback for consumers. This drives efficiency at the point of new construction or infrastructure replacement (new car) which is a separate driving force than elasticity. i.e. higher prices, especially predictable escalating prices, lead to smarter long-term investments and greater efficiency. Example – in BC they have seen their fleet become more fuel efficient, faster than expected as new car buyers opt for more efficient vehicles due to the new simple payback equation.
    3. Innovation – In my opinion this is the most important part of a price on carbon. We absolutely have some technology that is scale-able and can make incremental improvements to address the problem. However, as an energy engineer I will tell you we aren’t there yet. To really achieve the dramatic transition needed within our energy sector we need to foster rapid innovation. Innovation is primarily driven by differential or relative pricing not the final price. A price on carbon creates a differential retail price between energy sources based on the amount of carbon they emit. This price signal remains constant (assuming the price on carbon is constant) regardless of what the going rate is for energy. Biodiesel for example will likely never be much cheaper than diesel, because it is in limited supply and a direct substitute for diesel, so it will always track with the market price of diesel. However a carbon tax creates a strong economic incentive or “financial bounty” for anyone who can produce a fuel that can deliver the same benefits of diesel while not producing as much carbon pollution (biodiesel). A predictable economic bounty for developing technologies and energy sources that reduce carbon pollution of only $.25 cents per gallon can have a far greater impact on new innovation and start-ups than $1 or $2 dollar higher diesel prices. i.e a price on carbon drives innovation towards low carbon technologies regardless of how high or low energy prices go in the future.

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