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California’s Carbon Border Wall

With all that’s been happening in Washington DC, you may have taken your finger off the pulse of California climate change policy. But now’s a good time to check back in. There’s a new cap-and-trade proposal in town, and it’s turning lots of heads in the state capital.

California is deep in deliberations over cap-and-trade as it prepares to meet a new and ambitious GHG emissions reduction target. The state is aiming to reduce emissions to 40% below 1990 levels by 2030. This makes the GHG emissions reductions we’ve achieved so far look timid.

While the state has charted an emissions reduction path out to 2030, the existing GHG cap-and-trade program sunsets in 2020. This means the legislature needs to reauthorize – or replace – the current program to meet this post-2020 ambition. The 260 million metric ton question: What policy can most effectively deliver on this target?

The new cap-and-trade proposal, SB 775, would replace the existing cap-and-trade program in 2021. It has some pundits swooning. David Roberts of Vox writes a glowing endorsement of what he sees as a “clean break” from California’s existing GHG emissions trading program. But other policy experts offer a different view. Economist Rob Stavins argues there’s no need to “repeal and replace” the state’s effective cap-and-trade system. Professor Ann Carlson warns that it could “cause many more problems than those it attempts to solve”.

The proposal covers a lot of ground in 19 pages (Dallas Burtraw provides a great review here). I want to unpack one key piece: the proposed border adjustment. This may sound wonky and weedy, but it’s really important because it aims to bring imports under California’s cap-and-trade program. There’s a lot to like about this idea in theory. But the reality could be a different story.

The Leakage Problem

To put this border adjustment into context, let’s quickly review the problem it’s trying to address. The problem is that California’s climate change policy applies to only a small subset of the sources contributing to the global climate change problem. Pricing carbon only within the state could potentially send business – and associated emissions – out of state.

Suppose you are a California-based producer of an emissions-intensive product, such as cement, glass, or refined oil products. Under a statewide cap-and-trade program, you are required to purchase emissions permits for your GHG emissions. In other words, the policy increases your production costs. If out-of-state producers can supply the California market, this could mean you lose California market share to out-of-state rivals who don’t face the same cost increase. If you are a California-based operation that exports its products, this could make it harder for you to compete in out-of-state markets. In either scenario, the policy can shift production out of California. The associated emissions “leakage” erodes emissions reductions achieved within the state.

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The Current Response

Concerns about leakage loom large, so it is essential that California’s cap-and-trade program incorporate some meaningful response to this problem. Right now, the response comes in the form of free permit allocation. A share of permits (approximately 15%) are distributed free to those industries that are deemed to be at leakage risk.

You may be wondering how requiring firms to purchase permits – and then handing them back for free- achieves anything at all. The key is that emitters are required to turn in permits to cover their emissions, but these same firms are allocated free permits based on production. So you (the producer) see both an emissions tax (which provides an incentive to invest in emissions abatement) and a production incentive (which helps to ‘level the carbon playing field’ with out-of-state producers and thus mitigate leakage).

If we are concerned about emissions leakage (and we should be), this output-based free permit allocation approach can strike a balance between incentivizing emissions abatement and mitigating leakage. That’s the good news. The less-good news is that this strategy comes with side effects. For one thing, it dilutes the carbon price signal that California consumers receive when they are making their consumption decisions. It also allocates the revenue from the sale of valuable permits to industry when this revenue could alternatively be put towards other good uses.

The Proposed Alternative

There’s more than one way to skin this leaky cat. SB 775 proposes an alternative that I think most (all?) economists would prefer in theory. The idea is simple and elegant. First, identify imported products whose price would be materially impacted by the carbon permit price. Then require importers of these products into California to purchase permits for the emissions baked into their product. As for California-based exporters, they are exempt from the obligation to purchase permits for emissions associated with products sold outside the state (the SB 775 language on this is hard to parse…. thanks to Michael Wara for clarifying this important point!)

Why is this the theoretically preferred approach? For one thing, consumer prices in California rise to fully reflect the carbon price signal. This helps us consumers account for the full costs of our consumption, and adjust our behavior in response. Second, California can use the revenues from the sale of permits for other purposes, versus freely allocating to industry (although exempting exports means no revenues are collected from exporting firms).

The upshot is that this border adjustment seems like a winning proposal in theory. But the winning horse, in theory,  need not be the most fit to ride through the real-world challenges that lie ahead.

Comparisons between an elegant proposal-on-paper and the existing workhorse that’s spent years slogging through messy policy implementation can be misleading. It’s easy to find flaws in the current permit allocation approach to leakage mitigation when compared against some theoretical ideal. But the more relevant point of comparison is the border adjustment after it hits the buzzsaw of reality.

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Here’s my wet-blanket list of reality-bites concerns:

  • We import lots of stuff from lots of places: Under the border adjustment, California will need to estimate the carbon emissions baked into all the emissions-intensive products we import. There is already some precedent for this kind of accounting exercise covering one product under the state’s low carbon fuel standard (LCFS). Nine full-time staff have been hard at work estimating the GHG emissions factors for transportation fuels consumed in the state. This table summarizes the hundreds of “carbon pathways” (e.g. “South Dakota corn ethanol”, “Brazilian molasses ethanol”) that span the space of transportation fuels. It can take months to estimate a single pathway. The number of source-product combinations would increase dramatically under the border adjustment.
  • A cap on consumption emissions is harder to measure: It’s worth pointing out that, under a border adjustment, the state’s emissions targets and the associated emissions cap would have to be redefined. California currently caps emissions from in-state production. But under a border adjustment, the cap-and-trade regulation would cap emissions associated with in-state consumption. This means using the aforementioned emissions factors to estimate emissions in our imports, and subtracting the emissions from in-state production that get exported outside the state.
  • Export reshuffling? Under the SB 775 proposal, emissions associated with California production destined for export markets would be eligible for a border tax “refund”, whereas emissions associated with production that stays in California would remain under the cap. This asymmetric treatment of what stays home and what gets sent outside of California creates an incentive to re-allocate more emissions-intensive production to the export market in order to avoid the carbon price.
  • Legal challenges:  The border adjustment could pose a triple threat to the program: challenges from within the state, challenges under the commerce clause, and challenges from WTO. The legal resources required to defend this provision could be large. Notably, the SB 775 language does include an escape clause. If a judicial opinion, settlement, or other legally binding decision reduces the state’s authority to implement the border adjustment, the legislation authorizes a return to free allowance allocation for the affected products.  But this return would be messy, in part because it would require a re-adjustment of the emissions cap

Conclusion

California is demonstrating a working example of how emissions leakage can be mitigated in a regional emissions trading program. There’s no question that the current approach falls short of the theoretical ideal. But the real question is:  could an alternative approach work better? SB 775 has raised the profile of an important conversation about what those alternatives could look like.

My concern with the border adjustment proposal is that it seems to put the cart before the proverbial horse. Success hinges critically on our ability to come up with legally-defensible measures of greenhouse gas emissions intensities for all the carbon-intensive products we import. It’s worth noting that exploratory work along these lines is already underway (Resolution 10-42 directed the Air Resources Board to review the technical and legal issues related to a border adjustment for the cement sector). Given all that’s at stake, we should double down on these efforts to develop and test this approach before we bet the farm on its real-world durability.

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17 thoughts on “California’s Carbon Border Wall Leave a comment

  1. One piece missing in this article is that a border adjustment provides an incentive for other jurisdictions to create their own carbon pricing systems that match California’s. With a border adjustment, energy intensive imports from China or Iowa would have to pay a carbon fee to California, unless they have their own matching carbon price. That provides an incentive to other countries and states to collect the carbon fee themselves rather than have it go to California.

    I don’t know if California’s imports are enough to make this a driving force, but if the US were to implement a similar plan it would quickly motivate other countries to follow suit.

    A free allowance system does not provide the same motivation. This could be a big win in exporting California’s ambitious climate goals outside our borders.

    • There’s a fair amount of literature on using tariffs to set border taxes on GHG emissions. Here’s one paper for example: http://www.rff.org/files/document/file/RFF-DP-16-09.pdf. California can’t impose the same system on other states due to the interstate commerce clause. In addition California isn’t a big enough market to force other states to cave–it hasn’t worked in the West where California has tried to get other states to adopt the same electricity renewables standards, and California is nearly 50% of the market in the region.

  2. This begs a bigger question: Why are we so focused on getting every last ton of GHG reduction out of California, when instead we should be focused on creating a system that can easily accommodate integrating with other jurisdictions and encourages others to join the effort? What California does alone is absolutely meaningless in changing climate change risk. It requires a truly global effort. Putting up border walls won’t accomplish this.

  3. The original Montreal Protocol had a provision for national accounting of chlorofluorocarbons (CFCs): production plus imports minus exports, for (a) bulk amounts; (b) amounts in products; and (c) amounts to make products (e.g., CFCs that were used to clean electronics in computers that were then exported from Japan to US). Due to the tightening of the rules on CFC emissions due to discovery of the Antarctic Ozone Hole, this accounting system never got completely implemented as CFC usage at all was phased out. For CFC accounting, the system might well have been made workable given its relatively limited range of uses. For the State to develop such a system for GHGs, or even just CO2, will indeed be challenging, especially as producers of the same product may use different sources of electricity, for example. It is for this reason that a tax on carbon in fuels has been viewed as much more workable, if one could get everyone to apply the tax–but that is also a problem. I wonder if having each manufacturer put on a greenhouse gas label regarding its greenhouse gas footprint might be a more workable way to have the numbers developed. There is actually an effort underway under the broader auspices of the American National Standards Institute/Leonardo Academy (and also being pushed up to international level) to require such an effort by companies to replace the very limited carbon footprint approach at the company level; I would think that having this conveyed on a per product level might thus not be much more difficult. This way not just California could use such information, all calculated in a standard manner. Potential contacts on this effort are Stan Rhodes and Tobias Schultz at SCS Global Services in Emeryville, CA.

  4. Thanks for posting this.

    A small point: California does not count GHG emissions for batteries mandated for the grid, such as the sodium sulfur battery in San Jose. This battery comes from Japan, where electricity is overwhelmingly fossil fuel. All grid batteries are manufactured out of state, so far as I know. Since the energy to manufacture the sodium sulfur battery is high, compared to the amount of energy it will store over its lifetime, perhaps life cycle GHG cost of batteries should be a part of our GHG calculation for electricity. We know where batteries are manufactured, and current mandated numbers are small.

    http://pubs.rsc.org/en/content/articlelanding/2013/ee/c3ee24040a#!divAbstract

  5. I find it difficult to take this proposal seriously. How do you keep the people and businesses from leaking permanently into other states where they would be less subject to the onerous taxation scheme proposed herein? Or is that a feature of the scheme? The state leaks a sufficient amount of people and industry to other states that the mitigation goal is met?

    • This article does not focus on the dividend aspect of SB775 where the majority of the revenue from the carbon price is given back to California residents as a quarterly check. Most low and moderate income households would actually end up with more money under this system.

      Businesses are protected by the border adjustment. People are protected by the dividend.

      Plus the dividend puts money into consumers’ pockets, which they will spend at local businesses. This can create jobs and boost GDP.

      A well designed climate policy can actually mean more people moving to California for the new main street jobs, the dynamic green tech sector, and the quarterly dividend checks (not to mention the clean air!).

      • As pointed out in the post, the border adjustment is unlikely to protect California businesses. The revenue distribution may be a good idea, but it can be addressed separately.

      • Tony, I see you’re connected with CalFACT which supports a carbon tax. SB 775 moves the opposite direction from a carbon tax in reforming the cap & trade program by decreasing compliance flexibility. I can see the advantages of a carbon tax, and increasingly appreciate its simplicity compared to what has evolved out of the cap and trade programs. So I suggest that CalFACT oppose, not support, SB 775.

        • CalFACT sees SB775 as moving cap and trade much closer to a steadily rising carbon tax due to the price collar which provides a much more predictable price trajectory for businesses and consumers. While we would prefer a simple upstream carbon tax a a pricing mechanism, the political reality of California is that we have a lot of people invested in cap and trade.

          I don’t see how SB775 decreases compliance flexibility. Do you mean by eliminating offsets?

          • Forcing more transactions within state, and eliminating linkages to other jurisdictions is the biggest problem.

            The current CATP already has price collars. Seems the ARB can adjust those if it wants rather than going through the even clumsier process of legislation.

            A carbon tax provides two benefits, neither of which SB 775 provides. The first is that it is fairly simple to administer. The CATP has turned out to be much more complex than we original envisioned (just spend some time trying to go through the regs.) The second is that all of the revenue accrues to the government to be dispensed as it sees fit. Under SB 775, many (if not most) of the transactions will be outside of the auction and so the revenues go to private parties, who may or may not spend it on the other socially desirable activities. Just wanting tighter price collars seems a poor justification for pretending that this might work like a carbon tax.

  6. Increasing natural gas energy efficiency? The DOE states that for every 1 million Btu’s of heat energy that is recovered from natural gas combusted exhaust and this recovered heat energy is utilized, 117 lbs of CO2 will not be put into the atmosphere. This is accomplished with the technology of Condensing Flue Gas Heat Recovery. Exhaust temperatures can be reduced to well below 100F, and some days the exhaust temperature will be below the ambient outdoor temperature.
    In every 1 million Btu’s of combusted natural gas are 5 gallons of recoverable water. Why allow all this water to get into a jet stream and come down as rain in the Midwest or on the east coast when it can be utilized in California?
    California is about more than reducing CO2 emissions. They want to reduce global warming and they want to conserve water. Increasing natural gas energy efficiency will do more, as well as reduce natural gas bills.

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