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Cap-and-Trade and Innovation

Pricing carbon will help drive R&D, but the market will still be bumpy.

Virtually all economists agree that one of the biggest selling points for pricing greenhouse gases (GHGs) – whether a carbon tax or cap-and-trade — is that it will boost innovation in low-carbon technologies.

But will innovation return the favor in California’s cap-and-trade market by making it function more smoothly, saving it from the potential Achilles’ heel of extremely low or high prices?

CaTInnovationFig1I’ve argued previously that extreme low or high prices are the most likely outcome of cap-and-trade for GHGs, unless there are administrative price bounds. The most important insight from the research Jim Bushnell, Frank Wolak, Matt Zaragoza-Watkins and I have done is that the level of uncertainty in the state’s “business as usual” (BAU) emissions — due to macroeconomic growth, technological change, and other factors that are mostly beyond our control — is much greater than the reductions that can be relied upon as a GHG price rises, at least within a politically-acceptable range. As a result, a cap-and-trade market for GHGs, driven by unpredictable BAU emissions, will likely end up at an administratively-determined price floor or price ceiling, with the associated emissions substantially below the cap or above it.

That doesn’t mean that cap-and-trade is a bad idea. But it does demonstrate the importance of a credible price floor that creates significant incentives to abate emissions and invest in R&D, and of a credible price ceiling that will prevent a political backlash if GHG emissions end up higher than hoped for.

CaTInnovationFig2Our conclusion has been closely scrutinized, poked, and prodded, as it should be. One of the most common issues raised has been the way in which we incorporate innovation, particularly technological breakthroughs in low-carbon energy.

In a nutshell, here’s the concern: Our conclusion of extreme low or high price outcomes is partially driven by our calculations suggesting that there is relatively little identifiable GHG abatement likely to occur in response to a GHG price between, say, $10 and $60 per ton, roughly the range that politicians in Sacramento indicate they might be able to live with. But — one critique goes — a higher GHG price will increase the value of low-carbon technologies and drive innovation. That means there is more price-responsive abatement than we accounted for – a more elastic abatement supply curve, in econospeak — so more chance that the market will reach equilibrium at a moderate price.

That would be true if R&D expenditures exhibited a smooth, predictable and timely effect on the cost of an alternative technology. Then, as the price of GHG allowances rose, R&D effort would climb, and the cost of abating GHG in some sector would incrementally, reliably fall. In that case, innovation would help provide an automatic brake on emissions as the emissions price rises, just as we can get from higher gasoline prices changing driving and vehicle purchase choices, fuel switching in electricity generation, or investment in improved energy efficiency.

But that is not how innovation works. Yes, a higher allowance price will drive up R&D on low-carbon technologies, but the effect on GHGs will not be smooth, predictable, or quick.

CaTInnovationFig3It won’t be smooth, because innovation isn’t a well-functioning spigot that can be turned up or down with a twist of the R&D funding handle. Some technologies don’t advance much no matter how hard you turn (think wave power, cellulosic biofuels, or fusion) and others have bursts of progress after years of modest improvements (as with batteries). A carbon price will help twist the handle, but it’s unlikely that it will deliver just the level of innovation that makes a technology cost-competitive if, and only if, the price of carbon is in the $10-$60 range (which, just to remind you, raises gasoline prices roughly 8 to 50 cents per gallon).

<WARNING: Even more geeky paragraph, which can be skipped if you aren’t in the mood right now (or ever)> Yes, we could still get a smooth response if there were hundreds of independent research bets in different sectors, each affecting a small share of emissions. Then the law of large numbers would deliver a smooth innovation response. But the vast majority of anthropogenic GHGs are from burning fossil fuels. The R&D bets on how to replace them are highly correlated across sectors of the economy. When major breakthroughs happen in alternative energy, thankfully, they impact a broad swath of emissions. Unfortunately, the same is true of major improvements in technologies that produce high-GHG energy – most recently fracking, but in the mid-20th century it was surface mining of coal.

Nor is the effect of a GHG price on innovation predictable. Cap-and-trade enthusiasts point to tremendous improvements over the last decade in solar PV, wind power, batteries, and electric vehicles, all of which have come down in cost to the point they are nearing competitiveness in some settings. That’s great, but that has happened with a zero or miniscule GHG price in the industrialized world. It’s no evidence of the degree to which innovation will respond to a market price on carbon.

CaTInnovationFig4And the innovation response to a carbon price won’t be quick. Those examples of exciting alternative technologies that are now nearing competitiveness were the soon-to-be technologies during the energy crises of the 1970s. Economic incentives since then have waxed and waned due to subsidies and fossil fuel price fluctuations, with associated cycles of R&D investment, but only 40 years later are we now starting to see technologies become a major force.

Even if the response of innovation to the state’s carbon price is uneven, unpredictable, and lagging, couldn’t the cap-and-trade price accelerate adoption of low-carbon sources as they get close to cost competitive? Yes it could, but only to the extent it is economic to exceed adoption levels that are already required by other California laws. Those mandated levels of renewable electricity, low-carbon transportation fuels or electric vehicles will occur even if the cap-and-trade price is zero (and thereby increase the probability that it will be). In California, those mandates are very aggressive.

Still, we need to stay focused on the real goal, which is global reductions in GHGs. A significant emissions price in California can help incent the innovations we need to get there, even if that price is an administratively-determined floor or ceiling. It just looks a lot more like a carbon tax.  Nuthin’ wrong with that.

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.

11 thoughts on “Cap-and-Trade and Innovation Leave a comment

  1. An fascinating discussion is price comment. I feel that it’s best to write more on this subject, it may not be a taboo topic but generally persons are not enough to talk on such topics. To the next. Cheers

  2. Severin, forgive me for noting all the examples of “innovation in low-carbon technologies” you cite have limited potential for making a meaningful contribution to efforts to address climate change.

    For example: grid-scale batteries, which renewables enthusiasts seem to believe can be transformed into “sources of energy” by the application of sheer exuberance, will be forever incapable of reducing our dependence on fossil fuels:

    1) When they’re used to store energy from the grid they only make it dirtier through resistance losses;
    2) They remain prohibitively expensive, for even the most entitled economies of the world;
    3) Incapable of supplying a steady, unlimited stream of electricity, they force the question: “How many days of storage can we afford before the lights go out?”;
    4) They make having backup electricity at-the-ready even less profitable than it is now.

    I think we’ve ended up at this point because most cap-and-trade enthusiasts are frightfully unaware of the physics of grid energy, climatology, and the urgency of our problem. All their well-intended efforts at constructing price floors or calculating the elasticity of abatement curves amount to fiddling on the deck of the Titanic, where passengers scrambling to save their lives care little about whether they’re hearing Mozart or Haydn. They’re thinking: “Put down the damn fiddle, and help me find something that floats.”

    • Bob, you’re stuck in the technologies of the 1970s. Battery and other storage options are already addressing these issues, plus a 100% clean grid won’t be “dirtier” by increased generation. Further, batteries of sufficient scale will reduce fossil generation needed for flexible capacity by 1) reducing the ramp rate that increases incremental heat rates and 2) eliminating the need for overnight commitment of fossil (which is too often ignored in these types of analysis.)

      • The physics of energy conversion tells us that there is loss in each conversion from chemical [eg fossil] to heat to electricity and back to chemical [battery] and then back again to electric. Wind is conversion from kinetic [linear] to rotational to electric. Solar from photonics to electric. The fewer the conversions the more efficient the system. And one must include the end-of-life disposal of the vehicles: solar panels, the framing metals, etc, for wind: the concrete foundations, and towers, and the single-use roads out in to the places where the winds blow strongest and regularly.
        Anybody analyzing this must factor in the FULL life cycle of the choices.

        It may well be that improving the efficiency of the use of energy is the low-hanging-fruit that must be addressed first. Automobiles over the last few years have become lighter and more energy efficient – my similar size and performance cars over the last 20 years have gone from 15mpg to now 25mpg. And I bet they can go to perhaps 50 or more in the next 20 years.

      • mcubedecon, you’re stuck in technology of the 17th century, when wind turbines were wonderful for milling grain. Now, we have “dispatchable” electricity, which can run milling machines any time of the day or night – even when it’s not windy!

        I wish we could start over in the 1970s. I was in high school in Illinois, home to the Manhattan Project, Argonne National Laboratories and the Fermi National Accelerator Laboratory. To Illinois residents, it was obvious nuclear would one day replace coal, oil and gas to generate electricity. But about that time there was a detour – the Rockefeller Foundation managed to convince American hippies nuclear was dangerous, and because hippies spent more time smoking weed than going to school they believed it. Using protesting skills learned during the Vietnam War, they finely honed the skill of running up costs of new nuke plants, and generally getting in the way.

        That was the time of the Arab Oil Embargo, and like the U.S., France was hit hard. But the French were smart enough to “get stuck in the technology of the 1970s” and never looked back. The country now generates 75% of its electricity economically, dependably, and 100% carbon-free by splitting atoms.

        So mcubedecon, the day solar and wind generate 75% of any nation’s electricity with no carbon emissions, the day they join with batteries to power a grid for more than an infinitesimal fraction of a second, the day when renewable technology accomplishes what nuclear accomplished 40 years ago – then you can lecture me on what will and won’t happen in energy. I’m not holding my breath.

  3. “That’s great, but that has happened with a zero or miniscule GHG price in the industrialized world. ”

    Without an EXPLICIT GHG price… The shadow prices of many of the CARB Scoping Plan were well over $100/tonne. Those prices weren’t allowed to converge because there is little or no trading among the programmatic objectives or participants.

  4. Good day Severin Borenstein
    California still consumes a lot of natural gas at large commercial buildings and by our food and beverage industry and other energy intensive industries and at our power plants. When natural gas is combusted there is exhaust that gets vented into the atmosphere.
    For every 1 million Btu’s of heat energy that is recovered/removed from the combusted exhaust, and the recovered heat energy is utilized, 117 lbs of CO2 will not be put into the atmosphere.
    To get the maximum amount of recovered from the combusted exhaust the technology of Condensing Flue Gas Heat Recovery needs to be deployed. Instead of venting hot exhaust, cool exhaust will be entering the atmosphere. There will be days when the exhaust temperature will be cooler than the outside air temperature. We call it mass cooling.
    In every 1 million Btu’s of combusted natural gas are 5 gallons of recoverable water. Today all that water is being vented into jet streams where it is coming down as rain in the mid west and east coast. We could use that water here.
    There is a picture on the bottom of your article showing cooling towers. How many million gallons of water is being put hourly into the atmosphere? We have a technology to capture that water.

    I look forward to your reply.

    Have A Fantastic Day!
    Sid Abma
    (805) 462-1250
    http://www.SidelGlobal.com
    http://www.SidelSystems.com

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