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The High Cost of Low Carbon Prices

Industry and utility customers should chip in to support the carbon price floor.

The Covid-19 crisis has led to all sorts of dramatic changes in lifestyles and economies. The energy sector is no exception. In past months we have seen plunging electricity demand, negative oil prices (but a stubbornly persistent mystery gasoline surcharge), and, also cleaner air. Air pollutants of all types, including greenhouse gasses (GHG), are down dramatically, but it’s not like we can declare victory in the battle against climate change.

It is for times like these that California designed shock absorbers into its GHG cap-and-trade regulations. If California had established a strict GHG cap, it would suddenly look much easier to comply with. It is quite possible, under the new “business as unusual,” that a carbon cap that looked aggressive 10 months ago could be now reached with little extra effort. That means prices of carbon allowances would likely plunge to near-zero, absent intervention in the market.

But as readers of this blog know, California’s cap is not really a cap, rather it is a flexible policy instrument that automatically tightens the cap when emissions plunge for external reasons (like a global pandemic), and would automatically expand the cap if reductions proved far more costly than the projections of California regulators. This feature is one of the most clever and under-appreciated aspect of California’s cap-and-trade system. It helps to stabilize the carbon price during good times and bad, which preserves a consistent market incentive for clean-tech firms to innovate and for consumers to shift their purchases toward low-carbon options.

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California’s Carbon Price Floor is Sagging

However, there has been one major design flaw in this price-stabilization policy, and despite many changes over the years, it remains unaddressed. This is the fact that the responsibility for maintaining a stable “floor” price of GHG falls almost entirely on California’s State share, allowing many others to enjoy the benefits of a stable carbon price without shouldering any of the costs of achieving it.

This might get a little wonky, but it’s a fairly straightforward notion. A carbon cap is enforced by requiring every regulated entity to acquire an allowance (or permit) for every ton of GHG it emits. If an entity doesn’t want to pay for an allowance, it has to reduce its emissions. Total emissions are limited by the number of allowances in circulation. The more allowances in circulation, the higher the cap, and vice-versa. Allowances find their way into the world through one of two channels. They are either allocated (at no charge) to a covered entity, or they are sold in a quarterly allowance auction.

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California Alone Supports the Floor

The GHG permit price floor is maintained by reducing the number of allowances in circulation when demand for those allowances drops. In other words, the cap gets “tighter” when demand for GHG allowances is low enough that the price would otherwise drop below a target minimum level. Now, you may think a fair way to achieve this reduction in allowances would be to give a proportional haircut to everyone who receives a share of allowances. But that’s not how it is done. Instead it is the state of California’s share that gets cut first, giving the allowances assigned to everyone else (electric utilities, refineries, even the University of California) a higher priority. In most quarters, there is no reduction to the allowances of these other groups, even when California’s allowance sales are drastically reduced. It’s as if OPEC got together and said, “we need to reduce world oil output by 20 million barrels a day, so Saudi Arabia should cut is production by 20 million, so the rest of us can continue on as usual.”

As a result of this policy, the proceeds from the auction that go to the state are far more volatile than the underlying carbon price. This is because, while the price is stable, the quantity of permits sold by California can swing wildly from quarter to quarter (Figure 1). In the last auction, held in late May, the state sold very few future vintage permits and zero permits for the current vintage. Similar auction “washouts” were experienced in 2016 and 2017. By contrast, the value of allowances that are directly allocated to various industry and other entities remains relatively stable and benefits from the reduction in state allowance sales.

Screen Shot 2020-06-14 at 10.48.18 PMThere is a common sense alternative to the current system: Reduce the direct allocation of free allowances (currently comprising more than half of allowances issued per year) proportionately to the California allowances unsold in the auction. In this way every recipient of allowances takes the same proportional haircut, although the timing of these adjustments would require some thought to properly align the allocated quantities with the amounts that clear the auction.

A more extreme alternative, if one wanted to prioritize the stability of state revenues, would be to completely reverse the current policy and have the allowance haircuts fall completely on the allocated parties, leaving the state allocation relatively unchanged. When the price is at the floor, this leaves California with almost no revenue uncertainty.

This would not be a costless change. The “losers” would be the entities who currently receive a stable allowance value regardless of how few allowances are sold in the auction. The single largest group of these entities is the electric utility sector, and those allocated revenues are sent on to electric ratepayers in the form of carbon credits on bills. Another group is the trade exposed industries who have argued that, without these allocations, they would be at a competitive disadvantage to firms in other states that do not apply carbon regulations.

However, the intent of these allocations has been to “soften the blow” of high carbon prices. For example, the allocations to utility customers – which were based upon historic emissions – were partly motivated by the expectation that carbon pricing would more quickly increase rates of the more carbon intensive utilities. It stands to reason that the amount of softening needed would be less when the carbon price is at its floor and, by implication, the burden of further carbon reductions is relatively lessened. These haircuts only apply under these “low emissions” conditions. Given that the state budget is already under immense strain, sharing the burden of price stabilization between electricity ratepayers, industry, and the state would be a fair, common sense change to the current system.

Notes: Sagging floor image from tarheelbasementsystems.com. Supported floor image from floridafoundationauthority.com.

Keep up with Energy Institute blogs, research, and events on Twitter @energyathaas.

Suggested citation: Bushnell, James “The High Cost of Low Carbon Prices” Energy Institute Blog, UC Berkeley, June 15, 2020, https://energyathaas.wordpress.com/2020/06/15/the-high-cost-of-low-carbon-prices/

 

13 thoughts on “The High Cost of Low Carbon Prices Leave a comment

  1. James, not sure you are understanding the policy objective behind the Industry Assistance program. Those allowances are only distributed to trade exposed firms which CARB has determined could leave the State if fully exposed to a carbon price when other States are not currently imposing a carbon price, This leakage of production would serve no GHG emissions benefit (i.e., the emissions just move to another State) while costing the California economy jobs and tax base. Your suggestion that we try to preserve CARB auction revenues at the expense of trade exposed industries (who would be forced under your alternative to purchase more allowances during a period of economic distress) would completely undermine the policy objective behind the Industry Assistance program. It would drive increased leakage of production. So not only would eventually lose the auction revenue (because you forced the trade exposed firms to leave California so they no longer need CARB’s alllowances) but you also lose the economic production (i.e., jobs and tax base). Most analysts would call that a lose-lose proposition.

  2. “Industry and utility customers should chip in to support the carbon price floor.”

    LOL – the extra CO2 thus far has been entirely beneficial to humanity. I’d say the industry should be reimbursed millions for “un-recouped benefit they provided to humanity.”

    • Jonathan
      Your statement assumes that industries have an existing property right in the atmosphere to dispose of their emissions. The fact is that they don’t have a property right–they simply haven’t had to pay for those disposal costs up to this point because the transaction costs of enforcing that disposal charge was greater than the perceived value of the protecting the resource. (An apparent mistake on society’s part.)

      • “ Your statement assumes that industries have an existing property right in the atmosphere to dispose of their emissions.”

        No, I am simply employing exactly the same argument that the climate alarmists are employing. If businesses are to be charged for some notional “harm” resulting from their operation, oughtn’t they be owed by all the people who incidentally benefitted in ways not imagined before their existence? I’m simply trying to highlight the fact that in none of these schemes to further tax the most heavily taxed substance in this solar system are there any plans whatsoever to take any action with the proposed revenues that will make a bit of actual difference to the alleged “problem.” It is instead simply a way for politicians to grab more tax money while pretending they are doing it “for our own good.”

        Both are silly arguments given that the theory of “inferred harm” from CO2 is utterly fictitious.

        And what about the “harm” caused by those 7 billion greedy consumers? Well, the alarmist punitive solution will in fact be shouldered by them – most hurting the poor, as always, in the form of yet another hidden tax. The best solution? Stop trying to punish the poor over fictitious science. Be happy that oil makes us more prosperous and healthy, and be glad that within 30 years it will be replaced by something even better.

        • Again, your asserting a property right for industries simply because that right has laid unused up to this point. Legal doctrine, e.g., the public trust doctrine and Native American fishing rights, contradict that conclusion. The public always has the power to assert its control over public good rights at any time. (Whether that’s politically astute is a different matter. Also whether industries should be compensated for a premature loss of investment if they have been complying with earlier regulations also is a different situation.) Industries have had free use up to now–that does not bestow a property right unless the doctrine of prescriptive rights applies (which gets a lot more complicated.)

          • Yes – the logic is flawed in either direction. That was my point. I’m glad you understand.

            There is no “carbon cost,” it is a fiction invented by activists seeking to expand government.

          • If there’s no carbon cost, then there’s no fossil fuel cost, or land cost, or labor cost, which of course is ridiculous. Society is now asserting its collective property rights over public goods. Property rights need not be limited to separable goods and services. So now society is charging a price or limiting the use of that resource. Those who deny this principle simply want to continue to have their economic activities subsidized by others.

          • “If there’s no carbon cost, then there’s no fossil fuel cost, or land cost, or labor cost, which of course is ridiculous.“

            Lol, it’s funny watching you struggle to do battle with the cognitive dissonance set up by your preconception. The only ridiculous thing is your flawed assumption that there MUST be a “cost.” There is in fact a cost to extract and refine fossil fuels, but the land is still there and in some places, notably Anwar, is MORE hospitable to nature than before. Carbon, we already discussed – at any leve humanity will ever see due to burning fossil fuels, it is a net boon.

            “ Society is now asserting its collective property rights over public goods.”

            “Society” is a fiction, and has no such rights. If you believe otherwise, please feel free to point out the individual human known as “society.” S/He can file a case in court. Until then, that is merely sophomoric political babbling, the sort employed when people cannot support their ridiculous theories on science with the facts.

            “ Those who deny this principle simply want to continue to have their economic activities subsidized by others.”

            Wow, did it hurt to perform those mental gyrations? The only people in favor of subsides are you whackadoodles. I say, end ALL subsidies – they are all political scams. Like “Carbon costs.”

          • “Society” is why humans evolved to be the dominant macrospecies on the planet. Just as corporations, which are a collection of individuals can own property rights, so can a larger group as a government or generically as a society. I’m waiting to see individual shareholders exercise their separable property right over that auto factory. And those governments can exercise their property rights to nonseparable public goods such as environmental quality or networks in which efficient pricing is impossible. You’re arguments require at least two premises which you have failed to prove: that climate change and GHG emissions are not harmful and that we can function as an anarchy.

  3. Electric Utilities are being challenged by a drop in electric sales and significant increases in non-payments from customers financially impacted by job losses and economic challenges from COVID 19. Now is not the time to tinker with a fragile market. Leave the cap and trade provisions alone for now and enjoy the cleaner air (primary goal of the program).

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