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.
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.
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.
There 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.
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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/