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Understanding and Refining Emissions Markets

Tweaking the market will help, but so will recognizing its limits.

After California’s May allowance auction settled at the minimum price and generated almost no revenues for the state, the long knives are again out in Sacramento for the state’s cap and trade program. What’s the point of a carbon market, some are asking, if price and revenue volatility make planning nearly impossible?

The disappointing auction has caused proposals for stabilizing the market price – such as those from the Independent Emissions Market Advisory Committee (IEMAC) in its 2019 report – to be taken more seriously, as they should be. But the tweaks suggested by the IEMAC and others aren’t likely to live up to the expectations of policymakers. That’s not because the proposed changes are unwise, but because the policymakers’ expectations are unrealistic.

RethinkingCaTFig2

Many California regulators and legislators want cap and trade to guarantee that the state reaches prescribed emissions targets by 2030, while at the same time maintaining a moderate allowance price, not at the floor, but not too high. Only by a stroke of pure luck could the program deliver on both.  To see why, let’s revisit the design options for an emissions market.

Cap and trade “classic” simply sets a cap on emissions and lets the price do all the work to get us there, with no restrictions. But if the demand for emitting the pollutant is high – which could be driven by a strong economy, cheap fossil fuels, and/or slow progress in low-emissions technologies – the price could spiral to astonishing levels. Cap and trade classic generally would get you to the emissions quantity, but possibly at an unacceptable economic or political cost. And if the demand for emitting is low – such as results from an economic downturn, expensive fossil fuels, and/or competitive low-carbon alternatives – it is quite possible to end up with a price of zero and no further incentive to ratchet down emissions at all. The price in cap and trade classic is hard to predict, because the future of the economy, fossil fuels, and emissions reduction technologies are hard to predict.

Emissions tax “classic” does the opposite. It sets a fixed price, which establishes a constant incentive to reduce pollution regardless of how much is being emitted. But then polluters emit whatever quantity they choose as long as they are willing to pay the tax. If the demand for emitting is high, the outcome will be high levels of emissions.

You might think that there must be a market alternative that isn’t purely setting price or purely setting quantity. In fact, the proposals to modify California’s cap and trade program are moves towards such a middle ground.

Actually, California’s program was never “classic” cap and trade. Even back  when it started in 2012, it had a pretty hard price floor, which effectively lowered the cap if there weren’t enough buyers at the floor price, and a very soft price ceiling, which released a limited number of additional allowances if the price got up to a fairly high level.

Modifications made since then – primarily as part of the 2017 law that extended the program through 2030 – as well as the changes currently proposed allow further adjustments to the cap, downward if the demand for emitting is low and upward if the demand is high. Some of the proposals create only transitory adjustments – such as shifting unsold allowances from one auction to be sold at a later auction – while others would make more permanent changes, such as removing allowances from the pool (i.e., shrinking the cap) if the price stays at the floor for a long time, or adding additional allowances if the auction price hits pre-specified levels.

RethinkingCaTFig3

In economic parlance, where cap and trade classic creates a vertical supply curve for emissions allowances (at a fixed quantity) and emissions tax classic creates a horizontal supply curve for allowances (at a fixed price), the new and improved cap and trade creates an upward sloping supply curve for allowances, restricting the quantity somewhat when demand and price are low, which prevents the price from going even lower, and expanding the quantity somewhat when they are high, preventing the price from going even higher.

What these modifications do is share the impact of unpredictable emissions demand between quantity adjustment and price adjustment, rather than putting the impact of demand uncertainty all on quantity (emissions tax classic) or all on price (cap and trade classic). What they don’t do is get us to the policymakers’ nirvana of predictable emissions quantity and price. Until someone figures out how to reliably predict both macroeconomic growth and technological progress that won’t be a realistic goal.

RethinkingCaTFig1

That’s not a flaw in emissions pricing. It’s a reality of any type of emissions control policies. Technology mandates – the alternatives to pricing – generally don’t ensure a total level of emissions (usually just emissions intensity), and never ensure the cost of achieving a given level of emissions.

I’m comfortable with that reality, because numerical goals for California GHG emissions – which are already less than 1% of global emissions – should never have been the primary target. California leads the world in knowledge creation. We should be focused on creating knowledge that reduces GHG emissions around the world. Pioneering and refining an economy-wide GHG cap and trade program helps, but so does developing the science that enables the next breakthrough in battery storage, drives down the cost of solar panels, or improves the efficiency of lighting, heating, air conditioning, or transportation.

Attempts to mandate both quantity certainty and price certainty in cap and trade are as likely to succeed as the Indiana legislature’s 19th century bill defining π to be equal to 3.2. Perhaps a better understanding of the economics of emissions mitigation policies will be another California contribution to knowledge.

 I’m still tweeting energy news stories/research/blogs most days @BorensteinS

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

Suggested citation: Borenstein, Severin. “Understanding and Refining Emissions Markets” Energy Institute Blog, UC Berkeley, July 6, 2020, https://energyathaas.wordpress.com/2020/07/06/refining-and-understanding-emissions-markets/

Severin Borenstein View All

Severin Borenstein is E.T. Grether Professor of Business Administration and Public Policy at the Haas School of Business and Faculty Director of the Energy Institute at Haas. 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. He chaired the California Energy Commission's Petroleum Market Advisory Committee from 2015 until its completion in 2017. Currently, he is a member of the Bay Area Air Quality Management District's Advisory Council and a member of the Board of Governors of the California Independent System Operator.

9 thoughts on “Understanding and Refining Emissions Markets Leave a comment

  1. Hello and thank you Mr. Borenstein! ..

    Gaming the cap & trade system was inevitable and a goal of the status quo from the start ..

    That’s why a so-called ‘carbon fee and dividend’ is also inevitable – providing financial resources to customers is needed in addition to and in combination with the current legislative efforts to de-carbonize. The market for clean air, electric vehicles is entering it’s production phase and the increased electrical loads which will need to be fulfilled is going to change the demand for ‘peak renewables’ and bend the duck curve very quickly.

    With the advent of advanced metering infrastructure (AMI) comes a partnership which should be facilitating ratepayers who wish to participate directly behind the meter in climate action just as our electric industry has been doing so in front of the meter.

    That hard line between ratepayer & our utility industry is softening. Distributed Energy Resources (DER) such as rooftop solar can ad flexibility to local operations but only if a policy of value stacking is in place.

    Incentives for the industry AND on consumer levels is required.
    We are all in this together.

    https://www.nacleanenergy.com/articles/35982/cleaner-ev-charging-can-reduce-curtailment

    Best regards, Jeff Gould

  2. The “middle ground” presented demonstrates the weakness that conservatives rightly knock liberals with of trying to perfect a system with unending complicated tweaks. Creating an inelastic supply curve (as classic cap-and-trade is) was always an economic horror and the current situation just demonstrates that. So it is certainly right to get away from that, but there is not really a need to create such a complicated plan.

    The right solution, if not the policitally acceptable one, was always to have a GHG tax. Setting the tax rate is not something that need be done once and engraved on stone tablets but can be adjusted on occassion to reflect technology and users responsiveness. In this economic uncertain times, it would be a planning benefit for everyone to have a bit more certainty. Such revenue could even help the knowledge creation that we all think is needed.

  3. “What they don’t do is get us to the policymakers’ nirvana of predictable emissions quantity and price.”

    Ah yes, politicians looking to the high priests of analysis to prognosticate flawlessly, and more importantly, to deflect responsibility for making difficult decisions under uncertainty. As John Krautkraemer, the late EDF attorney wrote four decades ago (to paraphrase), markets are about opportunities; governments are about guarantees. Using market-based instruments to achieve policy goals puts politicians in the uncomfortable position of having to tolerate some degree of visible uncertainty about achieving an objective.

  4. Here is an alternative approach in op-ed form to the climate-change problem. I adapted this from a paper that is undergoing final editing. My question is: Why can’t California consider more bottom-up (market-driven) measures?
    A Different Approach to Climate Change

    Climate change poses a daunting challenge for economists, political scientists, and the government: it features a global shared resource magnified by massive uncertainty over both physical and economic processes, we all contribute to its cause, and we all potentially bear the costs of its consequences. Three broad policy issues come to mind: (1) taking collective action, where cooperation of countries is essential to achieve targeted carbon reductions, (2) incentivizing individuals to reduce their carbon emissions, and (3) identifying the preferred institutional arrangement—namely, markets versus government—to alleviate the damages from climate change.

    Policymakers face the task of trading-off the risk from doing too little to combat climate change versus spending or regulating excessively. The “ideal” policy position on climate change depends critically on the size and likelihood of damages, in view of the best available scientific and other fact-based evidence. Reasonable people can disagree over the cost to society from an overly active climate strategy versus the cost of a passive one. Thus, they can agree on the scientific evidence but differ over the preferred strategy, which becomes more of a value judgment based on the trade-off between a robust economy and less climate change.

    Some analysts consider climate change a “wicked problem” that requires significant global efforts to reduce greenhouse-gas (GHG) emissions. But addressing climate change on a worldwide scale by substantially reducing GHG emissions to the level desired by activists would be extremely costly, politically infeasible, and virtually impossible. Notwithstanding the scientific evidence that climate change is occurring, the damaging effects on society are potentially catastrophic but highly uncertain.

    Nobel Laureate Ronald Coase once coined the term “blackboard economics” to describe the difference between what economists consider an ideal state (usually in terms of economic efficiency) and the outcome based on real-world government actions influenced by self-interest politics and highly imperfect information. What blackboard economics tells us is especially germane for different climate actions. It abstracts from the prevailing politics, the acquisition of tolerably accurate information (for example) on the social cost of carbon, the institutional setting, and the likelihood that an action will achieve its objective. Climate policy certainly falls into the space where government action could easily have adverse consequences.

    Another Nobel Laureate, Friedrich Hayek associate the term “pretense of knowledge” with politicians and bureaucrats who are under the illusion that they can predict the far-out future with reasonable accuracy and alone can solve problems without the aid of markets. This presumptuousness has triggered much harm from ill-conceived government actions, notably large-scale centralized planning, in an wide range of areas across the economy. Supporters of a carbon tax, for example, fall into this trap falsely believing that there exist reasonably accurate calculations for the damages from carbon emissions and the cost of abatement 50-100 years out into the future.

    A common perception is that, because the atmosphere is a global shared resource, any climate action should demand government-driven, worldwide collective action. Since any change in GHG emissions originating at the local level affects the entire world, any successful cooperation among countries would require virtual unanimity rather than just coalition-building. As past experience has shown, however, reaching mutual consent of multiple heterogenous countries is a Herculean act.

    With the obstacles and other problems faced by conventional climate policy, such as carbon-emission caps and targeted subsidies for clean energy, more attention should focus on institutions that provide market signals for individuals to adapt to climate change. These institutions include adaptation based on the pricing mechanism and other market forces; companies satisfying consumer and investor demands for clean products; and government assistance for basic research (which is inherently underfunded by the private sector) in clean-energy technologies and climate engineering. Regretfully, each of these so far has taken a back seat to GHG mitigation policies.

    Adaptation strategies have the feature of evolving over time in response to new information. It demands the latest information on when, where and how much the effects of climate change will occur. Adaptation can raise the “tipping point” at which GHG concentrations become catastrophic. Rather than controlling GHG emissions, it limits the damage that emissions can cause.

    When companies are pursuing social-oriented activities because that is what their investors, consumers and employees want, so-called stakeholder capitalism reflects the preferences of market participants. If market participants want companies to reduce their carbon footprint, then as profit-maximizers they should respond accordingly. More investors would be willing to provide capital funds and consumers to pay a higher price.

    • Cap & trade imposes a property right on a public good so that private individuals can trade that right. Those individuals then set the price through trading, a la Hayek. A carbon tax imposes a price on carbon without quantifying the property right a la Pigou. While certainty is comforting, nothing says that either the cap or the tax must be fixed and immutable over time. The adjustment proposals discussed in this post are consistent with making adaptive management. I don’t see what your proposal adds, other than throwing in subsidies as an alternative tool (which Borenstein also has written about.)

      • “Cap & trade imposes a property right on a public good so that private individuals can trade that right.”

        Except there is no scientifically documented “public good” being harmed – the harm part being necessary to establish a property right. In fact, the net effect of additional CO2 is positive, as predicted and evidenced by Global Greening.

        This isn’t a matter of “fake science” – it is in fact the science TELLING us it is not harmful, but is rather beneficial.

        Nor are the taxes so collected used to do anything remotely related to “remedying” the non-crisis.

        Cap and Trade is a political scam, period.

        • That you won’t even acknowledge that you’re not omniscient and that there’s even a risk of threatening climate change means that we can’t even agree on a basic common set of facts to have a discussion. You are demanding that I capitulate to your viewpoint of absolute knowledge to advance this conversation. Given that you stand with a very tiny minority that can’t even acknowledge that your view of the future has some degree of uncertainty undermines the rest of your credibility.

          You and Carl Wurster are well matched.

  5. “What’s the point of a carbon market, some are asking, if price and revenue volatility make planning nearly impossible?”

    That is the wrong question. The correct question is, what is the point of carbon markets at all? The answer: Purely politics. Why? Because to date, and for any foreseeable future, the extra carbon has been a net boon to humanity – not a negative as climate hysterics are shrieking. It will in fact never be a negative, as we will have stopped burning fossil fuels for energy by about 2050 for purely economic reasons – decades before any possibility of reaching levels of CO2 which might in any way be problematic. Thanks to Global Greening, the only part of AGW theory which has produced accurate predictions, CO2 levels will begin declining BEFORE the last gas powered car belches it’s last gasp.

    There are a lot of REAL pollution issues in the world. AGW is not among them.

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