Unused allowances are not an existential threat to the state’s market for greenhouse gases

Today’s blog is co-authored with fellow EI blogger, Jim Bushnell.

One of the most prominent and most controversial elements of California’s climate policy is a program commonly called “cap and trade.” But that name has never been entirely accurate, and it became less so with the legislation adopted last summer to extend the program to 2030. Now, a debate surrounding implementation of the new law is making it clear that confusion persists about how the program actually works.

You see, the so-called emissions “cap” in the program automatically adjusts so that it is actually very unlikely to set a hard limit on emissions. If the state’s greenhouse gas (GHG) emissions are lower than the emissions cap, the program puts a floor on the price of the tradable emissions allowances, essentially shrinking the cap to soak up extra allowances at the floor price. And if our emissions are high, it automatically expands the cap by selling all allowances demanded at a pre-determined ceiling price.

It is still possible for emissions to end up at the original cap, but only if emissions would be too high at the floor price, yet would scale back to the cap level in response to a price that is still below the ceiling. Our research (co-authored with Frank Wolak), released as an Energy Institute working paper last July, concluded that that is an unlikely outcome, with a probability of around 20% under even the most favorable assumptions.

In other words, it is only a small oversimplification to see our cap and trade program as more like a progressive tax: if emissions are low, the tax/allowance price is low (though not allowed to fall to zero), but if emissions exceed a “cap” level, the tax/allowance price resets to a higher level, as illustrated in the figure above. Environmental economists generally support this sort of hybrid market mechanism because it is adaptive. If we happen to have a weak economy or other external reason for lower than expected emissions, we don’t stop trying to further reduce emissions. And when external factors cause emissions to trend higher than expected, we don’t stick rigidly to a (pretty arbitrary) emission limit if it will cause great damage to the economy, or risk a political backlash.

The impact of an allowance “overhang” on California’s GHG market

A debate swirling in Sacramento these days demonstrates the importance of understanding the distinction between California’s hybrid market mechanism and a pure cap and trade that has no price floor or ceiling. Some observers are concerned that a large “bank” of unused allowances from the first legislated phase of the market — 2013-2020 — will be carried over to the next phase — 2021-2030. They have asserted that this allowance “overhang” would undermine the effectiveness of the entire program, arguing it would result in a “looser” cap on emissions. They have suggested that the aggregate cap on emissions through 2030 should be reduced by whatever quantity of allowances is carried forward from 2020.

But the flexible structure of California’s hybrid mechanism means that extra allowances do not put the program “in jeopardy” as a recent New York Times op-ed headline suggested. In fact, it is quite possible that a decision to lower the cap to account for the overhang would have little or no effect on actual emissions. The ultimate impact of the overhang is more about the expected future price of allowances than about the total amount of emissions.

What reducing the emissions cap by the “overhang” quantity would do is lower the aggregate emissions level at which the allowance price rises from the floor to the ceiling, as illustrated by the red dashed line in the figure below. That won’t make much actual difference if emissions were going to end up below or above the “overhang zone” anyway. If emissions were going to end up in the “overhang zone”, then reducing the cap by the quantity of overhang allowances would have the effect of raising the price of allowances from the floor to the ceiling.

So, is that overhang zone very likely? And if we do end up in that range, how much would total emissions be reduced by being at the ceiling versus the floor? Our July working paper sheds light on those questions. Not surprisingly, the answer depends on how big the overhang is and how responsive emissions are to a higher price. It also depends on how high the price would be allowed to go — that is, the administrative price ceiling — a figure that the Air Resources Board has not yet set. For our primary analysis, we assumed that the price ceiling would be $85/ton (in 2015 dollars), which now appears to be higher than where the regulatory process is likely to land.

The modest actual impact of the allowance overhang

One recent estimate, by Chris Busch, puts the overhang at the end of 2020 around 250-300 million metric tons (MMtons). Our research suggests that if the emissions “cap” for the program through 2030 were reduced by that amount, it would increase the probability of being at the price ceiling from about 34% to about 64% and reduce the probability of being at the floor by about the same amount. And, we estimate that moving from the price floor to the ceiling would elicit about an additional 140 MMtons of direct abatement through reduced California consumption of gasoline, diesel, natural gas, and the fossil fuels used to generate electricity.[1]

In other words, our best estimate is that reducing the emissions cap by the quantity of overhang allowances would increase by about 30 percentage points the probability of getting an additional 140 MMtons of emissions reduction. That works out to a probability-weighted average total reduction of about 42 MMtons through 2030. That figure overstates the expected impact if the actual price ceiling is lower than $85/ton.[2]

Now 42 MMtons of emissions over 10 years is not chump change. Using the most recent estimates of the social cost of carbon, around $40/ton, that works out to about $1.7 billion through 2030. But neither is it a fundamental change in a program that covers California sectors with current emissions of around 350 MMtons per year, and that aims to reduce those emissions by about 750 MMtons in aggregate from 2021 through 2030. Plus, all of this needs to be viewed in the context of annual global emissions of approximately 36,000 MMtons.

Cap and trade yields uncertain reductions, just like all climate programs

One concern with the flexible structure of California’s cap has been that it does not provide certainty that California will reach its climate goals. That’s true of the cap and trade program, but it is equally or more true of every other program in California’s climate initiative, including regulations on building and appliance energy efficiency, increased vehicle fuel efficiency, lower-carbon transportation fuels, and increased electricity generation from renewable sources.

The impacts of all of those “command and control” regulations are highly uncertain. However, because they tend to have a narrower and seemingly more tangible focus, such regulations are sometimes thought of as producing more “real” reductions than carbon pricing. Jim blogged about that misperception in 2016, and many other EI blogs have provided concrete illustrations (for instance on energy efficiency in schools, building codes, vehicle electrification, and fuel economy standards). Measuring the true costs and benefits of such programs, including greenhouse gas reductions, is very difficult.

In designing all these programs, state policymakers have had to balance a desire for significant emissions reductions with the recognition that regulations that are seen as overly harmful to the economy would set climate policy back both locally and globally. The flexible cap is meant to provide such a balance.

Adjusting the cap is a political and policy choice, not a scientific imperative

We are not arguing for or against changing the emissions cap to offset any allowance overhang at the end of 2020. There is no known threshold for California emissions at which global climate change takes a sudden turn. Thus, a decision to adjust the emissions cap would primarily be one of politics and policy judgement, as was the decision to set it at its current levels in the first place. There is no clear scientific guidance.

Nonetheless, it is important to understand what such an adjustment would, and would not, mean for the emissions market that California has established. Neither choice would jeopardize the market. Rather, the decision would change the probabilities of allowance prices in a way that would be expected to have a modest impact on the state’s emissions through 2030.

[1] These 140 MMtons from the price rising to the ceiling level, are in addition to the roughly 76 MMtons that we estimate would result from a price at the floor level.

[2] Reducing the emissions cap would also change slightly the probability of ending up with a price above the floor and below the ceiling, butthe impactof that change on expected emissions would be negligible.