With all that’s been happening in Washington DC, you may have taken your finger off the pulse of California climate change policy. But now’s a good time to check back in. There’s a new cap-and-trade proposal in town, and it’s turning lots of heads in the state capital.

California is deep in deliberations over cap-and-trade as it prepares to meet a new and ambitious GHG emissions reduction target. The state is aiming to reduce emissions to 40% below 1990 levels by 2030. This makes the GHG emissions reductions we’ve achieved so far look timid.

While the state has charted an emissions reduction path out to 2030, the existing GHG cap-and-trade program sunsets in 2020. This means the legislature needs to reauthorize – or replace – the current program to meet this post-2020 ambition. The 260 million metric ton question: What policy can most effectively deliver on this target?

The new cap-and-trade proposal, SB 775, would replace the existing cap-and-trade program in 2021. It has some pundits swooning. David Roberts of Vox writes a glowing endorsement of what he sees as a “clean break” from California’s existing GHG emissions trading program. But other policy experts offer a different view. Economist Rob Stavins argues there’s no need to “repeal and replace” the state’s effective cap-and-trade system. Professor Ann Carlson warns that it could “cause many more problems than those it attempts to solve”.

The proposal covers a lot of ground in 19 pages (Dallas Burtraw provides a great review here). I want to unpack one key piece: the proposed border adjustment. This may sound wonky and weedy, but it’s really important because it aims to bring imports under California’s cap-and-trade program. There’s a lot to like about this idea in theory. But the reality could be a different story.

The Leakage Problem

To put this border adjustment into context, let’s quickly review the problem it’s trying to address. The problem is that California’s climate change policy applies to only a small subset of the sources contributing to the global climate change problem. Pricing carbon only within the state could potentially send business – and associated emissions – out of state.

Suppose you are a California-based producer of an emissions-intensive product, such as cement, glass, or refined oil products. Under a statewide cap-and-trade program, you are required to purchase emissions permits for your GHG emissions. In other words, the policy increases your production costs. If out-of-state producers can supply the California market, this could mean you lose California market share to out-of-state rivals who don’t face the same cost increase. If you are a California-based operation that exports its products, this could make it harder for you to compete in out-of-state markets. In either scenario, the policy can shift production out of California. The associated emissions “leakage” erodes emissions reductions achieved within the state.

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The Current Response

Concerns about leakage loom large, so it is essential that California’s cap-and-trade program incorporate some meaningful response to this problem. Right now, the response comes in the form of free permit allocation. A share of permits (approximately 15%) are distributed free to those industries that are deemed to be at leakage risk.

You may be wondering how requiring firms to purchase permits – and then handing them back for free- achieves anything at all. The key is that emitters are required to turn in permits to cover their emissions, but these same firms are allocated free permits based on production. So you (the producer) see both an emissions tax (which provides an incentive to invest in emissions abatement) and a production incentive (which helps to ‘level the carbon playing field’ with out-of-state producers and thus mitigate leakage).

If we are concerned about emissions leakage (and we should be), this output-based free permit allocation approach can strike a balance between incentivizing emissions abatement and mitigating leakage. That’s the good news. The less-good news is that this strategy comes with side effects. For one thing, it dilutes the carbon price signal that California consumers receive when they are making their consumption decisions. It also allocates the revenue from the sale of valuable permits to industry when this revenue could alternatively be put towards other good uses.

The Proposed Alternative

There’s more than one way to skin this leaky cat. SB 775 proposes an alternative that I think most (all?) economists would prefer in theory. The idea is simple and elegant. First, identify imported products whose price would be materially impacted by the carbon permit price. Then require importers of these products into California to purchase permits for the emissions baked into their product. As for California-based exporters, they are exempt from the obligation to purchase permits for emissions associated with products sold outside the state (the SB 775 language on this is hard to parse…. thanks to Michael Wara for clarifying this important point!)

Why is this the theoretically preferred approach? For one thing, consumer prices in California rise to fully reflect the carbon price signal. This helps us consumers account for the full costs of our consumption, and adjust our behavior in response. Second, California can use the revenues from the sale of permits for other purposes, versus freely allocating to industry (although exempting exports means no revenues are collected from exporting firms).

The upshot is that this border adjustment seems like a winning proposal in theory. But the winning horse, in theory, need not be the most fit to ride through the real-world challenges that lie ahead.

Comparisons between an elegant proposal-on-paper and the existing workhorse that’s spent years slogging through messy policy implementation can be misleading. It’s easy to find flaws in the current permit allocation approach to leakage mitigation when compared against some theoretical ideal. But the more relevant point of comparison is the border adjustment after it hits the buzzsaw of reality.

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Here’s my wet-blanket list of reality-bites concerns:

We import lots of stuff from lots of places: Under the border adjustment, California will need to estimate the carbon emissions baked into all the emissions-intensive products we import. There is already some precedent for this kind of accounting exercise covering one product under the state’s low carbon fuel standard (LCFS). Nine full-time staff have been hard at work estimating the GHG emissions factors for transportation fuels consumed in the state. This table summarizes the hundreds of “carbon pathways” (e.g. “South Dakota corn ethanol”, “Brazilian molasses ethanol”) that span the space of transportation fuels. It can take months to estimate a single pathway. The number of source-product combinations would increase dramatically under the border adjustment.

Under the border adjustment, California will need to estimate the carbon emissions baked into all the emissions-intensive products we import. There is already some precedent for this kind of accounting exercise covering one product under the state’s low carbon fuel standard (LCFS). Nine full-time staff have been hard at work estimating the GHG emissions factors for transportation fuels consumed in the state. This table summarizes the hundreds of “carbon pathways” (e.g. “South Dakota corn ethanol”, “Brazilian molasses ethanol”) that span the space of transportation fuels. It can take months to estimate a single pathway. The number of source-product combinations would increase dramatically under the border adjustment. A cap on consumption emissions is harder to measure: It’s worth pointing out that, under a border adjustment, the state’s emissions targets and the associated emissions cap would have to be redefined. California currently caps emissions from in-state production. But under a border adjustment, the cap-and-trade regulation would cap emissions associated with in-state consumption. This means using the aforementioned emissions factors to estimate emissions in our imports, and subtracting the emissions from in-state production that get exported outside the state.

It’s worth pointing out that, under a border adjustment, the state’s emissions targets and the associated emissions cap would have to be redefined. California currently caps emissions from in-state production. But under a border adjustment, the cap-and-trade regulation would cap emissions associated with in-state consumption. This means using the aforementioned emissions factors to estimate emissions in our imports, and subtracting the emissions from in-state production that get exported outside the state. Export reshuffling? Under the SB 775 proposal, emissions associated with California production destined for export markets would be eligible for a border tax “refund”, whereas emissions associated with production that stays in California would remain under the cap. This asymmetric treatment of what stays home and what gets sent outside of California creates an incentive to re-allocate more emissions-intensive production to the export market in order to avoid the carbon price.

Under the SB 775 proposal, emissions associated with California production destined for export markets would be eligible for a border tax “refund”, whereas emissions associated with production that stays in California would remain under the cap. This asymmetric treatment of what stays home and what gets sent outside of California creates an incentive to re-allocate more emissions-intensive production to the export market in order to avoid the carbon price. Legal challenges: The border adjustment could pose a triple threat to the program: challenges from within the state, challenges under the commerce clause, and challenges from WTO. The legal resources required to defend this provision could be large. Notably, the SB 775 language does include an escape clause. If a judicial opinion, settlement, or other legally binding decision reduces the state’s authority to implement the border adjustment, the legislation authorizes a return to free allowance allocation for the affected products. But this return would be messy, in part because it would require a re-adjustment of the emissions cap

Conclusion

California is demonstrating a working example of how emissions leakage can be mitigated in a regional emissions trading program. There’s no question that the current approach falls short of the theoretical ideal. But the real question is: could an alternative approach work better? SB 775 has raised the profile of an important conversation about what those alternatives could look like.

My concern with the border adjustment proposal is that it seems to put the cart before the proverbial horse. Success hinges critically on our ability to come up with legally-defensible measures of greenhouse gas emissions intensities for all the carbon-intensive products we import. It’s worth noting that exploratory work along these lines is already underway (Resolution 10-42 directed the Air Resources Board to review the technical and legal issues related to a border adjustment for the cement sector). Given all that’s at stake, we should double down on these efforts to develop and test this approach before we bet the farm on its real-world durability.