Almost 10 years ago, California’s legislature passed Assembly Bill 32, the Global Warming Solutions Act of 2006. AB 32 set the most ambitious legally binding climate policy in the United States, requiring that California’s greenhouse gas emissions return to 1990 levels by the year 2020. The centerpiece of the state’s efforts—in rhetorical terms, if not practical ones—is a comprehensive carbon market, which California’s leaders promote as a model policy for controlling carbon pollution. Over the course of the past 18 months, however, California quietly changed its approach to a critical rule affecting the carbon market’s integrity. Under the new rule, utilities are rewarded for swapping contracts on the Western electricity grid, without actually reducing greenhouse gas emissions to the atmosphere. Now that the Environmental Protection Agency is preparing to regulate greenhouse gases from power plants, many are looking to the Golden State for best climate policy practices. On that score, California’s experience offers cautionary insights into the challenges of using carbon markets to reduce greenhouse gas emissions.

For years, Southern California Edison imported electricity from the Four Corners Power Plant, a coal-fired facility in northwestern New Mexico. When California’s groundbreaking carbon market took effect in 2013, Edison, like all other in-state utilities, became responsible for the climate pollution from its generating fleet. A few months later, the company sold its interest in the coal plant to an Arizona utility (APS, 2013). Whatever replacement supplies Edison selects will be cleaner than coal, the most carbon-intensive fossil fuel, and Edison will report reduced emissions in California’s carbon market.

At first this sounds like a positive story: Policy puts price on carbon, pollution falls. But this transaction will not reduce net greenhouse gas emissions to the atmosphere. The coal plant will keep emitting pollution just as before—only now it serves customers in Arizona, not California.

As it has with many other environmental issues before, California aims to set an example for the United States on climate policy. The key to its success, according to state officials, is a comprehensive carbon market—featuring “good policy design, clear oversight and strong enforcement” (Nichols, 2014). Ironically, one of the most visible consequences of the market’s first year is a rush to swap coal power imports for cleaner replacements, limiting the extent to which California’s policy leadership actually helps the climate. Is this perverse outcome the unavoidable consequence of California acting without its neighbors’ support, or could the state have done more to ensure that its market creates real environmental benefits?

An efficient theory The slow birth of American climate policy coincides with a transition in the way our country manages its environmental problems. Most of our national environmental laws were drafted at a time when both political parties supported government regulation of the private sector. That was, of course, a different era. Since then, the center of national political opinion has shifted dramatically in favor of the free market. And that trend is visible in contemporary environmental policy, which, over the last few decades, has moved away from traditional regulatory approaches to controlling pollution. Flexible, market-based mechanisms are now the preferred route. The thinking goes something like this: Rather than impose specific requirements on individual companies or industries, it is more efficient for the government to set economy-wide policy targets and let the private sector find the cheapest way to meet them. In theory, this not only increases the flexibility of regulated industries’ compliance options but also reduces the policy’s administrative complexity. Thus, if done right, economic approaches to environmental policy should result in a win-win. Enter a uniquely American invention, the carbon market—also known as emissions trading or cap-and-trade.1 The idea is simple, though the practice is not. Economic theory says that all a government needs to do is: set a quantitative cap on emissions; create and freely distribute or auction emissions permits, with the total number of permits equal to the cap; and require polluters to turn in a permit for each unit of pollution they emit. With this framework in place, the government steps back to let the private sector do what it does best: trade permits to minimize costs. The most critical component of a carbon market is the cap. Typically, the cap is expressed as a maximum quantity of emissions allowed in any given year, with each year’s limit declining toward a long-term goal. Think of it like a game of musical chairs—with carbon pollution as the players, and the chairs representing emissions permits. At the end of every year, the music stops and the players must seat themselves. When there are more people than chairs, market forces dictate who leaves the game and who can stay; the government’s role in this analogy is only to set up the rules and remove the correct number of chairs at each stage. So long as the government counts the right number of chairs, everything should work out fine.

California’s climate policy After the United States withdrew from the Kyoto Protocol and elected George W. Bush, whose administration strongly opposed legally binding federal climate policy, momentum shifted to the states. California moved to claim its traditional role as an environmental policy leader by passing AB 32, the Global Warming Solutions Act of 2006. Most notably, this bill requires California’s emissions to fall to 1990 levels by the year 2020. AB 32 also designated a primary regulator, the California Air Resources Board (CARB), making CARB responsible for developing specific policies and measures that would lead California to its 2020 target. The key to understanding California’s climate policy system lies in recognizing the overlapping structure of the instruments that CARB and other agencies eventually adopted. Arguably the state’s best-known climate policy is its comprehensive carbon market, which CARB designed and implements. At the same time, California has a number of robust regulatory programs that apply to sectors that are also covered by the carbon market. For example, California has one of the strongest renewable portfolio standards (requiring utilities to purchase 33 percent of their electricity from renewable sources by 2020), as well as world-class energy efficiency programs and a clean transportation fuels policy. Climate experts refer to these programs as “complementary policies”—a phrasing that suggests they exist to support the primary instrument, a carbon market. In practice, however, the complementary policies do most of the work. When CARB created its plan for meeting California’s 2020 emissions target, it relied on complementary policies for approximately 80 percent of the reductions, leaving a mere 20 percent to “additional reductions” in the sectors covered by the state carbon market (CARB, 2008)—meaning that most of the emissions reductions are being accomplished by individual policies, not driven by the comprehensive market price on carbon. As my colleague Michael Wara (2014) explains elsewhere in this issue, the complementary policies effectively hide the true cost of California’s climate policy: Because most of the necessary emissions reductions are required by separate regulation, rather than left to the carbon market, the carbon price reflects only a fraction of the state’s climate policy efforts.2

California’s market design California benefits from the experience of the emissions trading systems that came before it. By carefully observing the early years of the European Union’s Emissions Trading Scheme (ETS), for example, CARB was able to avoid many of the hiccups that confronted its predecessors. These successes are all the more laudable because California has implemented the most comprehensive market to date. While the northeastern states’ Regional Greenhouse Gas Initiative controls only emissions from power plants, California’s market currently covers the power and industrial sectors (as does the European ETS), and will expand next year to include the transportation fuels and natural gas sectors. All told, this will encompass about 85 percent of the state’s total emissions—a comprehensive policy by any standard. On the other hand, California faces many new challenges that previous markets never had to address. In particular, the state must contend with the fact that it is only a small part of a regional electricity transmission grid stretching from the Pacific Ocean to the Rocky Mountains. The scale of the Western grid matters because California is a significant net importer of electricity. Recognizing that the emissions profile of its electricity imports is part of California’s carbon footprint, regulators rightly included electricity imports in the cap-and-trade program. But geography introduced new headaches. Because California is the only western state that prices its greenhouse gas emissions, utilities and power traders now face an incentive to swap their high-emitting imports for cleaner replacements—a practice known as resource shuffling. (Recall the earlier example of Southern California Edison divesting its interest in a New Mexico-based coal power plant: Emissions reported in California go down, but emissions across the western United States do not change.) If utilities are allowed to shuffle electric power imports, the emissions reductions they report in California’s carbon market will not reflect reduced emissions to the atmosphere. Instead, the dirty resources California utilities divest will continue polluting the air under new, unregulated ownership. Given this dilemma, what should carbon market regulators do?3

A quiet coup As it happens, the California Legislature anticipated these concerns. When the legislature delegated broad authority to CARB to create climate policy, it also issued guidelines that the regulator must incorporate in its policies. Specifically, state law requires that “to the extent feasible,” climate regulations must “minimize leakage.”4 California law defines leakage as “a reduction in emissions of greenhouse gases within the state that is offset by an increase in emissions of greenhouse gases outside the state.”5 In plain English, this requirement means that CARB should not give credit to actions that merely shift the responsibility for greenhouse gas emissions beyond state borders. Instead, AB 32 dictates that CARB should only recognize net reductions in emissions to the atmosphere. For a time, CARB followed this instruction. Its initial carbon market regulations banned resource shuffling, and went so far as to require companies’ executives to attest that they were not engaged in this practice.6 But this approach proved controversial. In the months leading up to the beginning of the market’s first compliance period, several stakeholders objected to the resource shuffling rules and began agitating for reforms. The first public proposal came from California’s investor-owned utilities, which in September 2012 advocated a series of exemptions to the prohibition on resource shuffling (Joint Utilities Group, 2012). The following month, CARB directed its staff to develop modifications to the resource shuffling regulations, providing 13 fully developed “safe harbor” exemptions to the definition of resource shuffling (CARB, 2012a)—directly comparable to, if not more permissive than, the Joint Utilities Group proposal. A few weeks later, CARB staff released a new regulatory guidance document that incorporated these safe harbors, almost word for word (CARB, 2012b). When a regulator issues a guidance document that publicly describes how to interpret its rules, that description provides a legal defense to any private party that reasonably relies upon it. After all, it would be extremely unfair if following the regulator’s own advice could get one in legal trouble. But consider what this meant for the carbon market. On the eve of the program’s launch in January 2013, the regulator quietly rewrote its own rules through informal guidance documents. Formally, its regulations prohibited resource shuffling. Yet CARB’s own guidance document indicated that this straightforward prohibition would not apply to 13 broad categories of transactions. Thus, when the market began operation in 2013, its practical function had already diverged from its formal legal rules.

The market springs a leak My colleague David Weiskopf and I had been studying CARB’s resource shuffling rules during this tumultuous time. We recognized that CARB faced an incredibly difficult task in writing effective and legally permissible cross-border accounting rules, yet we were surprised at the scope of CARB’s informal guidance document. We believed that a compromise was possible, to give utilities clear and flexible rules without undermining the environmental integrity of the market. Meanwhile, we were deeply concerned that the informal guidance document effectively revoked the prohibition on resource shuffling. We published our analysis of the safe harbors and the leakage risks they created in July 2013 (Cullenward and Weiskopf, 2013). Most important, we described how several of the safe harbors were broader than the underlying prohibition. In addition, we pointed out that two safe harbors explicitly allowed California utilities to divest their long-term contracts with out-of-state coal power plants. As it happens, these coal power imports account for a significant portion of California’s emissions. We calculated that if California utilities relied on the safe harbors to divest from just six coal power plants, they could cause between 108 and 187 million tons of carbon dioxide to leak out of California’s market—a quantity that is roughly equivalent to the expected size of the market, after accounting for the likely impact of the complementary policies. Furthermore, we realized that our analysis was consistent with calculations from CARB’s own economic advisory committee, called EMAC, which found that resource shuffling of all types could lead to leakage of between 120 and 360 million tons of carbon dioxide (Borenstein et al., 2013). (The EMAC report did not assess whether the safe harbors would enable leakage; it looked only at what the effects of resource shuffling would be if there were no prohibition against it.) In addition to presenting our concerns, we also developed a complete regulatory text to implement an alternative approach to controlling resource shuffling. Even if our suggestions could have been helpful, they probably arrived too late. That same month, CARB hosted a workshop to consider draft regulatory amendments that would codify the safe harbors into law. As it became clear that CARB would proceed without any public acknowledgement of the leakage problem, I wrote an op-ed in the San Jose Mercury News raising the issues described here (Cullenward, 2013a), as well as two comment letters addressing the technical and legal questions in the formal administrative process (Cullenward, 2013b, 2014a). Over the following months, three of the six coal power plants that Weiskopf and I identified became involved in resource-shuffling-related transactions, leaking between 30 and 60 million tons of carbon dioxide out of California’s carbon market (Cullenward, 2014b). Two of these contracts have already left the regulatory system, while a third—under which the Los Angeles utility LADWP imports power from the coal-fired Navajo Generating Station on tribal lands in Arizona—is on its way out. In a regulatory filing connected with its purchase of replacement power, LADWP even disclosed that a benefit of divestment from the Navajo Generating Station would be “relieving LADWP from having to purchase emission credits” in the carbon market (LADWP, 2013: 3). Yet, as I pointed out in my second comment letter to CARB (Cullenward, 2014a), there is little doubt that the utility’s divestment plan fits squarely in one or more of the safe harbors, and therefore does not violate CARB’s guidance. By the time CARB unanimously voted to approve its new regulations, it had substantial evidence that its safe harbors were facilitating significant leakage—despite AB 32’s clear requirements to the contrary.

A weak cap What does leakage mean for California’s climate policy? First and foremost, it means the “cap” in cap-and-trade is much less than it seems. Return for a minute to the analogy of carbon markets as a game of musical chairs. Earlier, I suggested that so long as the government sets out the right number of chairs (a shrinking supply of emissions permits), the game should run smoothly. But resource shuffling essentially allows players to leave the game—say, by offering them an open spot on a comfortable couch in a nearby room. If resource shuffling is allowed, counting the number of chairs no longer provides reliable information about the environmental performance of the system. And that’s the major flaw in California’s system. Now that resource shuffling is happening, we know that California’s supposed reductions reflect bad bookkeeping, because the market cap is no longer firm. If the remaining coal power imports leave the carbon market, or if utilities take full advantage of the other safe-harbor provisions, a significant majority of the market’s apparent emissions reductions will be attributable to leakage, not progress. Although the market is no longer producing the net emissions reductions for which it was designed, it does have other, positive impacts. Notably, it sets a minimum price, which was $11.34 per metric ton of carbon dioxide in July 2014. The price had previously ranged from approximately $13 to $20 per ton, but began a steady decline in approximately July 2013. As this article went to press, it rested slightly above the price floor, as can be seen at the California Carbon Dashboard website (http://calcarbondash.org). These data show that an oversupply of emissions permits—caused in no small part by reduced demand due to resource shuffling—has crashed the market price down to its legal minimum. Curiously, so long as these conditions persist, the market actually looks like a carbon tax. In other words, after years of complex negotiations, emissions trading, and hundreds of pages of market rules, California’s market operates much like the carbon tax (or “fee”) policies preferred by both moderate Republicans (Paulson, 2014; Shultz and Becker, 2013) and grassroots environmentalists (Citizens’ Climate Lobby, 2014)—only without the transparency and accountability mechanisms that motivate many of these advocates’ positions.7 Perhaps simplicity is a virtue in climate policy after all. In all fairness, California has managed to create the highest price on carbon pollution in the United States. It also has robust energy policies that are encouraging the expanded use of clean and efficient resources. These are all significant accomplishments, but the carbon price is still too low to do much good. We know it is lower than the actual cost of California’s clean energy policies—for example, CARB reports that California’s clean fuels policy credits were trading between $63 and $79 per metric ton of carbon dioxide during the last three months of 2013 (CARB, 2014), well above the carbon market price—and therefore the carbon market is not driving compliance in those sectors. In any case, the market price is certainly lower than the levels needed for the long-term transformation of the energy system.

A cautionary tale Can anything be done about the failure of California’s flagship carbon market to live up to expectations? Yes, but the political challenges are far greater than the technical issues. At this point, there is only one solution that can preserve the market’s integrity: CARB must observe the leakage that results from its permissive resource shuffling rules, then tighten the overall market cap accordingly. (In my musical chairs analogy, this means removing a chair for every person who leaves the game before the music stops.) But acknowledging and resolving the problem will likely increase the carbon market price, and hence political opposition. Some stakeholders prefer to place hope in new developments in state and federal climate policy. They argue that resource shuffling will be less of a problem if enough of California’s neighbors adopt their own climate regulations. For example, the leaders of California, Oregon, Washington, and British Columbia signed an agreement to harmonize their approach to climate policy (Center for Climate and Energy Solutions, 2013). There is little chance, however, of a similar agreement with southwestern states, where most of California’s legacy coal power imports originate. Waiting for the Environmental Protection Agency to act isn’t an option, either. Assuming that the EPA’s proposed rules are finalized and survive intense litigation, they won’t produce results until after 2020, the current end date for California’s legally binding market. (Moreover, the proposed federal rules do not apply to tribal lands, yet two of the three coal-fired power plants that have already leaked from California’s market are located in Navajo territory.) Thus, the prospects for California’s neighbors to independently resolve this problem are dim. Even if CARB fails to address the leakage issue, California’s experience offers useful insights into the politics of climate policy—though the precise lessons depend on one’s point of view. The optimistic perspective looks something like this: Perhaps the flaws in the current plan reflect realistic concessions on the road to deep, long-term emissions reductions. (State policy makers are currently discussing how to set a goal for 2030 and have a nonbinding aspirational target of reducing emissions 80 percent below 1990 levels by 2050.) Even the most proactive government officials have to navigate a maze of political obstacles, technically complex issues, and the constant threat of litigation—especially when working on controversial issues such as climate policy, which challenges powerful established interests. Sometimes policy makers make mistakes, and sometimes they make compromises. Whatever the case here, the good news is that a state can only rely on leakage once: After the high-emitting resources are gone, there are no more opportunities for resource shuffling. Instead of fighting over complex market rules, climate policy makers should focus on raising the minimum market price in future reforms. Their critics should remember that the complementary policies are unaffected by a weak market cap. Taking a less optimistic perspective, one might question the credibility of the market regulators. At the end of the day, CARB let the utilities write their own rules. Whether CARB intended to rely on leakage to artificially lower the market price, or simply didn’t understand what its economic advisers were saying about the probable consequences of these reforms, it deferred to the industry it was charged with regulating. Political realists who worry about costs should also be concerned with the environmental performance of policy instruments designed to keep costs low; California will need these policies to work if it is to achieve long-term climate targets. Equally important is consistency with the rule of law, which will be necessary to strengthen climate policy over the coming decades. From this perspective, relying on questionable accounting tricks is hardly the mark of a strong regulator that is prepared to impose tough rules for 2030 and beyond. If there is a broader lesson in California’s experience, it is this: The political and technical challenges of implementing climate policy are greater than most people appreciate—even within the expert community, which tends to view carbon markets as both eminently tractable (Newell et al., 2014) and politically expedient (Stavins, 2014). It is not enough to pass legislation or propose new regulations. Indeed, that is only the beginning.

Acknowledgements Thanks to Jonathan Koomey, Michael Wara, and David Weiskopf for their feedback and insights. Any errors and all opinions are my own.

Funding This research received no specific grant from any funding agency in the public, commercial, or not-for-profit sectors.

Notes 1

Many people incorrectly think of the carbon market as a European invention because the European Union was the first to apply it to climate policy. Europe did create the world’s largest carbon market, the EU Emissions Trading Scheme, as part of its Kyoto Protocol obligations (Ellerman et al., 2007). Nevertheless, emissions trading actually got its start in the United States. For example, the US Environmental Protection Agency developed cap-and-trade markets to control lead in gasoline in the 1980s (Stavins, 2014) and for sulfur dioxide pollution from power plants in the 1990s (Ellerman et al., 2000). 2

This is not to say that California’s climate policy is too expensive. My point is merely that the apparent cost observed in the carbon market is significantly lower than the true cost. 3

This challenge is not unique to California; it applies to nearly all sub-national carbon markets, including the Regional Greenhouse Gas Initiative and the pilot programs in China (Cullenward and Wara, 2014). So long as the carbon market is smaller than the region’s electricity market, cross-border accounting issues will be present. 4

See California Health and Safety Code (2014: §§ 35852(b), (b)(8)). 5

See Legislative Counsel of California (2014: § 38505(j)). 6

See California Code of Regulations (2014: § 95852(b)(2)). The attestation requirement was suspended soon after adoption and recently repealed in its entirety. 7

Although advocates of these policies use different terminologies, they share the common goal of putting a price on emissions—for all practical purposes, a tax. But framing matters in politics. Citizens’ Climate Lobby eschews “tax” and prefers “fee and dividend,” returning all revenue back to households. Shultz and Becker promote a “revenue-neutral carbon tax,” which they distinguish from other taxes by requiring that all revenues be returned to individual (and potentially corporate) taxpayers. Finally, others, like Paulson, refer simply to a carbon tax, without specifying how the revenue would be used.