In May, emissions allowance prices hit rock bottom in California. How can cap-and-trade work properly when prices are so volatile and difficult to predict? It makes life very difficult for businesses and investors, not to mention the state. Changes to the rules are being proposed to introduce more flexibility into the effective price floors, ceilings and the availability of allowances. But Severin Borenstein at the Energy Institute at Haas explains that there will always be a limit on how stable prices can be. That’s because they will always be greatly influenced by two factors in particular – swings in the macro economy, and clean energy breakthroughs – that are outside the control of cap-and-trade rules. He reviews the current problems and proposed solutions, and references the other main alternatives to cap-and-trade: emissions taxes, and technology mandates. Whatever happens, Borenstein is pleased to see that California is proving itself to be a valuable test case that the rest of the world can learn from.
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 stabilising 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.
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.
Carbon prices can rise too high or fall too low
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 taxes: a fixed disincentive has its limitations too
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.
California’s cap and trade already has some flexibility
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.
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.
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.
We’re learning, and that’s a good thing
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.
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
This article is published with permission
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