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Low Prices a Problem? Making Sense of Misleading Talk about Cap-and-Trade in Europe and the USA

Some press accounts and various advocates have labeled the Regional Greenhouse Gas Initiative (RGGI) as near “the brink of failure” because of the recent trend of very low auction prices. Likewise, commentators have recently characterized the European Union Emission Trading Scheme (EU ETS) as possibly “sinking into oblivion” because of low allowance prices. Since when are low prices (which in this case reflect low marginal abatement costs) considered to be a problem? To understand what’s going on, we need to remind ourselves of the purpose (and promise) of a cap-and-trade regime, and then look at what’s been happening in the respective markets.

The Purpose and Promise of Cap-and-Trade

A cap-and-trade system– if well designed, implemented, and enforced – will limit total emissions of the regulated pollutant to the desired level (the cap), and will do this (if the cap is binding) in a cost-effective manner, by leading regulated sources to each make reductions until they are all experiencing the same marginal abatement cost (the allowance price). Thus, the sources that initially face the highest abatement costs, reduce less, and those sources that face the lowest abatement costs, reduce more, achieving system-wide minimum costs, that is, cost effectiveness. So, the purpose and promise, in a nutshell, is to achieve the targeted level of aggregate pollution control, and – if the cap is binding – do this at the lowest possible cost.

RGGI Allowance Prices

The Regional Greenhouse Gas Initiative (RGGI) – a downstream cap-and-trade system for CO₂ emissions from the power sector in 10 northeast states (Connecticut, Maine, Maryland, Massachusetts, New Hampshire, New Jersey, New York, Rhode Island, and Vermont, with New Jersey now in the process of withdrawing from the coalition), was launched with relatively unambitious targets, principally in order to keep prices down to prevent severe leakage of electricity demand and hence leakage of CO₂ emissions from the RGGI region to states and provinces outside of the region (mainly from New York to Pennsylvania).

Emissions are capped from 2012 to 2014, and then, starting in 2015, the cap decreases 2.5% per year until it is down by 10% in 2019. This would represent a level of emissions 13% below the 1990 level of emissions. It was originally thought that this would be some 35% below the Business-as-Usual (BAU) level in 2019. Sounds good. What happened is not that the system performed other than designed, but that “business was not as usual.” That is, what happened is that unregulated power-sector (BAU) emissions in the northeast fell significantly. (See the graph below of the RGGI cap and historical emissions.)

For source, please click here.

So, Why Did Emissions Fall in the RGGI States?

This happened for three reasons. First, because of increasing supplies in the United States of low-cost, unconventional sources of natural gas, prices for this fuel have fallen dramatically since 2008. (See the graph below of natural gas and coal prices.) That has meant greater dispatch of electricity from gas-fueled power plants (relative to coal-fired plants), more investment in new gas-fired generating plants, less investment in coal-fired generating capacity, and retirement of existing coal-fired capacity, all of which has contributed to lower CO₂ emissions.

For source, please click here.

Second, the worst economic recession since the Great Depression hit the United States in 2008, causing dramatic reductions in electricity demand in the industrial and commercial sectors, reducing emissions. (See the graph below of quarterly percentage change in U.S. GDP, 2007-2009.)

For source, please click here.

Third and finally, moderate northeast temperatures have kept down CO₂ emissions linked with both heating and cooling.

Low Emissions, Low Allowance Demand, Low Allowance Prices

So, for the three reasons above, BAU CO₂ emissions from the power sector in the RGGI states are dramatically below what was originally (and quite reasonably) anticipated. The supply of RGGI CO₂ allowances made available at auction is – by law – unchanged, but demand for these allowances has fallen dramatically, hence the fall in RGGI allowance prices. (See the graph below of RGGI allowance prices, 2008-2010.)

For source, please click here.

Given that emissions are below the RGGI cap and – due to expectations regarding future natural gas prices – are likely to remain below the cap, there is no scarcity of allowances. Shouldn’t the price fall to zero? In theory, yes, except that the system has an auction reservation price of $1.86 per ton built in, thereby creating a price floor of precisely this amount.

Is RGGI a Failure?

So, the cap put in place by the RGGI system is being achieved, but it is not binding. RGGI may not be particularly relevant, but it is not thereby a flawed system; surely it is not a failure. Rather, a great environmental success has been achieved by the “fortunate coincidence” of low natural gas prices, economic recession, and mild weather. This is hardly something to be lamented.

True enough, the RGGI system does have flaws (such as its narrow scope limited to electricity generation, and its lack of a simple safety valve, as I have written about in the past). But the low allowance prices are evidence of a success outside of the RGGI market, not evidence of failure within the RGGI market.

If the RGGI states have the desire and the political will to tighten the cap in the future, then the system can again become binding, environmentally relevant, and cost-effective. That’s an ongoing political debate.

To be fair, I should note that the same outcome I have described here can be spun – perhaps for political purposes – quite differently. Recently, a self-described “free-market energy blog” commentator claimed – not without some justification – that RGGI is irrelevant or worse: “Bottom line, the program has raised electricity prices, created a slush fund for each of the member states, and has had virtually no impact on emissions or on global climate change.”

Phrased differently, due to exogenous circumstances (I’ve described above), the RGGI program is non-binding, and so has no direct effect on emissions, but its relatively low auction reservation price does lead to very small impacts on electricity prices, and produces revenues for participating states, revenues which those states would surely claim are of value for state-level energy-efficiency and other programs that indirectly do affect CO2 emissions. So, the real bottom line is that low RGGI allowance prices are not a consequence of poor system design or a fatal flaw of cap-and-trade systems in general, but rather a consequence of what are in reality some exogenous coincidences that have turned out to be good news for the environment.

Now, let’s turn to the European Union Emissions Trading Scheme (EU ETS).

EU ETS Allowance Prices

Unlike RGGI, the EU ETS has not been irrelevant. It has successfully capped European CO₂ emissions, achieved significant emissions reductions, and it has done so — more or less — cost-effectively. (More about this hedging on cost-effectiveness below). Not surprisingly, like RGGI, the EU ETS has some design flaws (principally, its limited scope – electricity generation and large-scale manufacturing – and lack of a safety-valve), but as with RGGI, its low allowance prices should not be taken as bad news, but to some degree as good news, and certainly not as a sign of failure of the EU ETS.

Hand-wringing in Europe over Low Allowance Prices

There has been much hand-wringing in Europe over the “failure of the system” because of low allowance prices. Indeed, Danish Energy Minister Martin Lidegaard said earlier this month that low carbon prices threaten the EU ETS.

Of course, he’s correct that EU ETS allowance prices are “low.” They are down from their historic average of about $20 per ton of CO₂ to about $9 per ton currently (having reached an all-time low of $7.88 in early April). Here’s a graph of EU ETS allowance prices (EUAs) over the crucial period of change, January 2007 to January 2009.

For source, please click here.

At this point in this essay, I probably don’t need to say that this pattern is partly explained by the global recession, which has hit Europe particularly hard (and now threatens a double-dip recession in a number of European nations). Lower European – and global – demand has meant decreased economic activity in Europe, hence lower energy demand, lower CO₂ emissions, and therefore lower demand and lower prices for EU ETS allowances.

Even if we assume a growth rate of European CO₂ emissions 1 percent less than the growth rate of GDP (represented by the dotted “counterfactual” BAU line in the graph below, which estimates what emissions would have been from 2005 to 2010 without the introduction of the EU’s Emissions Trading System), the evidence makes clear that the EU ETS has succeeded in reducing emissions significantly below what would be expected from the recession alone.

For source, please click here.

This is where an important caveat needs to be introduced. Also feeding into this allowance price depression has been a set of national and regional energy policies, such as those promoting use of renewables, which have served to reduce emissions, demand for allowances, and hence allowance prices (while rendering the overall CO2 program less cost-effective by ensuring that marginal abatement costs remain heterogeneous). So, to the degree that the low allowance prices are due to so-called complimentary policies, the low prices are bad news about public policy (in cost-effectiveness terms), not good news. But this refers to misguided complimentary policies (which fail to bring about any incremental emissions reductions — under the cap-and-trade umbrella — and drive up aggregate cost), not to any design flaw in the EU ETS itself.

Multiple Goals Typically Require Multiple Policy Instruments

No doubt, Minister Lidegaard is aware of the allowance price impacts of the recession, and I hope he’s aware of the allowance price consequences of these other energy and environmental policies. The problem arises, however, because he sees the fundamental purpose of the EU ETS as somewhat broader than what I described at the beginning of this essay (namely, achieving emissions consistent with some cap, and doing so cost-effectively – if the cap is binding). For him – and many other European observers – “the purpose of the ETS was to cap CO₂ emissions in the E.U. and ensure clear economic incentives for investment in renewables.” So, the hand-wringing is not about a failure to achieve emissions reductions cost-effectively, but to have prices high enough to achieve other goals – in this case, greater use of renewable sources of energy. For others, the “other goals” have involved allowance prices high enough to bring about some targeted amount of technology innovation.

As I have written at this blog in the past, having multiple policy goals typically necessitates multiple policy instruments. For example, if the goal is a combination of reducing emissions cost-effectively and having prices maintained at some minimum (whether to bring about greater use of renewable energy sources or to inspire more technology innovation), then two policy instruments are needed to do the job: a cap-and-trade system for the first goal in combination with a carbon tax in the form of a price floor (as in RGGI) for the second goal.

Don’t Throw Out the Baby with the Bath Water

In other words, the EU ETS has not failed, but the design was inadequate (that is, incomplete) for what politicians now seem to want. If the Europeans want a price floor in their system (or better yet, a price collar, which would combine a price floor with a safety valve, i.e., price ceiling), then this is certainly feasible technically and economically. Likewise, if the EU member states have the desire and the political will to tighten the cap in the future, there are a variety of ways in which they can accomplish this, rendering the program more stringent and increasing allowances prices. But, in any event, the European Commission’s Energy division, Environment division, and Climate division should sort out the real effects of the “complimentary policies” that have contaminated the EU ETS, and which fail to bring about additional emissions reductions but drive up costs. Whether any of this is feasible politically is a question that my European colleagues and friends can best address.

What’s Good for the Goose is Good for the Gander: Rahm’s Doctrine and Mercutio’s Complaint

In a January 2009 article – “The Big Fix” – in the New York Times Magazine, David Leonhardt introduced a frequently-employed political strategy into popular political culture by identifying it with the new President’s Chief of Staff, Rahm Emanuel:

Two weeks after the election, Rahm Emanuel, Obama’s chief of staff, appeared before an audience of business executives and laid out an idea that Lawrence H. Summers, Obama’s top economic adviser, later described to me as Rahm’s Doctrine. “You never want a serious crisis to go to waste,” Emanuel said. “What I mean by that is that it’s an opportunity to do things you could not do before.” … That’s the crux of the doctrine.

Exploiting a Crisis

Stated less sympathetically, perhaps, the argument seems to be that sensible political strategy calls for exploiting the existence of a crisis by using it as an opportunity (excuse) to pursue policies you want, whether or not they are the best responses to the specific crisis. The crisis in this case was the worst recession since the Great Depression, and the “opportunities” on the new President’s mind were ambitious policies for health care costs and coverage, energy and climate change, and taxes.

Killing Two Birds with One Stone: Fixing the Economy and the Environment

At about the same time that Leonhardt’s article appeared in the New York Times Magazine, Elizabeth Kolbert’s profile of green jobs activist Van Jones, “Greening the Ghetto: Can a Remedy Serve for Both Global Warming and Poverty,” was published in The New Yorker. Kolbert included the following passage:

When I presented Jones’s arguments to Robert Stavins, a professor of business and government at Harvard who studies the economics of environmental regulation, he offered the following analogy: “Let’s say I want to have a dinner party. It’s important that I cook dinner, and I’d also like to take a shower before the guests arrive. You might think, Well, it would be really efficient for me to cook dinner in the shower. But it turns out that if I try that I’m not going to get very clean and it’s not going to be a very good dinner. And that is an illustration of the fact that it is not always best to try to address two challenges with what in the policy world we call a single policy instrument.”

I elaborated on that analogy and explained my concerns about the “greening of the economic stimulus package” (one element of the White House attempt “not to let a serious crisis go to waste”) in my essay on “Green Jobs” at this blog in March, 2009.

Two activities — each with a sensible purpose — can be very effective if done separately, but sometimes combining them means that one does a poor job with one, the other, or even both. In the policy world, such dual-purpose policy instruments are sometimes a good, even great idea, but other times, they are not. Whether trying to kill two birds with one stone makes sense depends upon the proximity of the birds, the weapon being used, and the accuracy of the stoner. In the real world of important policy challenges — such as environmental degradation and economic recession — these are empirical questions and need to be examined case by case.

In this case, it was (and is) important to separate the two issues: (1) environmental degradation (which in economic terms calls for pricing the externality, i.e. getting relative prices right); and (2) the economic downturn (which calls for increasing and maintaining aggregate demand in the economy). Environmental regulations address the first issue, while broad-based fiscal and/or monetary policies address the second. So, in economic terms, the imperative is to get relative prices right (internalize externalities), and avoid tilting an economic stimulus package toward any particular type of activity (such as “green jobs”).

I argued in my March, 2009 essay (and argue now) that addressing the worst economic recession in generations called for the most effective economic stimulus package that could be devised, not a stimulus package that was diminished in effectiveness through excessive bells and whistles meant to address a myriad of other (legitimate) social concerns. (And, likewise, getting serious about global climate change would require the enactment and implementation of meaningful, dedicated climate policies.)

By the way, I do not wish to add any fuel to the current political fire raging over the bankruptcy of Solyndra, the solar power manufacturer supported by a $500 million Federal loan guarantee under the stimulus package. The failure of Solyndra was largely due to the collapse of silicon prices and the consequent increased competitiveness of conventional solar cell technologies. I will leave it to others to debate whether the government should have seen this coming.

My point rather is that there is a strong counterargument to Rahm’s Doctrine, and that counterargument is – in the words again of David Leonhardt – “hardly trivial — namely, that the financial crisis is so serious that the administration shouldn’t distract itself with other matters. That is a risk, as is the additional piling on of debt for investments that might not bear fruit for a long while.”

That’s the Goose – What About the Gander?

Do not think for a moment that only Democrats are quick to subscribe to and employ Rahm’s Doctrine. On the contrary, Republicans – particularly the ultra-conservative ones that are coming to dominate the Party – have recently embraced it with breathtaking enthusiasm by exploiting national concerns about the sluggish economy and stubbornly high levels of unemployment in order to pursue their anti-regulatory agenda and focused attack on the U.S. Environmental Protection Agency.

As I have also written at this blog (“Good News from the Regulatory Front,” April 25, 2011), the blanket characterization of environmental regulations as “job killers” is simply inconsistent with decades of economic research. In the short term, new environmental regulations can have either positive or negative effects on employment in particular sectors, but in the long term, their employment impacts are trivial when compared with those of the overall set of factors that affect national employment levels. Attacking EPA “to save jobs” is a shameful attempt to exploit economic fears in pursuit of an ideological agenda (whether or not that agenda has social merit).

Enter Mercutio

So, as is so often the case, this economist (like many – maybe most – others) disagrees with the economic arguments put forward by both sides in the political world. Talking about “job-killing environmental regulations” is dishonest, and no more than another cynical application of Rahm’s Doctrine. But the same must be said about the “greening of the stimulus,” and the ongoing, bloated claims about “clean energy jobs.” As usual, those of us in the moderate middle are left to echo Mercutio’s censure: “A plague o’ both your houses!”

Misguided Objection to Progressive Policy: The EJ Lawsuit Against Implementation of California’s AB 32 Climate Policy

On May 20th, San Francisco Superior Court Judge Ernest Goldsmith ruled that the California Air Resources Board had not adequately explained its choice of a market-based mechanism — a cap-and-trade system — to achieve approximately 20 percent of targeted emissions reductions by 2020 under Assembly Bill 32, the Global Warming Solutions Act of 2006.

The ruling was in response to a lawsuit brought by a set of “environmental justice” groups, who fear that the cap-and-trade system will hurt low-income communities. These groups hope — at a minimum — to delay implementation of the system, scheduled for January 2012. Their preferred outcome would be for California Governor Jerry Brown to abandon the approach altogether in favor of conventional regulatory mechanisms.

I’ve written about this controversy before, but the potential importance of Judge Goldsmith’s ruling suggests that it’s important to revisit this territory.

The National Context

As far as we know, Governor Jerry Brown plans to move forward with the implementation of Assembly Bill 32, the Global Warming Solutions Act, under which California seeks to take dramatic steps to reduce its greenhouse gas emissions. Questions have been raised about the wisdom of a single state trying to address a global commons problem, but with national climate policy developments having slowed dramatically in Washington, California is now the focal point of meaningful U.S. climate policy action. Indeed, for this reason, Nature Magazine recently labeled Mary Nichols, the Chairman of the California Air Resources Board, “America’s top climate cop.”

California’s Plan

A key element of the mechanisms to be used for achieving California’s ambitious emissions reductions will be cap-and-trade, a promising approach with a successful track record, despite its recent demonization as “cap-and-tax” by conservatives and other opponents in the U.S. Congress.

Under this approach, regulators restrict emissions by issuing a limited number of emission allowances, with the number of allowances ratcheted down over time, thus assuring ever-larger reductions in overall emissions. Pollution sources such as electric power plants and factories are allowed to trade allowances, and as a result, sources able to reduce emissions least expensively take on more of the pollution-reduction effort. Experience has shown that cap-and-trade programs achieve emissions reductions at dramatically lower cost than conventional regulation.

Concerns

Some groups in California have been very uneasy about the prospect of cap-and-trade. In particular, the Environmental Justice movement has long opposed this approach, citing concerns that it would hurt low-income communities. Professor Lawrence Goulder of Stanford University and I addressed such concerns in an article in The Sacramento Bee in March of 2008.

One expressed concern has been that a cap-and-trade policy might increase pollution in low-income or minority communities. The apprehension is not about greenhouse gases (the focus of AB 32), since these gases spread evenly around the globe and thus would have no discernible impact in the immediate area. Rather, it’s about “co-pollutants,” such as nitrogen oxides, carbon monoxide, and particulates, which can be emitted alongside greenhouse gases.

Because a cap-and-trade system would reduce California’s overall greenhouse gas emissions, it would also lower the state’s emissions of co-pollutants. Still, it’s possible, though unlikely, that co-pollutant emissions would increase in a particular locality. But here it’s crucial to recognize that existing air pollution laws address such pollutants, and so any greenhouse gas allowance trades that would violate local air pollution limits would be prohibited.

If current limits for co-pollutants are thought to be insufficient, the best response is not to scuttle a statewide system that can achieve AB 32’s ambitious targets at minimum cost. Rather, the most environmentally and economically effective way to address such pollution is to revisit existing local pollution laws and perhaps make them more stringent.

While much attention has been given to the effects of potential climate policies on environmental conditions in low-income communities, it’s also important to consider their economic impacts on these communities. Reducing greenhouse gas emissions will require greater reliance on more costly energy sources and more costly appliances, vehicles and other equipment. Because low-income households devote greater shares of their income to energy and transportation costs than do higher-income households, virtually any climate policy will place relatively greater burdens on low-income households. But because cap-and-trade will minimize energy-related and other costs, it holds an important advantage in this regard over conventional regulations.

Moreover, a cap-and-trade system gives the public a tool for compensating low-income communities for the potential economic burdens: If some emission allowances are auctioned, revenues can be used to mitigate economic burdens on these communities.

The Way Forward

All in all, cap-and-trade serves the goal of environmental justice better than the alternatives. This progressive policy instrument merits a central place in the arsenal of weapons California employs. Beyond helping the state meet its emissions-reduction targets at the lowest cost, it offers a promising way to reduce economic burdens on low-income and minority communities. For these reasons, the EJ lawsuit is not only misguided, but — if ultimately successful — will be counter-productive.