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Economics and Politics in California: Cap-and-Trade Allowance Allocation and Trade Exposure

In my previous essay at this blog – The Importance of Getting it Right in California – I wrote about the precedents and lessons that California’s Global Warming Solutions Act (AB 32) and its greenhouse gas (GHG) cap-and-trade system will have for other jurisdictions around the world, including other states, provinces, countries, and regions. This is particularly important, given the failure of the U.S. Senate in 2009 to pass companion legislation to the Waxman-Markey bill, passed by the U.S. House of Representatives, highlighting the absence of a national, economy-wide carbon pricing policy.

In my previous essay, I focused on three pending design issues in the emerging rules for the AB-32 cap-and-trade system: (1) the GHG allowance reserve; (2) the role of offsets; and (3) proposals for allowance holding limits. I drew upon a presentation I made on “Offsets, Holding Limits, and Market Liquidity (and Other Factors Affecting Market Performance)” at the 2013 Summer Issues Seminar of the California Council for Environmental and Economic Balance.

At the same conference, I made another presentation, which was on “Allowance Value Distribution and Trade Exposure,” a topic that is of great importance both economically and politically, not only in the context of the design of California’s AB-32 cap-and-trade system, but for the design of any cap-and-trade instrument in any jurisdiction. It is to that topic that I turn today. (For a much more detailed discussion, please see a white paper I wrote with Dr. Todd Schatzki of Analysis Group, “Using the Value of Allowances from California’s GHG Cap-and-Trade System,” August, 2012).

Why Does Anyone Care About the Allowance Value Distribution?

A cap-and-trade policy creates a valuable new commodity – emissions allowances. In a well-functioning emissions trading market, the financial value of these allowances (per ton of emissions, for example) is approximately equivalent to their opportunity cost, which is the marginal cost of emissions reductions. This is because of the existence of the overall cap, which – if binding – fosters scarcity of available allowances, and hence generates their economic value.

It should not be surprising, then, that the initial allocation of these allowances can have important consequences both for environmental and for economic outcomes.

Environmental Consequences of the Initial Allowance Allocation

No matter how many times I meet with policy makers around the world to talk about alternative policy instruments (for climate change and other environmental problems), I never cease to be struck by the confusion that abounds regarding the environmental (and the economic) consequences of the initial allocation of allowances in a cap-and-trade system. As I have written many times in the past at this blog, the initial allocation does not directly affect environmental outcomes. Regardless of the allocation method used, aggregate emissions are limited by the emissions cap. This is true whether the allowances are sold (auctioned) or distributed without charge. Furthermore, which firms or sources receive the initial allocation of allowances has no effect on either aggregate emissions or the ultimate distribution of emissions reductions among sources.

This independence of a cap-and-trade system’s performance from the initial allowance allocation was established as far back as 1972 by David Montgomery in a path-breaking article in the Journal of Economic Theory (based upon his 1971 Harvard economics Ph.D. dissertation). It has been validated with empirical evidence repeatedly over the years. (More below about the initial allocation’s potential effects on economic performance.)

However, it is also true that the initial allocation method can indirectly affect emissions. In particular, emissions leakage can arise if economic activity shifts to unregulated sources – this risk is greatest with auctions or free fixed allocations. In contrast, an updating, output-based allocation (used in AB 32 for “industry assistance”) can reduce leakage risk by making the free allocation of allowances marginal, rather than infra-marginal (as is the case with a simple free allocation).

Economic Consequences of the Initial Allowance Allocation

A favorite topic of academic economists is that the allowance allocation method in a cap-and-trade system can affect the overall social cost of the policy if the allowances are auctioned (sold by government to compliance entities), and if the revenues are then used to reduce distortionary taxes (such as taxes on labor and investment), thereby eliminating some deadweight loss and cutting overall social cost. I discuss this a bit more below, but for now let’s recognize that the combination of two California propositions and subsequent court rulings means that the State is not permitted to use the auction proceeds to cut taxes (rather, any auction proceeds must be used to achieve the purposes of AB 32, that is, reducing GHG emissions).

So, within the set of feasible options, the initial allowance allocation will not directly affect the cost-effectiveness of actions taken by emission sources to reduce emissions. In other words, aggregate abatement costs will not be directly affected by the nature of the initial allocation.

I was careful to use the word, “directly,” because the initial allowance allocation can indirectly affect economic outcomes. In particular, the use of updating, output-based allocations can: (1) lower the costs seen by consumers, which can reduce incentives to conserve; (2) avoid reductions in economic activity within California, with associated distributional impacts; and (3) avoid potential shifts of production to less efficient, more distant producers.

Auction Revenue Use

Decisions about how auction revenues are used can have profound consequences for the potential benefits of auctioning. There are three basic options.

First, as I emphasized above, in theory, reducing distortionary taxes provides the greatest net economic benefit (by reducing the social cost of the policy). But California’s unique legal context takes this option off the table.

Second, funding programs to address other market failures that are not addressed by the price signals provided by the cap-and-trade system can be meritorious. For example, information spillovers can be addressed through financing of research and development activities, and the principal-agent problems that infect energy-efficiency adoption decisions in rental properties can be addressed — to some degree — through zoning and other local policies.

The third and final option, however, is highly problematic, if not completely without merit, and yet, ironically, there are strong incentives in place for policy makers to go this third route. This third option is to use auction revenues to fund programs to subsidize emission reductions. There is a strong incentive to do this, because of California’s legal constraint to employ any auction revenues in pursuit of the objectives of the statute, that is, reducing GHG emissions.

What’s the problem? The AB-32 cap-and-trade system will cover approximately 85% of the economy. In other words, the vast majority of sources are under the cap. As I have explained in detail in several previous essays at this blog, under the umbrella of a cap-and-trade mechanism, (successful) efforts to further reduce emissions of capped sources will have three consequences: (1) allowance prices will be supressed (take a look at the hand-wringing in Europe over allowance prices in its CO₂ Emissions Trading System); (2) aggregate compliance costs will be increased (cost-effectiveness is reduced because marginal abatement costs are no longer equated among all sources); and (3) nothing is accomplished for the environment, in the sense that there are no additional CO₂ emissions reductions (rather, the CO₂ emissions reductions are simply relocated among sources under the cap).

Economics, Policy, and Politics

As I concluded in my previous essay, the California Air Resources Board has done an impressive job in its initial design of the rules for its GHG cap-and-trade system. Of course, there are flaws, and therefore there are areas for improvement. A major issue continues to be the mechanisms used for the initial allocation of allowances. Because of the economics and politics of this issue, it will not go away. But, going forward, it would be helpful if those debating this issue could demonstrate better understanding of the allowance allocation’s real – as opposed to fictitious – environmental and economic consequences.

The Importance of Getting it Right in California

Why should sub-national climate policies exist? In the case of California’s Global Warming Solutions Act (AB 32), the answer flows directly from the very nature of the problem — global climate change, the ultimate global commons problem.

The Standard Theory

Greenhouse gases (GHGs) uniformly mix in the atmosphere. Therefore, any jurisdiction taking action — whether a nation, a state, or a city — will incur the costs of its actions, but the benefits of its actions (reduced risk of climate change damages) will be distributed globally. Hence, for virtually any jurisdiction, the benefits it reaps from its climate‑policy actions will be less than the cost it incurs. This is despite the fact that the global benefits of action may well be greater — possibly much greater — than global costs.

This presents a classic free-rider problem, in which it is in the interest of each jurisdiction to wait for others to take action, and benefit from their actions (that is, free-ride). This is the fundamental reason why the highest levels of effective government should be involved, that is, sovereign states (nations). And this is why international, if not global, cooperation is essential. [See the extensive work in this area of the Harvard Project on Climate Agreements.]

What’s Missing?

Despite this fundamental reality, there can still be a valuable role for sub-national climate policies, as I wrote about in an essay at this blog in 2010 (which drew, in part, on work I did with Professor Lawrence Goulder of Stanford University). This is particularly true when appropriate national policies fail to materialize. The failure of the U.S. Senate to pass companion legislation to the Waxman-Markey bill, passed by the U.S. House of Representatives in June, 2009, highlighted the absence of a national, economy-wide carbon pricing policy.

Recently, another argument has arisen for the importance of California’s climate policy, namely its potential precedent and lessons for other jurisdictions around the world, including other states, provinces, countries, and regions.

The Importance of Getting the Design Right

Getting the design right of AB 32’s cap-and-trade system is particularly important, because the performance of the system will receive great attention from other jurisdictions around the world considering their own climate policies (as I argued recently at the 2013 Summer Issues Seminar of the California Council for Environmental and Economic Balance). In fact, from conversations I’ve had with government officials and others in many parts of the world, it’s clear that the performance of the AB 32 suite of policies, including its centerpiece – a GHG cap-and-trade system – is being very closely watched. The outcome of California’s program will affect the likelihood of future commitments being made by other jurisdictions beyond California, as well as the ambition of those commitments. And the system’s design and performance will have significant effects on design decisions in other states, provinces, countries, and regions.

Getting the Design Right

Current allowance prices, which are near the auction reserve (floor) price, should not diminish attention to getting the design details right. Market conditions could change, leading to price increases, in which case the details of design will affect environmental performance and economic consequences. Consideration of potential market rule changes to refine the program is prudent. It would be a mistake to wait until it’s necessary to make ad hoc decisions in a time of crisis. Three issues stand out (as I wrote recently in much more detail in a white paper with Dr. Todd Schatzki of Analysis Group, “Three Lingering Design Issues Affecting Market Performance in California’s GHG Cap-and-Trade Program”).

Issue 1: The GHG Allowance Reserve

A recent, credible study by University of California economist, Severin Borenstein, and colleagues suggests that allowances prices in the AB 32 cap-and-trade system are likely to remain relatively low over the remainder of this decade, and that the probability is small of triggering and exhausting the system’s allowance reserve, which is intended to moderate prices. Nevertheless, the possibility remains that as a result of unanticipated changes in the market (such as higher than anticipated economic growth in California, slower diffusion than anticipated of low-cost abatement technologies, etc.), the current reserve structure could lead to excessively high allowance prices if the reserve is exhausted. Establishing a mechanism now to avoid this potential future outcome is important to avoid ad hoc policy responses that might be developed in a crisis atmosphere.

A variety of mechanisms could be made available for providing incremental allowances to the reserve. For example, specific criteria could be established up front to grant the Governor discretion (allowed under AB 32) to relax compliance obligations. Or provision could be made to replenish the reserve with allowances from other cap-and-trade systems or from the post-2020 AB 32 system. Another possibility (recommended by Dallas Burtraw of Resources for the Future) would be overlapping compliance periods, which in effect provide for limiting borrowing, as well as banking, thereby providing an additional cushion on price changes.

Of course, the most effective device would be a simple safety valve (or price collar), whereby the government would offer to sell an unlimited number of allowances at a given price, thereby capping allowance prices and abatement costs. However, my understanding is that the authorities at the California Air Resources Board (ARB) believe that this would not be allowed under AB 32, since a safety valve could result in the statute’s specific emissions targets not being met.

Issue 2: Offsets

Offsets (emission reduction credits) from outside the AB 32 cap-and-trade system made available to entities with AB 32 compliance responsibilities can effectively limit allowance prices (and abatement costs). What are needed now are administrative procedures that are efficient (low transaction costs) and ensure the environmental integrity of offsets. This is fundamentally a question of balance. Too much attention to efficient procedures of providing a large number of offsets risks flooding the market with meaningless offsets that lack additionality. And a singular focus on environmental integrity will result in virtually no offsets being made available.

Up until now, relatively few offsets have been certified under existing ARB procedures. It would be helpful to identify an appropriate potential supply of offset types. Currently eligible offset types appear to be insufficient to take advantage of full offset flexibility. It’s also important to establish appropriate liability rules for offset integrity. A “seller-liability-first/buyer-liability-second” approach may offer efficiencies over the current buyer-liability approach.

Issue 3: Allowance Holding Limits

Limits on purchases and holdings of allowances, intended to discourage market manipulation, could put in place a “cure” that is significantly more harmful than the “illness” it’s intended to address. Rules for allowance holding and transacting are needed that carefully balance multiple considerations: potential market manipulation; maintenance of adequate market liquidity; cost-effective program compliance (for example, to avoid constraining allowance banking); and effective risk management.

To that end, potential improvements would include establishing greater flexibility for legitimate banking, hedging, and risk-management purposes. Also helpful would be tailoring holding limits to recognize market-participant differences, taking account of the size of a firm’s compliance obligations and the purpose of its holdings. Finally, more frequent auctions would be helpful, including near the end of compliance periods, when market manipulation is most likely.

The Path Ahead

The California Air Resources Board has done a remarkable job in its initial design of the rules for its path-breaking GHG cap-and-trade system. That’s not to say that it is perfect, or that it could be perfect. There will inevitably be unanticipated challenges that will arise, whether from complying firms, from the broader economy, from litigation, or from other legislation. The goal at this stage should be to design a system that is reasonably robust to such unanticipated shocks.

The Second Term of the Obama Administration

In his inaugural address on January 21^st, President Obama surprised many people – including me – by the intensity and the length of his comments on global climate change. Since then, there has been a great deal of discussion in the press and in the blogosphere about what climate policy initiatives will be forthcoming from the administration in its second term.

Given all the excitement, let’s first take a look at the transcript of what the President actually said on this topic:

We will respond to the threat of climate change, knowing that the failure to do so would betray our children and future generations. Some may still deny the overwhelming judgment of science, but none can avoid the devastating impact of raging fires, and crippling drought, and more powerful storms. The path towards sustainable energy sources will be long and sometimes difficult. But American cannot resist this transition. We must lead it. We cannot cede to other nations the technology that will power new jobs and new industries. We must claim its promise. That’s how we will maintain our economic vitality and our national treasure, our forests and waterways, our crop lands and snow capped peaks. That is how we will preserve our planet, commanded to our care by God.

Strong and plentiful words. Although I was certainly surprised by the strength and length of what the President said in his address, I confess that it did not change my thinking about what we should expect from the second term. Indeed, I will stand by an interview that was published by the Harvard Kennedy School on its website five days before the inauguration (plus something I wrote in a previous essay at this blog in December, 2012). Here it is, with a bit of editing to clarify things, and some hyperlinks inserted to help readers.

The Second Term: Robert Stavins on Energy and Environmental Policy

January 16, 2013

By Doug Gavel, Harvard Kennedy School Communications

President Obama’s second term in office began on Inauguration Day, January 21st, and the list of policy challenges facing his administration is daunting. Aside from the difficult task of addressing the nation’s economic woes, the president and his administration will also deal with the increasing complexities of global climate change, a rapidly changing energy market, entitlement and tax reform, healthcare reform, and the repercussions from the still simmering “Arab Spring.” Throughout this month, we will solicit the viewpoints of a variety of HKS faculty members to provide a range of perspectives on the promise and pitfalls of The Second Term.

We spoke with Robert Stavins, Albert Pratt Professor of Business and Government, and Director of the Harvard Environmental Economics Program, about energy and environmental policy issues the president will face in the next four years.

Q: What are the top priorities for a second Obama administration in energy and environmental policy?

A: The Obama administration faces a number of impending challenges in the energy and environmental policy realm in its second term, which I would characterize – in very general terms – as finding balance among three competing factors: (1) demands from some constituencies for more aggressive environmental policies; (2) demands from other constituencies – principally in the Congress – for progress on so-called “energy security;” and (3) recognition that nothing meaningful is likely to happen if the country’s economic problems are not addressed.

Q: What will be the potential challenges/roadblocks in the way of implementing those top priorities?

A: The key challenge the administration faces in its second term as it attempts to achieve some balance among these three competing objectives is the reality of a very high degree of political polarization in the two houses of Congress.

The numbers are dramatic. For example, when the Clean Air Act Amendments of 1990 that established the landmark SO₂ allowance trading system were being considered in the U.S. Congress, political support was not divided on partisan lines. Indeed, environmental and energy debates from the 1970s through much of the 1990s typically broke along geographic lines, rather than partisan lines, with key parameters being degree of urbanization and reliance on specific fuel types, such as coal versus natural gas. The Clean Air Act Amendments of 1990 passed the U.S. Senate by a vote of 89-11 with 87 percent of Republican members and 91 percent of Democrats voting yea, and the legislation passed the House of Representatives by a vote of 401-21 with 87 percent of Republicans and 96 percent of Democrats voting in support.

But, 20 years later when climate change legislation was receiving serious consideration in Washington, environmental politics had changed dramatically, with Congressional support for environmental legislation coming mainly to reflect partisan divisions. In 2009, the U.S. House of Representatives passed the American Clean Energy and Security Act of 2009 (H.R. 2454), often known as the Waxman-Markey bill, that included an economy-wide cap-and-trade system to cut carbon dioxide (CO₂) emissions. The Waxman-Markey bill passed by a narrow margin of 219-212, with support from 83 percent of Democrats, but only 4 percent of Republicans. (In July 2010, the U.S. Senate abandoned its attempt to pass companion legislation.) Political polarization in the Congress (and the country) has implications far beyond energy and environmental policy, but it is particularly striking in this realm.

Q: In the Obama administration’s second term, are there openings/possibilities for compromises in those areas?

A: It is conceivable – but in my view, unlikely – that there may be an opening for implicit (not explicit) “climate policy” through a carbon tax. At a minimum, we should ask whether the defeat of cap-and-trade in the U.S. Congress, the virtual unwillingness over the past 18 months of the Obama White House to utter the phrase “cap-and-trade” in public, and the defeat of Republican Presidential candidate Mitt Romney indicate that there is a new opening for serious consideration of a carbon-tax approach to meaningful CO₂ emissions reductions in the United States.

First of all, there surely is such an opening in the policy wonk world. Economists and others in academia, including important Republican economists such as Harvard’s Greg Mankiw and Columbia’s Glenn Hubbard, remain enthusiastic supporters of a national carbon tax. And a much-publicized meeting in July, 2012, at the American Enterprise Institute in Washington, D.C. brought together a broad spectrum of Washington groups – ranging from Public Citizen to the R Street Institute – to talk about alternative paths forward for national climate policy. Reportedly, much of the discussion focused on carbon taxes.

Clearly, this “opening” is being embraced with enthusiasm in the policy wonk world. But what about in the real political world? The good news is that a carbon tax is not “cap-and-trade.” That presumably helps with the political messaging! But if conservatives were able to tarnish cap-and-trade as “cap-and-tax,” it surely will be considerably easier to label a tax – as a tax! Also, note that President Obama’s silence extends beyond disdain for cap-and-trade per se. Rather, it covers all carbon-pricing regimes.

So as a possible new front in the climate policy wars, I remain very skeptical that an explicit carbon tax proposal will gain favor in Washington. Note that the only election outcome that could have lead to an aggressive and successful move to a meaningful nationwide carbon pricing regime would have been: the Democrats took back control of the House of Representatives, the Democrats achieved a 60+ vote margin in the Senate, and the President was reelected. Only the last of these happened. It’s not enough.

A more promising possibility – though still unlikely – is that if Republicans and Democrats join to cooperate with the Obama White House to work constructively to address the short-term and long-term budgetary deficits the U.S. government faces, and if as part of this they decide to include not only cuts in government expenditures, but also some significant “revenue enhancements” (the t-word is not allowed), and if (I know, this is getting to be a lot of “ifs”) it turns out to be easier politically to eschew increases in taxes on labor and investment and turn to taxes on consumption, then there could be a political opening for new energy taxes, even a carbon tax.

Such a carbon tax – if intended to help alleviate budget deficits – could not be the economist’s favorite, a revenue-neutral tax swap of cutting distortionary taxes in exchange for implementing a carbon tax. Rather, as a revenue-raising mechanism – like the Obama administration’s February 2009 budget for a 100%-auction of allowances in a cap-and-trade scheme – it would be a new tax, pure and simple. Those who recall the 1993 failure of the Clinton administration’s BTU-tax proposal – with a less polarized and more cooperative Congress than today’s – will not be optimistic.

Nor is it clear that a carbon tax would enjoy more support in budget talks than a value added tax (VAT) or a Federal sales tax. The key question is whether the phrases “climate policy” and “carbon tax” are likely to expand or narrow the coalition of support for an already tough budgetary reconciliation measure. The key group to bring on board will presumably be conservative Republicans, and it is difficult to picture them being more willing to break their Grover Norquist pledges because it’s for a carbon tax.

What remains most likely to happen is what I’ve been saying for several years, namely that despite the apparent inaction by the Federal government, the official U.S. international commitment — a 17 percent reduction of CO₂ emissions below 2005 levels by the year 2020 – is nevertheless likely to be achieved! The reason is the combination of CO₂ regulations which are now in place because of the Supreme Court decision [freeing the EPA to treat CO₂ like other pollutants under the Clean Air Act], together with five other regulations or rules on SOX [sulfur compounds], NOX [nitrogen compounds], coal fly ash, particulates, and cooling water withdrawals. All of these will have profound effects on retirement of existing coal-fired electrical generation capacity, investment in new coal, and dispatch of such electricity.

Combined with that is Assembly Bill 32 (AB 32) in the state of California, which includes a CO₂ cap-and-trade system that is more ambitious in percentage terms than Waxman-Markey was in the U.S. Congress, and which became binding on January 1, 2013. Add to that the recent economic recession, which reduced emissions. And more important than any of those are the effects of developing new, unconventional sources of natural gas in the United States on the supply, price, and price trajectory of natural gas, and the consequent dramatic movement that has occurred from coal to natural gas for generating electricity. In other words, there will be actions having significant implications for climate, but most will not be called “climate policy,” and all will be within the regulatory and executive order domain, not new legislation.

Q: Are there lessons that a second Obama administration can draw upon from the first administration, or from history, when constructing its energy & environmental policy over the next four years?

A: It will take a great deal of dedicated effort and profound luck to find political openings that can bridge the wide partisan divide that exists on climate change policy and other environmental issues. Think about the following. Nearly all our major environmental laws were passed in the wake of highly publicized environmental events or “disasters,” including the spontaneous combustion of the Cuyahoga River in Cleveland, Ohio, in 1969, and the discovery of toxic substances at Love Canal in Niagara Falls, New York, in the mid-1970s. But note that the day after the Cuyahoga River caught on fire, no article in The Cleveland Plain Dealer commented that the cause was uncertain, that rivers periodically catch on fire from natural causes. On the contrary, it was immediately apparent that the cause was waste dumped into the river by adjacent industries. A direct consequence of the observed “disaster” was, of course, the Clean Water Act of 1972.

But climate change is distinctly different. Unlike the environmental threats addressed successfully in past U.S. legislation, climate change is essentially unobservable to the general population. We observe the weather, not the climate. Notwithstanding last year’s experience with Super Storm Sandy, it remains true that until there is an obvious, sudden, and perhaps cataclysmic event – such as a loss of part of the Antarctic ice sheet leading to a dramatic sea-level rise – it is unlikely that public opinion in the United States will provide the tremendous bottom-up demand that inspired previous congressional action on the environment over the past forty years.

That need not mean that there can be no truly meaningful, economy-wide climate policy (such as carbon-pricing) until disaster has struck. But it does mean that bottom-up popular demand may not come in time, and that instead what will be required is inspired leadership at the highest level that can somehow bridge the debilitating partisan political divide.

Postscript: Please note that the Kennedy School series on the second term of the Obama administration also includes an interview with my colleague, Professor Joseph Aldy, offering his own views on potential environmental policy developments in the next four years.