While International Climate Negotiations Continue, the World’s Ninth Largest Economy Takes an Important Step Forward

A little more than two weeks ago, while some 195 nations prepared to meet in Doha, Qatar, for the Eighteenth Conference of the Parties (COP-18) of the United Nations Framework Convention on Climate Change (UNFCCC) in an ongoing effort to hammer out a durable scheme of effective international cooperation, the ninth largest economy in the world took an important step forward to achieve its own ambitious greenhouse gas reduction goals.  I’m referring to the CO2 cap-and-trade allowance auction held by the State of California (which ranks just below Brazil and just above India in the size of its economy) on November 14, 2012.

The Design

Under the California auction design (a single-round, sealed-bid, uniform price auction), all allowances are sold at the same price, no matter what the specific bid submitted.  This is done by awarding the first allowances to the highest bidder, then the next highest bidder, and so on until all allowances (or bids) are exhausted.  The bid for the last allowance becomes the price of all allowances sold in the auction.  The auction had two parts:  a current auction of 2013 vintage allowances, and advance auction of 2015 vintage allowances.

The Results

Just a few days after the auction, the California Air Resources Board released the results.  In brief, they were as follows:

  • All 23,126,110 (metric tons of) allowances for 2013 emissions were sold, with the number of qualified bids exceeding the number available by about 6 percent.
  •  These 2013 vintage allowances sold for $10.09, just above the auction’s reserve price of $10.00.  (Note, however, that the bids ranged from $10 to over $90, with a median bid of about $13 and a mean bid of nearly $14.)
  • Some 97% of the allowances were bought by compliance entities, as opposed to investors of various kinds.
  • The advance auction of 2015 allowances produced significantly different results, with only 14% of available allowances sold, at the auction reserve price of $10.00.  (The bids ranged from $10 to about $17, with median and mean bids of about $11.)

Those are the results, but what do they mean?  Here’s my view of the implications.

The Implications

First of all, the fact that the auction ran smoothly and compliance entities and others put their money down is one important step in establishing the program’s credibility and operational success.

Second, given that all 2013 vintage allowances sold and there was significant demand above the clearing price (mean prices were $13.75 per MT), the cap is clearly binding.

Third, the expected marginal abatement cost (accounting for market uncertainty and regulatory risk) is roughly at the reservation price of $10/ton (fairly close to the current price in the European Union Emissions Trading System, it so happens).

On the one hand, it is very good news that the allowance price is as low as it is, because this is indicative of the market’s prediction of what the marginal cost of abatement will be.  Lower cost is good news for the California economy.  Of course, low prices mean smaller funds raised by the auction ($233 million raised by the 2013 auction, and $56 million by the 2015 auction).  However, given that the fundamental purpose of the auction is to cap emissions through the cap-and-trade system, not to raise revenues for the state, this doesn’t appear to be bad news either.

But there is some “bad news” in these low allowance prices, and in the 2015 results.  First, the 2015 results may indicate that there is significant “regulatory risk” that is lowering prices firms are willing to pay for allowances.  Such regulatory risk could arise from concerns that state legislators will back-pedal on the program, or that legal challenges to certain rules (for example, reshuffling requirements or regulation of out-of-state electricity) or Federal policy action in Washington will reduce allowance demand.

It could also arise from this being the first auction, bringing about reluctance to put a lot of money down before seeing any results.   Significant uncertainty over abatement costs could also have been a factor.  In these regards, it will be interesting to see whether bidding is much different at the second auction next year.

An Ongoing Concern

Other factors driving down demand for allowances and the auction price are the emission reductions that have already been achieved or are expected to be achieved by so-called “complementary programs,” such as energy efficiency programs, renewable portfolio standards, and low-carbon fuel standards.  You might think this is good news, but it’s not.  Why?

These “complimentary programs” exist under the cap of the cap-and-trade system.  Hence, there are two possible outcomes from this situation.  On the one hand, these additional programs can be irrelevant in terms of CO2 emissions; that is, their emission reductions would be achieved anyway by the cap-and-trade system on its own, which – remember – allocates the abatement burden cost-effectively across sectors and sources.  Or, on the other hand, these programs could achieve greater emissions reductions in some sector or by some sources than the cap-and-trade regime would have done on its own.  But, by doing this, the effect is simply to free up allowances for other sources and/or other sectors through the trading mechanism.

On the margin, nothing is accomplished in terms of additional CO2 emissions reductions; rather the emissions are simply relocated.  And, because under such circumstances marginal abatement costs are no longer equated, the allocation of the reductions is no longer cost-effective, that is, aggregate costs are driven up.  As I recently wrote, this is precisely what has happened in the European Union Emissions Trading System.  (By the way, for a more favorable view of the role of the complimentary measures under the California cap-and-trade scheme, see this essay by Dallas Burtraw and Clayton Munnings.)

So, this specific “bad news” about perverse policy interactions is not a problem of the cap-and-trade system per se, any more than it is in the European system.  Rather, the problem is with adding well-intentioned “complimentary programs” under the coverage of a cap-and-trade (or any “quantity-based averaging”) system.  Unfortunately, it is misguided public policy, at least from the perspective of this environmental economist.

Author: Robert Stavins

Robert N. Stavins is the Albert Pratt Professor of Business and Government, John F. Kennedy School of Government, Harvard University, Director of the Harvard Environmental Economics Program, Director of Graduate Studies for the Doctoral Program in Public Policy and the Doctoral Program in Political Economy and Government, Co-Chair of the Harvard Business School-Kennedy School Joint Degree Programs, and Director of the Harvard Project on Climate Agreements.