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.

About Robert Stavins

Robert N. Stavins is the Albert Pratt Professor of Business and Government at the Harvard Kennedy School, Director of the Harvard Environmental Economics Program, Chairman of the Environment and Natural Resources Faculty Group at the Kennedy School, Director of Graduate Studies for the Doctoral Programs in Public Policy and Political Economy and Government, Co Chair of the Harvard Business School Kennedy School Joint Degree Programs, and Director of the Harvard Project on International Climate Agreements. He is a University Fellow of Resources for the Future, a Research Associate of the National Bureau of Economic Research, the Editor of the Review of Environmental Economics and Policy, and a Member of: the Board of Directors of Resources for the Future, the Board of Academic Advisors of the AEI Brookings Joint Center for Regulatory Studies, the Editorial Boards of Resource and Energy Economics, Environmental Economics Abstracts, B.E. Journals of Economic Analysis & Policy, and Economic Issues. He is also an editor of the Journal of Wine Economics. He was formerly a member of the Editorial Board of Land Economics, The Journal of Environmental Economics and Management, the Board of Directors of the Association of Environmental and Resource Economists, a member and Chairman of the Environmental Economics Advisory Committee of the U.S. Environmental Protection Agency's (EPA) Science Advisory Board, the Chair of the Scientific Advisory Board of the Massachusetts Executive Office of Environmental Affairs, a Lead Author of the Second and Third Assessment Reports of the Intergovernmental Panel on Climate Change, and a contributing editor of Environment. He holds a B.A. in philosophy from Northwestern University, an M.S. in agricultural economics from Cornell, and a Ph.D. in economics from Harvard. Professor Stavins' research has focused on diverse areas of environmental economics and policy, including examinations of: market based policy instruments; regulatory impact analysis; innovation and diffusion of pollution control technologies; environmental benefit valuation; policy instrument choice under uncertainty; competitiveness effects of regulation; depletion of forested wetlands; political economy of policy instrument choice; and costs of carbon sequestration. His research has appeared in the American Economic Review, Journal of Economic Perspectives, Quarterly Journal of Economics, Journal of Economic Literature, Science, Nature, Journal of Environmental Economics and Management, Ecology Law Quarterly, Journal of Regulatory Economics, Journal of Urban Economics, Journal of Risk and Uncertainty, Resource and Energy Economics, The Energy Journal, Energy Policy, Annual Review of Energy and the Environment, Explorations in Economic History, Brookings Papers on Economic Activity, other scholarly and popular periodicals, and several books. He is the co-editor of Architectures for Agreement: Addressing Global Climate Change in the Post-Kyoto World (Cambridge University Press, 2007), editor of the fifth edition of Economics of the Environment (W. W. Norton, 2005), co editor of Environmental Protection and the Social Responsibility of Firms (Resources for the Future, 2005), editor of The Political Economy of Environmental Regulation (Edward Elgar, 2004), co editor of the second edition of Public Policies for Environmental Protection (Resources for the Future, 2000), and the author of Environmental Economics and Public Policy: Selected Papers of Robert N. Stavins, 1988 1999 (Edward Elgar, 2000). Professor Stavins directed Project 88, a bi partisan effort co chaired by former Senator Timothy Wirth and the late Senator John Heinz, to develop innovative approaches to environmental and resource problems. He continues to work closely with public officials on matters of national and international environmental policy. He has been a consultant to the National Academy of Sciences, several Administrations, Members of Congress, environmental advocacy groups, the World Bank, the United Nations, the U.S. Agency for International Development, state and national governments, and private foundations and firms. Prior to coming to Harvard, Stavins was a staff economist at the Environmental Defense Fund; and before that, he managed irrigation development in the middle east, and spent four years working in agricultural extension in West Africa as a Peace Corps volunteer.
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One Response to The Importance of Getting it Right in California

  1. Stuart Cohen says:

    Professor Stavins’ series of blogs on California’s cap-and-trade systems is incredibly insightful. However, It he conclusion in the August 16 blog, that using auction revenues to fund programs to subsidize emission reductions is “highly problematic if not completely without merit,” is absolutely wrong.

    The arguments are assuming a world in which all regulated sectors are somehow equal, or nearly so, hence the conclusion that “cost-effectiveness (of the cap-and-trade program) is reduced because marginal abatement costs are no longer equated among all sources”.

    This fully misses the difference between previous sectoral cap-and-trade programs, like RGGI, and California’s, which covers 85% of the economy: That 85% includes sources that are non-point source (to use old criteria pollution parlance). In California, Individuals driving autos and trucks are the single biggest source of all GHGs. The State is hoping that SB 375, a law that creates a regional planning framework and creates incentives to build homes and transportation systems that allow people to drive less, will result in the reduced driving.

    But there is no price signal/system in place to reduce driving in the same way that regulated power plants clearly see the signal. And the state is certainly giving no entity the power to disencentivize driving via price signals or to ration it like we did during the oil crisis, to meet AB 32 targets. Furthermore, driving is relatively inelastic. So higher allowance prices faced by fuel refiners starting in 2015, even if passed on to consumers, would not engender the needed reductions in driving.

    In theory, if driving is not reduced (and fuel efficiency does not improve beyond California’s adopted standards) the fuel refiners would demand more allowances, bidding up the price for allowances, and motivating other sectors to compensate with additional reductions. Yet if gas prices rise too quickly Gov. Brown and future Governors would likely relax compliance obligations rather than deal with CA-only gas price hikes.

    So without some way to reduce driving we may reach 2020 and have excessive driving as the reason CA did not reach the cap. If we can predict this is the case, then funding for strategies that reduce driving could be an economically and environmentally efficient way to ensure we actually achieve AB 32’s reduction targets and the State’s 2050 goals. This is especially true if you look at the report of ARB’s SB 375 Regional Targets Advisory Committee, which I served on in 2009/10 to help identify the factors and methodologies for SB 375’s GHG reduction targets by region. That report showed that these reductions are predicated on infrastructure and local government incentives that are dramatically underfunded and facing shortfalls of billions of dollars in every region.

    ARB understands that. And when you look at the Administration’s Final Investment Plan for Cap-and-Trade Revenues they suggest that, “Sustainable Communities and Clean Transportation” get the largest portion of funding.

    The Administration’s investment focus understands that the rather academic economic concept of “all else being equal” simply doesn’t apply when you are working to achieve reductions from 85% of the economy.

    But there are a few other compelling reasons they chose this investment strategy. First, investing in these sectors is essentially an indirect dividend to consumers. Investing in transportation choices and affordable homes clearly reduces driving, and has the potential to save California consumers billions of dollars per year. TransForm’s report Windfall for All outlines how large those savings could theoretically be. And that is before you get into the health, access and other “co-benefits” of transportation choices.

    Second, the broad societal benefits of improved transportation can build a strong constituency of local government officials, community groups, construction unions and others who suddenly see the benefits of the cap-and-trade revenues, and by extension AB 32. This does not figure into any economic analysis but may provide the biggest benefit of all. The oil industry is already waging battles against various AB 32 strategies; they just started another fake front group last week called “CARE”. With transportation fuels falling under the cap in 2015, they are now setting their sights on weakening or ultimately dismantling cap-and-trade.

    Finally, Professor Stavins’ is also concerned that allowance prices will be suppressed if revenues are used to subsidize emission reductions. There are at least a few reasons not to be too concerned about that. Low prices are proof that reductions are happening and will help dissuade legislators or ARB from cutting back on the planned number of auctioned (vs. free) allowances. Those will rise significantly in 2015. California also learned from the European Union and has a $10 per ton floor price. If there is not even demand for all the allowances at $10 we would be beating the cap!

    When it comes to economics, local land use codes and regional transportation systems defy most logic and are harder to impact than manufacturing, agriculture, building energy efficiency, or other sectors. I applaud ARB for understanding that subsidies are needed to even the playing field against entrenched subsidies that promote sprawl and driving. (Stuart Cohen, Executive Director, TransForm)

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