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.

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.