Category: Energy Policy

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.

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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.

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Thinking About the Energy-Efficiency Gap

Adoption of energy-efficient technologies could reap both private and social rewards, in the form of economic, environmental, and other social benefits from reduced energy consumption. Social benefits include improvements in air quality, reduced greenhouse-gas emissions, and increased energy security. In response, governments around the world have adopted policies to increase energy efficiency.  Still, there is a broadly held view that various barriers to the adoption of energy-efficient technologies have prevented the realization of a substantial portion of these benefits.

For some thirty years, there have been discussions and debates among researchers and others in academia, government, non-profits, and private industry regarding the so-called “energy efficiency gap” (or “energy paradox”) — the apparent reality that many energy-efficiency technologies are not adopted even when it makes sense for consumers and businesses to do so, based on their private costs and benefits. That is, decision makers appear to “under-invest” in energy-efficient technologies, relative to the predictions of some engineering and economic models.

What causes this gap?  The answer to that question could presumably help inform the development of better public policy in this realm.

Possible Explanations for the Energy-Efficiency Gap

Potential explanations for the energy efficiency gap tend to fall into three broad categories: (1) market failures, such as lack of information or misplaced incentives; (2) behavioral effects, such as inattentiveness to future energy savings when purchasing energy-consuming products; and (3) modeling flaws, such as assumptions that understate the costs or overstate the benefits of energy efficiency.  In this essay, I simply want to outline the types of hypothetical explanations of the gap that have been posited within these three broad categories.

Market-Failure Explanations

First, various Innovation Market Failures have been posited, including:  research and development (R&D) and learning-by-doing spillovers; inefficient product quality and differentiation due to market power; and inefficient introduction of new products due to consumer taste spillovers (for example, consumers becoming comfortable with a new technology).

Second, another set of potential market-failure explanations for the gap may be characterized as Information Problems.  These include:  lack of information on the part of consumers (learning-by-using or so-called experience goods; energy prices; energy consumption of products; and available substitutes); asymmetric information (the “lemons problem”); and split incentives and principal-agent issues (such as the frequently-discussed renter/owner dichotomy).

Third, there are Capital Market Failures and Liquidity Constraints, which may be a particularly significant issue in developing-country contexts.

Fourth, there are Energy Market Failures, including various externalities (environmental, energy security, congestion, and accident risk), as well as average-cost pricing of electricity.

Behavioral Explanations

The rise of behavioral economics has brought to the fore another well-defined set of potential explanations of the energy efficiency gap.  A variety of alternative taxonomies could be employed to separate these explanations, but one such taxonomy would categorize the explanations as:

Model and Measurement Explanations

The third category of possible explanations of the energy efficiency gap consists essentially of a set of reasons why observed levels of diffusion of energy-efficiency technologies may actually be privately optimal.

First, there is the possibility of unobserved or understated adoption costs, including unaccounted for product characteristics.

Second, there may be overstated benefits of adoption, due to inferior project execution relative to assumptions, and/or poor policy design.

Third, an incorrect discount rate may be employed in an analysis, when the correct consumer and firm discount rates should vary with:

  • opportunity cost of and access to capital
  • income
  • buying versus retrofitting equipment
  • systematic risk
  • option value (see below)

Fourth, there is frequently heterogeneity across end users in the benefits and costs of employing energy-efficiency technologies, so that what is privately optimal on average will not be privately optimal for all.  This can refer either to static (cross-sectional) heterogeneity or to dynamic (intertemporal) heterogeneity, that is, technology improvements over time, which raises two possibilities:  the reality of some potential adopters being short of the frontier, and the presence of option value to waiting.

Fifth and finally, there is the possibility of uncertainty (real, not informational, as above), irreversibility, and option value.  This could be due to uncertainty regarding future energy prices, or can be linked with option value that arises for delaying investments that have only minimal if any salvage value.

Public Policy and Next Steps

Determining the validity of each of these possible explanations — and the degree to which each contributes to the energy efficiency gap — are crucial steps in crafting the most appropriate public policy responses.

To inform future research and policy, Professor Richard Newell of Duke University and I have launched an initiative – sponsored by the Alfred P. Sloan Foundation — to synthesize past work on these potential explanations of the energy paradox and identify key gaps in knowledge.  We are conducting a comprehensive review and assessment of published and ongoing social-science research on the adoption of energy-efficient technologies, including scholarly literature, industry case studies, reports from national and sub-national governments, and, to the extent possible, consulting reports evaluating specific programs.

We are working with leading social scientists — including scholars from economics, psychology, and other disciplines — to examine the various possible explanations of the energy paradox and thereby to help identify the frontiers of knowledge on the diffusion of energy-efficient technologies.  We hope the products of this initiative will help decision makers in industry and government better understand the energy efficiency gap, and will thereby contribute to decisions that maximize the potential economic, environmental, and other social benefits associated with optimal adoption of energy-efficient technologies.  As materials become available, we will post them at the project’s Harvard website and the project’s Duke website, and I will alert readers of this blog.  In the meantime, please stay tuned.

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