Blog Post

A Landmark California Climate Program Enjoys New Opportunities

Dec 18, 2017 | Dallas Burtraw
California State House

One of the most impressive milestones in climate policy anywhere was California’s vote in Summer 2017, by a two-thirds bipartisan majority, to extend its cap-and-trade program through 2030. This followed the passage in 2016 of an extension to the state’s legally binding emissions cap, which falls by a hefty 40 percent from 2020 to 2030. California is also part of the Western Climate Initiative, which now links cap-and-trade programs in Quebec and Ontario.

The cap-and-trade program has been in effect since 2013. Emissions allowances are made available each year and they do not expire. Because emissions have been falling faster than initially expected, there is a growing pot of allowances that have not been used, implying that the associated emissions have not occurred. This happy circumstance gives the California Air Resources Board new freedom and opportunities as it develops detailed regulations in the next few months to implement the extension to the cap-and-trade program going forward.

But, some view this situation as a sign that the program is in jeopardy. Whether it turns out to be an opportunity or jeopardy depends on the continued stewardship by the state’s Air Board. But one viewpoint is paramount to keep in mind: the surplus situation is a nice problem to have.

The cap-and-trade program is part of a portfolio of policies in California. The state expected other regulatory programs that address electricity emissions, mobile sources, etc., to yield most of the necessary emissions reductions. Cap and trade accounts for a portion of the emissions reductions this decade, but it provides assurance that the overall emissions target will be achieved, and provides an important element of cost effectiveness. In the next decade, the state expects these other regulatory programs to account for 62 percent of the required emissions reductions, so cap and trade will play a growing role in picking up 38 percent of the slack.

Recently, Chris Busch at Energy Innovation has estimated that the volume of unused allowances entering the next decade could be nearly as large as the emissions reductions that the state ascribes to the trading part of its portfolio of policies—that is, about 38 percent of cumulative reductions that are expected in the next decade. The accrual of this surplus is good news, but the concern of some is that these unused allowances may flood the market and water down the state’s efforts in the next decade.

The economic reasoning behind cap and trade argues that inter-year banking of emissions allowances is important to mitigate possible short term price spikes, ease planning for firms, and lower overall costs. If allowances are held in private hands, they create an interest group that is vested in the program’s survival. However, as the overhang of unused allowances grows large, it creates a worry from the environmental perspective that the use of allowances from the large bank could erode the ambition of efforts set from this point forward.

The question for the state’s air board is whether the overhang is too large, and if it is, what to do about it. To answer that question there are several reasonable options.

Presently a large portion of the unused allowances reside in state accounts. This overhang accrued when demand in the auction was low, due to faster than expected emissions reductions, as well as regulatory uncertainty spawned by previous legal challenges. The auction price floor restricted sales when demand was low and ensured that allowances would not sell at basement prices. Recently, prices in the market have stiffened and all allowances offered in auctions have sold, and most previously unsold allowances will likely re-enter future auctions. The Air Board could consider program adjustments that would reduce the amount of allowances that re-enter the auction, which is the suggestion offered by Energy Innovation. The northeast Regional Greenhouse Gas Initiative (RGGI) made such an adjustment in 2012 by cancelling allowances that had previously not sold at their price floor, as well as reducing the issuance of new allowances to account for the volume held in private banks. RGGI plans another adjustment, if necessary, after 2021.

A complement to a bank adjustment would be to increase the auction price floor, which would ensure that allowances do not sell at low prices if there already are ample opportunities for emissions reductions. An even better idea, which RGGI also adopted, is an “emissions containment reserve” schedule that restricts the supply of allowances at various prices above the absolute price floor. For example, while no allowances will sell at a price below the price floor, this schedule might ensure that some allowances do not sell at a price somewhat above the price floor, and there might be multiple such price steps that automatically restrict the supply of allowances in circulation if the price is low. This is a feature of virtually all other commodity markets and would be a powerful improvement in program design in California.

A third alternative is to consider vintage differentiation of the value of allowances so that allowances’ value as an instrument for compliance changes over time. A similar approach was proposed by the Bush administration as part of the Clean Air Interstate Rule. This approach, as described by NextGen California, would discount the value of allowances with previous year vintages, and would discourage purchasing and holding allowances on a speculative basis. Further, unsold allowances would lose compliance value, automatically reducing the volume of emissions that could occur in the future.

A fourth and even simpler approach would be to move unsold allowances from the auction account into a different bucket, known as the allowance price containment reserve. Allowances from this reserve enter the market only at very high prices. This approach is already planned, but only to a limited extent, and the Air Resources Board might consider expanding it.

There are several effective options available for implementation in the extension of California’s cap-and-trade program, and the Air Board may want to consider adopting some of each approach. One issue to anticipate is that if the quantity of allowances that sell in auction is reduced, there might be fewer revenues for program-related investments that are helping address concerns of disadvantaged communities and helping to achieve emissions reductions, which in turn helps keep allowance prices low. However, if the supply is constrained, the price would be expected to be higher, and total revenue from the sale of allowances may not be much affected. In RGGI, our research found the introduction of a tightened supply schedule (the emissions containment reserve), if triggered by low demand, would actually yield an increase in revenue.

Finally, and importantly, the Air Resources Board is very aware that California will not end its ambitious climate policies in 2030 and the future will require even deeper emissions reductions throughout the economy. It is very likely the cap-and-trade program will continue as well. The trading program should continue to carry a bank and preserve the inter-annual flexibility that is a core element of the program. In 2030, the convenience value of banked allowances will be greater than ever. The bank could be sizeable then, as it is now. In that case, the emissions between 2020 and 2030 may not be very different from the cap over the decade. It would be a worthwhile goal for the Board to consider that emissions in the next decade should align with the issuance of new allowances.

Unused allowances held currently in state and private accounts provide a measure of safety to contain costs for California entities and for current and future partner jurisdictions in the linked trading markets. They also influenced the political outcome in extending the cap-and-trade program. But, the magnitude of these unused allowances is so great that it could undermine the state’s intent. There are various policy levers available to address this concern. The continuing decline in the emissions intensity of economic activity in California has delivered new opportunities to the Air Board. We can expect that the Board carefully consider these options as it turns now to begin the important task of developing detailed rules next year.

The views expressed in RFF blog posts are those of the authors and should not be attributed to Resources for the Future.