Is cap and trade the climate solution? The jury's still out
California and New England are about to find out what the market-based mechanism for reducing emissions can really do.
With the Trump Administration rolling back Obama era climate regulations, action to reduce greenhouse gas emissions in the U.S. is falling increasingly to the states. But how successful are different approaches for achieving such reductions?
Both New England and California have cut greenhouse gas (GHG) emissions since launching market-based cap and trade programs. But analysts say the programs are not the primary drivers of emissions reductions. If that is true, does cap and trade work?
The numbers are impressive. In 2016, the New England Regional Greenhouse Gas Initiative (RGGI) states cut their GHGs 8.4% below the cap. Since RGGI’s 2009 launch, those states have reduced total emissions 40% while their average electricity price fell 6.4%. California has cut its emissions 10% from 2004 levels and the total revenues generated by the trading program and designated for clean energy have passed $5 billion.
The two programs are different. RGGI caps only power sector emissions but governance is a collaboration of nine states. California’s economy-wide program is governed entirely by the California Air Resources Board (CARB). Economists and analysts agree they share one key attribute: The majority of recent emissions reductions have come not from the cap and trade programs but from other factors.
Key factors limiting the impact of such trading programs include an oversupply of allowances, which grant permission to utilities and other sources to emit CO2, and the political constraints of imposing excessive costs on consumers. These and other factors will need to be addressed as the programs enter their next phases.
Economics, mandates drive emission reductions
The most important factor driving recent emissions reductions was the 2008 recession and, because of it, “cap and trade has not been stress tested,” Stanford Law Professor Michael Wara told Utility Dive.
Stanford economist Danny Cullenward, the California Senate representative to CARB’s advisory committee on cap and trade, agreed. Because of state renewables mandates, energy efficiency standards and the recession, “power sector decarbonization was faster than expected and economic growth was slower than expected,” he told Utility Dive.
“Few emissions reductions can be attributed directly to the cap and trade programs,” he added. But both the RGGI states and California recently targeted significantly bigger GHG cuts by 2030 and both expect to get the cuts through their cap and trade programs.
Jesse Jenkins, an MIT Energy Initiative analyst, agreed neither program has really been tested as a driver of GHG reductions. “As important” was the revenue from allowance auctions, because it funded investment in clean energy and energy efficiency, he told Utility Dive.
That is about to change, Cullenward said. “The targets are much deeper and we're not going to luck our way into success. If we don't get to the 2030 targets in one of these jurisdictions, you're going to be able to point to design flaws in its cap and trade program.”
New England's power sector emissions focus
The RGGI states are Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire, New York, Rhode Island and Vermont. Virginia and New Jersey are expected to join in the near future. Each state has a proportional share of an overall RGGI-wide cap on CO2 emissions. Each fossil-fuel-powered generator of 25 MW or larger receives allowances for its part of the state’s cap. Each allowance permits the generator to emit one ton of C02.
Caps are ratcheted down on a pre-agreed schedule. Competitive market forces are expected to drive generators to reduce CO2 emissions. If a generator emits more CO2 than its allowances permit, it can purchase more in quarterly auctions, but that increases the cost of doing business. Through 2016, the RGGI auctions have produced $2.6 billion in total revenues.
“We sometimes call it a cap-and-invest program, but we do not dictate whether a state should invest its share of the auction revenue in energy efficiency, clean energy, conservation or rate-payer relief.”
Incoming Chair, RGGI
If a generator takes steps to emit less CO2, it can earn an immediate return by selling excess allowances in the auction. It can also benefit over the longer term by banking excess allowances against the expectation of a higher cost as the cap is ratcheted down.
Incoming RGGI Chair Ben Grumbles told Utility Dive the nine states’ “world-class, bipartisan collaboration” is based on two guiding principles: one is their “common purpose” to address CO2; the other is their commitment to “flexibility and autonomy.”
The states have important differences, he said. “We sometimes call it a cap-and-invest program, but we do not dictate whether a state should invest its share of the auction revenue in energy efficiency, clean energy, conservation or rate-payer relief.”
Affordability is also important, Grumbles said. If demand for allowances exceeds supply during a state auction and the price rises above a pre-set level, often called the ceiling price, that state’s cost containment reserve (CCR) of 10% of its allowances is released to limit the price increase.
RGGI’s 2016 review resulted in its just-released 2017 Model Rule, Grumbles said. It calls for a 30% reduction of the 2020 cap by 2030, which would put emissions more than 65% below the 2009 cap. It also calls for adjustments to protect against effects of allowances banked during the recession.
Another new provision modifies the CCR and the allowance ceiling price that triggers it. And the new rule adds the innovative emissions containment reserve (ECR). It requires states to withdraw up to 10% of auction allowances if the price falls below a pre-set floor, which would drive up demand and the excessively affordable price.
RGGI remains focused on the power sector, but is actively working with the region’s Transportation and Climate Initiative, which addresses other sectors' emissions, Grumbles said.
Acadia Center Policy Analyst Jordan Stutt said the most impressive thing about RGGI is that it has proved “ambitious emissions reductions” and “economic growth” can be achieved together. “A major part of that is the benefits from the reinvestment of auction proceeds,” he told Utility Dive.
California "has the all tools"
Both houses of California’s legislature passed AB 398 last summer, extending through 2030 the cap and trade program authorized by 2006’s Global Warming Solutions Act (AB 32).
The new law authorizes CARB to develop a Scoping Plan for a cap and trade mechanism that includes “price ceilings” and “price containment points.” The goal is to reduce the state’s emissions to 40% below the 1990 level by 2030. The law does not prescribe specific measures, except its approval of using revenues from allowance auctions for investment in clean technologies.
CARB’s just-released plan calls for cap and trade to be the “backstop” policy that drives complementary programs. They include zero emission vehicle regulations, the low carbon fuel standard, and the state’s 50% renewables by 2030 mandate.
The existing cap and trade program, launched in 2012 and now encompassing Ontario and Quebec, raises the same questions as RGGI about whether it is the program or the revenues it generates that drive emissions cuts.
Emissions in 2016 dropped 4.8% from the previous year. From 2012 to 2017, auctions produced total revenues of $6.5 billion that funded “projects intended to reduce GHGs,” according to a study by the state’s Legislative Analyst's Office (LAO).
The LAO recognized future economics and technology advances as the foremost variables in whether the 2030 goals will be achieved. Decisions CARB will make about price limits and emissions caps will also determine whether revenues will be $2 billion or $4 billion in 2018 and $2 billion or $7 billion in 2030.
The levels of the price ceiling and containment points will depend on whether CARB leans toward limiting cost or emissions, the economists said. But the first consideration for the program’s success is how the existing banked allowances will be used between 2020 and 2030.
Banked allowance threat
Energy Innovation economist Chris Busch found the volume of banked allowances in California large enough to be a threat to the success of the post-2020 market. Both Cullenward and Wara agreed.
The LAO study projected one feasible scenario in which “200 million banked allowances are carried forward into the post‑2020 program without any adjustments to the current caps, he reported. That would make 2030 emissions “over 30% higher than the levels likely needed to meet the state’s target,” according to the LAO.
Busch said the cap and trade program “is doing the job it was given” but “is not forcing reductions because the market is long on allowances.” He foresees “a disturbingly high chance” of not reaching the 2030 target “because the current banked allowance oversupply can be exploited in future years.”
University of California, Berkeley, economist Severin Borenstein argued Busch is incorrect. The “flexible structure” of the cap and trade program’s “hybrid mechanism" will impact “the expected future price of allowances” but not emissions reductions, he recently wrote.
But Stanford’s Wara agreed with Busch. “The volume of extra allowances is about the size of the reduction that the regulator wants from the program,” he said. If CARB "does not address this, emissions could end up being a lot higher.”
Wara said the three things CARB needs to address are oversupply, where the price ceiling is set, and whether or not the current price floor should be modified.
“Combining a modest carbon price with a clean energy standard and an emission standard that is broader than the electricity sector would be what economists call second-best policy, and what I call realistic policy that might actually work in the real world.”
Analyst, MIT Energy Initiative
Many economists argue the current allowance price, which has remained at or near the floor price since 2012, has transformed cap and trade into “a very modest carbon tax,” Wara said.
The legislature’s ambitious 2030 target could drive demand for allowances and keep the price at its ceiling, turning the program into a tax again, he said. “But it can be a hybrid instrument and act as a market in between the floor and the ceiling.”
Stanford economist Cullenward, who will soon join CARB's cap and trade market advisory committee, agreed the program has had a limited role in the state’s emissions reductions so far. “But the 2030 target is much deeper and it's going to do a lot more of the work.”
CARB will have to face the policy tradeoff of limiting the total cost or achieving the emissions goal, he said. “The Scoping Plan says absolutely nothing about the design of the program and there are a thousand different ways to do it. There are different implications for the choices [CARB] has, but the important question is what works.”
Cullenward expects emissions reductions in transportation, industry, and heating and cooling to play bigger roles and will push for more transparency and objective metrics to track progress. CARB has “all the tools they need and the discretion to formulate their plans as they see fit, but it is not a small task,” he said.
The political conundrum of cap and trade
California and the RGGI states are about to come face to face with what Kip Lipper, the California Senate’s Chief Energy and Environment Policy Advisor, calls the “Progressive Politician’s Conundrum.” A price on emissions that is visible and robust enough to change behavior likely means higher gasoline pump prices and higher energy bills, which "do not please voters," he said.
CARB’s response to the conundrum has been to apply a “carefully crafted” price that can go largely unnoticed but help fund complementary policies. “That may not be great environmental policy, but it has avoided giving the fossil fuel lobby a cudgel to wedge between elected officials and their constituents,” Lipper told Utility Dive.
MIT’s Jesse Jenkins’ work on the politics of cap and trade found “political constraints on carbon pricing” result in “much more modest carbon prices” and complementary regulatory policies. To an economist, that is inefficient and increases the cost of emissions reductions, he said. But it also results in “more politically sustainable and durable programs” and “some price is better than no price.”
The design of carbon pricing policies should assume political constraints, Jenkins said. “Combining a modest carbon price with a clean energy standard and an emission standard that is broader than the electricity sector would be what economists call second-best policy, and what I call realistic policy that might actually work in the real world.”
To get to the 2030 targets, we need to begin to look beyond the power sector, and “there's no way to reach 2050 goals without an economy-wide strategy,” he added.
Energy Innovation's Busch pushed back against Lipper's politician's conundrum. California’s new cost containment mechanisms will “counteract unacceptable economic effects,” he said. “Recognizing political realities is just smart.”
CARB has been an “environmental champion” but it has resisted facing the reality of the current allowance oversupply, he added. Specific performance evaluation metrics, timetables and course correction measures are now needed.
Cullenward said no cap and trade system has reached for “a really stringent level” of emissions cuts. A key coming debate “is whether or not the politics unlocks or frustrates the efficacy of the carbon pricing program.”