California’s Precarious Path to Climate Change Mitigation

Overtopping Embarcadero, San Francisco, during king tide. Courtesy California Coastal Commission, Photo © Mike Filippoff

This note discusses two key weaknesses that could undermine the achievement of the state’s ambitious GHG emissions reduction goals. The first weakness is the process of allocation for GHG allowances to regulated firms. Under California’s allocation process, cap and trade will exacerbate economic inequities and raise the total cost of the program. A new lawsuit threatens to increase those inequities and costs to the state, if successful.

The second weakness is counterintuitive: cap and trade programs do not induce technological innovation, yet California requires significant technological innovation to achieve emissions reductions goals. Section III.C. discusses the market failures in cap and trade, which preclude serious inducement of technological innovation. That section goes on to specify what California must do to correct these failures in pursuit of that innovation. When used in combination with the cap and trade program, these strategies will increase the effectiveness of California’s overall climate change mitigation plans.

View from Pacifica Pier during king tide, Pacifica, California. Courtesy California Coastal Commission. Photo © Jack Sutton

California Cap and Trade Basics

The state legislature approved California’s landmark climate change legislation, the Global Warming Solutions Act (“AB 32”), in 2006.[2] The bill designated California’s Air Resources Board (ARB) as the lead agency to develop regulations intended “to achieve the maximum technologically feasible and cost-effective greenhouse gas emission reductions” and to incorporate measures to achieve these reductions in a “scoping plan.”[3] It further requires that ARB review “market-based compliance mechanisms” and permits ARB to adopt such a mechanism as part of the approved regulations.[4] ARB published its Climate Change Draft Scoping Plan in June 2008, which included an economy-wide cap and trade program that sets firm limits on GHG emissions for 85 percent of the state’s emission sources.[5] ARB approved the final plan in August 2011.[6]

Can California’s Cap and Trade Program Succeed?

California’s Allocation Method

In 2009, ARB and the California Environmental Protection Agency established a committee charged with making recommendations for allocating California’s emission allowances to firms that would be regulated under the cap and trade program.[7] In March 2010, the committee recommended auctioning all allowances and distributing free allowances only when absolutely necessary to prevent impacts on particularly burdened, trade-exposed firms.[8] In making this recommendation, the committee cited the auctions’ greater transparency and ability to reduce the overall costs of California’s climate mitigation efforts.[9]

In October 2010, ARB staff proposed a more complex and nuanced proposal to the agency’s board of directors.[10] The staff proposed that electric distribution utilities receive allowances for free, which they would then auction out. The utilities would then use the proceeds to benefit energy customers impacted by the higher rates electric generation companies would charge to cover their cost of compliance.[11] As for the remaining allowances, ARB would auction them directly and use the proceeds to reduce the costs of implementing AB 32,[12] similar to the committee plan described above. Some allowances would be allocated for free to industry to ease transition and minimize “leakage”—the movement of local industry to other states.[13] The amount of allowances designated for this free allocation amounted to 17 percent of the total allowance pool.[14]

In December 2010, before the agency’s board of directors considered these proposals, ARB staff released a revised proposal. The key feature of this new proposal was that ARB would distribute for free nearly all the allowances that non-electricity sector firms needed for the first compliance period rather than limiting free allowances to minimize leakage.[15] The agency’s board of directors ultimately adopted this paradigm.[16]

The day before the first auction of allowances, the California Chamber of Commerce filed a lawsuit against ARB.[17] The complaint alleges that ARB does not have the authority to auction allowances and keep the proceeds to use for public purposes.[18] It argues that the legislature did not give ARB that authority in AB 32 because the statute only provides the authority to set up a fee schedule to recover costs of program administration. Alternatively, the complaint argues that even if the legislature did give that authority, it constitutes an illegal tax under the California Constitution, since AB 32 was not approved by a two-thirds majority in each house.[19]

The Chamber is opposing the auction mechanism because it is “the most costly way to implement AB 32.”[20] While it is true that ARB has not adopted the most cost-effective means of reducing carbon, increasing cost effectiveness would require increasing the auctioning of allowances and decreasing free allocations, as discussed below. The Chamber also claims that the “tax will negatively affect all California businesses and increase costs that will be passed down to consumers.”[21] However, businesses with free allowances may actually increase their profits over an unregulated scenario and still pass costs down to customers whenever possible, whether the allocation of allowances is free or by auction.

Wind energy reduces California's dependence on fossil fuels, the combustion of which contributes to climate change. Courtesy of Energy.Gov

California’s Allocation of Greenhouse Gas Allowances Limits the Effectiveness of the Cap and Trade System

Distributional Inequities in Free Allocation Models

Providing allowances free of charge is a common feature of cap and trade systems around the world. Policymakers have even seen it as a “virtual prerequisite” to garnering the political support to implement cap and trade at all.[22] These policymakers have purported to use free allowances to compensate firms for the new regulation of a previously free resource and to reduce the “economic shock” that could be experienced if firms had to pay for the allowances and raise their prices.[23] However, the weight of the evidence shows that allocating all allowances for free creates windfall profits for firms, effectively transferring wealth from low-income individuals to high-income individuals.[24]

When firms receive allowances for free, prices for consumer goods can go up, as firms tend to pass the supposed cost of carbon to their customers.[25] Even in a truly competitive market, free allowances have the effect of creating higher profitability and wealth for firms at the expense of consumers because the firms are compensated twice for one expense.[26] One study estimates that, “[i]f regulated industries got all their allowances free, they would receive an asset worth as much as seven times the real cost of compliance.”[27] These higher “windfall” profits go to shareholders, comprising primarily higher-income individuals.[28] Thus, free distribution of allowances disproportionately burdens low-income individuals with the costs of carbon regulation[29] and increases the total cost of the cap and trade program.[30]

Researchers have found evidence of “substantial” windfall profits in the European Union’s Emissions Trading System (ETS), which allocated the majority of allowances for free in its early phases.[31] Electricity generators raised prices to ratepayers even though they had received free allowances, even though actual cost increases for the firms were modest.[32] As a result, generators realized surplus profits estimated in the billions of dollars.[33]

Additionally, the “grandfathering” method of free allocation favors established firms over new market entrants. Grandfathering is a common model of allocation of emissions allowances that is based on the historic emission rates of each facility.[34] This type of allocation creates barriers to entry, since new firms with no record of emissions on which to claim their share of the pool of allowances, are usually required to pay to obtain the amount of allowances that their competitors receive for free.[35] Because new entrants are more likely than older firms to bring superior technologies to market, this reduced competition tends to hamper innovation and progress in the industry.[36]

Free allocation of allowances therefore distorts markets and advantages established firms and high-income shareholders to the detriment of lower-income customers while doing little to protect industry competitiveness. Contrary to the goal of a cap and trade program, it fails to incentivize the most cost effective means of emissions reductions.

Auctioned Allowances and the Optimal Allocation Strategy

Requiring GHG emitters to purchase allowances resolves many of the pitfalls of freely allocating allowances, including distributional inequity.[37] Selling allowances is consistent with the basic principle that emitters should pay for the pollution they create. In addition, selling allowances increases transparency in the carbon markets, promotes a level playing field for all participants—including new entrants to industry, and eliminates the windfall profits for higher-income individuals.[38] Moreover, program facilitators can use the proceeds of the sales of allowances to enhance the cost effectiveness and equity of the cap and trade program. These funds can be used, for example, to reduce distortionary taxes in order to decrease the cost of compliance on the economy,[39] fund research, development and conservation programs,[40] or as rebates to compensate customers—particularly low-income individuals, for price increases.[41] This combination of efficiency and opportunity has led researchers to find that auctioning allowances is the most cost-effective way to implement a cap and trade program.[42]

In the Northeast United States, the Regional Greenhouse Gas Initiative (RGGI) cap and trade program has auctioned their allowances since 2008.[43] In the first three years of the program, covered entities purchased approximately $912 million in allowances.[44] With nearly all of the funds programmed and spent by the ten participating states, RGGI produced $1.6 billion in economic value for the region and 16,000 new jobs.[45] While each state used their proceeds differently, the states collectively chose to make energy efficiency investments with a substantial portion of the proceeds. These included appliance and equipment replacement, auditing and benchmarking programs, and retrofitting and other construction measures to increase building efficiency.[46] These investments turned out to be the most economically productive use of the funds, as they reduced electricity consumption and power prices, and increased consumer disposable income and local spending.[47] RGGI’s experience is evidence that auctioning allowances can “produce positive economic outcomes” in regulated jurisdictions.[48]

By choosing to give away some of its allowances for free, California has already sacrificed the opportunity to minimize the costs of the program on the economy. California is likely overcompensating covered firms for the associated costs, which will result in windfall profits for those firms. It is critical that ARB, the legislature, and the courts protect the auction mechanism where it exists, not only to avoid further distributional impacts, but also to facilitate the achievement of the state’s climate mitigation goals through the effective use of auction proceeds.

A Dichotomy: Technological Innovation is Not Induced Through Cap and Trade, But it is Critical to Climate Change Mitigation

Cap and Trade Does Not Induce Innovation

Proponents of cap and trade have often cited induced technological innovation as a benefit of this market-based mechanism.[49] However, this popular notion of cap and trade is a misconception. Cap and trade systems alone “will not encourage the socially-desirable level of investment in research, development, and deployment of new technologies.”[50] In fact, they may even do less to foster innovation than other forms of regulation.[51] This is an important dilemma for California because the long-term emission reduction goals require innovation in the form of research, development, and deployment of new low-emission technologies.[52]

California is researching the potential for high speed rail. Courtesy California High Speed Rail Authority.

A simple way to understand how cap and trade disfavors innovation is to recall that cap and trade allows emitters to find the least-cost method of compliance, whether that be through reducing emissions or purchasing allowances.[53] Yet, widely adopted economic theory suggests that high costs are required to spur innovation.[54] Indeed, critical innovations, such as those needed to meet climate change mitigation goals, are typically expensive at the outset, from research to deployment, and only cheaper over time through economies of scale and experience with the technology.[55] Cap and trade will not incentivize this innovation, and it may even induce less innovation than traditional regulation.[56] Under traditional regulation, every facility must comply with mandated reductions individually, even where it is very costly. Under cap and trade, those facilities that can achieve compliance more cheaply will naturally make all of the reductions on behalf of all facilities. Therefore, innovations that would be economically viable under traditional regulation are actually discouraged under cap and trade as superfluous expense.[57]

Evidence from cap and trade programs in recent decades gives credence to these theories. In the case of six noted emissions trading programs, allowance prices have been lower than expected prior to the initiation of trading, reducing the incentive to invest in innovation.[58] For example, in both the Acid Rain program—which capped SO₂ allowances—and the NO_X Trading Program, the expected price range for allowances exceeded the actual price at all times except for short periods of price spikes.[59] At the same time, levels of innovation decreased. Indeed, following initiation of trading, patenting activity in relevant technologies for both programs dropped to levels far below activity in previous decades (during traditional regulation) and below levels of activity in the years leading up to the implementation of cap and trade.[60] Even deployment of existing technologies declined, as firms cancelled significant clean technology installations that were already in progress.[61] Investment dollars were directed instead at obtaining and banking allowances for future years’ use.[62] In the case of the Acid Rain program, firms banked so many allowances that emissions were able to exceed the cap for many years.[63]

Cap and trade systems’ negative impact on innovation can be traced to two phenomena: knowledge spillover and a lack of a strong price signal.[64] Knowledge spillover refers to the inability of innovators to fully reap the benefits of their innovations. There is a much higher social return to innovative activity than there is a private return because other firms may copy, imitate, or otherwise use the knowledge for their own gain without paying the innovator.[65] Because of this lack of return on investment, the incentives for research and development in cap and trade are inefficiently low from the perspective of the public good.[66]

Knowledge spillover also extends to technology deployment.[67] Early adopters “absorb the cost of working through the kinks” of new technology.[68] This produces knowledge and refinements that other firms adopt free of those costs.[69] Therefore, investments in existing technologies will also be suboptimal where “learning by doing” brings costs down for later adopters.[70]

A strong price signal for the emissions allowances is also necessary to induce innovation. Cap and trade systems generate a strong price signal via high allowance prices when the emissions cap is stringent, long-term, and credible. This induces technological innovation as firms are motivated by “the expectation that future costs will be high.”[71] Emissions property rights must be clearly defined and inspire confidence in their enforceability “far into the future.”[72]

Most cap and trade systems, however, lack a stringent cap, and consequently, these systems lack a strong price signal. This disincentivizes technological investment and foregoes the chance to maximize environmental benefits.[73] Commentators doubt that “government can be depended on” to provide continuous incentives over the long-term.[74] In fact, even with a stringent cap, the government is unable to give a credible long-term price signal because the high price required to induce innovation initially will not be maintained after new technology is created.[75] This goes back to knowledge spillover: once the technology is available, competition will drive down the price of carbon, eliminating the opportunity to earn a return on investment.[76] The government’s inability to set a strong price signal in cap and trade systems disincentivizes private sector investments that could drive the technological advancements necessary to mitigate climate change.[77]       

Why California Needs Technological Innovation and How to Get There

It is clear that the development and deployment of new technologies will be required to achieve radical emission cuts.[78] These emissions reductions can be achieved by a combination of technologies currently available on the market, technologies that have been demonstrated but not deployed, and technologies that are still in development, but may be commercially viable within the next few decades.[79] Areas where key advancements must be realized are in energy efficiency to decrease demand, including building, transportation, and industrial efficiency;[80] electrification of most forms of transportation and building heating;[81] decarbonization of electricity generation;[82] and biofuels for sectors that cannot be electrified, such as heavy-duty transport.[83]

Highly efficient electric vehicles help reduce emissions of greenhouse gases. Courtesy Environmental Protection Agency.

However, each of these technologies requires more than a cap and trade system to spur their development and implementation. For instance, while technology for building efficiency exists,[84] policies and funding are necessary to motivate adoption since the free market does not support it. On the other hand, industrial efficiency measures are still largely under development and have not been demonstrated.[85] Similarly, key steps to decarbonize energy generation require further research and development, including advancements in carbon capture and sequestration (CCS), energy storage, and implementation of the “smart grid.”[86] The area requiring the biggest leap in technological advancement is in fuels, specifically fossil fuels for transportation and natural gas for electricity load-balancing.[87]

How will California induce innovation in these areas? The basic cap and trade model that has been adopted has not resolved the problem of knowledge spillover, and the cap is neither stringent nor long-term.[88] Research suggests that a broad portfolio of policies and programs will be more effective than cap and trade alone because “[m]ultiple market failures justify multiple instruments.”[89] In fact, when combined with instruments designed to address knowledge spillover, emissions can be reduced at a lower cost than through cap and trade alone.[90]

Researchers cite the effectiveness of regulatory “demand pull” type policies in addition to the traditional cap and trade program.[91] Renewable portfolio standards, for instance, have been a “highly effective means of inducing technological change”[92] and have contributed to the decarbonization of the energy supply that California requires. Green building codes are important for capturing a vast potential for energy efficiency[93] that will take the state a long way toward emissions targets. In addition product standards may capture energy efficiencies as well as induce technological innovation.[94]

California has many of these types of policies in place, which should significantly advance the realization of emissions reductions. The state has one of the most aggressive renewable portfolio standards in the nation, requiring energy providers to procure 33 percent of their needs from renewable sources.[95] ARB’s adopted scoping plan includes a comprehensive Green Building Strategy[96] and also addresses standards for vehicles, fuel, and appliances.[97]

However, researchers also suggest that the portfolio of programs and policies include “technology push” policies, which directly invest in technology innovation.[98] “Technology push” policies typically comprise government investment in research, development and deployment, or “everything from ‘basic’ fundamental research to supporting ‘applied’ research that has helped lower the operating costs and increase the performance of particular technologies.”[99] Such policies may take the form of subsidies or tax incentives, which “neutralize common barriers to technology adoption, such as limited access to capital, transaction costs, and technological or market risks.”[100] While some “technology push” methods have been criticized for failing to target the most likely candidates for success,[101] such problems can be remedied through carefully designed strategic funding alliances, like Stanford University’s Global Climate and Energy Project, which identifies and manages research in promising energy technologies,[102] or awarding prizes, like NASA’s Centennial Challenge “X Prize” for specified inventions.[103]

California must focus on “technology push” to improve its climate change mitigation strategy and overcome the knowledge spillover problem in cap and trade. The ARB’s scoping plan does not identify strategies to advance critical research programs in CCS, energy storage, or fuel decarbonization. It also does not support the needed transition to electrification, especially for our transportation systems.

However, the proceeds from the auction of GHG allowances provides an opportunity for the state and the GHG emitting entities to invest in technologies that will mitigate the impact of climate change. AB 1532, adopted by the California legislature last session, requires that those proceeds be used to “facilitate the achievement of reductions of greenhouse gas emissions.”[104] The bill specifically authorizes funding for some of these critical technologies, like energy efficiency, energy storage, vehicle infrastructure, and biofuels.[105] The specific plans for these investments are to be developed by the Department of Finance for the annual budget, with analytical support from ARB staff.[106]

This legislation should go a long way in supporting the technology investment that is needed in California. However, these hopes could be diluted through the allocation of funds for purposes technically within the broad language of AB 1532, but that do not resolve the market failures identified here. For instance, in the scoping plan, ARB identified possibilities for the use of these proceeds that included, inter alia, further subsidies to emitting entities and dividends or general tax cuts for consumers (as distinguished from consumer rebates for higher costs incurred due to the program).[107] It is likely that their future deliberations will be subject to the same pressures from varied interests groups demanding a share of the funds. Since the potential amount of proceeds of the auctions is already diminished by the decision to overcompensate emitting entities, it is even more critical that ARB narrow the focus of recommendations for the use of proceeds to correcting the weaknesses of the program.

Conclusion

Although California has a well-designed strategy for climate mitigation, the strategy also has some important weaknesses. In particular, the overall cost of the program to society will be high due to the overcompensation of emitting entities by consumers and the state for the cap and trade program. Further, success rests on the realization of technological innovation, which will require significant investment.

These weaknesses may be remedied in part through the use of the proceeds from GHG allowance auctions. However, these proceeds are under threat from new litigation by the California Chamber of Commerce, which could result in further distributional inequities in the cost of the program, disproportionately burdening lower-income individuals. In addition, they are subject to appropriation upon recommendation by the ARB. The ARB has already recommended the use of funds for purposes unrelated to correcting these most serious weaknesses. For California to succeed in its climate change mitigation goals and achieve the “maximum technologically feasible and cost-effective reductions in greenhouse gas emissions,”[108] the state must maintain a laser-like focus on using these public funds from the cap and trade auctions to reduce disproportionate and excessive costs and invest in critical technological innovation.

[ Click Here to Comment ]

Copyright 2013 Penni Takade. All rights reserved.

[ back to top ]