Guest Blogger Dallas Burtraw: Three Revisions Not to Overlook in California’s New Cap-and-Trade Proposal, SB 775

The Proposal Would Eliminate Allowance Banking and Offsets, and Add a Border Adjustment Mechanism

The California cap-and trade-program is already the most rigorous and best-designed allowance market in the world. Its purpose is to reduce greenhouse gas emissions that contribute to climate change. But now the program requires adjustments for political and legal reasons. These adjustments will be a vitally important legislative decision – for the state and the world.

An important new proposal on the stage is SB 775 (Senators Wieckowski and de Leon). This bill would preserve the most basic architecture of the program by maintaining an economy wide carbon market and various complementary policies, but it would make several important changes. Inevitably, one issue that will attract major attention will be the use of revenue raised in the auction of tradable emissions allowances in the carbon market. However, three other fundamental revisions that may get lost in the headlines are nonetheless crucial to the success of the market: banking, offsets, and the border adjustment.

Banking

The new legislative proposal would disallow the banking of emissions allowances that enables firms to save allowances from one year and use them in a later year. The banking feature introduces inter-annual flexibility that reduces compliance costs by enabling a firm to make an investment before it is required for program compliance if it is timely for its own planning, and to benefit by using the saved emissions allowances in later years. Sometimes banking in other programs has been criticized because the bank has grown to a substantial size, but that is an indication of fundamentally too many allowances and too little ambition in the program and not a problem caused by firms that reduce emissions through early action. Every successful program has enabled emissions banking; and indeed the exception proves the rule. The RECLAIM program in southern California did not allow emissions banking in 2000-2001, and as a result, firms had no incentive to install pollution controls before they were necessary. Consequently, “just in time emissions reduction” behavior coincided with a low hydro year and the restructuring of California’s electricity market to exacerbate the state’s electricity crisis. In general, the absence of banking can be expected to amplify price volatility, for example as hydroelectricity generation varies year to year. If prices spike in any given year and hit the price ceiling, then under SB 775 additional emissions allowances in excess of the emissions cap would enter the program. This is in contrast to the program currently, wherein such allowances would come from under the cap from a different year.

Banking has been a useful way to manage costs and prevent such price spikes from occurring. Further, firms that hold an allowance bank have a stake in the longevity of the program, which is politically valuable.

One motivation to end banking and to sever a connection between the market in 2020 and 2021 is the anticipation that allowance prices will rise when greater stringency is introduced in 2021. With banking and a connection in place between 2020 and 2021, one would expect emissions allowance prices to rise now because allowances obtained now could be used after 2021. These allowances would result from additional action to achieve emissions reductions sooner than required, which is unequivocally a good thing! But a price increase in the near term would take place before new uses of revenue have taken effect, including sending revenue dividends directly back to households that could soften the impact of the price change, as SB 775 would start operating in 2021. However, to announce that banked allowances will have no value after 2020 would have an opposite, deleterious effect. It would drive down allowance prices right now and remove the incentive for additional emission reductions in the near term. It also would undermine the credibility of regulatory programs in general that attempt to use economic incentives to achieve environmental goals.

The concern reflected in the language of SB 775 can be fixed without eliminating banking or severing the new program from the old one. A smart approach would be to discount the value of allowances carried over (banked) from 2020 into 2021, which is similar to the approach attempted in the Clean Air Interstate Rule (CAIR) at the federal level. (The approach in CAIR was not upheld in court for reasons that are unrelated to the California context.) The final planning of a smooth transition between 2020 and 2021 might be best left to the Air Resources Board, but in any event, allowance banking should be part of that transition if the program is to continue to perform well in the near term and through the next decade.

Offsets

A second design change is the elimination of offsets, which enable firms to purchase allowances resulting from emissions reduction measures achieved outside the market. In principle, this is a good idea because all emissions contribute equally to climate change and if cheaper emission reductions are available outside the market then they should be harvested. Also, these offsets sometimes have ancillary ecological benefits and bring otherwise unregulated sectors such as forests and agriculture into the domain of a carbon constrained economy. However, offsets are controversial because it is difficult to ensure that the emissions reductions are additional, that is, that they reflect behavior or investment that would not have happened anyway. And, with growing awareness of the associated air quality impacts of fossil fuel use especially in low-income communities, offsets are often described as providing get-out-of-jail cards for regulated firms that may erode the integrity of the cap-and-trade program and delay overall improvements in our environment.

This is not the place to contest the legitimacy of offsets, but their availability provides a form of cost management that builds important political coalitions and has at least some positive environment benefit inside the carbon market and beyond. One alternative that could maintain these environmental benefits, if offsets are deeply divisive in the program design, might be to direct a small revenue stream from the allowance auction to purchase emissions reductions outside the carbon market. The Air Resources Board could evaluate offset projects ex post to ensure that reductions actually have been achieved, and after verification they could constitute additional allowances that enter the program perhaps to populate a cost containment reserve and enter the market if costs rise.

Border Adjustments to Address Leakage

A third design change is the move toward a carbon-related border fee affecting many imports and exports to the state. If this sounds like the buried lead in this story, it might be.

California faces the profound challenge of promoting climate policy ahead of other jurisdictions, which opens the possibility the carbon intensive activities in other jurisdictions will have an unfair economic advantage that erodes California’s climate efforts and its economy. Heretofore, the state has given a limited number of emissions allowances for free as an incentive to keep production in the state to firms that are exposed to competition from abroad. However, this is criticized because it feels like another get-out-of-jail card. In fact, the program allocates less than 15 percent of allowances in this way and that share is decreasing.

In contrast, a border adjustment would assess the carbon content of imported goods and require the surrender of emissions allowances, while rebating some allowances to exporters in order to preserve their competitiveness. Economists have pointed to conceptual advantages of this approach, but the practical and legal challenges are daunting. Furthermore, these adjustments would affect the overall emissions outcome in the state, complicating the efforts to achieve the emissions target. SB 775 stipulates that free allocation would continue if the border adjustment were not successfully implemented. A better approach might be to keep the current approach in place, while directing the Air Resources Board to begin a research program to develop a border adjustment mechanism that could be reviewed and potentially implemented in the future.

International Implications

A major accomplishment of California’s efforts, recognized on the international stage, is the linking with Quebec and probable linkage next year with Ontario. As built, SB 775 would most likely decouple these programs, providing a body blow to international linkage in climate policy. The increased stringency of SB 775 would likely not precipitate this; California’s current and prospective partners are entertaining similar future ambitions. Rather, the features of SB 775 that are likely to make linking impossible are the exclusion of banking and offsets and the introduction of border adjustments. These features are not fundamental to the stringency goal of SB 775, and as indicated, they could make achieving that goal more difficult. Hence, they should be held up for thorough discussion and analysis and potential revision before a vote by the legislature this summer.

Dallas Burtraw is the Darius Gaskins Senior Fellow at Resources for the Future.  He may be contacted at [email protected]

This is part of a series, with links compiled at The Future of California’s Greenhouse Gas Cap and Trade Program After 2020.

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Reader Comments

8 Replies to “Guest Blogger Dallas Burtraw: Three Revisions Not to Overlook in California’s New Cap-and-Trade Proposal, SB 775”

  1. On the subject of banking you say “These allowances would result from additional action to achieve emissions reductions sooner than required, which is unequivocally a good thing!”

    Is that true when actual emissions are below the cap as they are now?

    Wouldn’t some banking occur just by firms purchasing the available allowances now and saving them until the price has increased – without any reduction in emissions?

    This would then provide emissions above the expected cap in those future years, keeping prices lower and allowing emissions to continue at a higher rate.

    This would also provide a windfall to those holding these allowances as they rise in value.

    Am I missing something here?

    If my assumptions are correct then this seems very equivocal to me.

    1. It is a good point that if firms have been given allowances for free that are in excess of their compliance obligation and they have built a bank then if the price of allowances rise they will receive a windfall profit. I suggest that a transition between the current and new program can be implemented by applying a discount rate, as was described in the CAIR program. For example a pre-2021 vintage allowance might be worth only 0.6 tons in 2021. ARB is well placed to do this calculation. ARB might describe a policy intent to preserve the economic value of banked allowances but not to let them enjoy a windfall as the program becomes more stringent. This would also reduce the magnitude of banked emissions, because an allowance from before 2021 would be worth less than one ton.

      Thank you for the comment.

      1. With sincere respect to Dallas, who makes important and thoughtful points in his essay above, I think he has this one wrong. His suggestion might offer a way to avoid windfall profits, and is worth consideration on those merits.

        But Tony Sinra’s question also reflects concerns about the environmental integrity of banking surplus allowances from the current program into the new period. And he is right to be concerned: those extra allowances do not represent real emission reductions. We know this because companies don’t need them to demonstrate compliance because emissions from covered sectors are below the program’s cap. Whether or not we take away an allowance on the margin has no effect on market prices or on emissions.

        And when a surplus allowance from one oversupplied trading period is used in another, it allows regulated companies to emit more in the future period, not less. That is decidedly a bad outcome from an environmental integrity perspective.

        I would compare this to the debate over offsets. A properly regulated offset that represents a real emission reduction in a northwestern forest has equal climate benefits as a reduction in a company’s CO2 emissions in California. In the current system, a company can submit this offset credit while continuing its in-state emissions. In this case there is a potential environmental justice trade-off: an out-of-state forest is protected instead of the company reducing its climate emissions in a disadvantaged community (and potentially delivering co-benefits in reduced local air pollution). Overall program costs are reduced.

        Using a banked allowance from an oversupplied trading period is similar, but strictly worse. Like an offset credit, use of this banked allowance would allow a company to continue emitting in California. But unlike an offset, no forest is protected. There is no emission benefit, either in terms of greenhouse gases or local air pollution co-benefits. Thus, banking oversupplied allowances presents a significant environmental integrity concern while raising the same environmental justice impacts that motivate opposition to carbon offsets.

        Those who advocate banking between the current market and a new program period are also advocating to reduce the environmental integrity of the future market—to the tune of some 240 million tons of carbon dioxide equivalent, which is a good estimate of the total number of oversupplied allowances in the market, including the allowance price containment reserve. Each of these unused allowances would allow for a 1:1 increase in future emissions, though if discounted per Dallas’ suggestion that ration would fall accordingly. But in fact any use of these instruments comes at the expense of environmental integrity.

        I don’t mean to suggest this is anyone’s intended goal, but it is a necessary consequence of banking allowances from today’s oversupplied market, and needs to be part of the debate.

        Best,
        Danny

  2. Regarding offsets:

    With the tight price collar provided by SB775 are offsets really needed as a price containment mechanism? I would say no.

    If these offset projects are indeed valuable and effective ways to reduce GHG emissions, then couldn’t we do just as well to fund them through use of some of the revenue from the carbon price, for instance as part of the Greenhouse Gas Reduction Fund or something equivalent. Why retain a separate system for verifying projects and allocating funding to carbon reduction? If they are not truly valuable then they should not be prioritized.

    It would certainly seem appropriate for us to allocate any such funds to projects within California that are not covered by cap and trade, and/or to projects in disadvantaged communities, especially those which also reduce pollution that is harmful to our health.

    Elimination of offsets would support the goals of prioritizing direct emissions reductions as mandated by AB197 and called for by Environmental Justice groups from across the state.

    1. Thank you for agreeing with this point. If the state has a policy preference to harvest offsets (and there are good reasons for this) then that might be paid for from the GHG investment fund. In the blog, I mentioned that these offset credits might be deposited to the cost containment reserve as part of the price collar. As currently constituted in SB 775, as I read it, the allowances that come in at a price ceiling would be additional to the program with no environmental value. If instead the cost containment reserve was populated with offsets, there would be an environmental value.

      Implicit in my suggestion is the idea that the state might want to limit the quantity of allowances that can enter at the price ceiling.

  3. Dallas,

    I completely agree that banking is a very useful feature in programs that have a hard cap (RECLAIM, Title V, current CA cap-and-trade, RGGI, EU ETS). But my question is how to think about banking in a context like SB 775 where there is a price ceiling. My intuition is that interactions between banking and the price ceiling could lead to unintended outcomes. In particular, it’s far less clear that banking early when there is a price ceiling front loads reductions.

    Consider the following: if banking is allowed in a program with a rapidly rising price ceiling (e.g $10/ton/year plus CPI as in SB 775), won’t firms have a strong incentive to buy allowances at the ceiling (exceed the cap) in early years purely in order to use these allowances later, and by doing so undermine the environmental integrity of the program purely in order to save money. This is the major concern with allowing inter-year banking in the post-2020 program.

    I’m sure that the authors of SB 775 would welcome alternative suggestions that both preserve banking and the environmental integrity of the post-2020 program.

    Warm regards,
    Michael

    1. Michael,

      (Because your own nice essay raises similar issues, I am going to post this comment there in reply. Thank you for writing.)

      I think that banking with discount (flow) control can transparently and predictably adjust the value of an allowance based on its vintage and whether it is drawn from the cost containment reserve. This will avoid the problems you anticipate and improve the program’s performance.

      Your premise is that the price will rise to the price ceiling. While I understand why some modelers have conjectured this, and while I don’t think this will be the result (for reasons I discuss below), I agree that the program design has to accommodate this possibility. This leads to your suggestion of no banking between the current program, and no inter-annual banking in the new program. I follow your reasoning, but….

      It is similarly possible in principle that the price will not be at the price ceiling, but will reside between the ceiling and floor, a corridor that widens by $5 every year to be quite wide by the end of the decade. While I think it is most likely that the price will be near the price floor fifteen months into the new program and thereafter, I realize others including good economists at Berkeley using VAR methods suggest that a price in the corridor is unlikely, at least in the current program. Nonetheless, if prices are in the corridor there would be substantial cost savings if firms could smooth inter-annual price changes and plan their investments taking advantage of inter-temporal flexibility through banking.

      A strong program design should accommodate the full range of possible eventualities. Banking is valuable to reduce costs and guard the program against price fluctuations, especially if prices are in the corridor after 2021. It is also essential to make sure the current program remains successful through 2020 and all possible cost effective emissions reductions (and associated air quality improvements) are realized. These goals can be achieved by applying a discount rate to adjust the value of an emissions allowance that is banked between the current and the new program, such that there is no windfall profit and the allowance overhang in the private bank does not enable emissions that undermine the goals in the new program.

      A similar approach can be applied on an inter-annual basis to any allowances that are purchased at the price ceiling. Those allowances could be designated “last out” of a holding account, meaning that all other allowances have to be used first to prevent strategic behavior, and they could be discounted to reflect the $10 annual change in value associated with the change in the price ceiling. ARB is well placed to develop this aspect of the program design.

      I think the price is more likely to be near the price floor than the price ceiling for several reasons, including additional measures likely to be taken by local and state policymakers, behavioral change and promised technical innovation. But it doesn’t matter if I am wrong. Banking with this discount (flow) control will endow the program with more flexibility resulting in less cost without bad environmental consequences. In fact, banking may reduce the draw on the price ceiling in any given year and have environmental benefits.

      Finally, the bottom line is that linking with other programs is likely to hinge on emissions banking. Preserving those relationships is important.

      1. Hi Dallas,

        Thank you for this thoughtful reply. I’ll be in touch shortly.

        Warm regards,
        Michael

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