Removing excess cap-and-trade allowances will reduce greenhouse gas emissions

Removing excess cap-and-trade allowances will reduce greenhouse gas emissions

Summary of responses to Severin Borenstein and Jim Bushnell

Last month, the California Air Resources Board (ARB) identified the cap-and-trade program as the single largest component of its approved Scoping Plan for meeting California’s ambitious 2030 target for greenhouse gas (GHG) emission reductions. However, the program has a large oversupply of emission allowances—that is, the number of allowances issued to date have been far in excess of the emissions from sources regulated under the program.

Several prominent economists have argued that this oversupply could undermine the effectiveness of the cap-and-trade system in achieving emission reductions in support of the 2030 target. If oversupply spurs companies to “bank” extra allowances for future use, polluters could be able to comply with the program while their emissions significantly overshoot the emission cap in 2030 (see here, here, and here). To address this risk, some have suggested that ARB lower the emissions cap for the period 2021-2030, reducing the supply of allowances to ensure that the program delivers its intended reductions.

A new analysis this month by two prominent economists—Professors Severin Borenstein of UC Berkeley and Jim Bushnell of UC Davis—argues that lowering program caps to address market oversupply would not actually have much effect on the state’s emissions. Borenstein and Bushnell argue that the program cap is no longer binding because ARB must sell unlimited allowances at a new ceiling price. If prices reach this level, they argue, removing excess allowances to address market oversupply would not have any additional effect.

Although Borenstein and Bushnell’s analysis makes important contributions to the state climate policy discussion, their assertion that addressing market oversupply would not substantially affect emissions depends on several core assumptions that differ from ARB’s views as well as what the cap-and-trade extension bill, AB 398, now requires. In this note, we review their calculations and offer three responses:

1. AB 398 requires ARB to reduce additional emissions for every allowance sold at the price ceiling. Although ARB has not identified how it would achieve this outcome and there are reasons to be skeptical of this requirement, AB 398’s environmental integrity provision is current law. If enforced, it would give full effect to strategies that address market oversupply, resulting in a much greater benefit than what Borenstein and Bushnell project—although some of those benefits may accrue outside California.

2. The new analysis suggests that ARB may need to set a higher price ceiling to ensure the effectiveness of the cap-and-trade program. Borenstein and Bushnell calculate that a market design which eliminates oversupply has a nearly two-thirds chance by 2030 of reaching a price ceiling close to what is set in current regulations. Many of these scenarios would not constrain the emissions covered by the cap-and-trade program. Rather than justify inaction on oversupply, the new analysis suggests it may be necessary for ARB to consider a higher price ceiling than that in current regulations in order to deliver on the reductions the Scoping Plan calls for from cap-and-trade.

3. ARB’s expectations for the program suggest that addressing market oversupply will reduce emissions more than Borenstein and Bushnell calculate. ARB asserts that cap-and-trade will be much more effective at reducing emissions than do Borenstein and Bushnell. Although ARB hasn’t publicly justified its view, the Board’s assumptions would, if true, cause oversupply adjustments to be much more effective at reducing emissions.

Fundamentally, this discussion illustrates how different market design choices can interact and why it is important to analyze proposed market designs on a comprehensive basis. It also indicates the need for ARB to explain how the market reforms it will adopt under AB 398 are consistent with the role the Board has identified for cap-and-trade in the final 2017 Scoping Plan.

ARB has not yet produced any analysis of how its cap-and-trade market design choices will produce the emission reductions identified in the Scoping Plan. We hope that such an analysis is forthcoming and will be as transparent in its assumptions and model structure as the work that Borenstein and Bushnell have published.

To read the full research note, please download the PDF report.