Jessica Green in Nature: Don't link carbon markets

In a new Comment at Nature, NYU political science professor Jessica Green argues against the prevailing theory that emerging carbon markets can and should link together to pursue a coordinated global carbon pricing policy. Citing problematic interactions between the EU Emissions Trading System (EU ETS) and Clean Development Mechanism (CDM), as well as California's cross-border electricity emissions accounting woes, Jessica makes the case that governance challenges limit the viability of linked carbon markets

Many policymakers argue that the next logical step is to combine cap-and-trade efforts into one global carbon market. According to prevailing economic theory, linking markets together should promote trading, smooth financial flows and lower the overall cost of reducing emissions. A global price on carbon emissions would emerge without the need for long and fractious diplomatic negotiations.

But reality is more complicated. Initial attempts to join up trading schemes in Europe and in California and Quebec have led to price crashes and volatility, not stability. It is becoming clear that cap and trade works only under special circumstances — when one entity controls the market and parallel initiatives do not undermine it.

Personally, I wouldn't make the general argument that market links themselves have led to low and volatile prices. Those are common outcomes in all emissions trading systems, not necessarily a product of the market links themselves—though the presence of a market link does mean that volatility in one system is readily transmitted to another, so the distinction I'm drawing is perhaps a minor one.

Sometimes the link itself is a driver of low prices, such as in the EU ETS / CDM link. CDM offset credits contributed to the oversupply of compliance instruments in the EU ETS; when EU regulators banned problematic CDM credits in Phase III of the EU ETS they nevertheless allowed allowance banking in between Phases II and III, with a large quantity of allowances from Phase II made available for banked use in Phase III as a result of CDM credit used in lieu of allowances in Phase II. Hence, the connection between the EU ETS / CDM market link and persistent low carbon prices is a direct one. 

In contrast, the California-Québec market link has little to do with causing the ongoing anemic allowance auctions and low market prices that followed. However, this link illustrates an important governance challenge I documented in an earlier paper that Jessica cites. On the eve of California's formal market launch, last-minute reforms to cross-border electricity trading rules led to significant reductions in expected market demand without acknowledgement in the public regulatory process whereby California and Québec linked carbon markets. Analytically, it is possible to show that either: (1) California regulators told their Québécois counterparts about the expected consequences that they denied in the public regulatory process in California; (2) California regulators were aware of the expected consequences but neither disclosed them to their Québécois counterparts nor in the public regulatory process; or (3) that California regulators ignored the findings of their own expert advisers, believing that no consequences would follow from their internal market reforms.   

Whatever the case, the California-Québec experience highlights how administrative and oversight requirements are much higher in linked markets where all participants seek to share governance responsibilities and not just let one jurisdiction become the de facto group regulator. This also reinforces Jessica's main point, which is that the consequences of regulatory reforms in one jurisdiction necessarily affect all of the linked jurisdictions as well—especially when one jurisdiction is much larger than its smaller trading partners. On that basis alone the concerns she raises are important to consider, even though I tend to describe market links primarily as vectors for volatility, rather than drivers. 

If linking carbon markets turns out to be too difficult to pursue in practice, does that mean carbon markets won't be effective as a means to some future coordinated climate policy? Not necessarily. Carbon markets can be designed to achieve specified price trajectories, using price floors and ceilings (or together, a price collar to ensure that market prices stay within a specified range). In this application it is actually quite simple to coordinate carbon market prices with carbon pricing policies in other jurisdictions—by comparing and negotiating carbon price trajectories across instruments and jurisdictions, just as in tax policy coordination. 

Update: on a second read, I realize my post might come off as critical of Jessica's work. That wasn't my intention. I'm very happy that Jessica has published this important essay and hope it will lead to more conversations within and between the social science communities that research climate policy. 

Two new comment letters on state energy and climate policy

Earlier this December Michael Wara and I finished a pair of comment letters on two critical California policy processes.

The first letter (see here) concerns the proposed expansion of CAISO's wholesale electricity market to include PacifiCorp and potentially other western utilities. While regionalization could better facilitate integration of renewable energy resources, it also raises a set of legal and governance challenges because California takes a decidedly different approach to energy and climate policy than its neighbors in the Intermountain West. Michael and I have participated in one particular process in which CAISO and CARB have discussed how to better account for greenhouse gas emissions in a regional market (past comment letters here and here). Because California is the only western jurisdiction to price the carbon emissions associated with power imports, out-of-state utilities have an incentive to preferentially send their low-carbon resources to California while keeping high-emitting resources for themselves. As a result, it is possible that high-carbon out-of-state resources turn on to serve new California load, but via a regional electricity market low-carbon resources are deemed delivered to California—an automatic kind of resource shuffling that produces the false appearance of low emissions on California's books. 

Earlier in CAISO's process, Michael and I had raised concerns that CARB's preferred way of accounting for these resource shuffling impacts would raise significant legal risks under the dormant commerce clause and Federal Power Act. (That this is the first process in which CARB has publicly recognized the potential for resource shuffling, despite intentionally gutting their rules on this issue a few years back is ironic—but that's another story.) After additional discussion, CAISO eventually selected a different approach, one that Michael and I believe will do a good job of accurately identifying the marginal power plant that is dispatched to serve California load and accounting for those greenhouse gas emissions. It's refreshing to see regulators tackle technically complex issues in service of reaching a workable, pro-climate outcome. While greenhouse gas accounting is only one of several issues to resolve—notably, there are additional governance challenges and the lack of post-2020 legal authority to price carbon, without which no regional market can accommodate state climate policy—we are grateful that CAISO has been so responsive to stakeholder feedback. 

The second letter (see here) addresses a Discussion Draft of CARB's 2030 Scoping Plan. The 2030 Scoping Plan is part of a process to determine how California will reach a bold new target established by SB 32, which requires statewide greenhouse gas emissions to fall 40% below 1990 levels by 2030. Hitting the 2030 target will require annual emission reductions in the next decade that are approximately ten times as steep as those needed to get to our much more modest 2020 target. So it should go without saying that careful analysis is needed to develop a robust implementation strategy, especially under the incoming Trump Administration. 

What CARB has so far put forward falls well short of that mark. On several key dimensions, CARB not only fails to satisfy the best possible analytical standards, but occasionally ignores basic scientific methods. For example, in order to develop a strategy to reach a deep reduction target some fifteen years in the future, it is necessary to have some sense of what the business-as-usual trajectory will be. Over that kind of time period, the future is very uncertain. Yet CARB has not been willing to engage in any kind uncertainty analysis. Instead, the regulator claims to know with precision what the future will look like both with and without its preferred (but largely unspecified) policy interventions. CARB also insists on using quantitative models that don't include macroeconomic feedback or carbon pricing—a curious choice for analyzing a deep climate mitigation target that the agency proposes to reach in part via carbon pricing policies.

On top of that, CARB's clear preference to maintain its flawed cap-and-trade program would, by the regulator's own calculations, lead to an emissions trajectory that misses SB 32's target. Because cap-and-trade allows regulated entities to bank extra allowances not needed in any given year, the program is designed to encourage companies to reduce emissions early and save those extra allowances for later—enabling companies to comply with the cap-and-trade program requirements while emitting significantly more emissions than is allowed under SB 32 in 2030. The figure below shows CARB's preferred implementation plan in green: in this scenario, emissions fall lower in the late 2010s but remain relatively high, ultimately missing the 2030 target by a wide margin.

Source: Figure III-3 in CARB's 2030 Scoping Plan Discussion Draft

Source: Figure III-3 in CARB's 2030 Scoping Plan Discussion Draft

Worse still, CARB continues to take an unreasonable approach to considering the potential role of carbon taxes. It's been obvious for years that the regulator has been opposed to carbon taxes on ideological grounds, though the precise reasoning has never been clear. Ultimately, where the legislature has granted the agency discretion to choose between competing instruments, it's the agency's business to act on its well-reasoned preferences. Problem is, CARB is now citing climate denier websites to attack British Columbia's carbon tax in order to support CARB's preference for cap-and-trade.

Yes, that's right: the nation's leading climate regulator—presumably through careless neglect—is now relying on right-wing blogs to make its case. As Michael and I wrote in our most recent comment letter: 

Lastly, we were surprised to find that one of the references CARB relies on to establish its criticism of British Columbia’s carbon tax—a blog called “The American Thinker”—is a reliable source of articles that dispute the scientific consensus on climate change [see footnote 98 on page 97 of CARB's Discussion Draft]. Recent headlines include “Climate Change: Where is the Science?” and “Trump and the Climate Change Clown Show.” One imagines that the blog’s publishers never expected to be cited favorably in a key California climate policy planning document; certainly we never expected a moment like this.

Frankly, the American Thinker incident does not reflect well on the sincerity of the scoping plan process. We encourage CARB to consider an explicit retraction. We also hope that in the future, CARB will be more selective in the sources on which it relies, particularly when criticizing the policies of other jurisdictions with which it collaborates on climate policy.

I hope that CARB will aim for a much higher standard in future drafts of the 2030 scoping plan, and not just in its footnotes. The regulator needs to take a much more balanced and well-supported approach to comparing cap-and-trade and carbon taxes, expand its modeling to include models that can address carbon pricing and macroeconomic feedback, and develop a rigorous uncertainty analysis. Meanwhile, we should all pay more attention to what the legislature does in 2017 because even CARB's preferred plan will require new legislative authority. 

New publication in the Energy Law Journal

My former UC Berkeley student Andy Coghlan and I have just published an article in the new issue of the Energy Bar Association's Energy Law Journal.

Our paper analyzes how the California state constitution constraints the future of carbon pricing in state climate policy. We find that extending the carbon market's authority after 2020 while retaining collection of revenue from government-run allowance auctions likely requires a 2/3 legislative supermajority under California's Proposition 26. Simple majority legislative strategies may be possible, but present both novel legal risks and significant policy consequences, such as precluding the collection of government revenue via 100% free allocation of allowances. 

In addition to speaking to the live issue of the role of carbon pricing in California's post-2020 climate policy strategy—see this new comment letter from me and Michael Wara on the California Air Resources Board's 2030 scoping plan process—our paper highlights how carbon pricing is critical to the future of western electricity markets.

As Michael and I have pointed out repeatedly (see here and here), plans to expand California's wholesale electricity market (CAISO) depend on California employing a state-level carbon price to ensure that only low-carbon resources are dispatched to serve California customers. That approach is consistent with the way CAISO operates its current Energy Imbalance Market (EIM), which applies California's secondary carbon market price to out-of-state power plants that wish to sell to California customers.

That basic market design is set to continue in any expanded CAISO energy markets. After several rounds of public comment, CAISO has prepared a "straw proposal" for how the EIM and an expanded CAISO energy market would operate. As with the EIM, the expanded energy market would apply California's state-level carbon price to out-of-state resources that are deemed to be dispatched to serve California customers. 

Whether and how to expand CAISO's energy markets is a complicated subject, but one thing should be clear: California needs to have the legal authority to impose a carbon price on imported electricity in order to make this market design concept work. In my view, however, that authority almost certainly expires at the end of 2020 without legislative re-authorization—see a comment letter from me and Michael Wara here for a full analysis.

If California wants to expand CAISO's energy markets, state policymakers will first need to extend carbon pricing authority beyond 2020. Absent a carbon price, there is no way to ensure that a regional electricity market including states whose energy and climate policy priorities could not be more different will not undermine California's policy goals. And as Andy and I describe in detail in our new paper, achieving that post-2020 carbon pricing authority likely requires a 2/3 legislative supermajority. 

Thanks to ELJ Editor-in-Chief Bob Fleishman for the opportunity to publish with ELJ; to  ELJ Articles Editor Kevin Poloncarz for his comprehensive and thoughtful feedback; and to the student editors at the University of Tulsa College of Law for their excellent assistance.