Hot air and offsets in California's post-2020 carbon market

California policymakers need to carefully balance supply and demand in a post-2020 carbon market in order to address cost containment and environmental outcomes at the same time. Two critical issues are (1) what to do with the significant supply of excess allowances in the pre-2020 system and (2) what role carbon offsets should play in the post-2020 program.

To explain these concepts and provide quantitative context for their impact on market design, I prepared a short policy brief. Both offsets and excess allowances have the potential to independently overwhelm the supply/demand balance in the post-2020 period and therefore require careful study. 

Supply of carbon offsets, pre-2020 hot air allowances, and post-2020 demand Units: million compliance instruments (MMtCO2e)

Supply of carbon offsets, pre-2020 hot air allowances, and post-2020 demand

Units: million compliance instruments (MMtCO2e)

Allowing covered entities to use today's oversupplied allowances in tomorrow's program introduces the problem of "hot air": because these excess permits aren't needed with emissions today falling below program caps, their future use increases total emissions. If allowed, these allowances would enable covered entities to comply with the program on paper without actually reducing their emissions—hence the term "hot air." Unfortunately, the estimated size of current market oversupply is comparable to the role ARB projects for the post-2020 cap-and-trade program. 

Carbon offsets generate credits for emission reductions that take place outside of the cap-and-trade program. At current limits—8% of total emissions—offsets could generate more credits in the post-2020 program than ARB projects the cap-and-trade program will need to deliver. 

As an aside, ARB assumes perfect foresight in its calculations of the emission reductions required to reach the SB 32 target for 2030 and in the role cap-and-trade will need to play in achieving those reductions. This is not the right way to think about a fundamentally uncertain future; we could need significantly more or less mitigation depending on economic growth, oil prices, technological change, and a host of other factors we can't know in advance. For the purposes of illustrating the importance of hot air and carbon offsets, however, it is reasonable to compare the size of these two issues against ARB's calculations. 

Linking, Banking, and Offsets

As the California climate policy conversation begins to focus on the design of a post-2020 carbon market, one of the issues that has drawn the most criticism—and frankly, the most inaccurate criticism—is how SB 775 contemplates California's approach to linking its carbon market with similar programs in other jurisdictions.

Critics have alleged that SB 775 makes it impossible for California to develop new market links, typically with an argument in one of three flavors:

  • Linking. Some have suggested that SB 775’s new requirements for linking are unduly burdensome and would frustrate future market links.
  • Banking. Some have argued that SB 775’s limited banking provisions render its market design incompatible with other jurisdictions’ choices.
  • Offsets. Because SB 775 prohibits carbon offsets in the post-2020 market, others have suggested this makes it impossible to link with other jurisdictions that don’t ban offsets.

Each of these concerns is misplaced, as I’ll explain below. I agree with constructive critics that the conversation around banking merits additional discussion; even though I don’t believe the current proposal would complicate future market links, any independent movement on the banking conversation will make linking even easier than what is presently contained in SB 775.

Contrary to critics’ claims, SB 775 proposes a market that is just as open to new market links as the current program. 

Linking

California’s carbon market is currently linked to a similar but smaller market in Québec, and Governor Brown recently made the necessary findings to begin a market link with another program in Ontario. Notably, however, neither of these jurisdictions has a post-2020 carbon market at this time—and nor does California. 

SB 775 would create a new trading program in the post-2020 period that does not begin as linked to any external market. This is a sensible starting position because nobody actually has a post-2020 market to link to at this time. Nevertheless, SB 775 remains open to future market links. The proposal would require new conditions on links to protect the political sustainability of the new market design, building on existing rules governing market links.  

Current state law requires the Governor to make four affirmative findings before the Air Resources Board is allowed to finalize regulations to link its carbon market to an external program. These requirements were established by SB 1018 in 2012 and are codified in California Government Code § 12894.

SB 775 would leave these standards in place and require the Governor to make two additional findings:

  • First, that the prospective linked market has minimum carbon prices that are equal to or greater than those in the California market.
  • Second, that the prospective market link wouldn’t threaten the performance or purpose of the climate dividend established by SB 775.

These new conditions clarify the general requirement under SB 1018 that the prospective linked program have program requirements that are “equivalent to or stricter than” California’s system (Cal. Gov. Code § 12894(f)(1)). In essence, the new requirements merely ask the Governor to confirm that the revenue recycling provisions in SB 775 aren’t disrupted because the Air Resources Board decides to link with an external jurisdiction with much lower market prices. In that instance, significant revenue could flow from regulated companies in California to out-of-state actors, rather than back to California residents via the dividend.

If Québec, Ontario, or other jurisdictions adopt comparable minimum carbon pricing trajectories, SB 775 would enable the Air Resources Board to link its post-2020 market to these external programs. Again, however, none of these governments has established a post-2020 market.

If California policymakers have signaled to the state’s partners that the current market design will continue without modification, they have erred: AB 32 clearly does not provide the authority to continue the program without legislative re-authorization. Thus, the question of whether or not there will be a carbon market in California depends on the legislature providing the Air Resources Board with that authority. There will be no links without a new bill. As the first comprehensive proposal designed to deal with practical political constraints in the legislature, SB 775 provides a clear path for future market links, including continued market links with our current linked partner, Québec, and with our proposed linking partner, Ontario.

SB 775's new linking requirements are clarifications of the existing rules as those rules would apply in the context of the post-2020 market design. In other words, SB 775 is a step forward for those who want to see continued market links, not the end of the line.

Banking

SB 775 has limited banking provisions in the post-2020 period, requiring regulated entities to demonstrate compliance every year and limiting the compliance validity of allowances to the year in which they are sold at auction. This limited banking is a departure from the current market, which features unlimited banking. Although no one has specified exactly how these changes would pose a problem to market links, some respected voices—like Resources for the Future's Dr. Dallas Burtraw—have criticized SB 775’s banking provisions as posing a potential barrier to future market links.

Personally, I am not convinced that limited banking provisions are a barrier because there is no reason a program along the lines of SB 775 couldn’t be linked with an external market that features unlimited banking. But in any case, the reason for limited banking in SB 775 is to address a key challenge that follows from the inclusion of a rapidly rising price ceiling, and that problem needs to be managed independent from the linking process.

With a hard price ceiling, the regulator is obliged to issue unlimited permits at a specified carbon price—in this case, the world’s most ambitious carbon trajectory, not some modest safety valve that excuses industry from the program.

A price ceiling is necessary to contain costs and provide certainty that the Governor won’t face political pressure to suspend the program, as is his or her right under current law (Cal. Health & Safety Code § 38599). But it also poses a problem: if companies can buy unlimited allowances at a price ceiling that rises rapidly every year, they will have an incentive to buy extra allowances in the early years (at low prices) and bank these allowances for use in later years (at high prices). In this case, companies could effectively avoid the rising carbon price and therefore frustrate the core purpose of the program—producing a credible incentive to reduce climate pollution.

To date, there has been precious little discussion of how to manage the negative consequences of unlimited banking under a rising price ceiling. After the release of SB 775, however, some thoughtful economists have begun to share ideas on how this problem could be overcome—including Dr. Burtraw. I am optimistic that this technical conversation will bear fruit and could potentially allow the legislature accomplish its goals under a less restrictive banking rule.

Again, the SB 775 market design not require other markets to copy its banking rules as a precondition of linking. It is entirely possible to link a program with limited banking to a program that has unlimited banking, so critics' concerns are misplaced. As a result, SB 775 has no impact on the choices other jurisdictions make with respect to their domestic market rules on banking. 

And even if I am wrong, there remains room to solve the underlying problem of how to control the negative consequences of banking under a rising price ceiling. If that conversation proceeds, it could have the effect of removing any hypothetical barrier to future market links.

Offsets

Finally, I want to address a common misconception about SB 775’s prohibition on the use of controversial carbon offsets in the post-2020 period. Some have suggested that this prohibition would block California’s ability to link with markets that retain some use of carbon offsets. But this is neither the purpose of SB 775 nor the actual requirement of the proposal.

Those expressing this concern are presumably referring to one of the findings the Governor must make under SB 1018 before affecting a new market link:

The jurisdiction with which the state agency proposes to link has adopted program requirements for greenhouse gas reductions, including, but not limited to, requirements for offsets, that are equivalent to or stricter than those required by Division 25.5 (commencing with Section 38500) of the Health and Safety Code. (Cal. Gov. Code § 12894(f)(1).)

It could be argued that because SB 775 bans offsets, the Governor would be unable to make this finding where a proposed linking partner allows for carbon offsets. In this case, one might argue that the proposed linking partner does not have offset requirements that are "equivalent to or stricter than" California's. In legal terms, however, this argument is wrong for two reasons.

First, the more appropriate reading of the current linking standards is to compare the provisions governing the standards that would apply to carbon offsets under state law. In his findings approving market links with Québec and Ontario, Governor Brown compared these program’s offsets standards to California’s own requirements that market-based measures like carbon offsets produce emission reductions that are “real, permanent, quantifiable, verifiable, and enforceable” (Cal. Health & Safety Code § 38562(d)(1)) (see findings here and here).

Under SB 775, a future Governor could approve market links to programs that include carbon offsets using a similar comparison. Current law requires our partners to maintain minimum carbon offset standards, and that is good policy. Any post-2020 carbon market should maintain this standard even if it precludes the use of these instruments for compliance in California. After all, the environmental integrity of each linked market affects that of all others, so minimum standards will always be required to continue market links.  

Second, it is important to recognize that the SB 1018 linkage findings are not judicially reviewable (Cal. Gov. Code § 12894(g)). In other words, the only recourse for someone who disputes the Governor’s findings is through the political process, not the courts. A court cannot and will not review the Governor’s standards, which gives the Governor significant leeway in interpreting the linking requirements.

As a result, SB 775 should not be read to preclude market links with jurisdictions that retain the use of responsible carbon offsets. In my view the bill would benefit from an amendment to clarify this outcome, but in any case, nothing about current state law or its proposed modification under SB 775 would prohibit market links with jurisdictions that retain the well regulated use of carbon offsets.

Conclusion

Contrary to some concerns, SB 775 does not frustrate the prospect of future carbon market links. In fact, it is a step forward because future links are possible if and only if the legislature re-authorizes cap-and-trade with a 2/3 vote.

Under SB 775, jurisdictions that match California’s climate ambitions are welcome to join the new trading period. The state’s partners would remain free to choose their own market designs as they see fit—including on banking and carbon offsets. Governor Brown has already concluded that the market designs in Québec and Ontario are consistent with California standards in terms of their minimum treatment of offsets; he or his successor would presumably do so again.