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.
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.