California’s Cap-and-Trade Plan Shies Away from Free Permits

'Auctioning Has Advantages Over Free Allocation in Almost Every Respect'

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As federal cap-and-trade legislation stalls in the U.S. Senate and comes under international scrutiny in Copenhagen, California policymakers are moving forward with their own design for a carbon-capping strategy.

California’s Global Warming Solutions Act of 2006 (AB 32) mandated that the state cut its emissions back to 1990 levels by 2020, and then decrease emissions to 80 percent below 1990 levels by 2050.

To reach those targets, policymakers plan to launch California’s own state-based carbon-trading scheme in 2012, but some important details are still being worked out.

The first question is one that has also tied up policymakers in Washington: What is the most effective way to distribute the emission allowances that will eventually make up the state carbon trading market?

The answer recommended by a committee studying the allocations issue is very different than Washington’s. Rather than give away the majority of permits to polluters for free — the path Congress is using to win over votes from fossil fuel-heavy states — the committee recommends the permits be auctioned.

Allowance Allocation Methods

Members of the California Air Resources Board (ARB) met on Friday with experts from the Economic and Allocation Advisory Committee (EAAC) to discuss the committee’s newly-released draft report, which outlines a set of recommendations that shift away from free allocation of emissions allowance value.

“We recommend that ARB should rely mainly on auctioning, the main reason being that auctioning has advantages over free allocation in almost every respect,” committee chairman Larry Goulder, a professor of environmental and resource economics at Stanford University, told listeners on Friday’s conference call.

The EAAC expects a carbon allowance auction to offer the benefit of increased transparency, compared with the administrative processes commonly used to assign allowances in a free allocation scenario.

“Administrative approaches can involve complicated formulas that mask the true recipients of the value and the magnitude of the value being distributed,” the committee wrote. “The assignment of value raised through an auction could be made just as complicated, but it is likely to be more accessible to observers because it would involve a direct transfer of dollar value.”

Unlike free allocation, a carbon auction could also provide chances to ease the mounting cost of running a state carbon-trading system.

“The government could use auction revenue to reduce existing taxes on productive resources like labor and capital that are widely believed to inhibit economic efficiency… reduc[ing] the overall cost of a cap-and-trade program substantially compared to an approach that distributes allowances for free,” the report said.

But free allocation may still have a place in the eventual design of California cap-and-trade, committee members said. It could help address the issue of “emissions leakage” — the fear that high production costs in carbon-regulated regions will drive demand for goods (and with it the emissions from the carbon-intensive production of those goods) into regions without carbon regulation. The leakage effect could spell trouble for the California economy if California firms lose market share to out-of-state competitors.

To prevent leakage, the EAAC report suggests that some allowances be allocated to vulnerable industries based on updating calculations of output. “The policy mitigates leakage because the allocation is received in proportion to the level of production; if production levels change, so does the value received.”

Uncertainties Remain

Committee members on Friday acknowledged that several gray areas remain to be resolved in the two years before California cap-and-trade is implemented.

There’s the issue of legality, for one. The committee’s findings remain largely theoretical at this stage, but according to EAAC member Rick Frank, policymakers will have to verify that plans for an allowance auction meet existing state and federal regulations.

“Right now, I see our collective charges as identifying some of these legal issues but not being unduly constrained or letting them affect our policy decisions,” Frank said.

And as California cap-and-trade develops, it also stands in the shadow of pending regional and federal carbon-trading systems.

Participation in a regional system like the one being developed by the Western Climate Initiative, or the passage of the national energy legislation currently in Congress, would be game-changers for California’s evolving system. In fact, the House-passed American Clean Energy and Security Act (ACES) would preempt any state or regional program for six years, putting California planners at a standstill.

“Even if a federal proposal did not involve direct preemption, the emergence of a national cap nonetheless would affect the price of allowances in state programs,” the EAAC report notes. “It might also affect the environmental integrity of state programs because a national cap could mean that any emissions reduction in one state would enable an emissions increase in another state without changing overall national emissions, as long as total national emissions remain under the national cap.”

Though state policymakers have tried to align the development of cap-and-trade with other emerging systems, they can’t predict the future. That’s why, so far, the ARB has made no hard-and-fast design decisions based on the policy recommendations.

“We’re basically calling for flexibility in recognition of the fact that future narratives are unclear,” Goulder said. “Leakage would be much less of a problem with the emergence of regional system and even less a problem in the event of a federal system.”

Alternative Measures

As negotiations continue over the details of cap-and-trade, some critics say California legislators should be looking at entirely different emissions-reduction solutions that won’t unfairly burden industries and harm consumers.

Officials who reviewed early drafts of the proposed emissions trading scheme worried that the responsibility for paying high carbon costs would land squarely on the shoulders of California ratepayers.

“Our original position was making sure that ratepayers only paid their fair share,” said Dan Ashuckian, deputy director of energy for the California Public Utility Commission’s Division of Ratepayer Advocates (DRA).

“Our concern was that ARB was piling on more responsibility for the electricity generation sector than other sectors, and that when you added up all the emission reduction requirements, the electricity sector has close to 50 percent of expected emission reductions when they’re only responsible for producing about 25 percent of emissions. So we felt it was a little heavy-handed on that sector, and that this would drive up costs on electric sector.”

Instead, the DRA favors the establishment of a flat carbon tax.

“If you put a cost on carbon production, that hopefully influences how people operate within the market.

"Cap and trade gives you certainty in the tons of emissions you’ll reduce. Carbon tax gives you certainty on the cost, and how much emissions actually get reduced is dependent on how that market reacts,” Ashuckian explained. “We would rather see price certainty than emissions certainty.”

With a cap-and-trade system steadily taking shape, the DRA knows it’s not likely that policymakers at this juncture will shift their attention to a new model. Nevertheless, the DRA’s concerns reflect the difficulties still standing in the way of an emissions trading program moving forward.

Which industries should bear the heaviest burden to reduce the state’s massive emissions total — and to which entities should allowance value be distributed to ease this burden?

“We’ve talked about the various possible recipients, but we haven’t yet come to terms with how much or what share of the overall pie should go to various recipients,” Goulder said. “That’s an extremely difficult issue.”

The advisory committee will meet again on Tuesday to hammer out more details of the draft report, before releasing its final allocation recommendations on January 11.


See also:

California, Other States Lead the Charge Toward Copenhagen

California Adopts Landmark Emissions Reduction Blueprint

How Congress Threatens to Undermine the Clean Energy Future: Handouts and Offsets

Cap and Trade in Perspective: Stopping Acid Rain

Cap and Trade in Perspective: The European Version

Cap and Trade in Perspective: Carbon Trading in the Northeast