By Energy Innovation Director of Research Chris Busch.
University of California Professors Severin Borenstein and Jim Bushnell’s recent blog (abbreviated BBB, for blog by Borenstein and Bushnell) commented on Energy Innovation’s research into California-Quebec-Ontario carbon market oversupply, taking issue with the title of our New York Times editorial, “A Landmark California Climate Program Is in Jeopardy.” We agree the title chosen by the paper’s editors was misleading, as the program is on its soundest footing in years.
While the op-ed title missed the mark, oversupply remains an important topic for California’s climate policy. BBB concludes otherwise, but the analytical framework it applies has an important limitation: The possibility of emission reductions from switching fuels is intentionally omitted.
Fuel switching involves substituting low- or zero-carbon fuels for more carbon intensive ones – for example, driving electric vehicles instead of gasoline-powered ones, generating electricity from renewable electricity instead of natural gas, using electricity for residential consumption instead of natural gas, or creating steam from renewables instead of fossil fuels to pry oil from the state’s recalcitrant oil fields. Fuel switching away from carbon-intensive energy is a core strategy California must achieve to meet the statewide limit on carbon emissions set under Senate Bill (SB) 32, so to exclude it essentially assumes no possibility for success in meeting the statewide statutory limit.
BBB does not discuss the SB 32 target for 2030, limiting statewide carbon emissions to 260 million metric tons (MMT) of carbon dioxide equivalent, which drives our recommendations, but the California Air Resources Board (CARB) is required by law to develop a strategy to meet the SB 32 target and has set future carbon market cap levels with the intent of meeting this goal. However, current oversupply, left unaddressed, creates the risk for early banked allowances to substantially knock the state off the post-2020 trajectory implied by those same cap levels. Dallas Burtraw of Resources for the Future captures these policy implications in his recent blog stating “the magnitude of these unused allowances is so great that it could undermine the state’s intent.”
The policy recommendation we propose would allow for continued year-to-year flexibility, without requiring changes to banking rules. What it would do is correct for fortuitous and unexpected early compliance, consistent with a point BBB makes: “If we happen to have a weak economy or other external reasons for lower than expected emissions, we don’t stop trying to further reduce emissions.”
A Highly Inelastic Abatement Cost Curve Raises Doubts About “Most Favorable” Assertion
A bit more discussion of the BBB methodology is warranted. Due to the lack of fuel switching, their analytical framework allows for only a relatively limited amount of emissions reductions between the carbon market’s price floor and price ceiling (far fewer than CARB has assumed), producing a highly inelastic abatement supply curve. The underlying research paper upon which BBB is based, a research paper by the blog authors with Stanford Professor Frank Wolak, is transparent about these assumptions, explaining:
“Some estimates of the long run elasticity of demand for each of these energy sources suggest more elastic demand. Those estimates, however, generally include in price elasticity of demand for a given energy source the response of switching to other fossil fuel energy sources. In contrast, we are interested here primarily in changes that reduce the consumption of all GHG-emitting energy.”
“We assume that the elasticities of demand for electricity and transportation fuels are in the range of -0.2 to -0.4. While some estimates of the elasticity of demand for transportation fuels are somewhat higher than -0.2 to -0.4, such estimates include changes in vehicle choice behavior. Abatement from such change in fleet composition are already reflected in the auto fuel economy adjustments discussed above.”
As mentioned, fuel switching will be important across sectors, but especially in the crucial transportation sector. Switching from gasoline and diesel to low-carbon alternatives (especially electric vehicles) is a fundamental transportation sector decarbonization strategy, and assuming carbon pricing will not play a role in this decarbonization is a strong assumption.
In five years, automakers have promised to deliver dozens of electric vehicles to market, which could increase transportation sector price elasticity. In the 15-year period BBB considers, nearly all of California’s vehicle fleet will turn over.
BBB seems to be based on the view that it is prudent to exclude the possibility of fuel switching given uncertainties about the pace of technology innovation. It views the pace of innovation as largely disconnected from policy and too uncertain to model. The transparency around the assumption that no breakthrough innovations will occur is commendable, though it is perhaps at odds with the assertion that that BBB the analysis adopts the “most favorable assumptions.”
While it is true that technology breakthroughs are hard to predict, the diffusion of known innovations (out of the lab in demonstration or early commercialization efforts) through increased adoption, which prompts learning by doing and economies of scale, makes incremental progress somewhat predictable. Some fuel switching may be allowed by this more incremental innovation, but regardless, excluding the possibility of fuel switching in a study emphasizing uncertainties is too strong of an assumption and policymakers may fail to grasp it in interpreting the results described in BBB.
Here’s the bottom line: Innovation is happening at unprecedented levels with ever-increasing numbers of clean technologies entering the marketplace. For these reasons, BBB’s underlying price elasticities are too limited in its accounting for the potential amount of abatement from cap and trade. Those wishing to delve more deeply into understand the methodological arguments are invited to review this technical appendix.
Apart from domestic climate imperatives, external factors argue for an oversupply adjustment sooner rather than later. California is vigorously working to add new jurisdictions to the linked Western Climate Initiative program, having already added the Canadian provinces of Quebec and Ontario, with more partners on the horizon. California’s promotion of climate action outside of the state’s borders is certainly a good thing, however program adjustments will become more difficult in the future as new partners are added, because each additional jurisdiction increases the complexity of reaching consensus on program design changes.
At a January 4th legislative oversight hearing, CARB Chair Mary Nichols said the agency is undertaking a fresh look at reconciling its avowed desire to increase emissions reductions from cap-and-trade over the 2020s with systemic oversupply in the first phase of the program.
“There’s no question that there is also a tension between the desire to keep prices moderate and predictable and relatively smooth versus the desire to use the price of allowances to drive even more aggressive action… and in the past… there’s no question that we took the side of…” the former, “but we also understand we need to make sure that the program is doing its job in terms of sending the message that you need to keep investing and be investing now in things that are going to reduce emissions over the long run, so those are the kinds of questions we are looking at as we come up with our proposals in response to the new legislation…”
It is also worth pointing out that every carbon cap has turned out to be more readily achieved than had been anticipated ex-ante. While California’s emissions reduction target is aggressive and the state should not promise to get there at any cost, the introduction of a true price ceiling through AB 398 should increase confidence in adjusting for first phase oversupply to increase the chance that the cumulative emission reductions aimed for over 2021-2030 actually materialize. CARB should set a price ceiling that the state should not fear hitting in concert with adjusting for oversupply. That’s a responsible compliance strategy that balances economic and climate risks.