Friend or Foe: California’s Cap-and-Trade Emissions Market
Updated: May 6, 2022
Joseph Woodward served as the President of the Boston Political Review during the 2019-2020 academic year.
Illustration: Wesley Bedrosian/Americas Quarterly
An Introduction to Carbon Markets
Emissions Trading Systems (ETS) are market-based approaches to lowering greenhouse gas emissions by incentivizing polluters to scale back emissions over time. In most trading systems, a governing agency sells or gives away permits to pollute to private market players. Each permit allows the polluter to emit one metric ton of carbon dioxide, or the equivalent amount in another greenhouse gas (GHG).
Once the regulating agency has set the total emissions cap, market players can then buy and sell permits as they please. The market acts as a dual incentive: the more a company pollutes, the more permits they will need to buy; and the sooner companies decarbonize, the more permits they can then sell to their competitors. Adapt and you will raise your top line. Stagnate and the market will depress your bottom line.
ETS are designed to lower the emissions cap each successive year. This effectively heightens the above incentives over time. Thus, the biggest advantage to employing an ETS over carbon taxes (often referred to as “carbon pricing”) is that pollution under the cap is guaranteed to decrease over time. A carbon tax makes excessive polluting costly. ETS make it illegal.
In 2013, California launched the world’s fourth largest cap-and-trade ETS with the bold goal of reducing greenhouse gas emissions to just 20% of 1990 levels by 2050. The program now covers about 80% of statewide GHGs, and it has been expanded several times since its inception. It is the cornerstone of the state’s climate policy, and was recently extended beyond 2030 by a bipartisan supermajority in both houses of California’s state legislature.
In the long run, the dual incentive is supposed to promote clean energy transitions. Polluters are given regulatory predictability and consistency in the short term. In exchange, California is depending on the tightening emissions cap to incentive green energy transitions. The end goal is not just to pollute less, but to inspire investment, development, and, eventually, the implementation of cleaner alternatives.
Regulators must also manage a delicate balance: incentivize clean energy production without pushing carbon-intensive industries across borders. For example, overbearing ETS may push energy-producing companies to move their plants out of the state, then import energy into the region. This is the political, economic, and environmental catastrophe that politicians fear most. The state would lose thousands of jobs, meaningful tax revenue, and the ability to oversee the polluters that have now escaped their reach.
Recall that ETS can be advantageous over carbon pricing because ETS can guarantee emissions will decrease over time (unlike taxes, which simply make it costly to pollute). So why don’t we see more such programs implemented across the nation? One answer is that ETS are far more difficult to implement than taxes. Regulating agencies need to be created and entire asset markets must be governed.
California’s cap-and-trade regulating agency is the California Air Resource Board (CARB). The two laws creating and extending the ETS give CARB broad authority to implement and oversee the program. However, the administrative agency has recently been unable to meaningfully adapt to exogenous market variables (external factors that can shift supply and demand pressures). This in turn has created glaring loopholes in its flagship cap-and-trade initiative. And there lies a dangerous regulating error: the illusion of effectiveness.
How Do Prominent Stakeholders View the Program?
Prominent environmental groups have heralded the program as a pioneer in North America and crucial to decarbonizing the state’s $3 trillion economy. The Environmental Defense Fund, a large U.S.-based environmental advocacy group, published a report in 2019 praising the program and detailing step by step how other governments can replicate the system. The report states “California’s cap-and-trade program is directly benefiting residents through climate investments from auction revenues, new clean energy jobs, and local air quality initiatives.” Indeed, total emissions and economic carbon dependency (a metric of how carbon intensive an economy is) are down more than 10% each since the inception of the program, while job growth and gross state product outpace the national averages by even wider margins. Advocates of the program also point to permit revenues benefiting disadvantaged communities as evidence the program is a positive force to promoting environmental equity in the state.
Source: Environmental Defense Fund
Interestingly, major polluters in the state also seem to be receptive to the program. British Petroleum, one of seven oil and gas “supermajors,” has heralded the program as “a new standard [for a cleaner economy]” on their website. In 2021 alone, the Western States Petroleum Association – the largest oil and gas lobbyist in California – spent $3.4 million to protect the cap-and-trade program in its current form. CARB itself has also resisted calls to reform the program. Remarkably, climate hawks and polluters alike seem to support the program.
The Headwinds: Oversupply
In recent years, a few curious paradoxes have arisen. Total permits allocated per year have decreased from 2016-2019. According to everything stated above, one would expect emissions to follow suit. However, oil and gas emissions were up 3.5% over that span. Residential emissions have been rising steadily since 2014 as well. Across several large industries under the cap, emissions do not seem to be decreasing at all.
A historic oversupply of permits explains these anomalies. The blame for the oversupply is twofold. First, the supermajority coalition in the California legislature (tax laws need a two-thirds majority to pass in California) was subject to both heavy lobbying and compromise that provided CARB dangerously vague guidelines on the program. Without clear direction on implementation, permit pricing, and non-compliance penalties, CARB has been frustratingly slow in lowering the emissions cap. CARB’s cautiousness could be due to U.S. Courts increasingly cracking down on administrative agencies acting outside of their legislative remit. Lowering the cap at an aggressive rate could induce widespread non-compliance, which would undoubtedly spark lawsuits questioning CARBs methods or even its authority.
Second, CARB has proven incapable of quickly shifting permit allowances to account changes in demand. Exogenous market variables – such as a once-in-a-century pandemic – can dramatically alter energy needs, sending the price of permits at or near their price floor. Shifts in industry-specific demand are also to blame. As one industry may be subject to stricter regulations – by either a separate state or local initiative – other industries then benefit from the lower demand if the cap is not promptly adjusted. Above all else, CARB must be nimble with the times.
Before discussing how best to address these shortfalls, it may be helpful to explain why the oversupply is so harmful to the program. First, polluters are not incentivized to pollute less in the short term. Managers can buy permits for pennies on the dollar and boast their compliance with the program. In turn, firms’ projects that transition to cleaner alternatives now seem far more costly than buying sufficient allowances to cover current pollution levels.
The second, and far more damaging effect is that polluters can buy permits in bulk while they are cheap. Since permits do not have an expiration date, a savvy manager will save them for when prices do go up because the emissions cap is eventually lowered. This strategy is referred to as “banking” allowances, and it is widespread across the economy.
The nonpartisan California Legislative Analyst's Office (LOA) estimated the “cumulative oversupply of allowances in California’s cap-and-trade program through 2020 [ranged] from 100 million to 300 million allowances.” With polluters sitting on a mountain of permits, it is no wonder they openly endorse the program’s future. The program will be a license to pollute, not an incentive to decarbonize.
Source: California LAO
Thus, while environmental advocates and legislators alike are expecting emissions to decrease with the emissions cap, banked allowances provide the opportunity for emissions to actually exceed the cap. Without a shift in direction, the cap-and-trade program designed to guarantee decreasing emissions will be foiled.
The Headwinds: Patchwork Regulation
California, in general, has already implemented some of the nation’s most ambitious initiatives to tackle GHG emissions. Many of them do appear to be successful. However, most of the state’s vast environmental programs and policies are localized to only a few industries. This creates a hodgepodge of regulation that can skew market-wide trends. While one industry may be benefiting from laxed regulation, its true effects will be hidden on the whole because of other, more successful environmental policies. For example, according to the U.S. Energy Information Administration, California ranks as the 41st state in the union by per-capita energy-related emissions reduction since 2018. Meanwhile, some policies, such as the Low Carbon Fuel Standard, have undoubtedly proved successful in their targeted industry. Equating the many industry-specific successes to economy-wide progress is a critical misrepresentation.
Furthermore, a patchwork of regulation in a few industries can actually hinder the cap-and-trade program’s effectiveness. As such, another unfortunate paradox arises: as more successful localized initiatives are implemented, the current cap-and-trade program becomes more detrimental. Consider an example: the Low Carbon Fuel Standard is on track to reduce emissions by more than 10% by the end of the year. By 2030, that number is projected to double. It is a resounding success. But what does that mean for the broader ETS market? As market players in the transportation industry need fewer permits to support their businesses, the market demand for permits drops. Oversupply deepens and incessant polluters are rewarded by another industry’s success.
The Headwinds: Environmental Inequality
Climate change disproportionately endangers disadvantaged communities and socially vulnerable communities. These dangers are systemic. Health complications, air quality, economic opportunities, and property casualty are all worsening at quicker paces for minority populations.
Source: New York Times
Compounding the above issues, polluting facilities are disproportionately located in disadvantaged communities. Communities of color and impoverished communities are both 20% more likely to live within 3 miles of industrial polluting facilities than other socioeconomic communities. It is no wonder an Environmental Protection Agency report published in 2021 found that Black Americans are 34% more likely to currently live in areas with the highest projected increases in childhood asthma diagnoses. That report analyzed six of the “worst impacts of climate change.” All six were found to be heightened in minority and low income communities.
Born from this inequity, CARB is mandated to invest a portion of its cap-and-trade auction revenues in disadvantaged communities. The 2021 report on the program’s revenue allocation states 50%, or $5.2 billion, of the funds were invested in disadvantaged and low-income communities. That is well above the 35% required by law to be invested in such communities. The funds have led to beneficial initiatives such as affordable energy-efficient housing investments, planting trees in areas with elevated carbon levels, and subsidizing electric or plug-in vehicles.
While any initiative attempting to address environmental inequity is laudable, the current initiatives are reactive, not proactive. Take, for example, the initiative to grow urban forests and plant more trees in and around disadvantaged communities. These carbon sequestering projects lower average temperatures and can even reduce crime. But while it may be helpful to the environment and no doubt beneficial to these communities, a green space won’t incentivize a nearby power plant or manufacturing facility to emit less carbon.
Three Problems, One Solution
Given these interlocked issues, some climate and environmental justice advocates are now calling for the program to be scrapped. This narrative, however, is misguided. The program is flawed, yes. But it is also more than savable.
So, how can CARB correct for the hundreds of millions of excess permits in the market? (“Market” here does not necessarily refer to permits that are for sale, but a broader definition that captures the banked allowances firms have stored in their rainy day fund.) First, they need a few more economists on their staff. After that, there is a relatively simple escape from this catch-22.
CARB must expedite their planned decrease in permits. It sounds straightforward, but a delicate balance must be struck: firms must be incentivized to either use or sell their banked permits without a sharp decrease that induces wide-spread noncompliance. Fortunately, CARB will not need to guess how dramatic the permit cuts need to be. The market will tell them.
Any announcement of a stricter allocation strategy would promptly send market prices up. The difficulty, however, is sustaining that higher price. Analogous markets, such as the stock market, can actually view stricter monetary policies (in this case the Federal Reserve raising the federal funds rate) as good news, in relative terms. In the below example, the market reacted exuberantly to the Fed’s decision to only raise interest rates by 0.25 percentage points, instead of the more hawkish 0.5 points.
The market predictably dipped after the announcement, only to sharply rebound as investors’ fears of a more dramatic monetary policy adjustment subsided. If CARB’s tightening of permit allocations is not sufficient to drag banked allowances out of firms’ reserves, expect the inverse to occur to permit prices: an immediate increase in allowance prices followed by a dramatic drop at the news of sheepish market tightening. Permit prices would then settle somewhere below their price before the news broke.
Of course, a downside of quickly tightening the emission cap is that it negates two of the most attractive features of the program: regulatory predictability and consistency. However, one could argue that is exactly what the program needs. Most CEOs do not have a twenty-year vision. Most of them barely have a five-year plan. Executives are worried about their next shareholder meeting and how they will spin their earnings report. It is long overdue to bring energy transitions to the forefront of each shareholder meeting. Thus eliminating – or at the very least lessening – the predictability that allows managers to push climate transitions onto their successors would expedite green investments and transitions.
Assembly Bill No. 398, which passed in 2017, actually tasked CARB to “Evaluate and address concerns related to overallocation in the state board’s determination of the number of available allowances for years 2021 to 2030, inclusive, as appropriate.” That is a quite vague directive. In part due to compromises needed to create a two-thirds supermajority, the state legislature left it to CARB’s discretion on how address banked allowances. So what was CARBs reaction? For a few years, inaction. Then, finally, in late 2021, the price began to separate from the auction price floor when CARB announced its biggest single-year decrease in permit allocations (see graph below).
Despite increasing energy demand due to a humming economy, total permits allocated in 2022 decreased 12.8% from 2021, more than 4 times the annual average decrease between 2017 and 2021. Shortly thereafter, however, prices fell again to just $3 over the price floor. The emissions market, as the stock market did shortly after the Federal Reserve’s tightening policy, shrugged off the policy adjustment.
Nonetheless, CARB must continue to aggressively cut emission allocations. Market prices of permits after last year’s allocation cuts indicate the action was more of an annoyance than a wake up call for firms. Without bold legislative action, CARB’s future emissions cap reduction strategy will determine the program’s success.
On Environmental Inequity
To more adequately mitigate environmental dangers on disadvantaged populations, CARB should take action to heighten polluters’ operating costs in such communities. The California Environmental Protection Agency has already drawn boundaries around heavily-polluted disadvantaged communities. Using those maps, CARB has several proactive approaches it could choose to pursue. The simplest approach would be to add a surcharge to any permit used to cover emissions within the EPA’s boundaries. Polluters with the option of using different facilities outside of the boundary will choose to shift for more emissions out of these communities, provided the surcharge is a sufficient amount. A drawback is that the surcharge would be passed on to the consumers. Indeed, the broader economy would bear some of the burden, but dispersed out across a broader socioeconomic population than just the low-income or minority community benefitting from the surcharge.
A more nuanced approach would be to differentiate permits on the basis of their geographic usage. This, in effect, would create separate tranches of emissions covered under the total cap. The market for separate permits would be subject to different supply and demand pressures, and thus create separate prices. This approach would also alleviate some of the patchwork regulation headaches mentioned above, as some regulated industries are invariably localized in certain regions. As prices of different tranches divide, CARB will have more targeted levers to adjust supply accordingly.
Either of the above approaches, or any new proactive initiative to lower emissions in disadvantaged communities, should be used in addition to the current investment in these communities. Supplementing the long-term investments CARB has already initiated will alleviate the immediate strain on these communities.
Similarly, while CARB may have overlooked critical factors on its carbon market, the program still has a very bright future. CARB should continue last fall’s aggressive emission reduction to address the three concerns mentioned above. More importantly, the program should be protected from attempts to have it repealed. For it is far easier to criticize a promising initiative still in its adolescence than it is to replace it with a new one.