9.3: The Cap-and-Trade Experiment

Cap and trade is one of the highest-profile features of California’s emission reduction efforts. In the 2008 Scoping Plan, it accounted for 34.4 of the 174 MMT CO₂e of estimated reductions. These reductions would come about as cap and trade put a price on carbon, giving firms and individuals the financial incentive to reduce emissions. Just as importantly, cap and trade provided assurance that the AB 32 target would be met, assuming that the system functioned as intended. Should one of the other measures in the Scoping Plan fall short of expectations, cap and trade would soak up the shortfall.

During the debates over AB 32, cap and trade was a point of contention. From an economic point of view, cap and trade allows a given emission target to be achieved in the most efficient way possible (Chapters 11 and 12 for a more in-depth analysis). However, California was emerging from a bruising experience with a cap-and-trade program for a different pollutant—the RECLAIM program for nitrogen oxides in Southern California, which was partially suspended after permit prices rose from about $2,000 to more than $120,000 per ton during California’s electricity crisis. Another set of concerns related to environmental justice. Because cap and trade does not specify where and how emissions will be reduced, it is possible for an inequitable outcome to occur, with middle-class, majority-white, higher-income communities benefiting the most.

Design of cap and trade in California

The compromise was for AB 32 to authorize, but not require, CARB to implement “market-based compliance mechanisms”—in other words, cap and trade. CARB ultimately opted to use this authority, and the detailed system design was informed by a market advisory committee of prominent academics, state and local officials, and other parties. However, most of the emission reductions in the Scoping Plan were to be achieved through more-traditional command-and-control regulatory measures rather than the cap-and-trade system—effectively mandating many of the reductions that would have occurred anyway through the market-based approach of cap and trade. This hybrid system—part market based, part regulatory—may have reflected a lack of confidence in cap and trade, the political realities, and/or CARB’s traditional regulatory expertise. In 2016, new legislation (AB 197) reaffirmed the role of command and control in California’s climate policy.

When launched in 2013, the cap-and-trade system covered large electric power plants and industrial facilities. In 2015, it was extended to apply to fuel distributors, meaning that the heating and transportation sectors would be covered as well and that the program would encompass nearly 85% of California’s emissions. Cap and trade for transportation does not mean that individual drivers need to buy and sell carbon allowances. Rather, this task is handled by fuel distributors, and the cost is passed on at the pump. In practice, cap and trade has added about 14 cents to a gallon of gasoline, providing a small incentive for drivers to choose more fuel-efficient cars and to drive less.

The cap in cap and trade refers to the limited number of emission allowances that are issued. One allowance gives the right to emit 1 ton of CO₂, and a polluter subject to the cap must purchase or otherwise obtain enough allowances to cover its emissions. The number of allowances issued by CARB each year is planned to gradually fall to 334 million in 2020—achieving the 2020 emissions goal, provided that sufficient emission reductions are also achieved by “non-capped” polluters, that is, those that remain outside the cap-and-trade system. These non-capped pollution sources include hydrofluorocarbons and other “super pollutants” (Chapter 15), emissions from agriculture and land use change, and methane emissions from the decomposition of organic waste in landfills.

CARB’s decisions regarding the distribution of emission allowances internalized the lessons learned from problems with previous cap-and-trade programs, such as the European Union Emissions Trading Scheme (EU ETS) and the RECLAIM program for nitrogen oxides in Southern California. In particular, two innovations aimed to avoid the price volatility experienced in Europe (where the prices of allowances have on occasion fallen to near zero) and in Southern California’s RECLAIM program:

• An auction reserve price—this is the minimum price at which CARB will sell allowances. It started at $10 in November 2012 and rises each year at 5% plus inflation. The reserve price ensures that cap and trade will always provide a financial incentive to reduce emissions, and it avoids the risk that the price will fall to zero.
• An allowance reserve or “safety valve”—this is an extra pool of allowances that CARB only issues if the price rises above a given level. Together, the reserve price and the allowance reserve make the price of carbon more predictable, enabling firms to plan their investments with greater confidence.

California’s cap-and-trade experience

In general, California’s experience with cap and trade has been a success and has avoided many of the pitfalls of trading programs in Europe and the northeastern US (Chapter 12). Emissions have fallen while the state’s economy has prospered. The auction price has normally been slightly above the reserve price, and statewide emissions have declined along with the cap. Several major criticisms, however, remain.

One concern relates to the reshuffling of electricity contracts. That is, California’s electric utilities have swapped out purchases of out-of-state coal-generated electricity in favor of cleaner sources elsewhere on the western electricity grid, which extends far beyond the state’s borders. However, some of these coal-fired power stations have continued to sell electricity to consumers in other states, swapping out contracts in the opposite direction. Thus, while California reports lower emissions, the net reduction—considering emissions in other western states—is more limited. Coal plants simply sell their power to customers in Nevada, Arizona, or New Mexico instead.

Another concern for cap-and-trade integrity is carbon offsets. An offset is a certified emission reduction from a project that is not subject to the cap-and-trade program. In California, offsets allowed by CARB mainly come from forestry and agriculture, such as projects to reduce methane emissions from flooded rice fields. Polluters can use an offset credit in place of an emission allowance. If all offsets were “real” and “additional,” there would be no cause for concern, but in practice many offset projects may have been undertaken anyway.

A third potential challenge is the volume of allowances that firms have accumulated. More than 200 million allowances have been banked, or held by polluters for future use or sale. Such banking means that emissions are lower in the short term, but this practice may threaten the state’s ability to achieve longer-term reductions.

A broader criticism of the cap-and-trade program relates to equity and environmental justice. As noted above, while cap and trade provides a price signal to reduce emissions and it limits overall emission levels, it does not prescribe where those reductions take place. In the first 3 years of California’s trading program, some polluters increased emissions, while others reduced emissions. Those that increased emissions tended be located in places with more people of color, lower-income people, and other marginalized groups (although this analysis excludes emissions from transportation, which account for the majority of local air pollution impacts). This would not be a problem if the pollution were confined to CO₂ alone—while a major cause of climate change, CO₂ does not have any direct adverse health impacts. However, factories, power stations, and other sources of CO₂ also tend to emit other pollutants, such as sulfur dioxide and particulate matter, that do have health consequences for people nearby. At least in its early years, cap and trade seems to have done little to realize the hopes of improved air quality in the state’s most vulnerable communities. Many of the co-pollutant reductions occurred out of state, as California’s electric utilities reduced their purchases of imported coal-generated power, while in-state emissions saw more-limited changes and even increased in some places.

The equity situation may improve as the cap declines and polluters in all parts of the state begin to reduce their emissions. However, a more direct approach to address environmental justice concerns is to strengthen even further the regulation of local air pollution (where location matters) separately from greenhouse gas emissions (where the global concentration matters, not the location of the source). Indeed, this direct approach was the tenor of the state legislature in Assembly Bill 617 (AB 617) in 2017, which was enacted as a parallel measure to the extension of the cap-and-trade system. AB 617 requires CARB and its local counterparts to implement additional air quality monitoring in heavily polluted communities, to accelerate the introduction of pollution control technologies, and to develop a statewide strategy to reduce local air pollution in the worst-affected communities.

Figure 9.3.1 Use of revenues from cap and trade. Figures show appropriations from the Greenhouse Gas Reduction Fund ($ million) through fiscal year 2018–2019. Data from California Air Resources Board.

Another positive contribution to equity—and to other state goals— comes from the revenue generated by auctioning a portion of the emission allowances. Through early 2019, the auctions have generated $10.3 billion for the state’s Greenhouse Gas Reduction Fund. By law, at least 35% must be spent on projects that benefit and are located within (or, in a few cases, within a half mile of) low-income neighborhoods and disadvantaged communities that are disproportionately affected by pollution. Figure 9.3.1 shows how the money raised to date has been used. Some projects focus on general emission reductions—for example, high-speed rail, encouraging housing close to public transit, water efficiency, and manure management. However, other projects specifically target lowincome communities, such as the Low-Income Weatherization Program that funds energy-efficient appliances, new windows, water heaters, and other improvements that both reduce emissions and reduce household energy bills.