Climate Policy Lessons from California by David Montgomery

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California was the first state to enact comprehensive legislation to reduce greenhouse gas emissions, and a key part of that plan – the emission trading system – will sunset in 2020. Paradoxically, environmentalists are leading the opposition to California Governor Brown’s effort to extend and improve the cap and trade system, and businesses are supporting it. This conflict serves as an illuminating case study of the difficulties that states face in making climate change policies work.

The cap and trade system has been hailed as the great achievement of California’s climate strategy but it has been hamstrung by the proliferation of regulatory measures. Although Governor Schwarzenegger highlighted emissions trading in his Executive Order that introduced the strategy, he made the colossal error of turning design of the strategy over to California’s existing bureaucrats. As a result, the “Scoping Plan” that emerged was 80% regulation and at best 20% cap and trade. The bulk of the emission reductions would come from fuel economy standards, mandates for alternative fuels and renewable electricity generation, efficiency standards, regulations on shipping and trucking, industrial process standards, etc. listed in a 198 page appendix to the Scoping Plan. The cap and trade system would clean up around the edges to achieve the remaining reductions.

As a result, the ability of the cap and trade system to achieve certainty in emission reductions while minimizing cost was destroyed. The proliferation of command and control regulations (known in California as “complementary measures”) made the cost per ton of emissions avoided in the transportations sector several times higher than the cost per ton of emissions avoided in the electricity sector, and doubled the overall cost of achieving California’s goals.

There were several reasons for this failure to rely more heavily on cap and trade, and they are still in play. One is clearly bureaucratic incentives and inertia. The Air Resources Board was given the lead, and its approach to air quality regulation has always been heavily command and control. Every other state agency was invited to submit its ideas on how to reduce emissions, and naturally every one suggested more regulations that it could issue and administer.

There is also simple arrogance. The California Air Resources Board has a long history of asserting that it has a better understanding of technology and economics than the industries it regulates, and has not hesitated to tell them what technologies to develop and adopt. Cap and trade means leaving these decisions up to individual businesses, and the ARB has never been willing to relinquish that power.

Although one environmental organization, the Environmental Defense Fund, was from the start a strong supporter of cap and trade, many environmental organizations preferred strict command and control regulations for the ostensible reason that they gave greater certainty that reductions would be achieved. Underneath this rationale, which is entirely specious with a cap and trade system that puts a strict limit on the total number of emission permits that may be traded, is their desire to use regulation to achieve purposes beyond its ostensible objective of reducing greenhouse gas emissions.

In particular, these environmental organizations and allied trade associations prefer the regulatory approach because it promotes specific fuels and industries that would not survive if a cap and trade program were used exclusively. Thus California’s low carbon fuel standard mandates use of ethanol and other biofuels, creating a market and increasing profits for their producers. California’s renewable portfolio standard requires utilities to buy solar, wind and other “renewable” energy sources no matter how their cost compares to natural gas. California’s electric vehicle program creates a market for battery manufacturers and car-makers like Tesla. And so on to creation of smaller and smaller market niches for favored “Green” industries that could not exist otherwise. Relying solely on cap and trade would be at least equally likely to achieve California’s climate goals, but cap and trade would direct investment to the most cost-effective approaches and in the process leave behind more costly but politically favored fuels and technologies.

The so-called Environmental Justice movement took this opposition to cap and trade even further, though the fact that greenhouse gases are no more concentrated near their sources than half the world away should have kept climate policy off their radar. Nevertheless, EJ activists raised specious concerns about cap and trade allowing factories and powerplants to continue polluting poor neighborhoods. They then demanded increased funding for unrelated policies or programs benefiting their constituents as the price for moderating their opposition.

Willful ignorance has been encouraged by the California press which panders to the Environmental Justice movement with misrepresentations of how cap and trade works combined with horror stories about how it would allow industries to continue to pollute poor neighborhoods. Some news articles characterize cap and trade as allowing businesses to pay to pollute, without mentioning that the overall cap guarantees that emission targets will be met. Others moan about how the greenhouse gas cap and trade program failed to solve pollution problems unrelated to climate change.

Some real problems with the California climate strategy were raised by businesses concerned about how the system could damage to their ability to compete with out-of-state suppliers. For some products and regulations, this is not an issue and for others it is critical.

For example, all suppliers of fuels into California, no matter where they are located, must comply with the low carbon fuels standard, and likewise suppliers of electricity. But oil refiners outside California are subject to neither California’s regulations of emissions from the refining process nor its cap and trade program.

These costs are borne only by California refiners, and since gasoline is a fungible commodity easily shipped to California from other states, tighter regulations or high prices for emissions allowances could cause California refiners to shut down. If this were to happen, there would be no reduction in global greenhouse gas emissions, just a shift in those emissions from California to other states. And since those emissions do no local harm, the result would be costs to California with no benefit for global warming.

To deal with this problem, it is necessary to identify industries that are vulnerable in this way and to modify how they are treated under both regulations and cap and trade. This is an unavoidable problem when states attempt to go it alone in dealing with the global phenomenon of climate change. But it also invites rent-seeking by industries and accusations of caving in to big business or big oil.

All of these obstacles to adoption of a sensible and cost-effective policy can be seen in the controversy over renewal of authority for a cap and trade program. The specific bill supported by Governor Brown deals with some of industry’s concerns, by restricting the authority of state agencies to issue new regulations on greenhouse gas emissions covered by cap and trade and by limiting both how high and how low the price of emission allowances can go.

All of this makes perfectly good sense. The legislation would prohibit the Air Resources Board from issuing new regulations requiring additional reductions in emissions from refiner processes. This provision has been attacked as caving into big oil, when in fact it does nothing but reduce the chances that California refineries will shut down and be replaced by refineries from outside the state with even higher greenhouse gas emissions. It has no effect on California’s total emissions, as the overall cap under cap and trade takes care of that. And if additional emission controls at refineries are cost-effective at the price of carbon established by cap and trade, they will be undertaken anyway.

Likewise setting upper and lower limits on carbon prices is a balanced and useful step. Many environmentalists complained about how low carbon prices were in recent auctions by the state of some permits. By setting a lower limit on carbon prices, the cap and trade system gives a more consistent incentive to reduce emissions, and by setting an upper limit it gives businesses more certainty about future regulation. In this the cap and trade system comes to resemble a carbon tax. In typically inconsistent fashion, the same Environmental Justice organizations that oppose Governor Brown’s approach have come out in favor of the carbon tax that it emulates (https://www.bna.com/carbon-tax-next-n57982086840/ ).

Nevertheless, Governor Brown’s proposal has aroused the ire of all those opposed to cap and trade in the first place, and the Environmental Justice movement has already been offered its pound of flesh. In companion legislation, existing industrial facilities are required to install the best available controls to reduce their other, non-greenhouse gas emissions.

No wonder other states are slow to emulate California’s lead in establishing a cap and trade system. What governor wants to take on the headaches now plaguing Governor Brown as he faces interest groups that want to distort the cap and trade system, weaken its ability to achieve cost-effective emission reductions, keep provisions that weaken in-state businesses, or just demand payoffs in the form of additional unrelated programs to benefit their constituencies? California has provided more enlightenment about how difficult it is to construct an efficient, market-based program than about how to do it well. It will be instructive to see who wins in the current battle to reauthorize cap and trade.

Editor’s Postnote: The voters of California approved the continuation of the state’s Cap and Trade program for ten years. Read a full accounting of the election results here

David Montgomery was formerly Senior Vice President of NERA Economic Consulting. He also served as assistant director of the US Congressional Budget Office and deputy assistant secretary for policy in the US Department of Energy. He taught economics at the California Institute of Technology and Stanford University and was a senior fellow at Resources for the Future.

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