An Rx for cap and trade


Gov. Jerry Brown and legislators are negotiating whether and how to extend California’s cap-and-trade program. They might ask themselves why.

To date, California’s cap-and-trade program has been a disappointment. Allowance prices in state auctions trade at the price floor, and and the program has delivered little reduction in greenhouse gas emissions.

Some state leaders argue the outcome so far demonstrates that other policies – such as increased auto fuel efficiency and requiring more electricity from renewable sources – have reduced emissions without much help from a price on carbon.

That view is partially right. But a study three colleagues and I have completed shows the main driver of variation in greenhouse gas emissions is the economy. Emissions aren’t perfectly linked to economic output. But more jobs and more output requires generating more electricity and burning more fuel, the largest drivers of emissions in California.

Because it is extremely difficult to predict future economic growth, there is uncertainty about how much greenhouse gases an economy will spew, even in the absence of any climate policies – what climate wonks call the business-as-usual scenario.

If the economy grows more slowly than anticipated, business-as-usual emissions will be low and attaining a prescribed reduction will be much easier than expected. If the economy takes off, emissions will be much more difficult to restrain.

The impact of variation in economic growth on emissions is much greater than any predictable response to a price on emissions, at least to a price that is within the bounds of political acceptability.

Our finding has important implications for extending California’s program beyond 2020. If the state’s economy grows slowly, the price in a cap-and-trade market will be very low. In that case, however, the program will do little to reduce greenhouse gases, because business-as-usual emissions will be below the cap.

If the economy does well, the cap will be constrained and allowance prices could skyrocket, leading to calls for raising the emissions cap or shutting down the cap-and-trade program entirely.

The probability of hitting a middle ground – where allowance prices are not so low as to be ineffective, but not so high as to trigger a backlash – is very low. It’s like trying to guess how many miles you will drive over the next decade without knowing what job you’ll have or where you will live.

California’s cap-and-trade program can be saved. But it will require moderating the view that there is one single emissions target that the state must hit. Instead, the program should be revised to have a price floor that is substantially higher than the current level, which is so low that it does not significantly change the behavior of emitters.

And the program should have a credible price ceiling at a level that won’t trigger a political crisis. The current program has a small buffer of allowances that can be released at high prices, but would still have risked skyrocketing prices if California’s economy had grown at faster pace.

Essentially, the floor and ceiling would be a recognition that if the cost of reducing emissions is low, we should do more reductions, rather than just letting the price fall to zero. If the cost is high, we should do less, rather than let the price shoot to unacceptable levels.

My first choice would be to replace cap and trade with a tax on greenhouse gas emissions, setting a reliable price that would make it easier for businesses to plan and invest. But cap and trade is the law in California. With a credible price floor and ceiling, it can still be an effective part of the state’s climate plan.

Putting a price on greenhouse gas emissions creates incentives for new technology, and might motivate large-scale switching to low-carbon energy sources as their relative costs change. The magnitude of these effects could be large, but they are extremely uncertain, which is why price ceilings and floors are so important in a cap-and-trade program.

Severin Borenstein is E.T. Grether Professor of Business and Public Policy at U.C. Berkeley’s Haas School of Business.