March 6, 2017

California Heads Down a Command-and-Control Blind Alley as Carbon Pricing Falters

Although at the federal level the biggest barrier to decarbonizing the economy is a lack of political will, in California, public opinion seems more supportive. In a recent poll, 69 percent of California voters backed policies to cut emissions. Yet the state’s carbon policy is in disarray. Its flagship cap-and-trade carbon pricing scheme is faltering, while plans to make up for its uncertain future by tightening command-and-control measures risk taking the state down a blind alley.

The economic concept behind cap-and-trade is to give companies an incentive to reduce emissions by requiring them to buy a permit for each ton of carbon dioxide they emit. The higher the price of permits, the greater the incentive. Prices are set by monthly auctions supplemented by a secondary market, in which permits can change hands privately.

The problems this policy currently faces are both economic and legal. The immediate economic problem is a surplus of permits relative to demand. Recent monthly auctions have seen the price fall to the minimum allowable level, currently just over $13 per ton. In some months, as few as 11 percent of permits on offer have actually been sold. Some optimists bravely maintain that low prices show the program is cutting emissions faster than expectedbut even if that is the case, it does not change the fact that low prices mean weak incentives to cut emissions going forward.

The cap-and-trade program’s legal woes are making the problem of low prices worse. Business groups have challenged it in court on the grounds that cap-and-trade is really a tax in disguise, but one that did not receive the two-thirds supermajority in the state legislature that is required for new taxes. If the suit succeeds, the program is likely to expire in 2020. The legal uncertainty adds to the program’s economic problems by undermining the demand for permits, thus keeping prices close to the floor.

To be sure, California has not depended entirely on cap-and-trade to control carbon emissions. It maintains strict efficiency standards for cars, air conditioners, and now computers. It also has an ambitious program to decarbonize its electric grid. Currently, California state law calls for half of all retail electricity to be produced from renewable sources by 2030, with an intermediate goal of 25 percent by 2016, reached slightly ahead of schedule.

With the threat to the cap-and-trade program in mind, State Senate leader Kevin De León introduced a bill in February that would raise the renewables goal to 100 percent by 2045. That has economists and even some environmentalists worried. As I have explained elsewhere for the case of auto emissions, excessive reliance on command-and-control regulations, rather than pricing, can enormously increase the cost of reaching abatement goals. The same is true of renewable energy mandates for the power grid.

The main economic problem facing renewable electric power is that of diminishing returns. It is possible to install great numbers of solar panels and wind turbines, and even to achieve economies of scale, measured in terms of the cost per kilowatt-hour of capacity, as the installations get larger. However, the problem remains of getting the power to users where and when it is needed. The output of solar and wind installations is variable, and the timing of output does not always coincide with the timing of demand. As the number of renewable installations attached to the grid goes up, the percentage of the potential power output that can actually be used goes down and the cost per kWh rises.

The problem of timing can be mitigated by building more storage capacity, but storage is expensive, too. The need for storage increases faster than in proportion to the renewable share of generation capacity, so more storage also leads to rising cost per kWh.

Price-based conservation measures like cap-and-trade or pollution taxes are well suited to dealing with the problem of diminishing returns. Putting a price on carbon emissions spreads the incentive to conserve over all types of energy use while giving an incentive to undertake the least-cost decarbonization measures first.

Suppose, just to pick a number, the price placed on carbon emissions is $20 per ton. When the share of renewables on the power grid is low, the cost of saving carbon by building more wind and solar capacity is likely to be less than $20 per ton, so more gets built. By the time renewables reach, say, 80 or 90 percent, the cost of saving one more  ton of carbon will be much higher. Taking low utilization rates and high storage costs into account, it will very likely be far more than $20 per ton.

Somewhere in between, there is a point where the cost of additional carbon reduction through renewable electricity just equals the price of carbon. Although it is not immediately cost-effective to expand renewable capacity, that does not mean an end to decarbonization. The threshold of cost-effectiveness will gradually increase over time as generation and storage technology improve. Meanwhile, decarbonization efforts will turn to other areas—such as the transportation or industrial sector—where it is more cost effective. If the level of emissions is still too high after all cost-effective measures have been taken in of these areas, then they can be driven lower still by raising the price of carbon.

For all these reasons, the proper response to the uncertain future of California’s decarbonization efforts should not be a retreat to more stringent command-and-control regulations. Rather, it should be to move forward to a stronger system of carbon pricing.

If the state’s cap-and-trade system were on strong legal footing, it might be enough to restrict the number of permits issued, or raise the minimum price of allowances, or both. However, in the event that the courts declare cap-and-trade to be a tax in disguise, the problem becomes one of assembling the two-thirds majority needed to pass a tax law—perhaps not impossible, if public opinion favors decarbonization as strongly as polls indicate. Such a supermajority could reauthorize the current cap-and trade  system, or better still, replace it with a robust carbon tax.

Should it prove impossible to overcome the legal and political barriers to appropriate carbon pricing, the future of decarbonization will be uncertain. Yes, it might be possible to get a simple majority in the legislature to vote for a bill like De León’s, but just setting an aspirational goal of 100 percent renewable power by 2045 would not necessarily produce a happy outcome. One study compares 100 percent decarbonization to the ramping up of aircraft production from near zero to 330,000 planes per year during World War II, in terms of the political will it would require. How would it be possible to summon up that degree of support for an inefficient command-and-control approach if there is not the will to pass a much less costly carbon tax, or even to put cap-and-trade on a proper legal footing? More likely, a premature effort to achieve 100 percent renewables would lead to missed deadlines, cost overruns, and the discrediting of the whole idea of decarbonization.