‘Golden State’ pursues ‘Goldilocks’ economy and environment in challenging climate as world looks on for what could become global model.

California’s grand experiment to place a price on carbon is about to get under way with a November 14 auction for pollution permits — the currency in its new cap-and-trade market program.

Creating a market with carbon the currency is part of California’s larger campaign, known by many in the state by the name of its enabling legislation passed in 2006, AB 32, or The Global Warming Solutions Act. Its goal: to cut CO₂ emissions to 1990 levels by 2020. Together with a separate low-carbon fuel standard, a 33-percent renewable electricity standard, and clean-car mandates for automakers, the new cap-and-trade initiative makes California a national leader in the effort to cut greenhouse gas emissions.

The basic economics of cap and trade for CO₂ are pretty easy to understand. It begins with a simple truth: Industries have no economic incentive to cut their emissions if the price of polluting is zero. Under cap and trade, polluters obtain a permit, also called an “allowance,” for every ton of CO₂ they emit. The government “caps” the total amount of CO₂ emissions allowed, and each year lowers that cap toward an eventual statewide emissions goal. The statewide limit applies to sources responsible for 85 percent of California’s greenhouse gas emissions.

Polluters whose carbon emissions exceed the amount allowed by their permits can buy additional permits from companies emitting less than their permits allow. That’s the “trade” part of cap and trade. The extra cost of emitting CO₂ provides the incentive to find ways to lower their emissions.

The state has already issued free permits to about 350 industrial businesses, and those permits cover about 90 percent of their estimated emissions. Now, they must either cut those emissions to the 90 percent figure or buy additional permits at the November 14 auction. Businesses that have more credits than they need can sell them at auction to businesses needing them. The state will also be selling permits.

The 350 covered businesses include cement plants, steel mills, food processors, electric utilities and refineries, collectively operating about 600 facilities across the state, the Los Angeles Times reported in a review of the program on November 6. Beginning in 2015, the cap-and-trade program will cover distributors of natural gas and other fuels, the story said.

Challenges Ahead … Including California’s Acting Alone?

The cap-and-trade market in California faces several challenges. Among them is the threat of market collusion and price-fixing, other cheating, and legal challenges from industries upset with the whole idea of the new market. And, of course, California is embarking on this cap-and-trade adventure largely alone — a fact that some of the program’s detractors say makes the new market a non-starter. Further complicating the effort is the prospect that some companies not wanting to play could relocate to another state, a phenomenon economists call “leakage.”

Why is California even launching a cap-and-trade market in the absence of a global market for carbon emissions? Those who raise that question point out that the state is responsible for only 10 percent of total U.S. emissions, its economy is only about 15 percent of the U.S. GNP, and it’s home to only about 10 percent of the nation’s population. All those “onlys” — of course — make California a titan nationally and globally, but what can it achieve on its own?

Rest of World Watching … Learning

Matthew E. Kahn, an economist at the University of California, Los Angeles, says he’s optimistic that California’s cap-and-trade experiment is worth doing — most significantly as a model for other states, the federal government, and other nations.

“I am a believer that … if California succeeds with this initiative, it could be a building block toward national legislation,” Kahn said during an October 29 webinar for journalists. The briefing was sponsored by the Donald W. Reynolds National Center for Business Journalism, at the Walter Cronkite School of Journalism and Mass Communication at Arizona State University.

The globe’s major economies will be paying attention to how California’s new carbon market progresses, Kahn added. “The rest of the world will be learning,” he said. “China will be watching us, South America will be watching us, and if we have success in California … and by success I mean the goldilocks effect of having economic growth and environmental progress, then this will create a domino effect.”

In an opinion column November 2 in the Sacramento Bee, U.C. Berkeley business professor Elizabeth M. Bailey and Stanford University economist Frank Wolak suggested that the success of California’s experiment will be measured by the degree to which it’s scaled up nationally and worldwide — not by the emissions it cuts within the state’s boundaries.

“A California-only cap-and-trade program for greenhouse gas emissions can ultimately produce substantial environmental benefits if it can be leveraged into a regional or national program that eventually links with similar programs in other parts of the world,” Bailey and Wolak wrote.

“In general, as the geographic scope of a market-based program that prices greenhouse gas emissions expands, the ability to have substantial environmental benefits likewise expands.

“Therefore, California’s governor and its Air Resources Board, which is charged with implementing the program, should focus on realizing these broader benefits down the road, rather than attempt to achieve sizable emissions reductions from state businesses in the near term.”

In the meantime, journalists covering California’s experiment will face several challenges. But in his webinar, Kahn reviewed a few important stories that reporters should pay attention to as cap and trade progresses.

In Tough Economy, Is This the Right Time?

One important and obvious question that Kahn said journalists should consider is whether raising the price of carbon, which essentially is what launching a cap-and-trade market does, is a good idea during tough economic times. Reporters can ask affected companies directly. A list of entities that fall under the cap-and-trade program is available here. The list, dated October 27, 2011, is preliminary, but it appears to be the most recent list available at the website of the California Air Resources Board.

Economists are divided over the long-term economic costs to the cap-and-trade program, Kahn said. Michael Porter at the Harvard Business School has argued that regulations can have negative costs (i.e., result in lower net costs) as companies become more efficient, Kahn said.

Other economists counter that there is “no free lunch” and that there will be costs to adapting to the new regulations, Kahn said.

Ensuring Market Oversight, Avoiding Another ENRON

Effective market oversight will be vital as the cap-and-trade program goes into effect, and the Air Resources Board has taken several steps to prevent gaming of the new carbon market. A review of the ARB’s oversight and enforcement measures is available here.

“There have been some who have worries that a kind of ENRON situation could occur, where bidders work as a team,” Kahn said. The ARB’s measures aim to minimize this.

Permit Pricing and the ‘Goldilocks Effect’

Journalists should also pay close attention to how permits are priced over time. While most permits initially are free, the cost will go up over time. The ARB is well aware that interest groups are arguing that the state has over-reached with this regulation, so it’s working hard to identify a price for permits that isn’t so high that it could lower profits and raise consumer prices, and not so low that there’s no incentive to innovate, Kahn said.

How Will California Spend the Resulting Revenue?

One big question: “How should California spend the revenue from the sale of permits?” The state hasn’t clearly specified how the money is to be spent, Kahn said, and there are debates about whether the money should be used to pay down the state deficit, invest in green jobs and technology, or be used in some other way.

Earlier this fall, California Governor Jerry Brown signed two bills related to the use of revenue from the sale of permits. One bill creates a new account to deposit the $3.6 billion in revenue anticipated from the sale of permits during the first year of the cap-and-trade program, and also directs the ARB to develop an investment plan for the revenue. The second bill requires that 25 percent of all auction revenue be spent in economically disadvantaged communities.

Judging Programs’ Success: Taxing Waste, Not Work

How will we know whether the cap-and-trade program is a success? Kahn said reporters can look for a few leading indicators. One, obviously, is whether the new market is resulting in lower greenhouse gas emissions. But another key measure is a company’s abatement costs — the cost to a company to reduce emissions. “We want to know if they’re incurring pain as they’re cutting greenhouse gas emissions,” Kahn said.

During the webinar Kahn briefly discussed the idea of “double dividends.” Government can limit the cost to companies of reducing pollution by bundling regulations that increase the cost of carbon with a reduction in corporate taxes. This is an idea that Kahn said Tufts University economist Gilbert Metcalf has discussed with lawmakers on Capitol Hill.

“The idea is to tax waste, not work,” Kahn said. “When you have that kind of revenue recycling, Republicans are much more willing to talk about these taxes on pollution.”

Back in California, how the state spends the revenues from the sale of permits — that is, whether it “recycles” those revenues into some kind of tax benefit for polluters — is worth watching.

Other questions reporters should consider:

• Does the new market result in gains in energy efficiency? Are there certain breakthroughs in certain industries?
• Does the new cap-and-trade market incentivize old polluting firms to take a new look at their activities and seek solutions they wouldn’t otherwise seek in the absence of regulation?
• Does the new cap-and-trade market motivate electric utilities to buy power from wind and solar power producers?
• Does the new market create incentives for nascent green energy industries to invest more in R&D, and also to increase capacity?
• What costs does the new market impose on industry?
• What regulatory failures crop up over time?
• Does the price of electricity rise for residential and commercial customers, and why?
• How will lower-income households cope with higher electricity costs, if they materialize?
• Who really bears the cost of the new cap-and-trade regulation?

The Threat of ‘Leakage’ to Other Areas

Another major challenge the state could face in the new cap-and-trade era is “leakage” — the potential for certain polluters to flee the state for another that doesn’t have a cap-and-trade initiative. But Kahn said there’s reason to anticipate this won’t be as big a problem as some people fear. He pointed to the covered entities list from the ARB, which shows that some of the most electricity-intensive industries on the list include primary metal manufacturing, paper manufacturing, and textile mills — industries that actually are concentrated in other parts of the country.

“This has made me optimistic that California will not have a big leakage effect,” Kahn said.

The Utility of Offsets

California’s new cap-and-trade program will also allow businesses to purchase a limited number of “offset” credits in order to meet their cap in emissions. These offset credits will be able to be purchased from ARB-approved projects that reduce greenhouse gas emissions off-site of the business.

One potential project, for instance, could set aside land for new forests, or perhaps another could protect forests threatened by bark beetle infestations.

The offsets sector of the new cap-and-trade market will require a new workforce of verifiers — professionals whose job it is to investigate the project to confirm its validity and make an accurate accounting of greenhouse gas emissions offset by the project. In this respect, California’s cap-and-trade market will create a new industry of professional environmental accountants.

Exploring how this verification process occurs and whether it works will be fertile ground for journalists. One key question involves whether an offset is actually adding to the effort to cut greenhouse gas emissions. The concept of “additionality,” Kahn said, is an important one. For example, have new forests been planted? Or, are we rewarding forests that would exist anyway in the absence of the cap-and-trade program?

California’s ARB does not now allow businesses to purchase offsets from a foreign company, but that could change in the future if verification, as well as an accurate and reliable accounting of the offset, could be made, Kahn said.

“But offsets can be prone to misuse,” The New York Times reported in an October 13 story on offsets and California’s cap-and-trade program. “Some have generated significant private profits while producing questionable environmental benefits. The European Union’s eight-year-old carbon trading market has been tarnished by fake credits and audits that failed to meet minimum standards. California’s offsets have already been challenged in court by environmentalists who argue that offset developers will earn money for actions that they would have taken even if the program did not exist.

“If there is a loss of confidence because there is a sense that people have been cheating and the offsets are not real, that will be a problem,” Kevin Kennedy, an economist with the World Resources Institute in Washington, told the Times.

Lawsuits and a Climate of Uncertainty

Kahn said he is worried about the impact legal challenges to California’s cap-and-trade market could have on its future. An absence of clear signals and concerns over lawsuits could undercut incentives to participate, Kahn said.

“California is becoming the second primary node for climate litigation,” Michael Gerrard, director of the Center for Climate Change Law at Columbia Law School, told E&E Publishing in a September 20 story that reviewed the legal threats to California’s efforts to cut emissions, including its cap-and-trade program. “Previously, it was mostly in Washington,” Gerrard said.

Chief among legal arguments expected against the cap-and-trade program is that it’s a tax, which would have to be approved by a “supermajority” of the California Assembly. The state maintains that the cap-and-trade program is a fee, not a tax.

“The tax question is ‘a very serious issue’ that will be ‘heavily litigated,’” said Richard Frank, director of the California Environmental Law and Policy Center at the University of California, Davis, School of Law, in that E&E story.

Added Damien Schiff, an attorney at the Pacific Legal Foundation, a Sacramento-based conservative legal group: “If cap and trade can be characterized as a tax as opposed to a fee, it would be constitutionally infirm.”

Resources for Media

California Air Resources Board Emissions Trading Program

Overview Articles

California’s landmark global warming law becomes real this week with first cap-and-trade auctions, San Jose Mercury News, Nov. 10, 2012

Auction to kick-start California carbon market, Reuters, Nov. 9, 2012

California’s Model Climate Policies Will Maintain Momentum in Obama Second Term, Inside Climate News, Nov. 8, 2012

An inside look at California’s cap-and-trade program, GreenBiz.com, Oct. 25, 2012 (interview with CARB spokesman Dave Clegern)

A grand experiment to rein in climate change, New York Times, Oct. 13, 2012

California’s Carbon Caps are Contentious but Coming, Forbes, July 31, 2012

Select Articles On Business Opposition

Business groups protest Calif. carbon market, Associated Press Sept. 20, 2012

Air pollution chief rejects calls to change California’s new greenhouse gas program, Fresno Bee, Sept. 20, 2012

Businesses complain about greenhouse gas allowance auction, Los Angeles Times, Sept. 20, 2012

Expert Sources

Matthew E. Kahn, Professor, UCLA Institute of the Environment, Departments of Economics and Public Policy

Selected Work by Matthew Kahn:

Climatopolis: How Our Cities Will Thrive In The Hotter Future, by Matthew Kahn

Severin Borenstein, E.T. Grether Professor of Business Administration and Public Policy in the Economic Analysis and Policy Group of the Haas School of Business at the University of California, Berkeley, Co-Director of the Energy Institute at the Haas School of Business

Energy Economics Exchange blog

Elizabeth M. Bailey, professor at the University of California, Berkeley, Haas School of Business and executive director of the Energy Institute at Haas.

Frank Wolak, Director, Program on Energy and Sustainable Development; Stanford Institute for Economic Policy Research Senior Fellow; Senior Fellow at FSI for International Studies and Holbrook Working Professor of Commodity Price Studies in Economics, Stanford University

Michael Porter, Bishop William Lawrence University Professor, Harvard Business School

Robert Stavins, Albert Pratt Professor of Business and Government; Director of the Harvard Environmental Economics Program; and Chairman of the Environmental & Natural Resources Faculty Group. John F. Kennedy School of Government, at Harvard University

Robert Stavins Blog, An Economic View of the Environment

Gilbert E. Metcalf, Professor of Economics, Tufts University