A Step Towards Fixing Up America’s Carbon Market

This article is the final part of a three-part series on America’s Cap and trade system. In this piece, we will discuss potential improvements that can be made to the current Cap and Trade system, and propose alternative market-based approaches to controlling pollution.

System’s Inefficient: Now What?

In our last blog post, we talked about why the whole Cap and Trade approach is resulting in undesirable outcomes, in terms of emission reductions, accountabilities of firms, and perhaps most importantly, to consumers.

But the convoluted network of private and public economic channels which are flowing under the current Cap and Trade system makes it very difficult to come up with an elegant solution.

What amendments can be made to the current program, and what additional measures can be introduced to reinforce the system? How do we make sure that the benefits of Cap and Trade are correctly distributed? Are there other approaches to controlling emission that ensure a more optimal outcome?

We will discuss some of these ideas in this third and last blog post.

A Brief Recap

Let’s first recap and ask ourselves the fundamental question behind this discussion: Is the Cap and Trade program working? Inefficiency aside, if the current system is not meaningfully contributing to the reduction of greenhouse gases, then there is simply no reason to uphold the program.

Going back to California’s exemplary (both good and bad) Cap and Trade program, the bold initiative by the state did achieve its initially set goals. But the Air Resources Board of California (ARB) hasn’t been reporting any numbers to show evidence that the Cap and Trade program is actually helping reducing pollution level.

Since then, a private study has shown that carbon emissions have in fact increased by 3.5% ever since the program started. And most of the C02 cuts came from electricity & related companies who had stopped using power coming from coal energy, while more than half of entities involved in the program actually increased average emissions within first few years. We also pointed out in our last blog post that institutions were banking away 200 million regulatory credits by end of 2018, and its possible that these numbers have grown.

Loose Cap and Low Prices

Many point fingers at the loose cap and low prices of carbon permits as the problem driving these issues; and they are likely correct. After all, the entire premise behind Cap and Trade is introducing a market-based approach to controlling pollution, and those two factors can critically affect market dynamics. The decreasing Cap will affect the supply of carbon credits, subsequently influencing their prices, and a higher floor prices will put further financial pressure on polluting entities.

Unfortunately, California’s Cap and Trade Program seems to be having a problem with both of these factors driving the carbon market.

Some claim that their initial Cap was set too high, which allowed companies to stash abundance of carbon credits for years to come, when the would become tighter. Furthermore, we saw the state distributing free permits to protect its competitive firms, which added on to the problem of loose cap and suboptimal, low prices on the permits.

Simply said, the permits are not scarce enough to put the needed financial pressure on polluting firms to reduce carbon output.

Potential Remedies

One idea is to introduce shorter expiration dates to these permits. We clearly don’t want firms banking on their regulatory permits just so they can be used to pollute beyond desirable quantities later in the future. Shorter duration periods for which these permits can be used for will force polluters to “make use” of their regulatory credits instead of piling them at home. Furthermore, this should effectively translate to a decrease in supply of available carbon credits.

Subsequently, the state may have to give up or reduce the amount of free permits that it distributes. We need to make sure the permit prices are high enough to impact the decisions of polluters. This could be complemented by an increased floor price of the permits.

As of 2020, the price of carbon is averaged to about $29 US dollars according to the IHS Markit Global Carbon Index. Unfortunately, the World Bank recommends a price of $40~80 US dollars to keep up with the current Paris Agreement, while another study found optimal prices to be over 100 dollars.

Offsets and Continuous Concessions

Another problem with the current Cap and Trade program is that it allows companies to purchase carbon offsets. Essentially, companies can “offset” their excess carbon pollution by paying for things likes environmental protections, cleanups, and whatnot.

The main issue is that the effect of these offsets may have been overestimated.

A study found that the 82% of the project generating 80% of these offset credit issued by the ARB did not contribute to true emission reduction due to “…lenient leaking accounting rules”. And the researcher claims these offsets could account for half the expected emission reduction from 2021–2030.

And it’s really no surprise the biggest purchasers of these offset credits are the biggest polluters in the state.

One of the obstacles in allowing for more stringent rules has been the polluting industries themselves. We’ve seen bills proposing for tighter controls over the Cap and Trade program, but unfortunately they’ve all failed to pass without amendments, under the huge amounts of lobbying and pressure from the oil industry. Consequently, concessions would have to be made between the government and the polluters if legislators want to keep the program running.

The EV and the Consumers

As we’ve mentioned in our first blog post, Tesla would not have had positive cashflow if it weren’t for their carbon credits. And this perhaps may be a result of the suboptimal incentive scheme placed by the Zero Emission Vehicle (ZEV) program. Maybe we shouldn’t be rewarding Tesla on its volume of sales, but rather on its affect in reducing pollution. Maybe we shouldn’t be rewarding Tesla at all, given that its positive offsetting affect on the environment is solely dependent on the usage of their cars, and hence on the consumers.

Problem with the current Cap and Trade program is that it fails to distribute its gains rightly. At the same time, it’s difficult to just pinpoint the places of adjustment because lot of the times, it is unobservable. We cannot observe the effectiveness of one singular EV driven by an everyday Joe in reducing air pollution. And even if we can, do we reward the vehicle maker for manufacturing greener technologies, or do we reward the consumers for the purchase and usage of these vehicles?

This is not a simple problem, and it will involve complex, articulate solutions. Governmental bodies and relevant industries must cooperate to maximize social welfare, and most importantly, distribute the benefits to those who truly deserve it.

This article is intended as a three-part series where we intend to update our stance and provide insight into alternatives to the current market mechanisms driving carbon neutrality. We are eager to learn so any feedback would be excellent. Thanks you for your time.