America’s Cap and Trade Problem

Photo by Arno Senoner on Unsplash

It all started with a conversation with a couple of friends of mine regarding Tesla.

Okay that’s not exactly true, let’s rewind a little bit.

In actuality we were actually trying to come up with a topic that would inform the contents of this very publication. You see, we were tasked with trying to figure out how to go about redesigning any apparent market failures we noticed that resulted in an inefficient outcome. Our conversation involved some dabbling in the NBA’s draft lottery inefficiency, hobbyist resale markets such as StockX and controversies regarding large tech firms not paying their fair share.

It wasn’t until our colleague said this one phrase, that we had collectively realized that our project had been set in motion:

“Tesla would not have a positive free cash flow, if it did not have regulatory credits.”

“Wait… are you sure?”

“Yeah, that’s one of the reasons why Burry is shorting it

It felt to us as if something had gone horribly wrong.

Why do these Credits matter?

Why we ought to care.

First off, don’t get me wrong. I think there should be inventive systems in place to incentivize carbon neutral innovation. These systems ought to penalize the negative externalities of firms which pollute, and reward the positive externalities of firms which don’t.

As it stands, the “Green Premiums” necessary for the adoption of net zero emission technologies remain far too high, an issue covered at length in Bill Gates’ latest publication on climate change aptly named “How to Avoid a Climate Disaster”. In it he writes:

… “there’s a good reason why fossil fuels are everywhere: They’re so inexpensive. As in, oil is cheaper than a soft drink. I could hardly believe this the first time I heard it, but it’s true.”

Gates claims that even adjusting for fluctuations in the pricing of oil, this phenomena persists in large part due to the fact that oil firms don’t pay enough for the negative externalities their business processes emit.

Conversely, Gates notes that several key issues, including inefficient deployment and refinement operations, extensive land use, lack of reliability, and storage, have made implementing green technologies prohibitively more expensive.

All of these factors contribute to the reality that, if governments don’t incentivize these systems monetarily, firms will continue to gravitate towards the cheapest source of energy to fund their endeavors.

One of the methods that legislators have implemented to limit the negative externalities of massive polluters is a regulatory program called cap-and-trade.

What is Cap and Trade?

Let’s look at some of the nuisances that we need to cognizant about.

Cap-and-trade is a market based approach which securitizes every (one) metric ton of carbon emission(s), where the price of said underlying security is then determined in the open market. In layman terms, it puts a price on pollution and allows firms to buy more of the ‘right’ to pollute by buying pollution credits (permits/regulatory credits) from their proprietors. The “cap” portion of cap and trade implies that regulators set a ceiling on the aggregate amount of pollution in the entire market or any given industry. In many programs, the cap is readjusted every few years effectively bringing down emissions over time. The “trade” portion of cap and trade therefore refers to the free trade of the credits in the open market.

The cap-and-trade system was the flagship device used in California’s 2013 extension to its broader climate change initiative, aptly named the California Global Warming Solutions Act of 2006 (AB32). Representing one of the very first implementations of the cap-and-trade system, more than 50 programs have sprung up across the world inspired by California’s initial attempt. AB32’s primary initiative is to reduce GHG (greenhouse gases) emissions to 1990 levels by 2020, 40 percent below 1990 levels by 2030, and 80 percent below by 2050. California will use these guidelines to determine the caps which they will set amending policies along the way.

In California, allowances are determined through a quarterly auction, while a small subset of the credits are kept in reserve. In California’s case, it also sets a reserve price in these auctions ensuring that pollution is priced appropriately. Firms working on de-carbonization are also rewarded regulatory credits for every metric ton of greenhouse gas they displace.

For a company like Tesla, According to Tesla’s financial filling in Q4 of 2020, the company was able to sell the regulatory credits it earned on selling zero emission vehicles (ZEV) for an eye watering 401 million dollars.

Tesla’s 2020 Fourth Quarter SEC filling

So what’s the issue?

How do firms like Tesla get factored into all of this?

In theory the policy seems tight.

Governing bodies generate revenue from permits created from thin air. Firms innovating towards zero emissions processes pay less to do business. And firms which innovate on lowering the emissions of GHG get a revenue boost.

However, the system sort of falls apart when we realize who has to make the real sacrifices in order to lower carbon emissions.

California’s ZEV incentive, in its current form, does not account for Tesla’s true carbon footprint. Cap-and-trade compensates Tesla for each vehicle’s long-term value while ignoring its upfront cost. It relies on consumers to run their vehicles to the ground in order to offset the EPA’s 4.6 metric ton estimate of annual carbon emissions. The value of electric vehicles solely lie in their constant usage.

However, the system rewards Tesla based on the volume of vehicles it sells, ignoring the fact that Tesla’s vehicles are not inherently carbon neutral. The mining of lithium for batteries, the induction drivetrains, aluminum for subframes, silicon for MCUs, and glass for the windows have all at some point been derived from a non-neutral supplier.

Manufacturing technology is not at a point where it can enable zero additive manufacturing (i.e. the supply chain is not carbon neutral). The inputs required to develop a product like a Tesla are more resource intensive than advertised.

If the average consumer takes on a lease term of 3–4 years, then one can infer that Tesla would not hesitate to try to move the consumer into a new vehicle, starting the emission cycle all over again.

Although it’s currently hearsay, this volume incentive appears to be so strong in fact that there has been evidence suggesting that Tesla would take a detriment in quality just to meet production quotas. Such as 3D printing a fix to an injection molded HVAC part instead of shipping customers a properly produced part.

(Yes, this is better than injection molding a new part from an emissions standpoint. But may be detrimental from a consumer’s point of view)

Munro Live’s teardown of Model Y: Model Y E23 — Octovalve Manufacturing Processes, HVAC Summary, 3D Printing, Patreon Giveaway

If the policy goal is intended to reach a carbon-neural economy, then it seems like the incentive systems are currently in the wrong place. These facts do not even consider the detriment to non-ZEV company pensioners and their eventual retirement.

All in all, there seems to be a whole plethora of modifications we can make to the current implementation of cap and trade. This publication is not meant as a piece meant to slam Tesla in particular as these market forces will propagate to all firms affiliated with these regulatory credits. And therefore should spark debate in what can be done going forward.

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.

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Minho A. Neelansh

Minho A. Neelansh

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