Good and bad options for changing California’s cap-and-trade program

California has been an environmental leader for decades, but still numerous cities in the state struggle with air quality. As state lawmakers debate the future of the cap-and-trade program to reduce greenhouse gas emissions, can they also find ways to reduce other air pollutants -- like ozone and particulate matter -- that make people sick?

The answer is yes. But some options are better than others.

Analysis of California’s climate policy shows that big cuts are needed to meet the state’s 2030 greenhouse gas reduction goal – and these cuts to carbon emissions will probably reduce other pollutants as well. By modifying the cap-and-trade program, California can improve the likelihood that criteria air pollutants get cut, too. Some of these options would reduce the flexibility businesses now have to comply with the program. This includes the ability to trade allowances, bank (save allowances for future years if you don’t need them now), and use offsets (verified reductions that happen at approved projects in California or elsewhere; the state sets strict rules on what counts as an offset).

The problem with eliminating these compliance options is that the program would lose elements that provide cost containment. In other words, it would likely get more expensive overall to achieve the same greenhouse gas reductions.

For example, eliminating the ability to bank allowances might backfire. Since the program is oversupplied right now (that is, there are more allowances available than emissions), banking is one of the main drivers of allowance demand and prices. If that option goes away, businesses will lose a big price signal to reduce greenhouse gas emissions, and emissions might increase in the near-term.

Another option is to add regulations on top of the cap-and-trade program. The state could regulate greenhouse gas emissions from refineries, which are also a large source of criteria air pollutants. The state could also enhance existing regulations for those other pollutants. It’s hard to predict how much pollution reduction either of these options would deliver compared to extending the cap-and-trade program as is, but they would at least increase certainty about criteria air pollution (though they might miss a big source of these emissions in the form of cars and trucks).

Yet another option is to create a price ceiling for allowances so that if auction prices reach a specific level, they can go no higher. This option does not address concerns about air pollutants, but does address concerns that future prices will be too high. The program already includes a version of this feature in how its allowance price containment reserve (APCR) operates. In the APCR, the reserve of allowances is built by pulling forward allowances from future years. If auction prices reach a specific price, allowances from the reserve are auctioned into the market; if they reach a higher price, more are released. The reserve has not yet been used by California businesses. A "hard" price ceiling similarly provides more allowances to the market when prices are high, but has an unlimited number of allowances. The downside to a hard price ceiling is that if too many allowances enter the market, the state might miss its greenhouse gas target.

There’s also talk about replacing the cap-and-trade program altogether. It could be replaced with a tax-and-dividend approach (a direct tax on greenhouse gas emissions with the revenue returned in part or in full to consumers) or just direct regulation of greenhouse gases. The tax might not be able to achieve the 2030 reduction goal, and regulations would be more expensive and eliminate some programs that reinvest carbon dollars into projects that reduce emissions.

Eliminating the cap-and-trade program could actually increase emissions over the near-term for the same reason that eliminating banking would. Some businesses are investing today in clean technologies and processes to avoid future long-term carbon costs. If that long-term certainty goes away, those businesses might postpone or abandon their plans.

So what are the good options?

One idea is to expand the APCR with more allowances borrowed from the future. This would give additional confidence to market participants about prices while keeping the program’s climate ambition intact.

Another option is to add a surcharge or tax on the use of offsets. This would still let offsets serve their cost-containment function, but would make businesses think twice about using them and make sure that all other ways to directly reduce greenhouse gases had been explored first.

While there is some uncertainty about how a new regulation would perform (and interact with the cap-and-trade program), directly regulating the criteria air pollutants of concern is probably the simplest policy option to improve air quality.