by Scott J. Bloomberg, CRA International
Many people ask me what I think the price of carbon will be. Because there currently is not a national carbon policy in the United States, neither I nor anyone else knows the answer, which will depend on the type of policy enacted and its stringency (not to mention other market forces).
But how much does the price of carbon even matter? Is a $30 carbon allowance price more or less costly to the economy than a $15 carbon allowance price?
The answer might seem simple ($15 is less than $30), but it is not, and the answer likely will get even more complicated.
If the only program to reduce carbon emissions were a cap-and-trade program (or a carbon tax) then the simple answer would be the correct answer. There has been a recent movement in the United States, however, toward combining market-based programs to reduce carbon emissions (e.g., cap-and-trade) with mandates that specify who will make specific reductions and when (and sometimes how).
These mandates take on many forms but recently have included renewable electricity standards, solar electricity requirements, energy efficiency standards, low-carbon fuel standards and corporate average fuel economy standards. There are three primary implications of this movement:
- The carbon price may no longer be indicative of the total cost of carbon reductions,
- The total cost of making the carbon reductions likely will be more costly to the economy (and, therefore, to all consumers), and
- The cost of reducing carbon emissions becomes somewhat hidden from consumers.
The key to understanding these concepts is to understand, first, how a cap-and-trade program functions, and second, how mandates affect the cap-and-trade program. A cap-and-trade program establishes a fixed quantity of allowances (the cap) that typically declines over time.
These allowances can be traded freely among market participants. The trading allows for the least-cost reductions to be made because those with opportunities to reduce emissions make their reductions only if they are less costly than buying an allowance.
The resulting market price of an allowance is the price that will motivate sufficient reductions such that the total quantity of emissions is equal to the cap.
A mandate, conversely, requires carbon emission reductions from specified sources, whether or not these reductions are cost-effective relative to other abatement options. If the mandated reductions are cost-effective, then they would have been made in response to the cap-and-trade program anyway, and there would not be any impact on the carbon allowance price (although there likely would be some additional costs associated with monitoring, measuring, complying and enforcing the mandate).
If the mandated reductions are not cost-effective (i.e., the reductions are more expensive than other reductions that would have been made to comply with the cap-and-trade program), then we see the three implications described above: The carbon price may no longer be indicative of the total cost of compliance, the total cost of compliance is higher and the cost of the policy becomes less transparent.
Equally important, there would not be any change in the total carbon emissions (as long as the mandated reductions also fall under the cap); if the regulations mandate more reductions in one area, there will be fewer in another area, in effect substituting more costly reductions for less costly ones.
A simplified example can demonstrate this point. Figure 1 shows a hypothetical marginal abatement curve showing the quantity of carbon reductions that can be made at a given price level (x-axis) and the price at which these carbon reductions can be made (y-axis). If a cap-and-trade program were to require a reduction of 1,650 tons, the economy would undertake the reductions from the least-cost options until the total reduction were achieved.
In this case, the last required reduction would occur at a price of $30 per ton removed, and this would be the resulting price of a carbon allowance. The total cost of achieving the reduction of 1,650 tons would be equal to the area of the red boxes below the $30 per ton price, or $28,500. This is the least costly means to reduce 1,650 tons. (This same result could be achieved with a carbon tax set at $30). Further, under this example, a cap that resulted in a $15 carbon allowance price would be less costly than a cap that resulted in a $30 carbon allowance price (and would yield fewer emission reductions). This relationship between carbon allowance price (and carbon emission reductions) would hold true for all cap levels.
Now, assume that a mandate is enacted at the same time as the cap-and-trade program requiring carbon emissions reductions from the particular sector or source represented by the rightmost bar of the marginal abatement curve in Figure 1. In this example (illustrated in Figure 2), the cost per ton removed for the mandated reductions is $50, which is higher than the market clearing price of carbon allowances of $30 from the example that included only a cap-and-trade program. Therefore, this mandate forces more costly reductions that would not have been undertaken in a pure cap-and-trade program to the beginning of the marginal abatement curve. This also pushes out less costly emission reduction options (e.g., those available at $20, $25 and $30 per ton) such that they are not undertaken given the emission reduction requirement.
There are several important outcomes from the combination of a mandate with a hard cap. First, the total quantity of reductions, which is what the cap enforces, is the same (1,650 tons) in the two cases. Some of the lower-cost reductions from the cap-and-trade program are simply replaced with higher-cost, mandated reductions.
Next, the last few tons of reductions needed to meet the cap would occur at $15, which implies a significant reduction in the resulting price of carbon allowances.
Third, the total cost of the reductions is $46,750, a significant increase in the total cost of compliance (total cost without the mandate was $28,500).
Last, comparing the cost with that in the first example, we can no longer say that a policy with a $15 carbon allowance price is less costly than a policy with a $30 carbon allowance price.
A comparison of the two, simple examples above demonstrates for consumers the negative consequences that can result from additional mandates. The reasons for this somewhat unintuitive result are straightforward. The mandate requires actions that are not preferred under a cap because they are more costly than the price level that would satisfy the cap. In the hypothetical example, if the mandate were a requirement to install a certain quantity of solar-powered generating units (perhaps as part of a solar renewable portfolio standard), then one can imagine the preferred, lower-cost options might be fuel switching from coal to natural gas, adding advanced coal with carbon capture and storage, adding nuclear or adding wind. In this case, the mandate effectively has picked the winner at the expense of lower-cost technologies that could have achieved the same goal of reducing carbon emissions.
Let us look at this from the perspective of a single power generator. Assume that the power generator currently emits 100 tons of carbon. Under a cap-and-trade program, the generator would need to reduce its emissions or purchase allowances for any remaining emissions and has four options to achieve this:
- Improve the efficiency of some existing coal-fired units (cost $10 per ton with potential reductions of 30 tons),
- Replace some coal generation with wind generation (cost $25 per ton with potential reductions of 80 tons),
- Replace some coal generation with solar-powered generation (cost $50 per ton with potential reductions of 70 tons), and
- Purchase carbon allowances at the market price of $30 per ton.
Under a purely market-based regulation, the generator will respond to the $30 market price by undertaking reductions from Nos.1 and 2, reducing emissions by 110 tons, thereby allowing the sale of 10 allowances at the $30 price. The total cost of this option is $2,000 ($10 x 30 + $25 x 80 – $30 x 10). In the second example where the mandate has been added, the generator has to choose No. 3 and then also would undertake reductions from No. 1. The total cost of this compliance strategy is $3,800 ($50 x 70 + $10 x 30). The mandate forced the generator to forego less costly reduction opportunities (No. 2) at the additional expense of No. 3. The lower market price of carbon ($15) removed the generator’s incentive to undertake any reductions under No. 2.
If the goal of a mandate is the same as the goal for the cap-and-trade program–presumably to reduce carbon emissions–then the mandate only serves to add unnecessary costs to be borne by all consumers. In the example above, both policies achieved the same carbon reductions, but the policy that included the mandates did so at a significantly higher cost to consumers. Ironically, market observers would not see evidence of this higher cost in allowance price signals.
Getting back to our original question, is a $30 carbon allowance price more or less costly to the economy than a $15 carbon allowance price? In our example, the $30 carbon allowance price that resulted from a standalone cap-and-trade program is significantly less costly to the economy than the $15 carbon allowance price that resulted from the addition of a mandate to the cap-and-trade program. When answering which policy is less costly, it is no longer sufficient to look only at the carbon allowance price; we must conduct an in-depth, economic analysis to find the total cost to the economy of the policy.
Scott J. Bloomberg is a principal in CRA International’s climate and sustainability group in Washington, D.C. His work is focused on the costs and consequences of state, regional and federal carbon policy and assisting companies in their preparations to operate in markets with uncertain future carbon policy. Reach him at email@example.com.