Market Forces

This article was originally posted at California Dream 2.0.

Following today’s California Air Resources Board’s (CARB) board meeting, the next major milestone in California’s efforts to reduce greenhouse gas (GHG) emissions is on November 14^th, when California will hold the first auction of carbon allowances for the Global Warming Solutions Act (AB 32) cap-and-trade program. EDF has closely followed the steps CARB has taken to prepare, including participating in their successful “practice auction” this past August.  In order to shed some light on the nuts and bolts of how these auctions will work and the process going forward, we’ve put together an Auction FAQ factsheet to help answer some basic questions.

Why is CARB Auctioning CO2 Allowances?

In terms of allowance distribution, the AB32 program includes a combination of free allocation and auctioned allowances.  While it is the cap that ensures that the targeted quantity of emission reductions are achieved – regardless of the choice of type of allowance distribution – there are important differences between auctioning and free allocation relating to issues such as transaction costs, market power, price certainty, and distribution of allowance value.

Perhaps most importantly, auctioning allowances creates proceeds that can be invested in a variety of ways to further the goals of AB32 – for example, financing emission reduction projects in either capped or uncapped sectors, keeping energy prices down, or preparing for the impacts of global warming.  In addition, twenty-five percent of proceeds are actually required to be used in ways that benefit disadvantaged communities.

Another advantage of auctioning CO₂ allowances is that it guarantees that all regulated entities have access to allowances on an equal footing. By holding an auction, California ensures that both large and small companies have access to allowances under the same terms, thus reducing the risk that the market becomes dominated by a few big players.

How the Auction Works

The California auction will be using a single-round, sealed-bid, uniform-price format. Under this format, companies submit confidential bids for a specific amount of allowances at specific prices (also called a bid schedule). The highest bidder is allocated their requested quantity of allowances first, then the second highest bidder, etc., until there are no more allowances.  Winning bidders receive the quantity of allowances they bid for at the uniform settlement price, which is determined as the value of the lowest winning bid – or more simply, the price at which the market clears. Regardless of their original bids, all winning bidders pay the same price. This auction format creates a clear market price, which is crucial for investors.

Using Auction Revenue to Further Emissions Reductions

There are abundant opportunities to invest the auction proceeds into sectors that deliver greenhouse gas reductions in California – from clean energy to clean transportation, energy storage and clean tech finance and investment. Not only do these investments further California’s greenhouse gas reduction goals, they can also provide considerable economic benefits, as well as substantial health co-benefits, while helping set California’s path towards sustainable economic growth. To learn more about investing AB32 auction proceeds to grow California’s clean economy, read the EDF Invest to Grow report.

Auctions will play an important role in California’s cap-and-trade program; they encourage a more stable market and create proceeds that can be used to make California’s efforts to cut climate change pollution even more effective. For more details about how the auctions are designed, how the bidding process works and what to expect on November 14th, see EDF’s Auction FAQ factsheet and the California Air Resources Board’s website (here).

By Emily Reyna. This article was originally posted at California Dream 2.0.

Last Thursday, California took an important step towards finalizing a major component of the state’s effort to cut climate change pollution, an economy wide cap-and-trade regulation that establishes a price on carbon pollution.  Along with an expert from EDF’s economics team, Jonathan Camuzeaux, I had the opportunity to participate in the first ever public “practice” auction for the Global Warming Solutions Act cap-and-trade program – and it was a runaway success.

The goal of yesterday’s practice was to test the new online exchange where users will be able to bid on “carbon allowances” starting in November of this year.

EDF decided to submit the paperwork to be among the first users to test the new auction system since there is a lot riding on the cap-and-trade program working. Once fully operational, California’s cap-and-trade market will introduce the most cost-effective way to reduce climate pollution, protect public health, and spur clean tech innovation.

Here’s how it worked:

During the practice auction we walked through a checklist of 33 tasks EDF designed to test the functionality of the system. What we found was that the auction system run by the California Air Resources Board (CARB) works much like other secure websites, such as that of an on-line bank or retailer.  Users sign in with a secure username and password and during the pre-determined open hours (bidding window), bidders place an order for as many emissions allowances as they want to buy, though only a certain number will actually be sold.  Bids from other organizations are rightfully kept private and hidden from view – making this a “sealed-bid” auction platform that is based on the system designed and currently in use in North America’s other cap-and-trade program for greenhouse gas (GHG) pollution in the Northeast.

During the bidding window, users were free to modify or rescind bids.  Once the bidding window closed all bids were final.  Since yesterday was only practice though, no money was actually exchanged or allowances sold once the bidding ended.

Our assessment:

From top to bottom, the AB 32 cap-and-trade auction system was easy and straightforward to use. Though we witnessed a few minor annoyances – such as being able to upload multiple bids at one time but only being able to delete one at a time – all of the market critical aspects were running well from our vantage point.  The next step will be for CARB to evaluate the bids and determine which are accepted and rejected based on the publically available market rules.

In all, after three hours of testing, our consensus is that the system works, and works well. California is ready to launch a new era of innovation, job creation, and economic stability. It is inspiring to see California taking climate action, and we believe success here will inspire other states, regions, and nations to develop similar climate programs.

By Jamie Fine, PhD and Ruiwen Lee

Jamie Fine is EDF’s Senior Energy economist, and a graduate of UC Berkeley’s Energy Resources Group; Ruiwen Lee is an economics fellow and graduate of Princeton University’s Woodrow Wilson School of Public and International Affairs. Originally posted on EDF’s California Dream 2.0 blog.

California’s energy and climate change policies have saved the state over one hundred billion dollars and dramatically reduced levels of environmental pollution since the early 1970’s. Yet these policies have been in the crosshairs of industry for decades, despite their demonstrated success. It’s not surprising that the latest study sponsored by the state’s main manufacturing lobbying group, the California Manufacturers and Technology Association (“CMTA”), ignores the achievements of these landmark policies while attempting to downplay the benefits of new laws that protect human health and the environment.

EDF’s team of economists looked behind the curtain of CMTA’s most recent tirade against clean air laws and found cherry-picked assumptions, secret modeling calculations, and confusion over basic economic principles. Accordingly, while CMTA’s new report maintains that it modeled the impacts of California energy and climate policies on the state’s economy, the results more closely resemble CMTA members’ manufactured products than actual economic analysis.

Cherry-picked data – CMTA’s report is based on the impact of seven different policies currently underway in California:  The 1) Low Carbon Fuel Standard (“LCFS”), 2) Pavley II car standards, 3) SB 375, 4) the Renewable Portfolio Standard (“RPS”), 5) Combined Heat and Power (“CHP”) standards, 6) new efficiency measures, and 7) the Global Warming Solutions Act of 2006 (“AB32”).

Though these policies have been carefully designed and the economic impacts studied, modeled, re-studied, re-modeled, and peer reviewed, the report’s analysis assumes significantly lower benefits and higher costs than nearly every other peer-reviewed analysis that currently exists.  With these new assumptions, each described in a mere sentence or two, the goal seems to have been to engineer a flimsy model that puts AB32 into a bad light.

Even more subtle assumptions are not immediately obvious at first glance. For example, in the electricity model, the report uses a simplistic “average change in electricity demand”, based on the ten-year historical decline in electricity use per unit of state output, to project future electricity demand.  However, this model does not consider the reduction in electricity demand from the energy efficiency measures that have only recently been implemented, or yet to be imagined by innovators – meaning the modeling output undercounts savings from day one.

In addition, this model is posing extremely pessimistic assumptions about new transportation fuels and the California LCFS.  These same assumptions are at the heart of a recent oil industry report, and fail to take into account policy-inspired innovation that will lead to newer transportation fuels in adequate supply.  As previously discussed here,  here and here, these pessimistic assumptions aren’t grounded in the reality of market incentives for innovation, making the CMTA report eerily similar to other oil industry “sky-is-falling” reports – this one just has a different cover.

Finally, like other faulty anti-AB 32 analyses that have been debunked, this newest CMTA piece fails to take into account the full range of benefits that can be achieved by implementation of California’s regulations.  For example, the analysis only calculates the costs to carbon-intensive commodities, ignoring the positive demand impacts on clean products and services.

Secret modeling calculations – The output presented in this new paper is based on an internally designed model that claims to weave together “24 interacting models that measure the combined impacts of AB 32.”  However, nothing more is presented than a few spreadsheets of model output and some graphs.  This amounts to a clear admission that the model simulated the operations of an entire economy and then offered the output as fact, without any discussion of range or uncertainty.  Simply put, CMTA’s new report says, “trust me” even though the findings are vastly different from prior, peer-reviewed scholars.

Confusion over basic economics – The principles that underpin cost analysis, though complex, are fundamental to the accuracy of the overall output of economic models.  In this report, CMTA has apparently gotten some of those basic principles backwards, meaning that the modeling results are likely to be fundamentally flawed.

For example, in the description of their direct cost estimation model for electricity, the report wrongly concludes that, “the cost of electricity is decreased by efficiency measures, which drives up demand.” In fact, it is the other way around – efficiency measures shift the demand curve down (given any electricity price, consumers use less electricity than before efficiency measures are implemented), so the cost of electricity is decreased, even as the quantity of electricity consumed is further reduced.

Model inconsistencies – In another area of the report, where it separately modeled electricity and natural gas price and demand impacts, it appears there is double counting and inconsistent assumptions due to confusion over the linkages between commodities markets. For example, even as the report predicts electricity generation from natural gas will decrease by 40% from 2012 to 2020 (Appendix D-6), overall natural gas demand will increase by 6% over the same period (Appendix E-1).  A simple question underpins the potential error of these inputs: when so much electricity is currently made using natural gas, how can the state reduce its use in the power sector by 40% while using so much more in the aggregate?

In yet another example, the report purportedly uses a simple summation of impacts (Appendix C-2) from modeling outputs to calculate policy “costs”.  However, since at least some of the commodity markets that have been analyzed are substitutes for one another, a simple summation method will almost certainly result in double counting. The report doesn’t make clear which commodity markets were modeled based on direct cost estimations, and which were separately modeled based on aggregated data – a wholly separate problem from the one described above.

The bottom line is, this report is deeply flawed in its analysis and its presumptions. If your summer reading list includes fiction, then by all means take the time to read it. But if you are looking for a well-documented and peer-reviewed examination of California’s anti-pollution laws, this report doesn’t make the grade.

For more information on modeling AB 32 policy and the overall benefits of AB 32 implementation, read here and here.