California on Wednesday will take a big step forward to promote clean air, as it holds its first auction to sell permits for carbon emissions in a move that will get the world's second-biggest carbon market off the ground.
Known as cap-and-trade, the program is the nation's first to extend economy-wide and will eventually encompass the electrical, industrial and transportation sectors responsible for 85 percent of California's carbon pollution.
Several successful emissions trading programs already exist. After a career of studying these programs, I find the California program will be the best-designed program in the world to date, and is likely to influence the design of emerging programs in Australia, South Korea and even China. Three features of the program deserve attention.
First, California has provisions to manage costs. The program allows for banking of emissions permits over time and for the limited use of emissions reductions, known as "offsets," outside of the regulated industries if they are less expensive. It also has a reserve of emissions permits that will be introduced to expand the supply of permits if their price rises to a very high level.
These provisions guard against prices that might become too high, but the experience common to virtually every previous trading program actually is that the price falls to a very low level. Although low prices can be good news, prices that are too low tend to undermine the incentive to make investments in innovation and punish early investments that have already occurred. Importantly, California has adopted a price floor to ensure that the incentive to innovate and invest does not erode over time.
Second, following the recommendation of a group of economists and other experts who served as an advisory committee to the state in 2010, California's program has a central role for an auction. In some previous programs, all of the emissions permits were given away for free. However, since permits can be sold in the market they have value, and firms can be expected to charge their customers for the use of permits by passing through their value in the price of electricity and other products. The result can be an increase in revenues for the firm that greatly outstrips the increase in costs, resulting in unfair profits.
To avoid this problem, other programs – including the world's largest, in the European Union – have moved to the use of an auction to distribute emissions permits. An auction has other advantages as well. It is transparent, so it helps expose potential market manipulation. It also makes the decision about the allocation of permit value explicit, hopefully leading to more efficient and equitable outcomes that are worthy of public support.
The third feature is the use of the value associated with emissions permits, and in particular the way the decisions have been achieved. Some permits are awarded for free to firms, but only if it is necessary to protect them from out-of-state competitors. This careful design preserves as much of the value as possible for investment projects related to the goals of the program, including protection of disadvantaged communities.
The important thing for citizens is that the designation of this value is happening in a public process. Arguments are sure to ensue about how to invest this money, but that is as it should be, and it beats the alternative, which would have these decisions made by private interests in closed rooms.
Although climate disruption is a global problem, its effects are felt locally and are likely to be quite serious in California if not addressed.
This provides the incentive for the state to take action and to encourage others to follow. But as important to Californians is the expectation that the state has a smart policy design and a transparent process, which reinforces the notion that in fact we are all in this together.