Our Impact: Cap-and-Trade Program Design

Nicholas Institute Pioneers Policy Tool to Balance Carbon Emissions and Allowance Prices for Cap-and-Trade Programs

This is the first in a 12-part series highlighting the environmental policy impacts of the Nicholas Institute for Environmental Policy Solutions over its first decade.

The death knell for greenhouse gas emissions trading appeared to have tolled in the United States when legislation for a federal cap-and-trade system failed in 2010. But, a pioneering element of this policy tool—the allowance reserve—survived to play a critical role in two landmark emissions trading programs: the Northeast’s Regional Greenhouse Gas Initiative (RGGI)—the country’s first regional cap-and-trade program designed to reduce power plant emissions—and California’s cap-and-trade program, the country’s first to cover multiple economic sectors.

The allowance reserve concept was developed by Tim Profeta, Brian Murray and Billy Pizer at Duke University’s Nicholas Institute for Environmental Policy Solutions and by Richard Newell of the Duke University Energy Initiative.

The key challenge for any cap-and-trade system, according to the researchers, is preventing emissions allowance prices from rising beyond the reach of potential purchasers.

“It’s critical to keep prices in a comfortable range,” said Murray. “By setting aside a number of allowances (the reserve) and incorporating a supplemental auctioning process to distribute them when the price per emission begins to rise, you hold down price escalation.”

To avoid that hazard, RGGI officials turned to the Nicholas Institute. Murray testified on several panels convened by the RGGI board to explain how the allowance reserve system makes emissions trading sustainable, efficient, and cost-effective—a necessity for creating a cap-and-trade program palatable to industry, environmental advocates, and the general public. RGGI subsequently instituted a cost containment reserve (CCR).

In 2012, Murray was asked by the California Air Resources Board (CARB) to provide recommendations on the design of an allowance reserve component for its cap-and-trade system. The next year, California’s program, the world’s second largest behind the European Union’s Emissions Trading System, adopted the reserve concept.

As states figure out how to comply with the U.S. Environmental Protection Agency’s proposed Clean Power Plan (CPP), there has been renewed interest in emissions trading. And, although no one has offered a specific proposal to use a carbon allowance reserve—a decision that would be left to individual states—there will still likely be interest in the balance between emissions reduction certainty and allowance price certainty that an allowance reserve can provide.

“Emissions trading programs can be customized to tradeoff price and emissions uncertainty, alleviating concerns about high or low prices by allowing for some variation in emissions,” said Pizer. “As the RGGI experience shows, more certainty about prices means less certainty about emissions—and vice versa. In 2010–2013, RGGI’s price floor reduced the emissions cap rather than allowing particularly low prices, and in 2014 RGGI’s allowance reserve increased the emissions cap rather than allowing particularly high prices. The ability of RGGI officials to tailor emissions certainty and price certainty, a key value of an allowance reserve structure, has been important to RGGI stakeholders. The allowance reserve has worked exactly as designed.”

Since 2009, emissions of carbon dioxide and other pollutants in RGGI states have declined 40 percent. The 2014 RGGI cap of 91 million tons represented a 45 percent reduction in the cap, which will decrease 2.5 percent each year from 2015 to 2020. By 2020, power plant CO2  pollution in the nine RGGI states is projected to be half of 2005 levels.

On the other side of the country, the California cap-and-trade system projects reducing greenhouse gas emissions from regulated entities in multiple sectors by more than 16 percent between 2013 and 2020.

To date, the state looks to be on track to meet its broader goal of reducing CO2 emissions to its 1990 levels by 2020. Since launching state-run auctions in late 2012, California’s program has sold more than $2.27 billion of CO2 allowances, which are being allocated to alternative or renewable fuel projects, along with other state projects.

California has set up an emissions trading market with Quebec and is seeking to broaden the partnership to include other Canadian provinces as well as U.S. states, an effort in which it is enlisting the counsel of Murray, who will spend early 2015 at the University of Ottawa working with Canadian policy makers.

The Nicholas Institute’s relationships with policy makers assessing emissions trading options have been forged not only through work on the policy design aspects of trading but also through subsequent efforts to analyze implementation of CO2 emissions control under section 111(d) of the Clean Air Act (CAA). The Nicholas Institute is using its CAA expertise to identify cost-effective strategies for reducing emissions while also addressing other energy sector challenges and informing the climate policy debate in the United States.

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--Story by Melissa Edeburn