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Investigation of the Effects of Emission Market Design on the Market-Based Compliance Mechanism of the California Cap on Greenhouse Gas Emissions

Report released by the University of Virginia PEAR Project Team on Feb. 18, 2013, co-authored by Charles Holt, PhD, Chair, Economics Department, Professor of Economics and Public Policy and William Shobe, PhD, Professor of Public Policy; Adjunct Professor of Economics; Director, Center for Economic and Policy Studies, Weldon Cooper Center for Public Service

UVAToday article by Brevy Cannon

Read full report here:Final Report.pdf

Executive Summary
• In January 2013 the California Air Resources Board (ARB) launched the world’s first economy-wide greenhouse cap and trade system. The state’s experience with electricity deregulation convinced ARB of the need to add unique design elements aimed at preventing:
‒ buyers from gaining dominant market positions that could give rise to undue market influence, for which ARB specified a ceiling on the maximum number of allowances one company could maintain (“holding limits”); and
‒ excessive price volatility for California carbon allowances that would disadvantage the state’s consumers and businesses, leading ARB to set aside a reserve of allowances to be sold at pre-established prices (“allowance price containment reserve, or APCR”). In addition, some economists have urged ARB to keep allowance prices from rising above the third tier of the APCR, which would effectively impose a “hard cap” on allowance prices.

• The holding limits and APCR provisions have been criticized for potentially creating their own problems, which could hinder the development of the California carbon market. In addition, concern has been expressed over the viability of these features during randomly occurring periods of especially high demand for emission allowances (e.g., years of low hydroelectric power availability.)
‒ In our analysis, we studied the impact of ARB’s program design on market behavior using experiments with student subjects in carefully controlled laboratory settings and simulations with experienced professionals in a richer but less controlled market setting.
‒ These complementary methods generated mutually reinforcing results but also provide added information about what factors might be driving the results.

• In both our experimental sessions and market simulations, we were able to detect patterns of differences attributable to the imposition of holding limits and the APCR on four key indicators of market performance, including 1) price discovery, 2) efficiency, 3) volatility, and most critically, 4) liquidity, which is regarded by many economists as the key factor in defeating market manipulation.

• In summary, we found that holding limits can have a significant negative impact across the board on each of the four market performance indicators. Tight holding limits (those that constrain normal operations of entities with large obligations) contribute to reduced liquidity, higher price volatility, less effective price discovery, and lower efficiency.
‒ Much of this effect occurs through reduced banking of allowances in holding accounts, which is critical given that the ability to bank reflects sources’ flexibility to manage risk and to mitigate the effects of increasing scarcity over time.
‒ The resulting reduced banking also translates into delayed reductions in greenhouse gases.

• Our results suggest that an APCR serves a useful function for emission markets. APCR did change subject behavior by lowering their risk of large price spikes. We found that subjects resorted to the APCR as structured by ARB more frequently and used it in different ways than we expected, both as a price insurance mechanism viewed by participants as a “seller of last resort” 1 and as a source of “borrowed” allowances used to hedge against future scarcity.
‒ In experimental sessions, subjects used (primarily) lower price tiers to smooth2 anticipated long-term scarcity and short-term risk of price spikes. The patterns of reserve use observed indicate that allowances available for direct purchase may have a value apart from what would be gained from selling additional allowances into the auction alone.
‒ In the professional simulations, we saw participants buy allowances to meet unfulfilled compliance obligations when close to a compliance deadline, even when market prices were well below the threshold tier prices.

• We conclude that the unexpected uses of the APCR in our experiments and simulations justifies further research into different forms the APCR could take, including its possible combination with other tools such as in-auction release of reserves or a hard price cap.

• There are still unresolved issues regarding the impact of California cap and trade market design elements. While our work focused almost exclusively on the electricity sector, the prospect in 2015 of inclusion of vehicle fuels under the cap represents a huge shift in allowance demand for the sector.
‒ From 2013–2015, our refiner test portfolio goes from being responsible for its direct carbon emissions to the carbon content of gasoline (a multiple of nearly 7.0 times),
‒ while its holding limits and limited exemption are based on its reported direct emissions.