How to manage carbon prices — Lessons from the Northeast

Recently, the U.S. Energy Information Administration posted a revealing graph that could be interpreted as suggesting that efforts to prevent high carbon prices in the Regional Greenhouse Gas Initiative (RGGI) emissions trading market have failed. RGGI is a consortium of northeastern U.S. states that have agreed to limit the greenhouse gas emissions of carbon dioxide from electric power generation through a regional emissions trading (i.e., cap-and-trade) program. To hold down price escalation, RGGI uses a pioneering Cost Containment Reserve (CCR), which added extra allowances to the program when the price per ton reached $4 this year. But the CCR has been exhausted for 2014 and the price has since risen to $5. A similar mechanism is part of the new California cap-and-trade program, but has not yet been exercised there.

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Rather than demonstrating the CCR's failure to control prices, we believe recent events show the RGGI CCR is working quite well — given the full parameters of the system — and parallels the successful use of a price floor in both RGGI and California. However, details matter, and while the RGGI CCR seems to be working as planned, the California design has raised questions. As more states come to grips with regulating carbon dioxide emissions from power plants under proposed Environmental Protection Agency (EPA) regulations, experience with the RGGI CCR demonstrates the potential to balance emission and cost concerns. But states must still decide how much balance they want and EPA must decide what will be allowed.

RGGI and the price floor

When RGGI was established in 2005, it was designed to reduce power plant emissions in participating states through emissions trading. Every power plant was required to submit an allowance for each ton of carbon dioxide emissions. A fixed number of these allowances were auctioned every quarter and then allowed to trade. Such programs have been used extensively to regulate carbon dioxide and other pollutants in jurisdictions around the world.

A relatively novel feature in RGGI (also included in California's recent carbon dioxide trading program) is a price floor in the auction. Bids below that floor (roughly $2) were not accepted and, if no one wanted to buy allowances at $2, they simply were not sold. Lo and behold, in the midst of RGGI's third year, carbon emissions began falling far below the RGGI cap, primarily because of the dramatic expansion of natural gas supplies and the Great Recession. What happened to RGGI? Allowance prices declined to the price floor and allowances went unsold — 18 percent in 2010 and 48 percent in 2011. California prices have similarly hovered at their price floor (roughly $10) but almost all of the allowances are selling.

By maintaining a positive allowance price and reducing the number of allowances in the market, the program's price floor created incentives for further emission reductions even as outside forces substantially altered the landscape. A $2 price, while small, still creates a $2 per megawatt hour incentive for coal plants to reduce emissions and $1 per megawatt hour incentive for natural gas plants.

At the same time, some observers were critical. Gov. Chris Christie withdrew New Jersey from RGGI in 2011, saying "(t)his program is not effective in reducing greenhouse gases and is unlikely to be in the future. ... The whole system is not working as it was intended to work. It's a failure." Yet the program worked exactly as designed and as economics predicted.

RGGI and the price ceiling

In 2013, the RGGI program made several adjustments as emissions remained far below the established cap and prices sat at the price floor. The emissions cap was shrunk by 45 percent, with a further 2.5 percent decline in the cap each year. A price ceiling was also established, which paired the existing price floor with a corresponding mechanism to limit high prices. This particular mechanism placed additional, above-the-cap allowances in the CCR. A certain volume of CCR allowances is available each year: 5 million in 2014 and 10 million each year thereafter. The CCR is tapped in any auction where the price hits an established ceiling, starting at $4 in 2014 and rising $2 per year until it reaches $10 in 2017. These additional allowances are intended to quench whatever additional allowance demand exists at each year's price ceiling. For a sufficiently large reserve, enough additional allowances will enter the market to precisely limit the price to its ceiling. A small reserve may be exhausted, however, in which case prices can continue to rise above the ceiling. For this reason, an unlimited reserve is often referred to as a "hard" price ceiling and a limited reserve as a "soft" price ceiling.

Like its price floor, RGGI quickly got to test its CCR price ceiling. In March 2014, RGGI held its first auction under the new rules. All 5 million CCR allowances were sold in this quarterly auction, which just cleared the market at the $4 CCR trigger price. With no more reserve allowances available in 2014, subsequent 2014 auctions have cleared at around $5 — above the 2014 CCR trigger price, but below the 2015 CCR trigger price of $6.

What does this tell us? The CCR works as designed. It was not large enough in 2014 to quench demand at the $4 price ceiling. But given that allowances can be banked, it also seems the market expects the $6 CCR price ceiling for 2015 will probably not be breached. If market participants expected prices above $6 in 2015, they would not want to trade allowances for $5 in 2014, given those 2014 allowances can be banked and used in 2015. Research in California suggests their reserve may not be large enough to rein in high prices there, a question that depends on the size of the reserve as well as the price ceiling relative to expected prices.

Ceilings and floors work: What do stakeholders want?

Economists have long recognized that concerns about high or low prices in an emission trading program could be managed in exchange for some variation in emissions. More certainty about prices means less certainty about emissions — that cannot be avoided. But programs can be designed to provide virtually any level of trade-off that stakeholders want — ranging from a hard cap with no price floor or ceiling on the one hand, to a pure emission tax on the other hand. The RGGI experience proves that various trade-offs and combinations in the middle work just as they are designed. As the EPA's new power plant rule is finalized, stakeholders and policymakers (both at the state level and at the EPA) need to decide what they want — more price certainty or more emissions certainty?

Pizer holds joint appointments as a faculty fellow at the Nicholas Institute for Environmental Policy Solutions at Duke University and as a professor in Duke's Sanford School of Public Policy. Murray is director for economic analysis at the Nicholas Institute for Environmental Policy Solutions and research professor at the Nicholas School of the Environment at Duke University. Newell is the Gendell Professor of Energy and Environmental Economics at the Nicholas School of the Environment and director of the Duke University Energy Initiative.