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California Poised to Launch GHG Cap-and-Trade Expansion with Major Design Flaws

As California prepares to launch a major expansion of its three-year-old cap-and-trade program, a new report identifies a series of major design flaws that make the program vulnerable to market meltdowns. The report also offers a number of solutions that would mitigate impacts passed on to California consumers.

On January 1, 2015, California will for the first time include transportation fuels – gasoline, diesel and propane – in the nation’s first carbon emission cap-and-trading scheme. No other state or country in the world has attempted to regulate the sale of gasoline and diesel under a cap-and-trade program.

“Past experience demonstrates the importance of proper design,” writes Jean-Philippe Brisson, a carbon markets expert with the Latham & Watkins law firm in New York and a former Goldman Sachs vice president and commodity trader.  “Market design flaws can result — and have resulted — in catastrophic implications for environmental markets around the globe.”

Mr. Brisson was commissioned by the Western States Petroleum Association to analyze the structure of California’s cap-and-trade program and assess its vulnerabilities prior to the January 1, 2015, expansion.  The program is administered by the California Air Resources Board (CARB).

Mr. Brisson concluded it was essential for CARB to address five major issues before expanding the program “to avoid a situation in which allowance prices spiral upwards.”  These design flaws include:

  • The current structure of the holding limit;
  • The infrequency of auctions;
  • The Air Resources Board’s cost containment policies;
  • CARB’s approach to markets and the rule of law, and;
  • The program’s relationship to impending federal GHG regulations.

The analysis made a comparison to a program in California designed to reduce emissions of oxides of nitrogen and sulfur through a similar, but much smaller, cap-and-trade system.  When demand for electricity soared during the state’s electricity market deregulation crisis, the emission credits created by the program spiked from $2,000 per ton of emissions to more than $60,000 per ton.

”In the context of the California cap-and-trade program, this precedent would be the equivalent of cap-and-trade allowance prices spiking from their current average of $12 to $360,” Mr. Brisson wrote.

“California’s petroleum industry has long supported well-designed market-based programs to reduce GHG emissions – with the emphasis on ‘well-designed,’” said Catherine Reheis-Boyd, President of the Western States Petroleum Association. “Mr. Brisson’s analysis shows what we fear most – design flaws that open the door for the kind of chaos and price volatility we saw in the disastrous attempt to deregulate our electricity markets in 2000 and 2001.”

WSPA has requested that CARB postpone expanding its cap-and-trade program to allow time for the agency to correct the design flaws identified by Mr. Brisson.

“Market design flaws, including those identified in this paper, may lay dormant for a period of time when markets are not under stress, providing a false sense of security to industry and regulators,” said Mr. Brisson. 

“When a program comes under pressure because of unforeseen conditions or simply because the program becomes increasingly stringent over time, latent market design flaws can significantly derail an environmental program, undermining both industries’ and regulators’ investments to achieve environmental objectives.  Accordingly, ARB should address these issues now rather than waiting until the program experiences a significant stress, at which point corrective action may come too late.”

View the entire report here.