Leakage from Sub-national Climate Policy: The Case of California's Cap-and-Trade Program.

• Author: Caron, Justin
• Position: Report

1. INTRODUCTION

Leakage occurs when greenhouse gas (GHG) restrictions in some regions increase emissions elsewhere. Climate policies can cause leakage via their impacts on trade, fossil fuel prices and factor movements. Leakage via the trade channel occurs when relative price changes induce substitution away from production in carbon-constrained regions and towards imports from unconstrained regions. The fossil fuel price channel is generally thought to increase emissions in unconstrained regions, as climate policies reduce fossil fuel prices and increase energy consumption in these regions. However, as noted by Burniaux (2001), if the supply of coal is more elastic than the supply of less carbon-intensive fuels, climate policies may reduce emissions in unconstrained regions (i.e., result in negative leakage). Negative leakage can also arise if energy efficiency improvements induced by the policy cause factor migration from unconstrained regions to constrained regions (Fullerton, Karney and Baylis, 2011).

The mechanisms behind leakage from national climate policies have been thoroughly investigated in the existing literature. The case of sub-national policies, however, is different in that traded good markets are more integrated at the national level than at the international level. Indeed, numerous gravity-based empirical exercises have found national borders to inhibit trade. Many studies including McCallum (1995) and Anderson and van Wincoop (2003) identify a strong "border effect" causing trade between U.S. states to be considerably larger than trade between states and Canadian provinces. Sub-national climate policies should thus suffer from larger domestic leakage rates than what is usually estimated across national borders, as trade flows more freely between states. However, there is evidence that state borders also limit trade (Wolf (2000), Coughlin and Novy (2011)) and that economic activity is very local, a fact that should limit estimates of domestic leakage. We provide a framework which captures both of these effects.

With federal initiatives to curb GHGs stalling in the U.S., sub-national polices have received greater focus.(1) To date, two regional cap-and-trade policies have been legislated in the U.S. First, 10 states in the northeast are members of the Regional Greenhouse Gas Initiative (RGGI). The program, which began on January 1, 2009, sets state-level caps on electricity emissions and allows trading of emission permits among states. Second, a cap-and-trade program on emissions from electricity generation and certain industries has operated in California since the beginning of 2013. Transport and other fuels will be included in this program from 2015, by which time the cap will cover an estimated 85% of California's GHG emissions sources. In addition to restricting emissions from in-state production, the policy requires permits to be surrendered for emissions embodied in imported electricity. At the time of writing, California's policy is the only economy-wide cap-and-trade program to be enacted in the U.S. and is set to become the second largest carbon market behind the EU Emissions Trading Scheme (ETS).

In this paper, we use a calibrated general equilibrium model to examine the leakage implications of sub-national climate policies using California's cap-and-trade program as an example. Moreover, legislation in both California and the EU allows for their programs to be linked with other systems and we accordingly investigate the effects of allowing trading of permits between California and the EU.

General equilibrium assessments of leakage from federal policies commonly estimate leakage rates between 10% and 30% (see, for example, Felder and Rutherford, 1993; Bernstein et al., 1999; Babiker and Rutherford, 2005; and Copeland and Taylor, 2005). Relatively few studies have focused on leakage from sub-national initiatives. One exception is Sue Wing and Kolodziej (2008), who consider the RGGI using a multi-state computable general equilibrium (CGE) model of the U.S. economy. The authors estimate that 49-57% of emissions abated by RGGI electricity generators will be offset by unconstrained sources. A shortcoming in the framework employed by Sue Wing and Kolodziej (2008) is that states source intranational imports from a national pool of exports. Additionally, as the authors do not track trade flows between each state and the rest of the world, their framework is unable to consider leakage to international sources.

Our point of difference is the calibration of the model to a dataset which includes 15 U.S. states or aggregated regions and 15 countries or regions in the rest of the world. The model tracks bilateral trade among all regions, including trade among U.S. regions and trade between U.S. regions and international regions. Due to its detailed treatment of trade flows, our model is ideally suited to examining leakage from sub-national climate initiatives in an economy-wide setting.

Several studies have investigated leakage from sub-national climate policies in the U.S. employing a partial equilibrium analysis. Fowlie (2009) analyzes leakage from an incomplete, market-based regulation of carbon dioxide (C[O.sub.2]) emissions in California's electricity sector using a stylized partial equilibrium, asymmetric oligopoly model. She finds that regulation that exempts out-of-state producers achieves approximately one-third of the total emissions reductions achieved under complete regulation at more than twice the cost per ton.

Bushnell and Chen (2012) use a model of the electricity sector for the western U.S. to examine the impact of alternative cap-and-trade designs. They find that an emissions cap only in California results in substantial leakage to other states. Chen, Liu and Hobbs (2011) simulate a market equilibrium model for electricity markets, transmission limitations and emissions trading. They find that total emissions reductions due to California's cap-and-trade policy are essentially zero when there is resource shuffling and that preventing resource shuffling results in a significant increase in the carbon price. Chen (2009) uses transmission-constrained electricity market models with an exogenous C[O.sub.2] permit price to investigate C[O.sub.2] leakage (and N[O.sub.x] and S[O.sub.2] emission spillovers) from the RGGI cap-and-trade program. His key result is that a larger C[O.sub.2] price is associated with higher allowance prices, but that leakage rates are falling with the C[O.sub.2] price. (2)

This paper has five sections. The next section provides an overview of California's cap-and-trade program. Our modeling framework is outlined in Section 3. Section 4 outlines our scenarios, discusses results and reports findings from a sensitivity analysis. Section 5 concludes.

2. CALIFORNIA'S CAP-AND-TRADE PROGRAM

California's Global Warming Solutions Act of 2006, Assembly Bill 32, was signed into law on September 27, 2006. The bill required the California Air Resources Board (CARB) to develop regulations and market-based measures to reduce California's GHG emissions to 1990 levels by 2020. The primary emissions reduction tool in the bill is a cap-and-trade program for GHG emissions. The CARB has finalized details of a cap-and-trade program on October 20, 2011 and the legislation was approved by the California Office of Administrative Law on December 13, 2011.

The legislation covers emissions of major GHG gases, including C[O.sub.2]. The first phase of compliance for the program began on January 1, 2013. Covered entities in the first phase include electric utilities, electricity importers, and industrial facilities that emit 25,000 metric tons or more of carbon dioxide equivalent (C[O.sub.2]e) annually. Industrial sources covered by the policy include petroleum refiners, producers of cement, iron, steel, glass and lime, and pulp and paper manufacturing.

Requiring allowances to be turned in for the emissions embodied in imported electricity is similar to imposing an electricity tariff. According to the legislation, emissions embodied in imported electricity are calculated as the sum of emissions from "specified" and "unspecified" sources, with adjustments for electricity from eligible renewable sources, electricity that is imported and exported during the same hour, and electricity from regions with a cap-and-trade policy linked to California's. A specified source is a particular generating unit or facility for which electricity generation can be confidently tracked. As a component of embodied emissions are traced back to emissions from individual generating units, a deliverer of electricity to the Californian grid could reduce its C[O.sub.2] liability by sourcing low-emissions electricity from a new source and diverting high-emissions sources previously sent to California to other states. However, such actions may be prevented by regulations that prohibit "resource shuffling", which is defined as "any plan, scheme, or artifice to receive credit based on emissions reductions that have not occurred, involving the delivery of electricity to the California grid" (CARB, 2011, p. 38). As enforcing the bill's resource shuffling regulations may require California to sanction importers based on actions by out of state third parties, the resource shuffling legislation raises several legal issues (Linklaters, 2011).

The second phase of compliance will commence on January 1, 2015 and will expand the set of covered entities to include an estimated 85% of California's GHG emissions, including emissions from transportation fuels, natural gas and other fuels. The legislation allows limited use of approved offset credits in lieu of allowances. Economic analysis by the CARB indicates that offsets will account for a maximum of 49% of emissions reductions and, due to tight eligibility restrictions, offset usage may be much less (Mulker, 2011). At the program's inaugural auction in November 2012...