Meredith Fowlie (Time to unleash the carbon markets):
This preference for using prescriptive policies –rather than market mechanisms- to coordinate abatement helps explain why carbon prices are so low. Some simple graphs summarize the basics behind this cause and effect.
In the cartoon graph below, each colored block represents a different abatement activity (e.g. coal-to-gas fuel switching, renewable energy investments, energy efficiency improvements, etc.). Think Sesame Street meets the McKinsey curve. The width of the block measures achievable emissions reductions. The height of the blocks measures the cost per ton of emissions reduced.
In this cartoon cap-and-trade story, suppose baseline emissions are 200 and policy makers are seeking a 25% reduction. If we rely entirely on a permit market to get us there, we’d allocate 150 permits and let the market figure out where the 50 units of abatement will come from. An efficient market would drive investment in the lowest cost options: A + B + 1/2 C. The total abatement cost incurred to meet the target would be (20 x $10) + (20 x $20) + (10X$50) = $1100. The market clearing price (and the marginal abatement cost/ton) would be $50.
Now imagine that, in addition to the permit market, complimentary measures are introduced to mandate deployment of options D and E. These mandates take us 80% of the way towards meeting the emissions target. The role of the carbon market has been seriously diminished – we need only 10 more units of abatement to hit the target.
Under this scenario, the carbon market will incentivize investment in 10 units of A. The permit price drops to $10. The total cost of meeting the emissions target rises to 10 x $10 + 20 x $100 + 20 x $150 = $5100. And we wring our hands about low carbon prices and broken carbon markets.
Of course, this cartoon picture omits lots of real-world complexities (see this important EI paper for a more detailed analysis of California’s abatement supply and allowance demand). But it illustrates two real-world considerations. First, when complementary measures mandate relatively expensive abatement options, the carbon price we observe in the market will not reflect the marginal cost of reducing emissions. Second, a reliance on complementary measures to reduce emissions can significantly drive up the costs of hitting a given emissions target.
In California and in Europe, there is growing evidence that low allowance prices in the carbon market belie much higher abatement costs associated with complimentary policies. For example, this paper estimates that the California Solar Initiative delivered emissions reductions at a cost of $130 – $196 per metric ton of CO2. California’s LCFS credit price (which reflects the marginal incentive to reduce a ton of MCO2e) is currently averaging around $120 per metric ton CO2. In Europe, researchers estimate that the implicit costs of renewable energy targets per metric ton of CO2 are on the order of hundreds of euros for solar (and wind in some locations).
