Might mess around and do a long thread explaining what "went wrong" with California's May cap and trade auction and how a person might "fix" it. Does the world need/want this?

Ok wow alright I'll do it.

First a disclaimer or two. Some of you may know that I have advocated in the past both to reauthorize CA's cap and trade program and for it to look a little different from how it looks now. This thread isn't rehashing any of that or pushing any particular changes right now.

You may also have heard that this year's CA budget proposal from the legislature includes language that would require the administration to look into some questions about C&T design. This thread isn't about that either.

Ok so let's start here: the idea that something "went wrong" in the May cap and trad auction. Those scare quotes are there bc whether something went wrong or whether the system did exactly what it should depends on what you want our C pricing system to do.

Nothing "goes right" in a pandemic and global depression. So the fact that the auction proceeded and the money didn't disappear on a plane to parts unknown is itself something of a victory.

But what did happen is that an event that many expected (pre-COVID) to deliver $300m or so to the state budget only delivered $25m.

We don't yet know how big the emissions reduction associated w the pandemic was that quarter, but it was certainly less than like 90%+. So what gives?

Let's say I run a ... widget factory. My company is called ... CarboCo. We are a family here at CarboCo. A family that generates 10million tons of carbon a year. 1 ton for every widget. We sell 10million family-friendly widgets every year for god and country.

CarboCo recognizes that we are in this together.

Anywhoozle: I digress. This is also a good time for another disclaimer: I'm gonna simplify a lot of stuff and use fake numbers for illustrative purposes from here out.

I'm also going to revise CarboCo's annual output to 12m widgets/toms of CO2 to avoid having to use decimals a couple tweets from now.

Ok so in a normal year, I put out 12mmtco2e. I have to surrender 1 cap and trade allowance per ton. But the state gives me 10M allowances for free to start out.

One way to think about why the state might do this is that our goal is to reduce carbon about 4% a year, so if CarboCo is beating that average, then great! Mission accomplished, no additional regulatory burden needed.

I'm gonna skip about 30 tweets worth of discussion here, but note that, if I could find a buyer, and if I have a bad year in widgets, I could sell those free allowances that I got for free to a third party. They have value and were given to me by the public.

Some would call that a subsidy.

Ok so here I am at CarbCo. I own 10M free allowances. In Q1, Q2, and Q3, I put out 9M tons CO2. In Q4, COVID hits. The widget market collapses and I only sell 1/3 of my normal quarterly. I.e.: I put out 1M tons of carbon, not 3M in Q4.

So I went into Q4 expecting to buy 2M allowances, but instead I buy zero.

Let's say my output only falls 1/3 instead of 2/3. I should be buying 1M tons, right? Not exactly.

I'm allowed to bank allowances, too. Maybe I have a bunch in reserve. First I burn through those. Then I go to the secondary market, where other companies are selling at a lower price than I can get at the auction reserve price.

So before I buy *any* allowances at the auction, I first go to my free allowances, then my personal stockpile, then the secondary market, and only as a last resort to the auction itself.

So that's part one of what "went wrong." There were just plenty of other places to get allowances free/cheap. So a dip in my demand of 1/3 could pretty easily result in a dip in my purchases at action of almost 100%.

Part two.

This part is much shorter. A lot of allowances are given to electric companies on consignment. This means the money from their sale goes back to the utility for specified purposes, instead of going to the state.

These allowances fund the California Climate Credit that exists on your electric bill, shows up without you expecting it, and you probably don't notice unless one month you're like "oh weird my electric bill is way lower for some reason."

It's a way of doing revenue recycling that makes sure no one notices the benefit they are receiving, so you get zero political goodwill out of it. Like the Obama stimulus that gave us all like ten dollars more per paycheck instead of one big fancy check.

Anyway.

Those consigned allowances get sold first at auction. The state only gets to sell allowances after the utilities sell out of theirs.

God this is taking a long time. Sorry, but you were very warned.

Ok but so this is factor two that magnifies the state's exposure to volatility in the carbon market: we only see revenue the margin of the marginal tons after all other sources are exhausted.

So let's circle back to the beginning now: is this what you want or expect the cap and trade market to do? Maybe. But I'm guessing that for most people who are aware of its existence but not the details, it is not the expectation.

Put another way, when you hear that CA has a carbon price that supports climate related investments, do you assume that a 30% reduction in demand during a bad quarter should result in a 95% drop in state revenue?

There are reasonable arguments that this should be your policy preference, like that the primary purpose of the market is a marginal emissions nudge, not a revenue generator.

But there are also good reasons for wanting to reevaluate it. For one thing, it's really hard to budget with so much exposure to uncertainty. Remember this is not normal uncertainty -- it's extra extra uncertainty.

And when what you are budgeting for is stuff that doesn't have another revenue source, that means those programs and investments are the most exposed of any in the budget. Effectively, they are the state's lowest budget priority.

And maybe they should be, but if you see them as essential, you may want a different program design.

Ok so Part 3.

If your goal is to reduce the state's exposure to volatility in the carbon market, but continue pricing carbon. what could you change?

You could give away a lot fewer allowances. You allow less allowance banking. You could increase the reserve price. You could develop an alternative formula for selling consigned vs. state-held allowances.

You could also do a carbon tax, but keep in mind that your carbon tax will have lots of arcane design features, too, that will have the effect of allocating risk and cost among the public and various for-profit entities. You still have to answer the same questions.

So let's wrap it up: what went wrong? The problem as I see it is that state programs that benefit the public directly take a disproportionate financial hit in the current system. This quarter exposed that vulnerability.

If you want to fix it, you could fund those programs in a way that doesn't live or die on cap and trade auctions, or you can reduce their exposure to risk in the auctions. Or you can keep the status quo and accept that exposure as an active policy preference.

Ok that's it. I'll answer some questions if you for some reason read this far and weirdly want more.