Climate Bill Analysis, Part 6: Strategic Reserve May Allow "Cap" to Rise by 10 Percent

Every climate bill, in the U.S. and abroad, contains provisions limiting how high carbon prices established by the policy can rise. The Waxman-Markey American Clean Energy and Security Act (ACES) is no different. As the Breakthrough Institute previously reported, ACES would allow polluters to purchase up to 2 billion tons per year of relatively cheap carbon "offsets," which could allow emissions in supposedly "capped" U.S. sectors to rise by up to 9% between 2005 and 2030. The EPA predicts that, largely due to the extensive use of offsets, carbon prices will remain less than $20 per ton of CO2 for the next decade.

Many proponents of ACES have argued that U.S. polluters will not utilize the 2 billion tons of authorized carbon offsets each year. The supply of credible offsets is limited, they say, and demand will eventually push their price above the cost of most alternative emission reduction strategies. (For now, let's put aside the fact that those same price pressures -- and the industries and sectors that stand to profit from selling more offsets -- will also be a powerful force for establishing weaker offset certification standards.)

However, even in the case where affordable offsets are unavailable, and emission allowance prices rise, ACES contains an additional cost containment provision that could allow U.S. global warming pollution to exceed the supposed emissions "cap" -- and "make up" for these additional emissions by purchasing several billion more tons of carbon offsets.

If allowance prices rise too much in any given year, this provision, known as the "strategic allowance reserve pool," would allow polluters to delay their emission reductions by purchasing emission allowances from the reserve pool, which would then be "refilled" over time with additional international forestry offsets. Based on our analysis, this provision could allow U.S. emissions to rise 10% above the "cap" in any year after 2016 and introduce up to 9.3 billion additional offset allowances between 2012-2050.

Therein lies a Catch-22 of ACES: if the annual use of up to 2 billion tons of offsets permitted by the bill is limited due to a restricted supply of affordable offsets, the government will pick up the slack by selling reserve allowances, and "refill" the reserve pool with international forestry offset allowances later. Here's how it would work (defined in section 726 of the bill).

The strategic allowance reserve would be established by taking a certain percentage of allowances originally reserved for the future -- 1% of 2012-2019 allowances, 2% of 2020-2029 allowances, and 3% of 2030-2050 allowances -- for a total size of 2.7 billion allowances. Every year throughout the cap and trade program, a certain portion of this reserve account would be available for purchase by polluters as a "safety valve" in case the price of emission allowances rises too high.

How much of the reserve account would be available for purchase, and for what price? The bill defines the reserve auction limit as 5 percent of total emissions allowances allocated for any given year between 2012-2016, and 10 percent thereafter, for a total of 12 billion cumulative allowances. For example, the bill specifies that 5.38 billion allowances are to be allocated in 2017 for "capped" sectors of the economy, which means 538 million reserve allowances could be auctioned in that year (10% of 5.38 billion). In other words, the emissions "cap" could be raised by 10% in any year after 2016.

As for the price, the reserve allowance auction price would have a floor of twice the EPA price estimate for the average allowance in 2012, rising by 5% plus inflation in 2013 and 2014. Afterward, the price floor would be 1.6 times the average allowance price for the previous three years. The reserve allowances not purchased each year would be put back in the reserve account. EPA predicts an initial allowance price of just $12-20 per ton in 2015, which would set the initial strategic reserve safety valve price at as low as $24 per ton. According to EPA, allowance prices will remain below $20 per ton until after 2020, meaning the safety valve price that triggers the reserve auction could ensure pollution allowance prices stay below $32 per ton for the first decade or more of the cap and trade program ($24*1.6=$32).

The public proceeds from the reserve auction each year would go toward purchasing international offsets from reduced deforestation. These offsets would be converted back into emission allowances and placed in the strategic reserve account (at a 5 offsets to 4 allowances conversion ratio after 2017, as with other international offsets). Interestingly, the legislation specifies that if the reserve account is filled to its original size, any additional allowances from international offsets would be allocated and auctioned as part of the normal allowance auction in a future year, adding even more offsets into the mix.

This first graph represents the impact the strategic allowance reserve could have on emissions in capped U.S. sectors during any year between 2012-2050. It also shows the additional impact on capped sectors if up to 2 billion tons of offset provisions were used in any given year (we aren't predicting this will occur, but showing the real maximum extent of emissions the bill authorizes, in contrast to the "hard emissions cap" it supposedly establishes). BAU is based on a projection by the World Resources Institute:

This second graph represents the impact the strategic allowance reserve could have on total, economy-wide U.S. emissions during any year between 2012-2050. It also shows the additional impact on U.S. emissions if 1.5 billion tons of foreign offsets potentially permitted by the bill are used in any given year:

Finally, these two graphs show the impact of the strategic reserve and full offsets on total U.S. emissions in 2020 and 2030 compared to other levels:

Since there is no limit on how many foreign offsets could be purchased and used to replenish the strategic reserve -- and since the original size of the allowance reserve is 9.3 billion less than the total number of allowances authorized for reserve auction (12 billion minus 2.7 billion) -- this provision could introduce up to 9.3 billion offset allowances to the cap and trade system, in addition to the 2 billion in annual offsets already authorized by the bill. At an average price of $15 per allowance, this would add up to $139 billion in international forest offsets. (Click here to download full spreadsheet analysis.)

In order for these offsets not to be utilized -- and for the emissions "cap" not to exist in name only -- two things must hold true. First, international offsets must be more expensive than emissions reduction opportunities in capped domestic sectors, and second, the cost of these domestic reduction opportunities must not trigger the widespread purchase of the reserve allowances. Otherwise, either private investors or the government will purchase large quantities of international offsets and the total allowable emissions in the supposedly "capped" sectors will be permitted to exceed the emissions "cap."

Whether or not this potentially high demand level for foreign offsets -- and the trading mechanisms inherent to the cap and trade system -- is comparable to the conditions that produced the global financial crisis, is up for debate (Friends of the Earth, at least, is worried). The financial crisis was caused by many factors, but a critical one was the massive global "savings glut" that resulted in extraordinary levels of demand for mortgage-related assets in the US. In this environment, there was little incentive to stop the sale of subprime mortgages.

The design of Waxman-Markey may create a set of conditions around carbon offsets all too similar to the conditions leading up to the financial crisis: an extraordinary level of demand, and very little incentive to stop the production and sale of "subprime" offsets. Remember, as conditions stand now, a well-known Stanford University study on international offsets concluded: "between a third and two thirds of emission offsets under the Clean Development Mechanism (CDM) -- set up under the Kyoto treaty to encourage emissions reductions in developing nations -- do not represent actual emission cuts."

If ACES is established and the U.S. suddenly enters the international offsets markets with an appetite for billions of tons each year, the pressures and motivations at play are arguably stacked in favor of weakened -- not stronger -- standards of integrity for carbon offsets. If and when carbon prices rise, the pressure will be on to mitigate price impacts on consumers, industry and the U.S. economy. At the same time, potential offset providers will see a new multi-billion dollar opportunity to expand their supply of offsets through weaker standards. Standing against these powerful interests will be the environmental community, fighting to convince policymakers to put longer-term environmental interests ahead of short-term energy price pressures and political backlash. Who do we think elected officials will listen to in that scenario?

And finally, what happened to the "hard cap" and "emissions reduction certainty" that cap and trade advocates have long promised?