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Guest Column: Containing the Costs of California's Low-Carbon Fuel Standard

Published December 10, 2013

Traffic on Interstate 5 in SacramentoBy C.-Y. Cynthia Lin

California is a clear leader in enacting greenhouse gas policies in the United States and around the world. But extreme compliance costs in programs such as the state’s Low Carbon Fuel Standard may compromise greenhouse gas policies currently in place, as well as discourage the adoption of similar programs in other jurisdictions. As a result, instituting a hard cap on LCFS credit prices using a transparent containment mechanism is imperative.

California's LCFS was created by Executive Order S-01-07 in 2007 by former Gov. Arnold Schwarzenegger. The standard is a key complimentary measure in achieving statewide reductions in greenhouse gas emissions required under Assembly Bill 32 (AB 32), the Global Warming Solutions Act of 2006. The standard requires substantial reductions in the carbon intensity of transportation fuels sold in the state by 2020. The program went into effect in 2011 and is currently in its third year of compliance.

Under the LCFS, obligated parties in California must reduce the weighted average carbon intensity of fuel sold in the state by pre-specified amounts each year. Obligated parties are defined as upstream producers and importers of gasoline and diesel fuel sold in the state.

As with similar policies that depend on the development of new technologies to meet the policy's goals, there is significant uncertainty as to how compliance with the standard may be achieved in coming years. Given the unpredictable nature of new technologies and the scale at which alternative fuels will need to be produced to maintain compliance across all obligated parties, there is reasonable concern regarding the potential for high and volatile costs of the program in coming years.

Volatility in compliance credit markets can undermine the underlying policy and cloud price signals for investors in low carbon intensity fuels. Economists have proposed a number of mechanisms aimed at limiting price volatility in compliance credit markets The LCFS credit market is unique from other compliance credit markets, particularly cap-and-trade permit markets, in that the California Air Resources Board does not directly control the number of credits. As a result, instituting safety-valve mechanisms such as those proposed in cap-and-trade markets come with unique design issues.

In ongoing research with Ph.D. student Gabriel Lade, we are studying multiple issues related to the costs of the LCFS in the near future, and are evaluating provisions designed to contain compliance costs at reasonable levels.

We found that compliance costs may increase rapidly in the future if there are large differences in marginal costs between traditional fossil fuels and alternative, low-carbon-intensity fuels, or if there are capacity or technological constraints to deploying alternative fuels, particularly those with low carbon intensity. In the absence of readily available, low-carbon intensity-fuel alternatives, the fuel market will adjust along two dimensions to maintain compliance with the LCFS: (1) by increasing the use of cheaper fuels below the standard such as ethanol derived from corn starch and sugar cane; or (2) by increasing fuel prices and reducing fuel consumption to a level where the standard is technologically feasible.  Both options will be associated with high LCFS credit prices. Because firms are able to bank credits over time, anticipated high costs in the future may lead to higher costs in the present before any constraints bind the industry.

The potential for compliance costs to increase rapidly in the near future motivates our recommendation to institute a hard cap on LCFS compliance credits through a mechanism such as an unlimited credit window or noncompliance penalty. Both mechanisms guarantee that compliance costs will never exceed either the credit window price or the non-compliance fee, and provide a clear and transparent alternative compliance strategy. Both proposals have the additional advantage of generating funds which may be used to increase investments in low carbon intensity fuel technologies. Importantly, neither mechanism will compromise the greenhouse gas reduction goals set by Assembly Bill 32.

C.-Y. Cynthia Lin is an associate professor at UC Davis and a member of Controller John Chiang’s Council of Economic Advisors. The opinions in this article are presented in the spirit of spurring discussion and reflect those of the author and not necessarily the Controller or his office.

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