Harnessing Carbon Value to Lower Costs in California

This issue brief examines how a small reform to the California carbon market could improve affordability by delivering billions of dollars to harden infrastructure, advance climate goals, and improve affordability in California. This reform kicks in only when allowance prices are low, harvesting emissions reductions when they are low cost.

The state’s most impactful efforts to reduce greenhouse gas emissions have been sector-specific policies such as building standards, vehicle efficiency standards, the renewable portfolio standard, and other measures. In this context, the cap-and-trade program contributes a numerical carbon budget for covered sectors and generates revenues to the Greenhouse Gas Reduction Fund to fund investments.

The cap-and-trade program also improves affordability by lowering cost.

Although sector-specific policies have been effective in driving emissions reductions, the average cost per ton reduced by these policies has typically been greater than the cost of emissions reductions under the cap-and-trade program, as identified by the price of an emissions allowance. For instance, the 2022 Scoping Plan estimated average annual cost (2022-2035) per ton of emissions reductions under most regulatory measures would be multiple times greater than the price of an emissions allowance, which represents the marginal cost of emissions reductions motivated by the carbon market. An exception is the zero-emissions vehicle standard, another market-based mechanism, and measures to reduce vehicle miles traveled, which have negative costs.

In other words, every emissions reduction motivated by the carbon market represents a cost savings for California.

A reform that would further improve the cost effectiveness of California’s climate policy portfolio is the introduction of an Emissions Containment Reserve (ECR), which we describe below, and which exists in other robust carbon markets. We find that in 2023-24, improved market design through the introduction of an Emissions Containment Reserve would have collected nearly $1.5 billion in benefits for ratepayers and the state’s Greenhouse Gas Reduction Fund.

An ECR would improve the contribution of emissions reductions from the cap-and-trade program in accelerating decarbonization of the state’s economy and boost ratepayer climate dividend and to the state’s Greenhouse Gas Reduction Fund. Moreover, this feature would be triggered only when allowance prices are low and when emissions reductions driven by the carbon market are less expensive than sector specific regulation, contributing in multiple ways to affordability in California. We identify several other benefits of an Emissions Containment Reserve including better alignment of the carbon market with the state’s overall climate policy portfolio, and reduced market uncertainty.

California’s policies should be designed to work in complementary ways. When regulations and investments from the state, municipalities, or private sector are effective in mitigating emissions, they reduce the demand for emissions allowances. Unfortunately, over a broad range of outcomes, successful regulations, investments, and policies do not affect the number of emissions allowances available in the carbon market and hence do not affect the emissions that occur.

As currently designed, emissions reductions that are achieved by regulations crowd out reductions that would be achieved by the carbon market. This phenomenon is known as the “waterbed effect” because the emissions cap acts like the volume of water in a waterbed, so that when regulatory policies push emissions down in one place, emissions rise elsewhere in the market. The price is affected by regulatory activities outside the market, but the emissions outcome is not affected, and the emissions reductions from the regulation are not additional.

The North American carbon markets (California, Quebec, Washington, and the Regional Greenhouse Gas Initiative) have measures to ameliorate extreme fluctuations in allowance price through the auction price floor, which defines the minimum acceptable bid in the auction. These programs also have allowance reserves that are triggered if prices reach high levels. In California, however, price movements over the broad range between the price floor price of $24 and the tier one reserve price threshold of $56 yield no changes in emissions. Prices have been in this range since 2017. Although the California emissions cap is steadily declining, variation in prices driven by complementary policies does not trigger additional reductions from the market.

Since 2018, California’s Independent Emissions Market Advisory Committee (IEMAC) has identified a potential adjustment to the market design through the introduction of an Emissions Containment Reserve (ECR) that would add a price step at about $40, midway between the price floor and reserve price threshold. As illustrated in Figure 1, this price step would apply to a fraction (e.g., 5 percent) of the allowances that would otherwise enter the market, and it would constrict allowance supply by removing these allowances from sale in the auction if the auction clearing price were below the price step. This feature is already implemented in RGGI. It is also an element of the authorizing legislation in Washington that was suspended in anticipation of potential linking with the California market, which does not yet have this feature.

A concern related to the waterbed effect is the accumulation of a large, privately-held allowance bank, now greater than 379 million tons, and greater than one year’s allowance supply. Such a large bank conveys a sense that the allowance supply is too generous and that future emissions reductions will be hard to achieve because the bank provides an ample allowance supply that will re-enter the market. The Regional Greenhouse Gas Initiative has responded to a comparable situation with administrative adjustments to reduce the supply of newly auctioned allowances to absorb the private bank into the market. California has also responded to changing economic conditions through adjustments to supply embodied in 2017 legislation reauthorizing the cap-and-trade program (AB 398), which was implemented beginning in 2021. However, regulatory and legislative adjustments are hard to anticipate and to achieve, spawning uncertainty in the market and delaying private sector investments.

The European Union responded to the accumulation of a large allowance bank (known there as the “total number of allowances in circulation”) which was coupled with low allowance prices through the adoption of a quantity-triggered approach to automatically adjust allowance supply. According to most economic appraisals, the EU’s quantity-based “Market Stability Reserve” approach may be less efficient than a price-based mechanism such as an Emissions Containment Reserve, because the quantity-based adjustment is delayed and difficult to predict. Nonetheless, the quantity-based approach has enabled a reduction in the size of the bank and a substantial increase in allowance prices in the EU (Perino 2018; Flachsland et al. 2019; Borghesi et al. 2023).

The instantaneous implementation of a price-triggered Emissions Containment Reserve in the allowance auction can be expected to enable better investment planning to achieve emissions reductions, compared to the delayed response of quantity-based or administrative (i.e., regulatory or legislative) approaches to adjusting supply. Further, administration of the Emissions Containment Reserve would be simple and precisely mirror the existent price floor mechanism.

As in many commodity markets, a reduction in allowance supply to support the allowance price can be expected to yield an increase in auction revenue. The value of allowances is determined by their number multiplied by their price. Much like reduced supply in commodity markets can increase the commodity’s value, if an Emissions Containment Reserve were triggered leading to reduced allowance supply, it would yield an increase in allowance value and auction revenues.

We have exercised RFF’s Haiku Emissions Market model (Roy et al. 2024) to estimate the influence of an Emissions Containment Reserve in California. As seen in Table 1, three times in 2023 the auction price fell below the proposed ECR price trigger level ($37.03), and three times again in 2024 ($40.09). Based on modeling, the absence of the Emissions Containment Reserve on average has lost over $240 million in benefits for ratepayers and the Greenhouse Gas Reduction Fund in each of the six auctions settling below the ECR trigger price since 2023. That is, the lost opportunities for revenues to the state accumulate to almost $1.5 billion since 2023.

Figure 2 illustrates the role price-responsive allowance supply plays in the California market. The four grey dashed lines represent the price ceiling (top) and two Allowance Price Containment Reserve price steps in the existing program, and the price floor (bottom). If the price reaches the APCR or price ceiling trigger levels, allowances in addition to the intended annual emissions budget are introduced to the program. The blue band in the left panel illustrates the range of modeled outcomes under high and low allowance demand scenarios representing alternative assumptions about economic activity and technological change (see Appendix). The red dashed line illustrates the proposed Emissions Containment Reserve, and the right panel illustrates the effect on allowance supply. If the Reserve were implemented, it would only be triggered in the low allowance demand (low price) scenario when the price is below the Reserve’s price trigger. In this scenario, up to 5 percent of the allowances expected to enter the market would not be sold in the auction, restricting supply and supporting the allowance price. The grey area illustrates the outcomes that would not be expected with the Reserve in effect, narrowing the range of expected outcomes given underlying uncertainty about allowance demand. This narrowed range increases expectations of minimum price and hence increases expected revenues.

An emissions containment reserve (ECR) could be introduced into the California market in order to raise revenues when allowance prices are lowest, preserve emissions reductions, and reduce market uncertainty. An ECR also better integrates the cap-and-trade program into California’s broader climate policy portfolio by mitigating the waterbed effect, making progress toward the state’s climate goals more cost effective.

A well-designed policy portfolio should strategically integrate policies and regulations such that any deviation from the most cost-effective emissions reductions is part of a planned sequence of reductions to reach net zero alongside complementary goals (Peng et al. 2025) or within current political constraints (Dolphin et al. 2020). A carbon market can be designed to adapt to these fluctuations in a way that establishes consistency for a government’s climate strategy within its broader goals, price stability, and long-term program credibility (Dolphin et al. 2023).

The carbon market is typically the most cost-effective tool within the state’s climate policy portfolio for achieving emissions reductions. The greater the mitigation that can be achieved through the market the greater the affordability for California households.