California's expensive policy for increasing CO2 emissions

In April, California adopted a Low Carbon Fuel Standard (LCFS).  Since then, Governor Schwarzenegger has been marketing the policy to other states and even Canada. (Both British Columbia and Ontario have agreed to adopt the standard).  Until recently, a LCFS was an element of the American Clean Energy and Security Act of 2009 (H.R. 2454) but was dropped after it became clear that the standard would sink the bill.  That's good news -- for now -- since the policy will, at best, be much more expensive and less effective than a carbon tax or a cap-and-trade scheme, and, at worst, increase global CO2 emissions. 

To see why, imagine you are a Canadian energy company that sells two types of automobile fuel -- Dirty and Less-dirty.   For simplicity, assume you sell 10 units of each fuel to California and to China.   Dirty contains much more CO2 than Less-dirty -- 19 lbs of CO2 per gallon versus 15.  Nonetheless, you make more money selling dirty -- $1 per gallon versus $0.5.  Table 1 shows the situation for your sales to California: Your total profit is $15 and your fuel produces a total of 340 lbs CO2 or an average of 17 lbs per gallon (340 lbs /20 gallons).

Table 1. Profit and emissions for California sales before the LCFS

Profits =

10 gal x $1.00 + 10 gal x $0.5 = $15

Average CO2 emissions =

(10 gal x 19 lbs + 10 gal x 15 lbs)/20 gal = 17 lbs / gal

Total CO2 emission =

10 gal x 19 lbs + 10 gal x 15 lbs = 340 lbs of CO2


Concerned about CO2 emissions, California adopts a Low Carbon Fuel Standard, which mandates that the average amount of CO2 contained in the portfolio of fuels you sell to the state must be no higher than 16.5 lbs.  Thus, you need to decrease your average by 0.5 lbs. How will you do it?

The effectiveness of the LCFS depends on you responding passively:  If, as shown in Table 2, you simply sell 3 more gallons of Less-dirty and 3 fewer of Dirty, you comply with the standard, and the Standard succeeds in lowering CO2 emissions.  Unfortunately, your total profit will decline to $13.50.  On the other hand, if you are not feeling so sheepish, you have two other, more appealing options.  Since China hasn`t adopted the same standard, the most obvious thing to do is simply move two gallons of Dirty from California to China and two gallons of Less-dirty from China to California.  In the industry jargon, this is called "shuffling".  Your profits stay the same and you comply with the standard.  Unfortunately, total global CO2 emissions stay the same - the Low Carbon Fuel Standard has no effect. 

 
Table 2. Profit and emissions for California sales before the LCFS - Passive Case

Profits =

8 gal x $1.00 + 12 gal x $0.5 = $15

Average CO2 emissions =

(7 gal x 19 lbs + 13 gal x 10 lbs)/20 gal = 16.4 lbs / gal

Total CO2 emission =

7 gal x 19 lbs + 13 gal x 10 lbs = 328 lbs of CO2


Though, in reality, there would be an effect: Since the standard causes your company to change what was its optimal sales strategy, it now cost you more to deliver your fuel.  If you are large enough or your competitors complied by doing a similar type of shuffling, then at least some of those increased costs will be passed onto consumers.

Suppose there were some other transaction costs or restrictions that prevented you from shuffling your fuels between California and China.  You still have another option: you can keep your sales of Dirty to California constant while increasing your sales of Less-dirty to California.  For instance, suppose you cut the price of Less-dirty in half in order to increase your sales to 17 gallonsAs shown in Table 3, by inflating your sales of Less-dirty, you comply with the standard and your total profit, $14.25, is higher than it would be if you decreased your production of Dirty. Nonetheless, though your average emissions comply with the standard, your total CO2 emissions actually increase to 445 lbs.  In other words, the LCFS causes a significant increase in CO2 emissions.

Table 3. Profit and emissions for California sales before the LCFS - Passive Case

Profits =

10 gal x $1.00 + 17 gal x $0.5 = $14.25

Average CO2 emissions =

(10 gal x 19 lbs + 10 gal x 10 lbs)/20 gal = 16.5 lbs / gal

Total CO2 emission =

10 gal x 19 lbs + 10 gal x 10 lbs = 300 lbs of CO2


This example is intentionally designed to lead to the extreme result where emissions increase.  Realistically, the LCFS will cause producers to do a combination of shuffling and price-cutting of relatively cleaner fuels to comply with the standard.  The result will be that CO2 reductions will be much lower than policy makers claim and the costs will be much higher.  In particular, Economists from UC Berkeley and Davis estimate it will cost between 5 and 10 times more for a LCFS to accomplish the same CO2 reduction as a carbon tax or cap-and-trade. 

Though the California Air Resources Board claims that the LCFS is not a tax and that it will lower energy prices, the opposite must be true.  In fact, the precise problem with the LCFS is that it subsidizes relatively cleaner fuels and over-taxes relatively dirtier ones.  Hence, producers produce too much of some fuels and too little of others.  Such market distortions impose large and real costs on an economy. The simple truth is that if you do not directly tax the consumption you want to discourage, then there will be efficiency losses -- it will cost more to accomplish the same reduction -- because the rational response of consumers and producers is always to try to maneuver around the policy's objectives, and a direct tax gives the least maneuvering room.   Which is why, if the policy is sufficiently indirect -- and the LCFS may be -- then you can actually make things worse.  

I imagine many policy makers are aware of these flaws.  However, since voters have signaled an unwillingness to accept higher energy prices to reduce CO2 emissions, the higher costs associated with a LCFS are likely considered a worthwhile tradeoff since the LCFS tax is hidden.  This is not just bad policy, it is undemocratic.

James Eaves is a Professor of Finance at Université Laval in Quebec City. He has published numerous articles related to energy and markets and blogs at practicalpolicy.com.
In April, California adopted a Low Carbon Fuel Standard (LCFS).  Since then, Governor Schwarzenegger has been marketing the policy to other states and even Canada. (Both British Columbia and Ontario have agreed to adopt the standard).  Until recently, a LCFS was an element of the American Clean Energy and Security Act of 2009 (H.R. 2454) but was dropped after it became clear that the standard would sink the bill.  That's good news -- for now -- since the policy will, at best, be much more expensive and less effective than a carbon tax or a cap-and-trade scheme, and, at worst, increase global CO2 emissions. 

To see why, imagine you are a Canadian energy company that sells two types of automobile fuel -- Dirty and Less-dirty.   For simplicity, assume you sell 10 units of each fuel to California and to China.   Dirty contains much more CO2 than Less-dirty -- 19 lbs of CO2 per gallon versus 15.  Nonetheless, you make more money selling dirty -- $1 per gallon versus $0.5.  Table 1 shows the situation for your sales to California: Your total profit is $15 and your fuel produces a total of 340 lbs CO2 or an average of 17 lbs per gallon (340 lbs /20 gallons).

Table 1. Profit and emissions for California sales before the LCFS

Profits =

10 gal x $1.00 + 10 gal x $0.5 = $15

Average CO2 emissions =

(10 gal x 19 lbs + 10 gal x 15 lbs)/20 gal = 17 lbs / gal

Total CO2 emission =

10 gal x 19 lbs + 10 gal x 15 lbs = 340 lbs of CO2


Concerned about CO2 emissions, California adopts a Low Carbon Fuel Standard, which mandates that the average amount of CO2 contained in the portfolio of fuels you sell to the state must be no higher than 16.5 lbs.  Thus, you need to decrease your average by 0.5 lbs. How will you do it?

The effectiveness of the LCFS depends on you responding passively:  If, as shown in Table 2, you simply sell 3 more gallons of Less-dirty and 3 fewer of Dirty, you comply with the standard, and the Standard succeeds in lowering CO2 emissions.  Unfortunately, your total profit will decline to $13.50.  On the other hand, if you are not feeling so sheepish, you have two other, more appealing options.  Since China hasn`t adopted the same standard, the most obvious thing to do is simply move two gallons of Dirty from California to China and two gallons of Less-dirty from China to California.  In the industry jargon, this is called "shuffling".  Your profits stay the same and you comply with the standard.  Unfortunately, total global CO2 emissions stay the same - the Low Carbon Fuel Standard has no effect. 

 
Table 2. Profit and emissions for California sales before the LCFS - Passive Case

Profits =

8 gal x $1.00 + 12 gal x $0.5 = $15

Average CO2 emissions =

(7 gal x 19 lbs + 13 gal x 10 lbs)/20 gal = 16.4 lbs / gal

Total CO2 emission =

7 gal x 19 lbs + 13 gal x 10 lbs = 328 lbs of CO2


Though, in reality, there would be an effect: Since the standard causes your company to change what was its optimal sales strategy, it now cost you more to deliver your fuel.  If you are large enough or your competitors complied by doing a similar type of shuffling, then at least some of those increased costs will be passed onto consumers.

Suppose there were some other transaction costs or restrictions that prevented you from shuffling your fuels between California and China.  You still have another option: you can keep your sales of Dirty to California constant while increasing your sales of Less-dirty to California.  For instance, suppose you cut the price of Less-dirty in half in order to increase your sales to 17 gallonsAs shown in Table 3, by inflating your sales of Less-dirty, you comply with the standard and your total profit, $14.25, is higher than it would be if you decreased your production of Dirty. Nonetheless, though your average emissions comply with the standard, your total CO2 emissions actually increase to 445 lbs.  In other words, the LCFS causes a significant increase in CO2 emissions.

Table 3. Profit and emissions for California sales before the LCFS - Passive Case

Profits =

10 gal x $1.00 + 17 gal x $0.5 = $14.25

Average CO2 emissions =

(10 gal x 19 lbs + 10 gal x 10 lbs)/20 gal = 16.5 lbs / gal

Total CO2 emission =

10 gal x 19 lbs + 10 gal x 10 lbs = 300 lbs of CO2


This example is intentionally designed to lead to the extreme result where emissions increase.  Realistically, the LCFS will cause producers to do a combination of shuffling and price-cutting of relatively cleaner fuels to comply with the standard.  The result will be that CO2 reductions will be much lower than policy makers claim and the costs will be much higher.  In particular, Economists from UC Berkeley and Davis estimate it will cost between 5 and 10 times more for a LCFS to accomplish the same CO2 reduction as a carbon tax or cap-and-trade. 

Though the California Air Resources Board claims that the LCFS is not a tax and that it will lower energy prices, the opposite must be true.  In fact, the precise problem with the LCFS is that it subsidizes relatively cleaner fuels and over-taxes relatively dirtier ones.  Hence, producers produce too much of some fuels and too little of others.  Such market distortions impose large and real costs on an economy. The simple truth is that if you do not directly tax the consumption you want to discourage, then there will be efficiency losses -- it will cost more to accomplish the same reduction -- because the rational response of consumers and producers is always to try to maneuver around the policy's objectives, and a direct tax gives the least maneuvering room.   Which is why, if the policy is sufficiently indirect -- and the LCFS may be -- then you can actually make things worse.  

I imagine many policy makers are aware of these flaws.  However, since voters have signaled an unwillingness to accept higher energy prices to reduce CO2 emissions, the higher costs associated with a LCFS are likely considered a worthwhile tradeoff since the LCFS tax is hidden.  This is not just bad policy, it is undemocratic.

James Eaves is a Professor of Finance at Université Laval in Quebec City. He has published numerous articles related to energy and markets and blogs at practicalpolicy.com.