With the potential for compliance costs to increase rapidly in the near future, the researchers recommended instituting a hard cap on LCFS compliance credits through mechanisms such as an unlimited credit window or noncompliance penalty.

Both these 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, the authors suggested. Both proposals have the additional advantage of generating funds which may be used to increase investments in low CI fuel technologies. Additionally, neither mechanism would compromise the greenhouse gas reduction goals set by Assembly Bill 32.

The LCFS program calls for a 10% reduction in the carbon intensity of fuel sold in California over the next decade. Obligated parties are upstream producers and importers of gasoline and diesel fuel sold in the state. The program is agnostic as to which fuels can be used to meet the Standard. As a result, the authors note, industry faces only technological and economic constraints in choosing the optimal fuel mix to comply with the program. For example, provisions are made such that electricity providers for plug-in vehicles as well as hydrogen fuel providers for hydrogen vehicles may generate credits under the LCFS which can be sold to regulated parties.

In many respects, the LCFS is a first-of-its-kind regulation. Due both to the unprecedented nature of the program as well as to the uncertainty regarding the ability of the renewable fuel industry to produce volumes of low CI fuels necessary to meet the required reductions, it is difficult to predict market outcomes and compliance scenarios in the market in coming years. Any forecast of future economic outcomes under the LCFS requires knowledge of the availability of alternative fuels at different market prices, the cost of producing each fuel, long-run trends in alternative fueling infrastructure, consumer preferences for alternative fuel and alternative fuel vehicles, as well as many other unknowns. Several groups have studied potential future compliance scenarios under the LCFS including Boston Consulting Group (2012) and ICF International (2013). Some studies claim to predict future outcomes, however, their results should not be viewed as forecasts, but rather as case studies of potential outcomes because of the uncertainty regarding the development of low CI fuels.

… Volatility in compliance credit markets can undermine the underlying policy and obfuscate price signals for investors in low CI fuels. Economists have proposed a number of mechanisms aimed at limiting price volatility in compliance credit markets, many of which we consider in this report. The LCFS credit market is unique from other compliance credit markets, particularly cap and trade permit markets, in that the ARB does not directly control the number of credits. As a result, instituting safety valve mechanisms such as those proposed in cap and trade market come with unique design issues.

—Lade and Lin

The study begins by discussing the basic economics of the LCFS using a simple model with two inputs which are used to produce fuel. It also explores the role of uncertainty and dynamics in the market, potential issues and implications of market power, interactions of the LCFS with the state’s cap and trade program, and the incentives to innovate and invest in low CI fuel technologies provided by the Standard.

Using this framework, the researchers then discuss a number of cost containment mechanisms proposed by the Air Resources Board (ARB) as well as other potential policies which may contain compliance costs. This includes the potential to link the LCFS market to other cap and trade allowance markets; issues regarding the establishment of a price floor for LCFS credits; and the effect of cost containment mechanisms on emissions as well as the interaction of potential market power issues with a cap on LCFS credit prices.

Developing a numerical model—calibrated so that it is similar to California’s gasoline market in 2010—they then simulate a number of market outcomes under an LCFS with and without various cost containment mechanisms.

Key findings of the study include:

• Current low CI fuel costs matter, and technological constraints to deploying low CI fuels can lead to volatile LCFS credit prices: The largest sources of potential compliance cost increases as the Standard becomes more stringent are high marginal costs of low CI fuels relative to conventional fossil fuels, and technological or capacity constraints to deploying low CI fuels.

• Anticipated future costs will affect current LCFS credit prices: Given that firms can bank credits over time, anticipated high future compliance costs will lead to high compliance costs before technological constraints are reached or the highest low CI fuel prices are realized.

• Expectations matter: Given the large amount of uncertainty regarding the availability of low CI fuels, high expected compliance costs can increase current compliance costs substantially.

The authors also made the following recommendations for cost containment:

• The ARB should institute a cost containment mechanism which places a hard cap on LCFS credit prices: Potential compliance costs are unknown. Given the potential for high volatility and prices in the LCFS credit market, the ARB should provide an additional compliance option which places a hard cap on permit prices by allowing for unlimited compliance through the option at a fixed cost. The authors favor establishing either a credit window for emergency compliance credits or a noncompliance penalty, where the trigger price is set to rise over time by the rate of inflation.

• The ARB can counteract decreases in incentives to invest in low CI fuels through directly investing funds raised through a cost containment mechanism in low CI fuels: Reinvesting funds raised through a cost containment mechanism can counteract decreases in incentives to invest in low CI fuels and can be used to directly address the cause of high LCFS credit prices. We recommend using the funds for per unit production subsidies for low CI fuels or grant programs for investments in production facilities of low CI fuels.

• Low CI credit multipliers will reduce compliance costs, but may decrease incentives to invest in low CI fuels and do not guarantee compliance costs will be contained: By not placing a hard cap on LCFS credit prices, options such as the low CI credit multiplier remain susceptible to large increases in compliance costs. In addition, the policy may decrease the amount of low CI fuel sold in the market and decrease the incentive to invest in those fuels.

California is a clear leader in enacting greenhouse gas policies in the United States and around the world. Extreme compliance costs in programs such as the LCFS 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 as suggested in our report is imperative.

—Lade and Lin

Resources

• Lade, Gabriel E. and C.-Y. Cynthia Lin (2013) “A Report on the Economics of California’s Low Carbon Fuel Standard and Cost Containment Mechanisms.” Institute of Transportation Studies, University of California, Davis, Research Report UCD-ITS-RR-13-23