Last week, following years of anticipation, the shoe finally dropped on EPA carbon regulations. Two or three things are notable in this. First, we’re on the road to a national climate policy!   Second, EPA is going out of its way to highlight how much flexibility it will give to States in implementing this policy. Traditionally, most regulations under the Clean Air Act have taken the form of “command and control” technology mandates for industries and equipment located inside dirty, “non-attainment” counties and regions. Economists have long complained about this and spoken of the virtues of more flexible, market-based approaches.

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That’s why there has been so much excitement amongst the econ-wonk community about the EPA’s embracing of flexibility. Instead of rigid technology requirements, which really aren’t a great tool for dealing with the CO2 in the electricity sector, states can find other ways to come up with equivalent reductions – like cap-and-trade!

So flexibility can be great, but there are some reasons to worry about too much flexibility when it comes to CO2 reduction strategies. While the announcement has had economists manning their whiteboards to extol cap-and-trade, it is not at all certain that “flexibility” will translate to “cap-and-trade.” The EPA is clear that it considers its regulation to be fundamentally based upon emissions rates (CO2/MWh) rather than limits on total CO2. This means an emissions rate (or emissions intensity) standard will likely be one of the flexible options. Emissions intensity standards, such as the low carbon fuel standard (LCFS) for fuels, are sort of the ugly stepsister to cap-and-trade. They attack environmental problems through rates, and have “trading” elements where one can comply with the rate standard, but they do not explicitly limit the total amount of pollution.

The complaint about intensity standards, as articulated by Stephen HollandJon Hughes, and Chris Knittel in their 438-part series “why we hate intensity standards,” is that while they raise costs on dirty sources that exceed the standard, they implicitly subsidize sources that are still dirty, but cleaner than the standard. Thus gas plants can receive implicit subsidies to replace the output of coal plants, even though gas plants still produce CO2.

Within a single state or region, this is dismissed by some as a lesser-of-evils, but there is a real potential for mischief if some states go one way (cap) and others go another way (rate standards). This is because an intensity standard subsidizes the output of plants cleaner than the standard.  Gas plants in Arizona could end up having their output subsidized by an Arizona standard to import power into California, displacing sources that would have otherwise been capped.  If the Arizona plants are dirtier than the California plants they displace, total emissions increase.

More generally, California is going have to come to grips with how its internal climate policy will interact with those adopted by other states. While the expansion of CO2 regulation to other states would appear to reduce concerns about negative spillovers, new compatibility issues will be created. California will face decisions about which states to partner with, and how to design its policies to better adjust to those adopted by states it chooses not to partner with.  If it joins other states under a common cap, California will have to confront the fact that its aggressive renewable electricity goals could simply create more head-room under the cap for other states to use fossil fuels (something I wish the city of Davis would appreciate).  Some issues, such as leakage, could be mitigated if neighboring states adopt programs similar to California. However, neighboring states could also adopt compliance pathways that are inconsistent with California’s, and even exacerbate concerns such as leakage and reshuffling.

I don’t want to sound too pessimistic. The EPA’s actions are a tremendous development in the climate policy arena. Just a year ago it was common at conferences to hear statements like “there will be no national climate policy in the US in the foreseeable future.” The Obama administration is using the tools at its disposal to push the ball forward and I am glad they are doing it. However, those who thought California’s worries about leakage will be solved by these developments need to think again. We still need to mind the gaps.