Leakage from sub-national climate initiatives

Transcription

1 Leakage from sub-natonal clmate ntatves Justn Caron Sebastan Rausch Nven Wnchester Ths verson: December 15, 2011 Abstract Ths paper consders leakage from sub-natonal clmate polces usng Calforna s capand-trade program as a representatve example. Our analyss s bult on a global model of economc actvty and energy systems that dentfes 15 US regons and 15 regons n the rest of the world. As Calforna s cap-and-trade polcy requres electrcty mporters to surrender emssons allowances, leakage depends on the ablty of out-of-state generators to reconfgure transmsson to reduce the carbon ntensty of electrcty suppled to Calforna. If exporters can dspatch carbon-free electrcty to Calforna and carbon-ntensve electrcty s rerouted to other markets, leakage s 47% of the decrease n emssons n Calforna. If exporters are unable to adjust the carbon ntensty of electrcty suppled to Calforna, as mported electrcty s relatvely carbon ntensve, there s negatve leakage to regons supplyng electrcty to Calforna and the aggregate leakage rate s 5%. We also observe negatve leakage to some regons due to changes n fossl fuel prces and that the mpact of the tradng of emssons permts between Calforna and the EU depends on the ablty of out-of-state generators to reconfgure electrcty supply. Keywords: Leakage, sub-natonal clmate polcy, tradable permts, emboded emssons, computable general equlbrum modelng. JEL classfcaton: C68, F18, Q54, R13. Wthout mplcaton, we would lke to thank John Relly for helpful comments and dscussons. ETH Zürch, Centre for Energy Polcy and Economcs, Swtzerland, and Massachusetts Insttute of Technology, Jont Program on the Scence and Polcy of Global Change, USA. Emal: jcaron@mt.edu. Massachusetts Insttute of Technology, Jont Program on the Scence and Polcy of Global Change, USA. Emal: rausch@mt.edu. Massachusetts Insttute of Technology, Jont Program on the Scence and Polcy of Global Change, USA. Emal: nven@mt.edu.

2 1 Introducton Leakage occurs when greenhouse gas (GHG) restrctons n some regons ncrease emssons n unconstraned regons. Clmate polces can cause leakage va ther mpacts on trade, fossl fuel prces and captal movements. Leakage va the trade channel occurs when relatve prce changes nduce substtuton away from producton n carbon-constraned regons and towards mports from unconstraned regons. The fossl fuel prce channel s generally thought to ncrease emssons n unconstraned regons, as clmate polces reduce fossl fuel prces and ncrease energy consumpton n these countres. However, as noted by Burnaux (2001), f the supply of coal s more elastc than the supply of less carbon-ntensve fuels, clmate polces may reduce emssons n unconstraned regons (.e., result n negatve leakage). Negatve leakage can also arse f energy effcency mprovements nduced by the polcy cause captal mgraton from unconstraned regons to constraned regons (Fullerton, Karney and Bayls, 2011). Wth federal ntatves to curb GHGs stallng n the US, sub-natonal polces have receved greater focus. Sub-natonal ntatves can generate hgher leakage rates than federal polces, as ntra-natonal trade s generally much larger than trade between regons n dfferent countres (Anderson and van Wncoop, 2003). Ths allows greater scope for leakage through the trade and, to the extent that fossl fuel markets are lnked, changes n fossl fuel prces. Addtonally, for geographcal reasons, there are greater possbltes for a terrtory to mport electrcty under a sub-natonal agreement than under a federal polcy. To date, two sub-natonal cap-and-trade polces have been legslated n the US. Frst, 10 states n the northeast are members of the Regonal Greenhouse Gas Intatve (RGGI). The program, whch began on January 1, 2009, sets state-level caps on electrcty emssons and allows tradng of emssons permts among states. Second, a cap-and-trade program on emssons from 2

3 electrcty generaton and certan ndustral ndustres wll operate n Calforna begnnng n Transport and other fuels wll be ncluded n the program from 2015, by whch tme the cap wll cover an estmated 85% of Calforna s GHG emssons sources. The polcy ncludes a border carbon adjustment (BCA) measure for electrcty mports from both domestc and nternatonal sources. At the tme of wrtng, Calforna s polcy s the only economy-wde cap-and-trade program to be enacted n the US and s set to become the second largest carbon market behnd the EU Emssons Tradng Scheme (ETS). In ths paper, we use a calbrated general equlbrum model to examne the leakage mplcatons of sub-natonal clmate polces usng Calforna s cap-and-trade program as an example. Moreover, legslaton n both Calforna and the EU allow for ther programs to be lnked wth other systems and we accordngly nvestgate the effects of permt trade between Calforna and the EU. General equlbrum assessments of leakage from federal polces commonly estmate leakage rates between 10% and 30% (see, for example, Felder and Rutherford, 1993; Babker, 2005; Babker and Rutherford, 2005; Bernsten et al., 1999; and Copeland and Taylor, 2005). Relatvely few studes have focused on leakage from sub-natonal ntatves. One excepton s Sue Wng and Kolodzej (2008), who consder the RGGI usng a mult-state computable general equlbrum (CGE) model of the US economy. The authors estmate that 49-57% of emssons abated by RGGI electrcty generators wll be offset by unconstraned sources. A shortcomng n the framework employed by Sue Wng and Kolodzej (2008) s that states source ntra-natonal mports from a natonal pool of state exports. As a result, the share of one state s exports n j s mports s the same for all j. Ths assumpton can bas results f emssons ntenstes and/or mports shares dffer across states. Addtonally, as the authors do not track trade flows between each state and the rest of the world, ther framework s unable to consder leakage to 3

4 nternatonal sources. Our pont of dfference s a computable general equlbrum (CGE) model calbrated to a dataset whch ncludes 15 US states or regons and 15 countres or regons n the rest of the world. The model tracks blateral trade among all regons, ncludng trade among US regons and trade between US regons and nternatonal regons. Due to ts detaled treatment of trade flows, the model s deally suted to examnng leakage from sub-natonal clmate ntatves. Ths paper has four further sectons. The next secton provdes an overvew of Calforna s cap-and-trade program. Our modelng framework s outlned n Secton 3. Secton 4 dscusses results and reports fndngs from a senstvty analyss. Secton 5 concludes. 2 Calforna s cap-and-trade program Calforna s Global Warmng Solutons Act of 2006, Assembly Bll 32, was sgned nto law on September 27, The bll requred the Calforna Ar Resources Board (CARB) to develop regulatons and market-based measures to reduce Calforna s GHG emssons to 1990 levels by The prmary emssons reducton tool n the bll s a cap-and-trade program for GHG emssons. On October 20, 2011, the CARB fnalzed detals of the cap-and-trade program and fled the legslaton wth the Calforna Offce of Admnstratve Law later that month. Emssons covered by the program nclude carbon doxde (CO 2 ), methane (CH 4 ), ntrous oxde (N 2 O), sulfur hexafluorde (SF 6 ), hydrofluorocarbons (HFCs), perfluorocarbons (PFCs), ntrogen trfluorde (NF 3 ), and other fluornated greenhouse gases. The frst phase of complance for the program begns on January 1, Covered enttes n the frst phase nclude electrc utltes, electrcty mporters, and ndustral facltes that emt 25,000 metrc tons or more of carbon doxde equvalent (CO 2 e) annually. Industral sources covered by the polcy nclude petroleum refners, producers of cement, ron, steel, glass and lme, and pulp and pa- 4

5 per manufacturng. Requrng allowances to be turned n for emssons emboded n mported electrcty s smlar to mposng an electrcty tarff. A key dfference, however, s that requrng allowances for mported electrcty wll ncrease the demand for and prce of permts, whch wll not occur under a tarff. The second phase of complance wll commence on January 1, 2015 and wll expand the set of covered enttes to nclude transportaton fuels, natural gas and other fuels. An estmated 85% of Calforna s emssons sources wll be covered n the second phase. Intally, most allowances wll be allocated for free. The dstrbuton of allowances to electrcty provders wll be based on hstorcal emssons and sales. Allowances allocated to ndustral facltes wll use a formula based on output. The allocaton of free allowances wll decrease and a larger share wll be auctoned over tme. Approved offset credts may be used to cover up to 8% of emssons permtted under the cap. Offset credts may be sourced from certfed offset programs n the US, Canada and Mexco; approved early acton offset schemes; and authorzed sector-based credtng programs n elgble jursdctons. Under current legslaton, offsets could account for up to 85% of the reducton n emssons. However, economc analyss by the CARB ndcates that, under reasonable assumptons, offsets wll account for a maxmum of 49% of emssons reductons and, due to tght elgblty restrctons, offset usage may be much less (Mulkern, 2011). CARB (2011, Subartcle 12, p. A-153) also sets out condtons for lnkng the Calfornan program to other schemes. Once an external ETS has been approved by the CARB, complance nstruments ssued by other programs may be used to meet Calfornan requrements. In ths connecton, Calforna has pursued a regonal approach to clmate polcy as a member of the Western Clmate Intatve (WCI). The ntatve was launched n February 2007 (orgnal wth fve member states) wth a goal of reducng regon-wde emssons by 15% from 2005 levels by 5

6 2020. Current partners nclude the US states of Arzona, Calforna, Montana, New Mexco, Oregon, Utah and Washngton and the Canadan provnces of Brtsh Columba, Mantoba, Ontaro and Quebec. 1 The agreement requres each member to mplement ts own cap-and-trade system and partcpate n a cross-border GHG regstry. The frst phase of the regonal cap-and-trade program was due to begn on January 1, However, although Calfornan authortes have been n close contact wth staff n some Canadan provnces, Calforna s the only partner that has set out mechansms for cappng emssons at the tme of wrtng. Progress towards cap-andtrade legslaton n other states and provnces has been hndered by the recesson and poltcal opposton. Notably, on February 2, 2010, Governor Brewer sgned an executve order statng that Arzona would not endorse a cap-and-trade program. Elsewhere, a cap-and-trade program has operated n the EU snce Detals of the EU- ETS are set out n Drectve 2003/87/EC (European Unon, 2003). Ths legslaton allowed the EU-ETS to be lnked to regms n other ndustralzed countres that ratfed the Kyoto Protocol. In 2009, the European Commsson amended the EU-ETS under Drectve 2009/29/EC. One amendment expanded the scope of EU clmate polcy to allow tradng of emssons permts between the EU-ETS and sub-natonal programs. Specfcally, amendment 27 of Artcle 1 added the followng paragraph to Artcle 25 of Drectve 2003/87/EC: Agreements may be made to provde for the recognton of allowances between the [European] Communty scheme and compatble mandatory greenhouse gas emssons tradng systems wth absolute emssons caps establshed n any other country or n sub-federal or regonal enttes (European Unon, 2009, p. 81). 1 Several regons are members of the WCI as observers. Observers nclude the US states of Alaska, Colorado, Idaho, Kansas, Nevada and Wyomng; the Canadan provnce of Saskatchewan; and the Mexcan states of Baja Calforna, Chhuahua, Coahula, Nuevo Leon, Sonora and Tamaulpas. 6

7 Table 1: Data sources. Data and parameters Source Socal accountng matrces blateral trade nternatonal regons Global Trade Analyss Project (GTAP, 2008), Verson 7 US states IMPLAN (2008) and gravty model (Lndall et al., 2006) US state-to-country blateral trade flows Orgn of Movement (OM) and State of Destnaton (SD), US Census Bureau (2010) Physcal energy flows and energy prces nternatonal regons GTAP (2008) US states State Energy Data System (SEDS), EIA (2009) Trade elastctes GTAP (2008) and own calbraton Energy demand and supply elastctes Paltsev et al. (2005) 3 Modelng framework 3.1 Data Ths study makes use of a comprehensve energy-economy dataset that features a consstent representaton of energy markets n physcal unts as well as detaled accounts of regonal producton and blateral trade for the year The datset merges detaled state-level data for the US wth natonal economc and energy data for regons n the rest of the world and s outlned n detal by Caron and Rausch (2011). Socal accountng matrces (SAM) n our hybrd dataset are based on data from the Global Trade Analyss Project (GTAP, 2008), IMPLAN (IMpact analyss for PLANnng) data (IMPLAN, 2008), and US state-level accounts on energy balances and prces from the EIA (2009). Table 1 provdes an overvew of data sources. The GTAP dataset provdes consstent global accounts of producton, consumpton, and blateral trade as well as consstent accounts of physcal energy flows and energy prces. Verson 7 of the database, whch s benchmarked to 2004, dentfes 113 countres and regons and 57 commodtes. The IMPLAN data specfes benchmark economc accounts for the 50 US states (and the Dstrct of Columba). The dataset ncludes nput-output tables for each state that dentfy 7

8 509 commodtes and exstng taxes. The base year for the IMPLAN accounts n the verson we use here s To mprove the characterzaton of energy markets n the IMPLAN data, we use least-square optmzaton technques to merge IMPLAN data wth data on physcal energy quanttes and energy prces from the Department of Energy s State Energy Data System (SEDS) for 2006 (EIA, 2009). 2 Data for trade between regons outsde of the US are taken from GTAP and reflect UN- COMTRADE blateral flows. Blateral state-to-state trade data n the IMPLAN database are derved usng a gravty approach descrbed n Lndall, Olson and Alward (2006). 3 As our results depend on benchmark electrcty trade flows between Calforna and neghborng states, we replace state-to-state electrcty flows from IMPLAN wth modeled data from Natonal Energy Renewable Laboratory s ReEDS model (Short et al., 2009). The ReEDS model smulates electrcty flows between 136 Power Control Areas (PCAs) and represents exstng transmsson constrants. Blateral US state-to-country trade flows are based on the US Census Bureau Foregn Trade Statstcs State Data Seres (US Census Bureau, 2010). Blateral exports and mports are taken from, respectvely, the Orgn of Movement (OM) and State of Destnaton (SD) data seres. 4 The OM and SD data sets are avalable at the detaled 6-dgt HS classfcaton level, whch permts aggregaton to GTAP commodty categores. We ntegrate GTAP, IMPLAN/SEDS, and US Census trade data by usng least-square opt- 2 Aggregaton and reconclaton of IMPLAN state-level economc accounts to generate a mcro-consstent benchmark dataset whch can be used for model calbraton s accomplshed usng ancllary tools documented n Rausch and Rutherford (2009). 3 The IMPLAN Trade Flows Model draws on three data sources: the Oak Rdge Natonal Labs county-to-county dstances by mode of transportaton database, the Commodty Flows Survey (CFS) ton-mles data by commodty, and IMPLAN commodty supply and demand estmates by county. 4 The OM seres does not necessarly represent producton locaton as states wth mportant ports of entry or ext mght be over-represented relatve to ther actual trade specalzaton. Cassey (2006) uses addtonal destnatonless estmates of state-level trade to test whether the orgn of movement s a sutable proxy for producton locaton. He fnds that whle there exst sgnfcant dfferences at the 6-dgt commodty level for some states, the data s generally of good enough qualty to represent the state of orgn. Moreover, we argue that our relatvely coarse aggregaton of commodtes and states s lkely to smooth out ths bas. 8

9 mzaton technques. Our data reconclaton strategy s to hold US trade totals (by commodty) from GTAP fxed and to mnmze the resdual dstance between estmated and observed US Census state-to-country blateral trade flows and estmated and observed SAM data from IMPLAN, subject to equlbrum constrants. For ths study, we aggregate the dataset to 15 US regons, 15 regons n the rest of the world, and 14 commodty groups (see Table 2). Countres dentfed n the model nclude Brazl, Canada, Chna, Inda, Japan, Mexco and Russa. EU member states are ncluded n a composte regon and several other compostes are ncluded for other world regons. The composton of US regons s llustrated n Fgure 1. A separate regon s ncluded for some states, ncludng Calforna and states that trade electrcty wth Calforna, but most US regons nclude several states. Our commodty aggregaton dentfes fve energy sectors and nne non-energy compostes. Energy commodtes dentfed n our study nclude coal (COL), natural gas (GAS), crude ol (CRU), refned ol (OIL), and electrcty (ELE), whch allows us to dstngush energy goods and specfy substtutablty between fuels n energy demand. Electrcty from fossl fuels and nuclear and hyrdo generaton s consdered n the model. Elsewhere, we dstngush fve energy-ntensve products Chemcal, rubber, plastc products (CRP), Ferrous metals (I_S), Non-ferrous metals (NFM), Paper products (PPP), and a composte of energy-ntensve manufacturng (EIS) other manufacturng (MAN), agrculture (AGR), transportaton (TRN), and servces (SRV). A concordance between GTAP commodtes and sectors dentfed n our study s provded n Table 2. Prmary factors n the dataset nclude labor, captal, and fossl-fuel resources. Labor and captal earnngs represent gross earnngs denomnated n 2004 US dollars. The calculaton of gross returns to each fossl-fuel resource s outlned n Secton

10 Table 2: Regons, commodty classfcatons and mappngs n the model. Regon Aggregated GTAP commodty Aggregated regon commodty New England NENG Processed rce AGR New York NY Grans AGR South East SEAS Sugar AGR North East NEAS Plant-based fbers AGR Florda FL Forestry AGR South Central SCEN Fshng AGR North Central NCEN Sugar cane, sugar beet AGR Texas TX Beverages and tobacco products AGR Mountan MOUN Bovne meat products AGR Pacfc PACI Bovne cattle AGR Calforna CA Dary products AGR Alaska AK Crops AGR Nevada NV Food products AGR Utah UT Meat products AGR Arzona AZ Ol seeds AGR Vegetables, frut, nuts AGR Russa RUS Vegetable ols and fats AGR Chna CHN Anmal products AGR Inda IND Coal mnng COL Japan JPN Natural gas extracton GAS Rest of Amercas LAM Crude ol CRU Rest of Europe and Central Asa ROE Electrcty ELE Dynamc Asa ASI Refned ol OIL Rest of East Asa REA Ar transport TRN Australa and Oceana ANZ Transport TRN Mddle East MES Water transport TRN Afrca AFR Communcaton SRV Europe EUR Constructon EIS Canada CAN Metal products EIS Mexco MEX Motor vehcles and parts EIS Brazl BRA Mnerals EIS Chemcal, rubber, plastc products CRP Ferrous metals I_S Metals NFM Mneral products NMM Paper products, publshng PPP Leather and wood products MAN Machnery and equpment MAN Manufactures MAN Transport equpment MAN Textles MAN Wearng apparel MAN Dwellngs SRV Insurance SRV Busness and fnancal servces SRV Recreatonal and other servces SRV Other Servces SRV Trade SRV Water SRV 10

11 Fgure 1: Aggregated regons for the US. 3.2 The numercal model Our modelng framework draws on a mult-commodty, mult-regon statc numercal general equlbrum model of the world economy wth sub-natonal detal for the US economy. The key features of the model are outlned below Producton and transformaton technologes For each ndustry ( = 1,..., J) n each regon (r = 1,..., R) gross output (Y r ) s produced usng nputs of labor (L r ), captal (K r ), natural resources ncludng coal, natural gas, crude 11

12 ol, and land (R r ), and produced ntermedate nputs (X jr ), j = : 5 Y r = F r (L r, K r, R r ; X 1r,..., X Ir ). (1) We employ constant-elastcty-of-substtuton (CES) functons to characterze the producton technologes and dstngush fve types of producton actvtes n the model: fossl fuels (ndexed by f ={CRU, COL, GAS}), refned ol (OIL), electrcty (ELE), agrculture (AGR), and non-energy ndustres (ndexed by n ={TRN,EIS,SRV,CRP,I_S,NFM,NMM,PPP,MAN}). All ndustres are characterzed by constant returns to scale (except for fossl fuels and AGR whch are produced subject to decreasng returns to scale) and are traded n perfectly compettve markets. Nestng structure for each type of producton system are depcted n Fgures A 1-A 5. Fossl fuel f, for example, s produced accordng to a nested CES functon combnng a fuelspecfc resource, captal, labor, and ntermedate nputs: Y fr = [ α fr R ρr fr fr + ν fr mn (X 1fr,..., X Ifr, V fr ) ρr fr] 1/ρRfr (2) where α, ν are share coeffcents of the CES functon and σfr R = 1/(1 ρr fr ) s the elastcty of substtuton between the resource and the prmary-factors/materals composte. The prmary factor composte s a Cobb-Douglas of labor and captal: V fr = L β fr fr K1 β fr fr (3) where β s the labor share. 5 For smplcty, we abstract from the varous tax rates that are used n the model. The model ncludes ad-valorem output taxes, corporate captal ncome taxes, payroll taxes (employers and employees contrbuton), and mport tarffs. 12

13 We adopt a putty-clay approach where a fracton φ of prevously-nstalled captal becomes non-malleable and frozen nto the prevalng technques of producton. The fracton 1 φ can be thought of as that proporton of prevously-nstalled malleable captal that s able to have ts nput proportons adjust to new nput prces. Vntaged producton n ndustry that uses nonmalleable captal s subject to a fxed-coeffcent transformaton process n whch the quantty shares of captal, labor, ntermedate nputs and energy by fuel type are set to be dentcal to those n the base year: Y v r = mn (L v r, K v r, R v r; X v 1r,..., X v Ir). (4) In each regon, a sngle government entty approxmates government actvtes at all levels federal, state, and local. Aggregate government consumpton s represented by a Leontef composte: G r = mn(g 1r,..., G r,..., G Ir ). (5) Consumer preferences In each regon r, preferences of the representatve consumers are represented by a CES utlty functon of consumpton goods (C ), nvestment (I), and lesure (N): [ ] 1/ρcr U r = µ cr mn [g(c 1r,..., C Ir ), mn(i 1r,..., I Ir )] 1/ρcr + γ cr N 1/ρcr r (6) where µ and γ are CES share coeffcents, and the elastcty of substtuton between lesure and the consumpton-nvestment composte s gven by σ l,r = 1/(1 ρ cr ). The functon g( ) s a CES composte of energy and non-energy goods whose nestng structure s depcted n Fgure A 6. 13

14 3.2.3 Supples of fnal goods and ntra-us and nternatonal trade Wth the excepton of crude ol, whch s a homogeneous good, ntermedate and fnal consumpton goods are dfferentated followng the Armngton assumpton. For each demand class, the total supply of good s a CES composte of a domestcally produced varety and an mported one: X r = C r = I r = G r = [ ψ z ZD ρd r [ ψ c CD ρd r [ ψ ID ρd r [ ψ g GD ρd r + ξz ZM ρd r + ξc CM ρd r + ξ IM ρd r + ξg GM ρd r ] 1/ρ D (7) ] 1/ρ D (8) ] 1/ρ D (9) ] 1/ρ D (10) where Z, C, I, and G are nter-ndustry demand, consumer demand, nvestment demand, and government demand of good, respectvely; and ZD, CD, ID, GD, are domestc and mported components of each demand class, respectvely. The ψ s and ξ s are the CES share coeffcents and the Armngton substtuton elastcty between domestc and the mported vartes n these compostes s σ D = 1/(1 ρ D ). The domestc mported varetes are represented by nested CES functons, and we dfferentate the followng structure for US regons (ndexed by s = 1,..., S) and nternatonal regons (ndexed by t = 1,..., T ). The mported varety of good s represented by the CES aggregate: M r = [ ( ) ρ M s π st y ρru /ρ RU sr + ] 1/ρ M t r ϕ tr y ρm tr f r = t [ ] 1/ρ M t ϕ tr y ρm tr f r = s (11) where y tr (y sr ) are mports of commodty from regon t (s) to r. π and ϕ are the CES share 14

15 D s + M s σ D Local and domestc (D ) σ DU Foregn (M s ) σ M Local Domestc σ SU y 1s y ts y T s y 1s y s s y Ss Fgure 2: Aggregaton of local, domestc, and foregn varetes of good for US regon s. D r + M r σ D Domestc Foregn (M t ) σ M US σ RU y 1t y t t y T t y 1t y st y St Fgure 3: Aggregaton of domestc and foregn varetes of good for nternatonal regon t. 15

16 coeffcents, and σ M = 1/(1 ρ M ) and σ RU = 1/(1 ρ RU ) are the mpled substtuton elastcty across foregn and ntra-us orgns, respectvely. The domestc varety of good for US regon s s represented by the CES aggregate: D r = [ ( ) ρ DU /ρ SU s r π sr y ρsu sr ] 1/ρ DU + η r y ρdu r f r = s y r f r = t (12) where η s a CES share coeffcent, and σ DU = 1/(1 ρ DU ) s the mpled substtuton elastctes between the local varety and a CES composte of ntra-us varetes. σ SU = 1/(1 ρ SU ) s the elastcty of substtuton across US orgns. Fgures 2 and 3 depct the nestng structures descrbed by Eqs. (7) (12) Equlbrum, model closures, and model soluton Consumpton, labor supply, and savngs result from the decsons of the representatve household n each regon maxmzng ts utlty subject to a budget constrant that full consumpton equals ncome: mn {C r,i r,n r} U r s.t. p ri r + p l rn + p c rc r = p k rk r + p V k r V K r + p R fr R fr + p l rl r + T r (13) where p, p c, p k, p V k, p R, and p l, are prce ndces for nvestment, labor servces, household consumpton (gross of taxes), captal servces, rents on vntaged captal, and rents of fossl fuel resources, respectvely. K, V K, R, L, and T are benchmark stocks of captal, vntaged captal, fossl fuel resources, labor, and transfer ncome, respectvely. Fossl fuel resources and vntaged captal are sector-specfc, whereas captal for nternatonal regons and labor for nternatonal and US regons are perfectly moble across sectors wthn a 16

17 gven regon but mmoble across regons. Captal n the US s assumed to be perfectly moble across US regons but mmoble across nternatonal regons. Except for labor, all factors are nelastcally suppled. Gven nput prces gross of taxes, frms maxmze profts subject to the technology constrants n Eqs. (1) and (4). Mnmzng nput costs for a unt value of output yelds a unt cost ndexes (margnal cost), p Y r and py v r. Frms operate n perfectly compettve markets and maxmze ther proft by sellng ther products at a prce equal to these margnal costs. The man actvtes of the government sector n each regon are purchasng goods and servces, ncome transfers, and rasng revenues through taxes. Government ncome s gven by: GOV r = TAX r r T r B r, where TAX, T r, and B are tax revenue, transfer payments to households and the ntal balance of payments (defct), respectvely. Aggregate demand by the government s gven by: GD r = GOV r /p G r (14) where p G r s the prce for aggregate government consumpton. Market clearance equatons for factors that are suppled nelastcally are straghtforward. The other market clearance equatons are as follow: 1. Supply to the domestc market must equal demand by ndustry, household, nvestment, and government: D r = ZD r + CD r + ID r + GD r. (15) 2. Import supply of good satsfes domestc demand by ndustry, household, nvestment, and government for the mported varety: M r = ZM r + CM r + IM r + GM r. (16) 17

18 3. Trade between all regons n each commodty s balanced: y sr + s r t y tr = s r y rs + r t y rt. (17) r 4. Labor supply equals labor demand. Numercally, the equlbrum s formulated as a mxed complementarty problem (MCP) (Mathesen, 1985; Rutherford, 1995). Our complementarty-based soluton approach comprses two classes of equlbrum condtons: zero proft and market clearance condtons. The former condton determnes a vector of actvty levels and the latter determnes a vector of prces. We formulate the problem n GAMS and use the mathematcal programmng system MPSGE (Rutherford, 1999) and the PATH solver (Drkse and Ferrs, 1995) to solve for non-negatve prces and quanttes Elastctes and calbraton As customary n appled general equlbrum analyss, we use prces and quanttes of the ntegrated economc-energy dataset for the base year 2004 to calbrate the value share and level parameters n the model. Exogenous elastctes determne the free parameters of the functonal forms that capture producton technologes and consumer preferences. Reference values for elastcty parameters are shown n Table 3. Values for Armngton trade elastctes n Table 4 are based on GTAP estmates. Gven the lack of emprcal estmates for σ RU, σ DU, and σ SU we use a rule of thumb that hypotheszes that the value at a gven nest s twce as large as the value at the parent nest. Secton 4.1 conducts senstvty analyss wth respect to these parameters. Fossl fuel producton levels are determned by the prce of fuel relatve to the prce of domestc output. The producton of fuel f requres nputs of domestc supply (e.g., labor and 18

19 ntermedate nputs) and a fuel-specfc resource. Gven the form of the producton functon n Eq. (2), the elastcty of substtuton between the resource and the rest of nputs n the top nest determnes the prce elastcty of supply (ζ f ) at the reference pont accordng to: ζ f = σfr R 1 α fr. (18) α fr The mputed returns to the exhaustble resource from ths procedure are then netted out from the rental value of captal nput n the database. Prce elastctes of supply are taken from Paltsev et al. (2005). We employ ζ COL = ζ GAS = 1 and ζ CRU = 0.5. In a smlar fashon, we calbrate the substtuton elastctes between the value-added composte and the sector-specfc resource factor for generaton from hydro and nuclear sources (ζ NUC = 0.25 and ζ HYD = 0.5). Labor supply s determned by the household choce between lesure and labor. We calbrate compensated and uncompensated labor supply elastctes followng the approach descrbed n Ballard (2000), and assume that the uncompensated (compensated) labor supply elastcty s 0.05 (0.3). 3.3 Specfctes of sub-natonal polces The mechansms behnd leakage from natonal clmate polces have been thoroughly nvestgated n the exstng lterature. The case of sub-natonal polces, however, s dfferent n that both factor and traded good markets are more ntegrated at the natonal level than at the nternatonal level. Indeed, numerous gravty-based emprcal exercses have found natonal borders to nhbt trade. The frst estmates of a "border effect" n McCallum (1995) have been revsed n Anderson and van Wncoop (2003), who fnd trade between US states to be 2.24 tmes larger than trade between states and Canadan provnces. Ths border effect can be replcated n an Armngton-type model by assumng that goods produced wthn the country are closer subst- 19

20 Table 3: Reference values of substtuton elastctes n producton and consumpton. Parameter Substtuton margn Value σ en Energy (excludng electrcty) 1.0 σ enoe Energy electrcty 0.5 σ eva Energy/electrcty value-added 0.5 σ va Captal labor 1.0 σ klem Captal/labor/energy materals 0 σ cog Coal/ol natural gas n ELE 1.0 σ co Coal ol n ELE 0.3 σ hr Resource Captal/labor/energy/materals n hydro ELE Calbrated σ nr Resource Captal/labor/energy/materals n nuclear ELE Calbrated σ am Materals n AGR 0 σ ae Energy/electrcty materals n AGR 0.3 σ er Energy/materals land n AGR 0.6 σ erva Energy/materals/land value-added n AGR 0.7 σ rklm Captal/labor/materals resource n prmary energy 0 σ gr Captal/labor/materals resources Calbrated σ govnv Materals energy n government and nvestment demand 0.5 σ ct Transportaton Non-transport n prvate consumpton 1.0 σ ec Energy Non-energy n prvate consumpton 0.25 σ c Non-energy n prvate consumpton 0.25 σ ef Energy n prvate consumpton 0.4 σ l Lesure materal consumpton/nvestment Calbrated Note: Substtuton elastcty for fossl fuel, nuclear, and hydro resource factors are calbrated accordng to Eq. (18) usng the followng estmates for prce elastctes of supply: zeta COL = ζ GAS = 1, ζ CRU = 0.5, ζ NUC = 0.25, and ζ HYD = 0.5). σ l s calbrated assumng that the compensated and uncompensated labor supply elastcty s 0.05 and 0.3, respectvely. Table 4: Reference values of Armngton elastctes n trade aggregaton. Parameter Substtuton margn Source/Value σ D Foregn domestc (and local) Based on GTAP, verson 7 σ M Across foregn orgns Based on GTAP, verson 7 σ RU Across US orgns for nternatonal regons 2 σ M σ DU Local domestc for US regons 2 σ D σ SU Across US orgns for US regons 2 σ DU s 20

21 tutes than goods from nternatonal sources. Ths s mplemented n our model n a smple manner, as noted above, by settng σ DU, the elastcty of substtuton between local (wthn-state) and domestc goods to equal twce the value of σ D, the elastcty of substtuton between domestc and foregn goods 6. Our model thus smulate a de-facto "border effect", and the wthn-country trade response wll be larger than the nternatonal response. Note that, by assumpton, ths effect wll be dentcal n each sector, whch s unlkely to be the case n practce. We recognze that a robust exercse would requre the emprcal estmaton of these elastctes n a structurally smlar framework. Such an exercse s however out of the scope of the present study and s left to further research. Factor markets are also more tghtly ntegrated wthn natonal borders than across them. Usng Canadan data, Hellwell and McKtrck (1999) fnd that the natonal border clearly reduces captal flows, whereas such resstance s not found for ntra-natonal borders (between provnces). Consequently, we assume that captal s mmoble between countres and perfectly moble between US states. Fnally, as our model s ntended to smulate a "medum-run" tme horzon, we assume labor to be reman mmoble between states as well as between countres. 3.4 Scenaros We evaluate leakage from Calforna s cap-and-trade program by consder fve scenaros. Our frst scenaro, whch we label "EU-ETS", smulates a cap-and-trade program n the EU. The EU- ETS ams to reduce 2020 emssons by 21% relatve to 2005 emssons. The reducton n EU emssons n 2020 wll be nfluenced by, among other factors, regulatons regardng the use of offsets, the bankng of allowances for use n phase three of the EU-ETS, and whether or not the 6 The sector-specfc estmates of whch are taken drectly from GTAP 21

22 EU proceeds wth plans to mplement a more ambtous 2020 cap. We represent clmate polcy n the EU by mposng a cap that reduces EU emssons by 30% relatve to benchmark emssons n our model. 7 Reflectng current legslaton, we apply the cap to emssons from Electrcty; Ol refnng; Chemcal, rubber and plastc products; Ferrous metals; Metals nec; Mneral products; and Paper products and publshng. The EU emssons cap s mposed n all other scenaros and changes n other smulatons are expressed relatve to values n the the EU-ETS scenaro. Accordng to emssons calculatons and projectons by Rogers et al. (2007), the goal to reduce Calfornan emssons to 1990 levels s equvalent to a 29% reducton n 2020 busness as usual emssons. As noted n Secton 2, offsets may account for a sgnfcant proporton of the reducton n emssons, but elgble offset programs may not be able to supply the maxmum quantty of offsets allowed. We take a cautous vew regardng the development of offset opportuntes and consder net-of-offsets cap that reduces Calfornan emssons by 15%. The cap s appled to Electrcty; Ol refnng; Chemcal, rubber and plastc products; Ferrous metals; Mneral products; Paper products and publshng; and the use of refned ol and natural gas n other sectors and n fnal demand. As noted n Secton 2, Calfornan legslaton requres permts to be turned n for emssons emboded n mports and s smlar to a tarff on out-of-state electrcty. The effectveness of ths measure n reducng leakage wll depend on how electrcty exporters respond to the tarff. If out-of-state producers can easly reconfgure transmsson so that low-carbon electrcty s exported to Calforna and carbon-ntensve electrcty s suppled elsewhere, the tarff wll have lttle mpact on leakage. On the other hand, f electrcty producers are unable to reroute supply, the polcy may lead to a large reducton n leakage n states producng (on average) carbon- 7 As we conduct a stylzed analyss, we only consder CO 2 emssons and we do not consder other measures to address clmate concerns, such as renewable electrcty standards and low carbon fuel standards. 22

23 ntensve electrcty. To bound leakage due to Calforna s cap-and-trade program, we consder two extreme responses by electrcty exporters. In one scenaro, CA Notarff, we assume that electrcty exporters can avod tarff charges by reconfgurng supply so that only carbon-free electrcty s suppled to Calforna. In another scenaro, CA Tarff, we calculate emssons emboded n mported electrcty usng emssons coeffcents n exportng regons n the benchmark data. Ths scenaro mplctly assumes that exporters do not adjust the composton of electrcty due to the polcy. The truth les somewhere between these cases and work n progress attempts to calbrate realstc responses by electrcty exporters. We execute two addtonal scenaros to assess the mpact of nternatonal tradng of emsson permts. One scenaro, CA-EU Notarff, allows tradng of permts between the two systems wthout a tarff on Calfornan mports of electrcty. The other, CA-EU Tarff, consders tradng of permts wth Calfornan electrcty tarffs. Fnally, n the EU-ETS, CA Notarff and CA Tarff scenaros, we mplement counterfactual exercses to dstngush leakage occurng va the trade channel from that occurng through the fossl fuel prce channel. Leakage due to trade s estmated by holdng the prce of fossls fuels constant n all regons and leakage through changes n fossl fuel prces s apprased by fxng mports of all commodtes except fossl fuels n all regons. As trade n factors s a substtute for trade n goods, we do not allow captal movements among regons n our decomposton analyss. 8 There are mportant nteractons between leakage channels, so we do not expect the sum of leakage across channels n our decomposton analyss to equal leakage when all channels operate smultaneously. 8 The restrcton of nter-regonal captal movements s only relevant for the US, as captal s regon-specfc n nternatonal regons. Also, labor s regon-specfc n all regons, so we do not mposes addtonal restrctons on labor moblty n our decomposton analyss. 23

24 Russa Rest of World Texas US S. East N. East Rest of US Chna Japan Dynamc Asa Europe Utah Pacfc Arzona Nevada Calforna Fgure 4: CO 2 emssons by regon. 3.5 Descrptve analyss of the data We descrbe key feature of our database before dscussng our smulaton results. Emssons by regon are dsplayed n Fgure 4. The US s the largest source of CO 2 emssons, and accounts for 25% of global emssons. The next largest emtters are Chna (18% of global emssons) and the EU (14%). Calfornan emssons are 5.5% of total US emssons (and 1.4% of global emssons). The largest sources of US emssons are the North East (26.9% of US emssons and 7.0% of global emssons), the South East (16.8% and 4.4%) and Texas (13.2% and 3.4%). As Calfornan emssons are a small proporton of global emssons, large leakage rates can be consstent wth small proportonal changes n emssons n other regons. Regons that export electrcty to Calforna (Arzona, Nevada, Utah and the Pacfc regon) account for a small proporton of total emssons. Leakage wll be nfluenced by the sectoral and regonal composton of Calforna s mports. Other manufacturng accounts for 36% of Calforna s total mports, energy-ntensve commodtes account for 30% and electrcty 2%. Most of Calforna s mports of Other manufacturng 24

25 are from nternatonal sources such as Chna (22%), Dynamc Asa (19%), Mexco (10%) and Japan (9%). The North East s a sgnfcant source of energy-ntensve manufacturng commodtes, especally Iron and steel (45% of total mports of ths commodty), Paper products (23%), Non-metallc mnerals (19%), Non-ferrous metals (16%), and Chemcal products (16%). Internatonally, Chnese products are a relatvely large share of Calforna s mports of non-metallc mnerals (10%) and chemcal products (8%). Arzona (37%) s the major source for Calforna s electrcty mports, followed by Nevada (28%), the Pacfc regon (22%) and Utah (12%). Electrcty s a sgnfcant source of emssons n all regons. We calculate the average carbon ntensty of electrcty n each regon by dvdng the value of electrcty by emssons from fossl fuels used n electrcty generaton. Klograms of CO 2 from each fossl fuel per dollar of electrcty producton for US regons are dsplayed n Fgure 5. Compared to electrcty generated n Calforna, electrcty from Utah s sx tmes as carbon-ntensve, electrcty from Arzona and Nevada twce as carbon ntensve, and electrcty from the Pacfc regon slghtly less carbonntensve. In other regons, electrcty n the Mountan, North Central and North East regons are relatvely carbon-ntensve. Hgh carbon ntenstes n these (and other) regons are due to large shares of coal-fred generaton n total electrcty producton. In contrast, emssons from natural gas account for 92% of total electrcty emssons n Calforna. CO 2 emssons emboded n mports are a functon of mport values and carbon ntenstes. Electrcty accounts for one-quarter of Calforna s total mported emssons. Around 45% of emssons emboded n mported electrcty are sourced from Arzona. The correspondng shares for Utah, Nevada and the Pacfc regon are, respectvely, 21%, 19% and 12%. Other manufacturng also accounts for a large share (29%) of mported emssons, and mports from Chna account for 62% of mported emssons assocated wth ths product. Only 11% of mported Other manufacturng emssons are from other US states. Chemcal products are another sgnf- 25

26 Natural gas Ol Coal Fgure 5: Klograms of CO 2 emssons per dollar of electrcty producton (2004$). cant source of mported emssons (12%), wth most emssons assocated wth producton n Chna and Texas. Aggregatng across regons, products sourced from US states account for 54% of total mported emssons, and the prncpal sources of mported emssons are Chna (25%), Arzona (9%) and Texas (8%). 4 Modelng results As dscussed n Secton 3.4, we consder fve scenaros. The EU-ETS scenaro mplements a capand-trade program n the EU and s used as a benchmark for other scenaros. Two scenaros consder a cap-and-trade program n Calforna wthout nternatonal tradng of permts, one wth neffectve electrcty tarffs, CA Notarff, and one wth effectve tarffs, CA Tarff. The CA- 26

27 Table 5: Emssons allowances prces, 2004$/tCO 2. EU-ETS CA Notarff CA Tarff CA-EU Notarff CA-EU Tarff Calforna EU EU Notarff and CA-EU Tarff scenaros evaluate a cap on Calfornan emssons allowng permt trade between Calforna and the EU, respectvely, wthout and wth effectve electrcty tarffs. Results are summarzed n Tables 5 to 7. CO 2 allowance prces, n 2004 dollars, are dsplayed n Table 5, and Table 6 presents leakage rates to each regon. Table 6 also dsplays aggregate leakage to regons that export electrcty to Calforna (Arzona, Nevada, Utah and the Pacfc regon), and other US and nternatonal (non-us) regons. Leakage to each regon s calculated as the ncrease n emssons n that regon dvded by the decrease n emssons mandated by the EU-ETS n the EU-ETS scenaro and by Calforna s cap-and-trade program n other scenaros. 9 Leakage depends on the extent to whch the polcy nduces ncreased producton of energyntensve goods, especally electrcty, outsde of Calforna, and how changes n fossl fuel prces affect energy use n other regons. To assess the contrbuton of changes n trade and fossl fuel prces, leakage due to each channel for aggregate regons for selected scenaros s reported n Table 7. The table also reports aggregate leakage () summed across the two sources and () smulated when both channels operate smultaneously (as reported n Table 6). CORRECTED : - EU PRICE (WAS 20, SHOULD BE 12.5?) In the EU-ETS scenaro, the allowance prce s $12.5 per metrc ton of CO 2 (tco 2 ) and the leakage rate to all regons s 19% of the reducton n EU emssons. The largest sources of 9 Leakage s commonly defned as the ncrease n emssons n non-constraned regons dvded by the decrease n emssons n constraned regons. Our calculaton s equvalent to ths defnton n scenaros wthout electrcty tarffs. When allowances are requred for mported electrcty, fewer allowances are avalable for domestc use and there s a smaller denomnator n our leakage formula than n conventonal leakage calculatons. 27

28 Table 6: Leakage rates, %. EU-ETS CA Notarff CA Tarff CA-EU Notarff CA-EU Tarff AK AZ FL NV NY TX UT MOUN NCEN NENG NEAS PACI SCEN SEAS AFR ANZ ASI BRA CAN CHN IND JPN LAM MES MEX REA ROE RUS Elec. Exporters Rest of US US Internatonal All regons Note: "Electrcty exporters" references regons that export electrcty to the Calforna (Arzona, Nevada, Utah and the Pacfc regon). 28

29 Table 7: Leakage due to fossl fuel prce and trade channels. EU-ETS CA Notarff CA Tarff Fossl fuel prces: Elec. exporters Rest of US Internatonal All regons Trade: Elec. exporters Rest of US Internatonal All regons All channels (summaton): Elec. exporters Rest of US Internatonal All regons All channels (smulated): Elec. exporters Rest of US Internatonal All regons leakage are Afrca and Chna. Leakage rates to all regons are postve. US emssons ncrease by 2% of the reducton n EU emssons. Table 7 ndcates that a large proporton of leakage occurs va the fossl fuel prce channel. Inspecton of fossl fuel prces reveals a decrease n the composte prce of fossl fuels and a decrease n the prce of coal relatve to the prce of gas. There s also leakage va the trade channel, manly due to ncreased EU mports of Electrcty, Iron and steel, and Metals nec. In the CA Notarff scenaro, the Calfornan allowance prce s $22/tCO 2. The allowance prce reduces Calfornan electrcty producton by 21% and there s a large decrease n the demand for natural gas. A large proporton of the reducton n Calfornan electrcty producton s replaced by mported electrcty, whch results n leakage to electrcty exporters. The largest leakage sources are Arzona (19%), whch experences the largest ncrease n electrcty exports 29

30 to Calforna, and Utah (12%), the most carbon-ntensve electrcty exporter. Decreasng electrcty producton n Calforna and ncreasng producton n electrcty exporters decreases the prce of natural gas and ncreases the prce of coal. These prce changes drve changes n emssons n other US regons. In regons wth a hgh proporton of electrcty generated from coal, such as North Central and North East, the prce changes reduce emssons from electrcty. The largest negatve leakage rate (-6%) s observed for the North East, however the proportonal change n North East emssons s small. Although the Mountan regon produces coal-ntensve electrcty, there s postve leakage to ths regon as the mpact of the coal prce s offset by ncreased electrcty exports to regons supplyng electrcty to Calforna. Electrcty emssons ncrease n regons producng a relatvely large proporton of electrcty from natural gas. In addton to ncreased electrcty emssons, the large leakage rate for Texas (11%) s due to ncreased n Chemcal, rubber and plastc products exports to Calforna. In aggregate, leakage to electrcty exporters s 41% and leakage to other US regons s 5%. There s only a small amount of leakage to nternatonal sources (2%). Due to a large ncrease n Calfornan electrcty mports, most leakage occurs va the trade channel. When the Calfornan tarff on mported electrcty s effectve, (CA Tarff ), the allowance prce s $55/tCO 2. Ths s much hgher than n the CA Notarff scenaro, as the electrcty tarff restrcts a low cost abatement opton for Calforna, and because allowances surrendered for mported electrcty reduces the quantty of allowances that can be used for n-state producton. The polcy ncreases Calfornan consumpton of electrcty generated n Calforna and the Pacfc regon at the expensve of carbon-ntensve electrcty from Arzona and Utah. As a result, there s postve leakage to the Pacfc regon (6%) and negatve leakage to Arzona (-42%) and Utah (-24%). Leakage to other regons s drven by changes n fossl fuel prces. In Calforna, there are two competng effects on the natural gas prce: () prcng emssons nduces a substtuton away 30

31 from natural gas and () the electrcty tarff ncreases demand for natural gas. The second effect domnates n our analyss. There s also decreased demand for refned ol n Calforna and for coal n regons exportng electrcty to Calforna. These demand changes decrease the composte fossl fuel prce and ncrease the prce of natural gas relatve to coal. Ultmately, these changes ncrease emssons n other regons, manly due to ther mpact on electrcty and transportaton. As n the CA Notarff scenaro, there s also leakage assocated wth ncreased Chemcal and rubber and plastc products n Texas. The leakage rate to US regons that do not export electrcty to the US s 58%, but there s negatve leakage wthn the US due to large decreases n emssons n Arzona and Utah. Leakage to nternatonal regons s 6% and manly occurs through the fossl fuel prce channel. The leakage rate to all regons s 5%, whch s substantally lower than n the CA Notarff scenaro. Internatonal tradng of emssons permts equalzes permt prces across the two systems. As the EU market for emssons permts s three tmes the sze of that n Calforna, the common permt prce s close to the EU autarky prce. In the CA-EU Notarff scenaro, the lower permt prce relatve to the correspondng case wthout permt tradng decreases leakage to US regons (from 46% n the CA Notarff scenaro wthout nternatonal permt tradng to 28% n the CA Notarff scenaro wth nternatonal permt tradng). Most of ths decrease s due to decreased Calfornan electrcty mports. Internatonal permt tradng ncreases emssons to nternatonal sources, whch s drven by the ncrease n the permt prce n the EU. In the case where the Calforna electrcty tarff s effectve, nternatonal permt tradng decreases the tarff on mported electrcty and, n a relatve sense, ncreases leakage to electrcty exporters (from -59% n the CA Tarff scenaro to -33% n the CA-EU Tarff scenaro). There s a reducton n leakage to other US regons, as the lower permt prce n Calforna reduces fossl fuel prce changes observed n the CA Tarff scenaro. The net mpact s a decrease n leakage to US 31