Leakage in California's Carbon Market: Preliminary Trading Is Consistent with Expected Impacts of Regulatory Changes

Abstract

California established a cap-and-trade market for greenhouse gas emissions as the core instrument in its comprehensive climate policy. State law requires that market rules minimize leakage of emissions to other states — a particularly important constraint in the electricity sector, where California is a major importer. In economic terms, an electricity importer that swaps a high-emitting electricity contract for a low-emitting replacement engages in a practice called resource shuffling, which results in leakage.

Although the initial carbon market rules flatly prohibited resource shuffling, the market regulator recently decided to exempt a broad series of activities from that prohibition under so-called “safe harbor” provisions. This paper quantifies the leakage impacts from early resource shuffling trades that have already occurred prior to completing these market reforms. I have argued elsewhere that the proposed reforms would permit significant resource shuffling, with a total leakage potential roughly equivalent to the size of the market after so-called complementary policies take effect. The transactions reviewed here are consistent with the criticism that the safe harbors effectively undo the prohibition on resource shuffling. As these transactions demonstrate, emissions have already leaked out of California’s carbon market at scale.

Keywords: Climate policy, carbon markets, leakage

JEL Classification: Q54, Q58, K23, K42