A Tale of Three Models – LCFS in Equilibrium

This is the first of several posts on models of the transition to alternative fuel vehicles. The first looks at a static equilibrium model of the California Low Carbon Fuel Standard (LCFS). Another will look at another model of the LCFS, called VISION-CA, which generates fuel carbon intensity scenarios. Finally, I’ll discuss Jeroen Struben’s thesis, which is a full dynamic model that closes crucial loops among vehicle fleets, consumer behavior, fueling infrastructure, and manufacturers’ learning. At some point I will try to put the pieces together into a general reflection on alt fuel policy.

Those who know me might be surprised to see me heaping praise on a static model, but I’m about to do so. Not every problem is dynamic, and sometimes a comparative statics exercise yields a lot of insight.

In a no-longer-so-new paper, Holland, Hughes, and Knittel work out the implications of the LCFS and some variants. In a nutshell, a low carbon fuel standard is one of a class of standards that requires providers of a fuel (or managers of some kind of portfolio) to meet some criteria on average – X grams of carbon per MJ of fuel energy, or Y% renewable content, for example. If trading is allowed (fun, no?), then the constraint effectively applies to the market portfolio as a whole, rather than to individual providers, which should be more efficient. The constraint in effect requires the providers to set up an internal tax and subsidy system – taxing products that don’t meet the standard, and subsidizing those that do. The LCFS sounds good on paper, but when you do the math, some problems emerge:

We show this decreases high-carbon fuel production but increases low-carbon fuel production, possibly increasing net carbon emissions. The LCFS cannot be efficient, and the best LCFS may be nonbinding. We simulate a national LCFS on gasoline and ethanol. For a broad parameter range, emissions decrease; energy prices increase; abatement costs are large ($80-$760 billion annually); and average abatement costs are large ($307-$2,272 per CO tonne). A cost effective policy has much lower average abatement costs ($60-$868).

Those are strong conclusions, and so far as I can determine from reading an early version of the paper and replicating a piece of the model, completely defensible. Oddly, I haven’t observed any impact on the policy debate around the LCFS or its cousin, renewable portfolio standards (RPS) for electricity. The reason may be as follows:

The political appeal of low carbon fuel standards has several components. First, federal resistance to the regulation of greenhouse gas emissions has limited states’ options. In particular, the options for addressing carbon emissions from the transportation sector, which accounts for 28 percent of U.S. emissions are severely limited. A LCFS might avoid these federal restrictions. Second, Pigouvian taxes, which can correct negative pollution externalities, have proven politically infeasible. A LCFS is not a tax. Third, cap and trade policies, which are more politically palatable, may be undermined by demand shocks. For example, the RECLAIM emissions market was almost destroyed by the California electricity crisis since it was argued that the rigid emissions limits contributed to high electricity prices. A LCFS, by regulating emissions rates rather than emissions, allows for higher emissions in years with higher demand. Finally, politicians are quite sensitive to the effects of policies on energy prices in general and on gasoline prices in particular. A LCFS certainly does not have a direct effect on prices, and one can imagine scenarios (and we will illustrate one) in which a LCFS reduces carbon emissions without increasing gasoline prices.

The appealing aspects of the LCFS come at a high price:

Despite this political appeal, we argue that low carbon fuel standards have a large cost in terms of efficiency and effectiveness. In particular, we show that a LCFS limiting carbon emissions per unit of energy (the energy-based LCFS) can achieve the efficient allocation only under unrealistic assumptions. Moreover, we find that, contrary to the stated purpose, a LCFS can actually raise carbon emissions. Additionally, we show that the best LCFS’”from a regulator’s perspective’”‘under-taxes’ all fuels and may require a nonbinding standard, i.e., the best standard may be no standard at all.

The intuition behind these effects is that the LCFS acts as an implicit tax on any fuel with a carbon intensity above the standard, but acts as a subsidy for any fuel with a carbon intensity below the standard. The efficient allocation cannot be attained since it requires that any fuel emitting carbon should be taxed (not subsidized) in equilibrium. Carbon emissions can increase because compliance with the LCFS can be achieved by reducing the production of high carbon fuels or increasing production of low-carbon fuels. In equilibrium, it is optimal for firms to do both. We show that it is possible that increases in carbon from ramping up production of the low-carbon fuel can outweigh the reduction in carbon associated with decreasing output of the high carbon fuel.

HH&K explore some alternatives that are more efficient than the LCFS, including some interesting options that use moving baselines and exploit individual fuel providers’ incentive to free ride.

I built a small model that incorporates the main features of the analysis and runs interactively (using Vensim’s Synthesim mode). It makes nice visuals of some of HH&K’s points. Playing with it, I noticed some additional issues with this kind of policy:

• knife-edge behavior of market volume of alternative fuels as you approach compliance limits (discussed last year): as the required portfolio performance approaches the performance of the best component options, demand for those approaches 100% of volume rapidly.
• differences in the competitive landscape for technology providers, when compared to alternatives like a carbon tax.
• differences in behavior under uncertainty.
• perverse behavior when the elasticity of substitution among fuels is low

These pose some big challenges for the LCFS. I’ll take a look at these in my next installment.