Escape from Third-Best: Rating Emissions for Intensity Standards

An increasingly common type of environmental policy instrument regulates the carbon intensity of transportation and electricity markets. In order to extend the policy’s scope beyond point-of-use emissions, regulators assign each potential fuel an emission intensity rating for use in calculating compliance. I show that welfare-maximizing ratings do not generally coincide with the best estimates of actual emissions. In fact, the regulator can achieve a higher level of welfare by properly selecting the emission ratings than possible by selecting only the level of the standard. Moreover, a fuel’s optimal rating can actually decrease when its estimated emission intensity increases. Numerical simulations of the California Low-Carbon Fuel Standard suggest that when recent scientific information increased the estimated emissions from conventional ethanol, regulators should have lowered ethanol’s rating (making it appear less emission-intensive) so that the fuel market would clear with a lower quantity.