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California’s signature climate policy is struggling through its awkward teen years

LOS ANGELES, CA - APRIL 29: California Governor Jerry Brown closes his eyes to concentrate on the words of a another speaker during a panel discussion at the 18th annual Milken Institute Global Conference where spoke about new efforts to cope with climate
California Gov. Jerry Brown, at a recent climate conference.
(Photo by David McNew/Getty Images)

California is known the world over for its aggressive efforts to tackle climate change, which include, among other things, a statewide cap-and-trade system.

Policy-wise, cap and trade is a modest piece of the puzzle. It’s responsible for less than a third of the carbon cuts driven by state policy — the rest come from an array of regulations, standards, and investments.

Politically, it’s a different story. The cap-and-trade program has boosted California’s reputation as an environmental leader; it is studied by jurisdictions all over the world. Perhaps most importantly, it generates revenue for a variety of domestic projects important to state politicians and voters.

And it is in trouble.

Whether that trouble is terminal, an awkward phase, or much ado about nothing depends on who you ask and, more importantly, how things play out in the next few years. (Reuters, LA Times, and SacBee also have good stories on this.)

The fateful question every carbon pricing program must answer: Who gets the money?

For those who have forgotten, or blocked it out, a cap-and-trade program is pretty simple.

The cap sets the total amount of greenhouse gasses the economy (or at least the portion of the economy covered by the program) can emit. For each ton of emissions allowed under a cap, the government issues a permit; businesses have to obtain a permit for each ton of GHGs they emit. Businesses can sell or trade the permits on a secondary market as well.

As the cap declines, the number of permits declines and, presumably, their value rises.

One question facing every cap-and-trade system is how to initially distribute each year’s new permits. Roughly speaking, they can be allocated to businesses for free or auctioned off to raise money for the government.

The macroeconomic effect of the program, and its effect on emissions, is the same either way. No matter how the permits are initially distributed, the market allocates them efficiently, the cap is met, and consumers end up paying the bill through energy costs (it all filters down eventually).

While permit distribution may not have environmental effects, however, it very much has political, social, and legal implications. That’s what we’re seeing play out in California.

Initially, state regulators (the California Air Resources Board, or CARB) chose to give away half the permits and auction the other half, with the amount auctioned rising over time. That remains a defensible decision, economically and politically, but it set in motion two dynamics that are now threatening the program.

On old lawsuit is coming back to haunt California

California is famous — and not in a good way — for having a supermajority requirement to raise taxes, via Prop 13. Any policy that raises taxes requires a two-thirds vote in the legislature, which is, needless to say, difficult to get.

So, if the state auctions a pollution permit and raises revenue from it … is that a tax?

In 2012, after the program was created but before it held its first auction, the California Chamber of Commerce filed a lawsuit alleging, among other things, that permit auctions are a tax and thus illegitimate, as they were not passed with a two-thirds majority, per Prop 13.

That argument was rejected by a Superior Court judge in 2013, but it’s been appealed. Recently, the appellate court issued a document asking some pointed questions of the state. Among them: exactly how a ruling against the program might be implemented by the state.

While that may not sound great, it doesn’t mean the court will rule against CARB. Nevertheless, it raises the level of uncertainty. And it helps explain the rather sudden collapse in the market. Just 11 percent of the available permits were purchased in the May auction, netting $10 million — compare that to $500 million in February’s auction.

Some of that has to do with oversupply (more on that later), but some is related to declining confidence that the program’s future is legally secure.

Lots of programs are depending on cap-and-trade revenue, and it’s drying up

The nice thing about auctioning permits is that they raise money for the government, which it can then spend on popular programs. The downside of that arrangement is that it makes revenue for popular programs dependent on swings in the carbon market. That has created a bit of a perverse situation.

All things being equal, it’s good news that permit prices are low, or that permits are going unpurchased. If permits are less expensive than expected, that means reducing carbon in the California economy is less expensive than expected. The cap is being hit at relatively low cost.

However, when permits are being auctioned for revenue, low permit prices mean low revenue. And the government is very much depending on that revenue.

About a quarter of it is dedicated to the (troubled) $68 billion high-speed rail line that Gov. Jerry Brown views as part of his legacy. "Brown has a $3.1 billion spending plan in his 2016-17 budget," says the SacBee. Meanwhile, from the LA Times:

If revenue remains weak, the bullet train could run out of money needed next year to match a federal grant. The state rail authority is depending on annual cap-and-trade revenue of $500 million to build the first operational segment from San Jose to Shafter, a plan that would probably fall apart if the auctions don’t recover.

Also threatened are the funds being spent in disadvantaged communities, as specified by SB 535, a hard-won provision of California’s cap-and-trade bill that says 25 percent of the auction revenue will be spent on disadvantaged communities (with 10 percent of that spent on projects located in those communities).

For example, a program to subsidize low- and no-emission vehicle purchases by low-income consumers is running out of funds.

Other uses for the funds include low-income solarization, affordable housing, and drought relief. If funding for all those programs dries up, there are going to be some extremely irritated constituents.

What will become of cap and trade after 2020?

Looming over all this is uncertainty about whether the program extends past 2020, the date of its statutory emissions target. With current policy in place, it’s going to hit that target (1990 level of emissions by 2020) and get close to its 2050 target (80 percent reduction from 1990 levels).

But is current policy authorized to keep going after 2020?

Brown issued an executive order establishing a 2030 target of 40 percent below 1990 levels, but, says Reuters, "California's Legislative Counsel Diane Boyer-Vine said the governor overstepped his authority in doing so." She says the program must end in 2020; CARB insists it has authority to continue on.

This one easy, er, super-hard trick can solve California’s cap-and-trade problems

There’s a way that California could secure the program against lawsuits, restore healthy levels of revenue, and vouchsafe the program’s authority through 2050, all at a stroke: Pass a new law.

If a new law extending the program is passed with a two-thirds majority, it will obviate any legal concern over the tax issue. And if it writes Brown’s ambitious target into law, and solves the program’s problem with "leakage," it will restore the value of permits and the predictability of auction revenue.

Most of all, it will put the program on sound long-term footing.

However, it’s not clear that such a bill could get to two-thirds in the state legislature. There’s a large faction of conservative Democrats from oil and gas districts in California who do not look upon cap and trade with charity.

They know Brown fiercely wants a bill like this, and they’re convinced he can’t get to two-thirds without them, so they’re looking to extract concessions.

For one thing, they want control over auction revenue spending, authority that now rests with CARB.

For another, they want to scrap the state’s low-carbon fuel standard (LCFS).

The LCFS requires oil refineries and distributors to continuously reduce the carbon-intensity of the fuel they sell in the state — 10 percent by 2020. The oil companies really, really hate this policy, which more or less forces them to fund their competitors.

But environmentalist love it, because it’s working. (It was recently readopted by CARB, with some tweaks). They view it as a deal breaker, too big a price to get to two-thirds.

The alternative, as they see it, is to get a stronger bill with a simple majority. This would be a bit of a gamble, since even if the Prop 13 lawsuit is resolved in the state’s favor, there’s still another lawsuit possible against the new bill based on Prop 26, which extended Prop 13’s rules on taxes to other kinds of fees, levies, and charges as well. The legal battles could drag on for years, but some environmentalists see that as an acceptable price to pay for a stronger bill.

The other fallback option is to do nothing, fight the lawsuits, have CARB act as though the program extends beyond 2020, and hope for the best.

Brown doesn’t want that. This is a matter of legacy for him. But for now, he’s in a tricky spot, pulled by opposing forces and faced with an array of suboptimal choices.

The consequences extend beyond California. The EU’s carbon market is struggling, like many others around the world, mainly because politicians consistently set targets too high, overallocate permits, and drive prices down. The federal policy that might revive those markets in the US, Obama’s Clean Power Plan, is currently stayed by the court.

If California’s cap-and-trade program can’t find its way through this current dumpster fire intact, it could give the reputation of carbon markets a stain that will be difficult to erase.