Whether California can avert a major cash shortage next year hinges partly upon whether the state can build Highway 50 carpool lanes without further environmental review and eliminate two state worker holidays.

Gov. Arnold Schwarzenegger is demanding further concessions from Democratic leaders in the latest round of state budget talks. It's come down to three key issues that pit business interests against labor unions and environmentalists: rollback of environmental review for construction projects, greater use of private investment and contractors, and deeper spending cuts, including those affecting the state work force.

Democrats say the governor is holding the state budget hostage for the sake of measures that have a relatively small economic impact and provide no immediate budget relief.

"It's like a child telling Santa, 'If you don't bring every single item on my list, then stay out of my chimney,' " Assembly Speaker Karen Bass said last week.

Schwarzenegger says that if he is to approve new taxes – something just two years ago he said he would never do – then he must also relax regulations and make deeper cuts in state spending.

The Republican governor last week rejected an $18 billion Democratic plan that would have partially solved the state's anticipated $40 billion shortfall through June 2010.

Senate President Pro Tem Darrell Steinberg, D-Sacramento, and Bass, D-Los Angeles, met twice with Schwarzenegger on Tuesday and said they plan to continue negotiating through Friday by phone and videoconference. The governor left the state for Christmas vacation late Tuesday.

While Democrats contend they gave Schwarzenegger a clear path to avoid running out of cash as soon as February, the governor vowed to hold out for more business-friendly solutions, even as the deficit clock he installed outside his office continues to climb higher each day.

Democrats and Schwarzenegger still disagree over whether the state should waive environmental review requirements for as many as a dozen state transportation projects, including one to build carpool lanes from Sunrise Boulevard to Watt Avenue on Highway 50 in Sacramento County.

The governor asked that the Highway 50 project be exempted from environmental review, allowing the $165 million widening to occur as soon as next summer. A Sacramento judge in July deemed the state Department of Transportation's environmental analysis inadequate, delaying the project, so Schwarzenegger's request would have circumvented that judicial hurdle.

Environmentalists were incensed that Schwarzenegger sought to avoid further review, and Democrats eliminated the project from consideration when crafting their own economic stimulus plan this month. Schwarzenegger's office said that was one of the reasons the governor vowed to veto their proposal.

While Democrats exempted eight projects from California Environmental Quality Act review, their bill requires Caltrans to conduct its own environmental assessments in those cases. Schwarzenegger said those assessments leave projects at risk for CEQA-like lawsuits and do nothing to expedite construction.

Schwarzenegger's demands provide him some political cover from accepting tax increases that businesses do not want. Businesses have long asked for changes in CEQA that would accelerate projects around the state.

"Without the governor's CEQA reforms, California won't be able to take advantage of the federal government's economic recovery plan and our employment will continue to suffer," said Allen Zaremberg, president and CEO of the California Chamber of Commerce.

The governor wants to streamline the permit process for transportation projects. Democrats are concerned about one aspect of the plan that creates a three-person appeals board made up of Schwarzenegger Cabinet members, which they said gives the administration too much control. Schwarzenegger's office last week estimated its overall transportation plan would expedite $1 billion in projects and create 18,000 jobs.

Call Kevin Yamamura, Bee Capitol Bureau, (916) 326-5548. Steve Wiegand and Aurelio Rojas of The Bee Capitol Bureau contributed to this report.