Dan Walters

Could California’s ‘cap-and-trade’ auction meltdown happen again?

Thousands of energy-producing wind turbines dot the landscape in the Palm Springs area as part of an effort by the state to shift utilities to non-carbon sources of power. Another part of the effort to reduce California’s carbon emissions, cap-and-trade, is facing uncertainty over the program’s legality and future.
Thousands of energy-producing wind turbines dot the landscape in the Palm Springs area as part of an effort by the state to shift utilities to non-carbon sources of power. Another part of the effort to reduce California’s carbon emissions, cap-and-trade, is facing uncertainty over the program’s legality and future. Los Angeles Times

The Capitol’s politicians were shocked last month when the state’s quarterly auction of “cap-and-trade” carbon emission allowances generated just 2 percent of anticipated revenues.

Suddenly, plans to spend billions of dollars, including critical financing for Gov. Jerry Brown’s pet bullet-train system, were in jeopardy.

Was it just a one-time aberration that the next auction in August will correct, or is the downturn at least semipermanent?

The answer won’t emerge until then, but major underlying factors are still there – including a glut of allowances and uncertainty over the program’s legality and future.

Nearly three weeks before the May 16 auction, an analysis circulating in financial circles predicted the meltdown with uncanny accuracy, based on the demand softness in the February auction and an immense amount of trading in the secondary market thereafter.

Market analysts believe that there are still far more allowances available for sale than buyers want or need, and thus future auctions are likely to fall short as well.

Cap-and-trade was adopted by the Air Resources Board in response to Assembly Bill 32, the 2006 legislation signed by Brown’s predecessor, Arnold Schwarzenegger. It required regulations that would reduce California’s carbon emissions to 1990 levels by 2020 with “a system of market-based declining annual aggregate emission limits.”

The notion was that carbon emitters, such as factories, power generators and refiners, would buy the allowances, whose numbers would slowly decline and whose prices would slowly increase, thereby incrementally forcing them to invest in technology to reduce overall emissions to the 1990 level.

As more sources of emissions came under its provisions – particularly automotive fuel – auction revenues increased sharply to more than $500 million per quarter.

By law, the revenues were to be spent on meeting the 2020 emissions goal, but politicians were pressured to underwrite a wide variety of purposes, some only tangentially attached to carbon reduction.

Assemblyman Adam Gray, D-Merced, in seeking a state audit of how cap-and-trade money is spent, supported by a coalition of business groups, termed it – accurately – “a feeding frenzy for a multitude of pet projects.”

One of the biggest is the bullet train, which is guaranteed a quarter of carbon auction proceeds, even though the Legislature’s budget analyst, Mac Taylor, warns that it would not, in fact, generate any net emission reduction by 2020.

Brown has proposed $3.1 billion in cap-and-trade spending, both money from previous years and an anticipated $2.4 billion in 2016-17.

The poor May auction cast a cloud on that plan. Department of Finance official Amy Costa told legislators June 2, “I would caution about reading too much into one auction.” But Taylor’s office urged legislators to limit spending to funds already in hand.

Ross Brown, one of Taylor’s analysts, cited “the legal uncertainty of the program” as a major factor in what Sen. Mark Leno called “such a precipitous drop” at the June 2 budget hearing.

Outside analysts agree. They point to two major uncertainties that encouraged speculators to dump their emission allowance holdings into the secondary market and emitters to reduce auction purchases.

One is a lawsuit filed by the California Chamber of Commerce and other business groups, contending that cap-and-trade is a multibillion-dollar tax that requires a two-thirds legislative vote. The Air Resources Board denies the allegation, portraying the auction proceeds as an incidental effect of emission regulation, not a purposeful revenue generator.

However, the fact that much of the money has been spent for purposes with little or no connection to carbon emissions, such as a $500 million shift into the state’s general fund, undercuts the ARB position.

The second uncertainty is whether the program can, under AB 32, continue after 2020 without being reauthorized by the Legislature.

Jean Fuller, the state Senate’s Republican leader, obtained an opinion from the Legislature’s legal counsel that it must end in 2020 unless reauthorized, in response to Brown’s executive order setting new emission standards for 2030.

The law “does not authorize (the ARB) or the governor to set an emission limit after 2020 that is lower than” the 1990 target, the opinion declares.

Brown and the ARB claim otherwise. They cite AB 32’s stated intention to “maintain and continue reductions in emissions of greenhouse gases beyond 2020.”

However, AB 32 also says the ARB “shall make recommendations to the governor and the Legislature on how to continue reductions of greenhouse gas emissions beyond 2020,” which implies that it needs reauthorization.

At a minimum, the future of cap-and-trade beyond 2020 is in legal doubt and could wind up in court.

Still another reason for the market’s decline is that while it was being created, the Legislature, the ARB and other agencies were also imposing direct controls on carbon emissions, particularly those involved in power generation, and they reduced the need for utilities to buy and spend emission allowances.

One reason the need is lower has to do with AB 32’s stated goal to “minimize leakage,” meaning emissions outside the state shouldn’t rise as California utilities shift to renewable power sources.

As applied to California utilities, it means that as they shed power supplies from out-of-state, coal-powered plants in favor of non- or less-polluting sources, they are supposed to ensure that the coal plants don’t provide more dirty juice to other states.

Danny Cullenward, a San Francisco-based energy policy analyst for the Carnegie Institution for Science, has published several papers asserting that several ARB rule changes, by providing “safe harbors” for the coal plants, fostered “resource shuffling” that allowed utilities to more easily meet California emission standards and thus reduced their need for ARB’s emission allowances.

“Basically it’s an accounting trick that creates the false appearance of emission reductions – or leakage, as economists call it,” Cullenward wrote as the rules were being proposed three years ago.

He noted that the ARB’s own economic advisory panel concluded that resource shuffling created “a persistent condition in which the supply (of emission allowances) would exceed market demand.”

Cullenward also suggested that in changing the rules and thus affecting the emission allowance market, California violated – in spirit, if not word – its alliance with the Canadian province of Quebec, which participates in California’s auction system.

The May auction’s poor results have, indeed, created a political stir in Canada, particularly about plans by neighboring Ontario to join the California auction next year.

A big piece of cap-and-trade’s complex legal-financial-political thicket is whether it could be reauthorized past 2020 if that’s deemed legally necessary.

It depends largely on whether it would require a simple majority legislative vote, such as the one that enacted AB 32, or the two-thirds vote required of a tax.

When AB 32 was passed, legal definitions of taxes and fees were somewhat vague, and taxlike fees were being imposed on business without two-thirds votes, thanks to a controversial state Supreme Court decision.

In reaction, business groups sponsored a 2010 ballot measure, Proposition 26, that tightened definitions. Under Proposition 26’s provisions, were legislative authorization needed to extend cap-and-trade beyond 2020, rather than simply action by the ARB, it could require a two-thirds legislative vote.

However, that would be difficult, and perhaps impossible, to obtain even if Democrats regain their two-thirds “supermajorities” in the Legislature this year, given the emergence of a business-friendly bloc of Democrats.

All in all, therefore, the future of cap-and-trade – and the pork barrel money it generates – is very murky.