Cap-and-Trade Revenues: Strategies to Promote Legislative Priorities

: Cap-and-Trade Revenues: Strategies to Promote Legislative Priorities MAC TAYLOR • L E G I S L A T I V E A N A L Y S T • JANUARY 21, 2016 AN LAO REPORT 2 Legislative Analyst’s Office www.lao.ca.gov AN LAO REPORT EXECUTIVE SUMMARY Cap-and-Trade Regulation Key to Meeting Emissions Goal. California’s cap-and-trade program to significantly reduce greenhouse gas (GHG) emissions by 2020 has two major components: (1) the regulation and (2) auction revenue. The relationship between these two components is complex, from both a policy and legal perspective. From a policy standpoint, the regulation is intended to ensure the state meets its GHG goals and provide an incentive for cost-effective emission reductions. A well-designed cap-and-trade regulation also generates auction revenue even though generating revenue is not a primary goal of the program. Requirement to Spend Auction Revenues on GHG Reductions Creates Policy Challenges. Under current law (and potentially under future court decisions), the state can only spend auction revenue on activities that facilitate GHG reductions. However, this requirement creates some significant policy challenges. First, spending auction revenue on GHG reductions is likely not necessary to meet the state’s GHG goals and likely increases the overall costs of emission reduction activities. This is because, in certain cases, spending on GHG reductions interacts with the regulation in a way that changes the types of emission reduction activities, but not the overall level of emission reductions. Second, the requirement to spend on GHG reductions limits the Legislature’s flexibility to use the revenue in a ways that could achieve other goals, such as (1) offsetting higher costs for households and businesses associated with higher energy prices; (2) promoting other climate-related policy goals, such as climate adaptation activities; or (3) promoting other legislative priorities unrelated to climate policy. Strategies to Promote Legislative Priorities. In light of these challenges, we present alternative strategies designed to help the Legislature promote its priorities more efficiently under two alternative scenarios: • Under a Requirement to Spend on GHG Reductions. Strategies that can be utilized under a legal framework which requires that revenues be spent on activities that facilitate the reduction of GHGs include (1) targeting uncapped emission sources, (2) targeting cost-effective emission reduction activities, (3) prioritizing other legislative goals, and (4) offsetting other state spending. Each of these strategies would help promote different legislative priorities and present different levels of legal risk. • Removal of Requirements to Spend on GHG Reductions by Reauthorizing Cap-and-Trade With Two-Thirds Vote. Removing the legal requirement to spend on GHG reductions would (1) provide the Legislature maximum flexibility to provide rebates or tax reductions to offset costs for households and businesses and/or use the funds to address its highest policy priorities, and (2) reduce legal uncertainty regarding the regulation beyond 2020. Moreover, as long as a well-designed cap-and-trade regulation is in place, the state will likely meet its GHG emission targets from major sources of emissions. www.lao.ca.gov Legislative Analyst’s Office 3 AN LAO REPORT 4 Legislative Analyst’s Office www.lao.ca.gov AN LAO REPORT INTRODUCTION California’s cap-and-trade program is one enhance its ability to: (1) promote cost-effective of the primary policies intended to help achieve GHG reductions, (2) reduce costs for energy users, the state’s greenhouse gas (GHG) reduction and (3) promote the highest legislative priorities. goals. In this report, we describe and assess On January 7, 2016, the Governor released a the relationship—from both a legal and policy $3.1 billion cap-and-trade expenditure plan for perspective—between the cap-and-trade regulation 2016-17. We do not analyze the specific proposals and the auction revenues that are generated as a included in the Governor’s plan in this report. result of the program. Based on our assessment, We plan to release a more detailed analysis of the we present general approaches to cap-and-trade Governor’s specific proposals in the coming weeks spending for the Legislature to consider that could as part of our 2016-17 budget analysis. BACKGROUND California’s Climate Change Policies • Design regulations, including distribution of emission allowances (discussed Climate Change and GHGs. Greenhouse below), in a manner that is equitable and gases are gases that trap heat within the earth’s minimizes costs and maximizes benefits to atmosphere, thereby increasing the earth’s California. temperature. Both natural phenomena and human activities (principally burning fossil fuels) produce • Ensure that activities undertaken to comply GHGs. Scientific experts indicate that higher with regulations do not disproportionately concentrations of GHGs resulting from human impact low-income communities. activities are increasing global temperatures, and that such global temperature rises (commonly • Ensure that activities complement efforts to referred to as global warming or climate change) achieve regional air quality standards. will likely cause significant problems, such as sea • Minimize emissions that are shifted out level rise, extended droughts, and heat-related of state because companies move the illnesses. production of goods outside of California AB 32 and the Scoping Plan. The Global due to higher costs associated with Warming Solutions Act of 2006 (Chapter 488 climate change regulations (referred to as [AB 32, Núñez/Pavley]), commonly referred to “leakage”). as AB 32, established the goal of reducing GHG emissions statewide to 1990 levels by 2020. The The ARB is required to develop a Scoping Plan legislation directed the Air Resources Board (ARB) to achieve the emission targets and update the plan to adopt regulations to achieve the maximum periodically. The first Scoping Plan was approved technologically feasible and cost-effective GHG by ARB in 2008 and the first update to the Scoping emission reductions by 2020. In addition, to the Plan was approved in 2014. As shown in Figure 1 extent feasible, ARB must: (see next page), the Scoping Plan includes a wide variety of regulations intended to help the state www.lao.ca.gov Legislative Analyst’s Office 5 AN LAO REPORT meet its GHG goal, including cap-and-trade, their emissions because, in theory, the number the low carbon fuel standard, energy efficiency of allowances available is less than the number of programs, and the renewable portfolio standard. emissions that would otherwise occur. Entities can Scoping Plan regulations are projected to reduce also purchase “offsets” to cover their emissions. emissions by 78 million metric tons of carbon Offsets are GHG emission reduction projects dioxide equivalent in 2020—roughly 15 percent undertaken by entities not subject to the state’s below what annual emissions are estimated to have cap-and-trade program, such as forestry projects been without the regulations. that reduce GHGs. Offsets were used to cover about Cap-and-Trade. About 30 percent of the 4 percent of emissions in 2013 and 2014. projected GHG emission reductions in 2020 Cap-and-trade is a market-based approach come from the ARB’s cap-and-trade regulation. to reducing emissions. (The other common The cap-and-trade regulation places a “cap” market-based approach is a carbon tax.) Market- on aggregate GHG emissions from large GHG based approaches differ from other regulatory emitters, such as large industrial facilities, approaches, such as traditional command-and- electricity generators and importers, and control regulations. Under traditional regulations transportation fuel suppliers. Capped sources of for reducing emissions, government requires emissions are responsible for roughly 85 percent of every business to install a certain type of emission the state’s GHG emissions. The cap declines over reduction technology or meet a certain minimum time, ultimately arriving at the target emission level emissions standard. In contrast, a market-based in 2020. To implement the cap-and-trade program, approach adds a financial cost to producing GHGs, ARB issues carbon allowances equal to the cap, which provides a financial incentive for private and each allowance is essentially a permit to emit businesses and consumers to reduce emissions. The one ton of carbon dioxide equivalent. Entities can private sector has flexibility to determine which also “trade” (buy and sell on the open market) the emission reduction activities are least costly. (For allowances in order to obtain enough to cover their more details on market-based approaches, see our total emissions. Some entities are forced to reduce 2012 report Evaluating the Policy Trade-Offs of California’s Cap-and-Trade Figure 1 Program.) Regulations Expected to Help State Meet What About Emission 2020 Greenhouse Gas Emissions Goal Goals and Cap-and- Trade Post-2020? MMTCO2E Regulations Reduction The administration Cap-and-trade 23 and Legislature have Low carbon fuel standard 15 both expressed an Energy efficiency and conservation 12 interest in achieving 33 percent renewable portfolio standard 12 Refrigerant tracking, reporting, and repair deposit program 5 significant post-2020 Advanced clean cars 3 GHG reductions. For Reductions in vehicle miles traveled (SB 375) 3 example, Executive Orders Landfill methane control 2 Other regulations 5 establish goals of reducing Total 78 statewide emissions to MMTCO2E = million metric tons of carbon dioxide equivalent. 40 percent below 1990 6 Legislative Analyst’s Office www.lao.ca.gov AN LAO REPORT levels by 2030 and 80 percent below 1990 levels Cap-and-Trade Auction Revenue by 2050 and direct ARB and other state agencies Some Allowances Auctioned, Some to implement measures, pursuant to statutory Given Away for Free. One important aspect authority, to achieve these goals. In addition, the of implementing a cap-and-trade program is Legislature has adopted major policies intended determining how to distribute allowances. In to achieve substantial GHG reductions beyond theory, allowances can be issued in one of three 2020. For example, Chapter 547 of 2015 (SB 350, general ways: (1) they can be given away for free, de León) requires (1) that a minimum of 50 percent (2) they can be auctioned by the state, or (3) some of all electricity sold by utilities be from renewable portion can be freely allocated while the other sources and (2) doubling energy efficiency savings portion is auctioned. As shown in Figure 2, ARB in electricity and natural gas by 2030. auctioned about 45 percent of 2015 allowances We note that, without new legislation, there is and gave 51 percent away for free. (Four percent of some legal uncertainty regarding ARB’s authority allowances are made available at predetermined Graphic Sign Off to: (1) enforce regulations to achieve more stringent prices—a strategy intended to moderate potential post-2020 GHG targets and (2) extend the cap-and- Secretary spikes in allowance prices.) Of the 51 percent of trade program beyond 2020. According to ARB, allowances given away for free, most were given Analyst AB 32 provides the authority to do both. However, to investor-owned utilities (IOUs) (16 percent), MPA based on our informal discussions with Legislative certain industrial emitters (14 percent), natural Deputy Counsel, it appears unlikely that AB 32 provides gas suppliers (11 percent), and publicly owned such authority. Although AB 32 states the intent of utilities (7 percent). State law and regulation the Legislature that the statewide GHG emissions require IOUs to auction their allowances and limit remain in existence and be used to “maintain and continue” reductions Figure 2 Some Allowances Auctioned by the State, in emissions beyond 2020, Some Allowances Given Away for Free post-2020 GHG targets below 1990 levels are not specified in 2015 Allowances statute, and AB 32 states that the GHG limit shall remain in effect unless otherwise amended or repealed. In State Auction addition, AB 32 explicitly Free Allocation authorizes ARB to implement a market-based mechanism through 2020, and it is unlikely that the authority provided elsewhere in AB 32 Othera allows ARB to continue to Total = 395 Million Allowances operate the cap-and-trade program after 2020. a Four percent of allowances were made available at predetermined prices—a strategy intended to moderate potential spikes in allowance prices. ARTWORK #150638 www.lao.ca.gov Legislative Analyst’s Office 7 Template_LAOReport_mid.ait AN LAO REPORT most of the resulting revenue must be credited to for 2012-13 through 2014-15, as well as our their industrial, small businesses, and residential projected revenues for 2015-16 and 2016-17. electricity customers. State Constitution Likely Requires Revenue Be Auctions Generate Billions of Dollars in State Used to Reduce GHGs. There is currently a court Revenue. The ARB has conducted 13 quarterly case challenging whether the state can continue cap-and-trade auctions since November 2012— collecting revenue from auctions. In a lawsuit generating roughly $3.5 billion in state revenue. against ARB, plaintiffs argue that the Legislature Beginning January 1, 2015, transportation fuel did not provide ARB the authority to auction suppliers were required to obtain allowances for allowances and collect state revenue. (Plaintiffs do the GHG emissions associated with the combustion not dispute ARB’s authority to operate a cap-and- of their fuels. Since transportation fuel suppliers trade program and give allowances away.) are not given free allowances, the number of state- They further argue that even if the Legislature auctioned allowances has increased significantly gave ARB the authority to collect auction revenue, over the past year—resulting in recent auctions such revenue constitutes an illegal tax. The Graphic Sign Off raising significantly higher amounts of state California Constitution requires that any increases revenue than past auctions. We project the state in state taxes be approved by a two-thirds vote Secretary will generate about $2.4 billion in auction revenue of the Legislature. Previous court decisions have Analyst in 2015-16 and $2.3 billion in 2016-17, assuming determined that certain types of “charges,” such MPA that auction prices stay at similar levels to recent as regulatory fees, are not considered taxes and Deputy auctions. We note, however, that the amount of require only a simple majority vote. The plaintiffs future auction revenue—especially revenue beyond argue that auction revenues are tax revenues and, the next couple of years—is subject to substantial since AB 32 was not passed with a two-thirds vote, uncertainty. Figure 3 shows actual auction revenues the state is collecting auction revenues illegally. In November 2013, the Figure 3 superior court ruled that the State Cap-and-Trade Auction Revenue charges from the auction have characteristics of a tax as well (In Billions) as a fee, but that, on balance, $3.0 the charges constitute legal regulatory fees. This ruling 2.5 has been appealed, and final 2.0 decisions from the appellate courts on these issues may 1.5 take years. If the courts’ final 1.0 decision on these questions 0.5 is to determine that ARB has the authority to collect 2012-13 2013-14 2014-15 2015-16a 2016-17a auction revenue, it is likely that the courts would a LAO estimate. establish some limits on how 8 Legislative Analyst’s Office www.lao.ca.gov ARTWORK #150638 Template_LAOReport_mid.ait AN LAO REPORT revenues can be used. Previous court decisions least 10 percent be spent on projects located within require the state to use regulatory fee revenue to disadvantaged communities. advance the goals of the regulatory program. In Administration Required to Develop addition, the superior court ruling identified the Investment Plan. The administration is required state’s intent to use the revenue to advance the goals to produce several reports, which are intended to of AB 32 (discussed below) as a significant factor in ensure funds are spent in a way that is legal and upholding ARB’s authority to conduct the auctions. consistent with legislative priorities. For example, Therefore, the courts would likely require the state every three years, the Department of Finance to target spending to GHG reduction activities must develop an investment plan that identifies since that is the primary goal of AB 32. The extent feasible and cost-effective GHG emission reduction to which the courts might allow the state to use investments. Among other things, the Three-Year the funds in a way that is intended to achieve other Investment Plan must: AB 32 goals (such as improving air quality and • Analyze gaps, where applicable, in current minimizing costs for households) or for activities state strategies to meeting the state’s GHG with less certain effects on GHGs is unclear. emission reduction goals. State Law Requires Auction Revenue Be Used to Reduce GHGs. Statutes enacted in 2012 • Identify priority investments that will direct the use of auction revenue. For example, facilitate the achievement of feasible and Chapter 807 of 2012 (AB 1532, Perez) requires cost-effective GHG reductions. auction revenues be used to further the purposes The administration released its first investment of AB 32. Revenues must be used to facilitate GHG plan in 2013 and is in the process of completing its emission reductions in California. In addition to second investment plan. reducing GHGs, to the extent feasible, funds must How Has Auction Revenue Been Spent So Far? be used to achieve other goals, such as: As illustrated in Figure 4 (see next page), auction • Maximize overall economic, revenue has been used to fund various programs environmental, and public health benefits and projects. For revenue collected in 2015-16 to the state. and beyond, statute continuously appropriates (1) 25 percent for the state’s high-speed rail • Complement efforts to improve air quality. project, (2) 20 percent for affordable housing and sustainable communities grants (with at • Lessen the effects of climate change on the least half of this amount for affordable housing), state (also known as climate adaptation). (3) 10 percent for intercity rail capital projects, and • Direct investment toward the most (4) 5 percent for low carbon transit operations. disadvantaged communities and The remaining 40 percent is available for annual households in the state. appropriation by the Legislature. Statute also requires that an outstanding loan of $400 million To address this last goal, Chapter 830 of 2012 in auction revenues to the General Fund be repaid (SB 535, de León) requires that at least 25 percent of to the high-speed rail project when needed by the auction revenue be used to benefit disadvantaged project. communities (as determined by the Office of Environmental Health Hazard Assessment) and at www.lao.ca.gov Legislative Analyst’s Office 9 AN LAO REPORT Figure 4 Cap-and-Trade Expenditures (In Millions) Program 2013-14 2014-15 2015-16a High-speed rail — $250 $600 Affordable housing and sustainable communities — 130 480 Transit and intercity rail capital — 25 240 Transit operations — 25 120 Low carbon transportation $30 200 90 Low-income weatherization and solar — 75 70 Agricultural energy and operational efficiency 10 25 40 Urban water efficiency 30 20 20 Sustainable forests and urban forestry — 42 — Waste diversion — 25 — Wetlands and watershed restoration — 25 — Other administration 2 10 31 Totals $72 $852 $1,691 a Based on LAO projection of $2.4 billion in revenue in 2015-16. The fund balance is projected to be $1.6 billion by the end of 2015-16. CAP-AND-TRADE REGULATION KEY TO MEETING EMISSIONS GOAL The state’s cap-and-trade program has Figure 5 shows a simplified example of how two major components: (1) the cap-and-trade a cap-and-trade program ensures emissions regulation and (2) auction revenue. Below, we do not exceed the number of allowances discuss how the cap-and-trade regulation is issued by the state. Without establishing a cap, designed to ensure the state meets its GHG Companies A, B, C, and D would each have one emission goals in a cost-effective manner. emission. To establish a cap, the state issues three Cap Ensures California Meets 2020 GHG allowances. As a result, only three companies can Target From Largest Sources of Emissions. From obtain an allowance and continue to emit, while a GHG emissions perspective, one of the primary one company is forced to reduce its emission. advantages of a cap-and-trade regulation is that Allowance Price Provides Incentive for the cap ensures total GHGs from major sources of Cost-Effective Emission Reductions. From an emissions do not exceed the limit established by economic perspective, the primary advantage of a the state. This is because the state issues a limited cap-and-trade program is that it creates a financial number of allowances, and large emitters are incentive to identify the least costly emission required to obtain an allowance for each emission. reduction activities. The supply and demand of Therefore, as long as GHG emissions are accurately allowances in a trading market generally determine measured and the regulation is adequately the price of an allowance. In our example, each enforced, the number of emissions cannot exceed company would only purchase an allowance if the the number of allowances (or the cap). allowance price (in this case, $11) is lower than 10 Legislative Analyst’s Office www.lao.ca.gov AN LAO REPORT their cost to reduce their emission. As shown in the our example. This is because the allowance price example in Figure 5, some emitters (Company D provides an economic incentive to find the mix in this case) will reduce emissions because it is of emission reductions and allowance purchases less costly ($10) for them to do so than purchase that minimize costs. (We note that although Graphic Sign Off an allowance. Remaining emitters will purchase Companies A, B, and C incur costs to purchase an allowance and continue to emit because allowances, economists generally do Snoetc croentasirdyer allowances are cheaper than reducing emissions. these to be net economic costs to socAientya, plyasrttly In theory, the level of overall emission reductions because the allowances do not result MinP aA reduction is achieved at the lowest cost possible—$10 in in emissions.) Deputy Figure 5 Cap-and-Trade Regulation Ensures Emissions Do Not Exceed Limit 1 2 3 Without Cap State Issues With Cap With Cost to Reduce Emission 3 Allowances Company A Company A Obtains AAlllloowwaannccee Cost to Reduce: $25 AAlllloowwaannccee $$1111 Company B Company B Obtains AAlllloowwaannccee Cost to Reduce: $20 AAlllloowwaannccee $$1111 Company C Company C Obtains AAlllloowwaannccee Cost to Reduce: $15 AAlllloowwaannccee $$1111 Company D Company D Cost $10 Cost to Reduce: $10 Emissions: 4 Emissions: 3 Emission Reduced: 1 Cost of Reduction: $10 Template_LAOReport_fullpage.ait ARTWORK #150638 www.lao.ca.gov Legislative Analyst’s Office 11 AN LAO REPORT It is important to note that, while covered has an incentive to reduce emissions if doing so is entities (such as electricity generators and less than the price of an allowance. transportation fuel suppliers) pay the direct costs of However, the distribution of allowances can purchasing allowances, at least a portion of the costs have significant indirect effects, such as on the are passed on to customers and other businesses overall level of emissions outside of California, in the form of higher product prices. As a result, and how the costs and benefits of the program are a wide variety of businesses and households have distributed. In general, economists recommend a financial incentive to use less GHG-intensive auctioning allowances rather than giving them away products. For example, transportation fuel suppliers for free. This is because auctions are considered a must purchase allowances associated with the more transparent, equitable, and efficient method emissions from gasoline consumption, but those of distributing allowances. (For more detailed costs are generally passed on to consumers in information on the potential benefits of auctioning the form of higher gasoline prices. As gasoline allowances, please see the nearby box.) The primary prices increase, businesses and households have exception to this recommendation is giving away an incentive to reduce gasoline consumption. The allowances for free to certain industries to prevent higher prices are key to ensuring that businesses leakage. Free allocations to prevent leakage can help and consumers have an incentive to consume fewer ensure the program is reducing overall emissions by GHG-intensive products. However, it also means ensuring emissions are not simply shifted to other that households and businesses that continue to states or countries. consume these products, such as gasoline, will pay . . . But Generating Additional Revenue more for those goods and services. Not a Primary Goal of Cap-and-Trade. While Auctions Are Generally the Preferred Method auctioning allowances is generally the preferred of Distributing Allowances . . . In theory, the method for distributing at least a portion of method of distributing allowances has no direct allowances, the primary goal of a cap-and-trade effect on the overall level of emissions or cost of program is to provide an economy-wide incentive emission reductions. This is because the overall for businesses and consumers to undertake level of emissions cannot exceed the number of cost-effective emission reductions. For this reason, allowances issued, regardless of how the allowances from an economic perspective, auction revenues are are initially distributed. Also, each company still often thought of as a byproduct of cap-and-trade programs and not their primary goal. REQUIREMENT TO SPEND AUCTION REVENUE ON GHG REDUCTIONS CREATES POLICY CHALLENGES As discussed above, state law requires that of the likely legal restrictions on the use auction revenue be spent on activities that of the funds. We continue to believe that facilitate the reduction of GHGs. In the past, targeting funding to GHG reduction activities our office recommended the Legislature use the is a reasonable strategy to reduce legal risk revenue to reduce GHGs—a recommendation because the funds are being used to achieve the that was largely based on our understanding primary regulatory goal of AB 32. In addition, 12 Legislative Analyst’s Office www.lao.ca.gov AN LAO REPORT Economic Advisory Committee Recommended Auctioning Allowances Economists generally recommend auctioning cap-and-trade allowances, rather than giving them away for free. For example, an economic advisory committee established by the Air Resources Board in 2010 recommended relying principally on auctioning as the mechanism for distributing allowances. Some of the advantages of auctions include: • Easier Treatment for New Entrants. Auctions treat new and existing companies equally because they all have to purchase allowances. New companies see the same cost as competitors when entering the market. In contrast, giving allowances away for free could create an advantage for existing companies if free allowances are based on previous production in California. • Maintains Price Signal. Under auctions, companies that have to pay for allowances will often pass those costs on to customers in the form of higher prices. From an economic perspective, this is an advantage because it provides an incentive for households and businesses to identify cost-effective opportunities to reduce emissions. In contrast, free allocations based on a company’s production can prevent product prices from rising and, thereby, reduce these price signals. This can result in higher overall emission reduction costs because consumers who have opportunities to undertake low-cost emission reductions no longer have a financial incentive to do so. • Avoids Windfall Profits for Companies. In certain circumstances, giving allowances away for free can result in “windfall profits” for certain companies if the value of the allowances they receive is significantly greater than the costs of complying with the regulation. This may be viewed as an unfair distribution of allowance value. Windfall profits for companies will not occur under auctions. • Opportunities to Reduce Taxes. Auction revenue can be used to provide economic benefits. For example, revenue could be used to reduce broad-based taxes (such as income or sales taxes), which could help reduce negative impact on economic activity. The one instance in which the committee recommended giving allowances away for free was to prevent leakage for certain industries. Allocating free allowances to certain companies based on their level of production can reduce companies’ incentive to shift production to other states. Under this approach, the state effectively provides these companies a subsidy for each unit of production in California—in the form of free allowances—to encourage them to continue to produce in California. While this can be an effective strategy for reducing leakage, the committee also noted that the state could accomplish the same objective by auctioning the allowances and using the resulting revenue to encourage production in California. www.lao.ca.gov Legislative Analyst’s Office 13 AN LAO REPORT funding projects that reduce GHGs can produce • State Subsidizes Emission Reduction From significant benefits, such as improved regional Company C. Company C could reduce its air quality. emissions at a cost of $15. However, the However, this approach creates significant state offers a $10 subsidy for Company C policy challenges because (1) spending a to reduce its emission. For example, the substantial amount of auction revenue on GHG subsidy might be a grant to install a more reductions in the capped sector is likely not energy-efficient production technology. necessary to meet the state’s GHG goals and likely Consequently, Company C can reduce increases overall costs and (2) the requirement emissions for $5, rather than $15. to spend on GHG reductions limits legislative • Company C Reduces Emissions and flexibility to achieve other goals. We discuss these Sells Allowance to Company D. With the policy challenges in more detail below. subsidy, it is now cheapest for Company C Spending Auction Revenue on GHGs to reduce its emission. So, it chooses to sell Unnecessary and More Costly its allowance. Company D has an incentive to purchase the allowance as long as it Spending auction revenue on GHG emission is cheaper than the cost of reducing its reductions from capped sources interacts with the emission ($10). Company D purchases the cap-and-trade regulation in somewhat complicated allowance from Company C—for $9, for and perhaps unexpected ways. Below, we discuss example—and continues to emit. these interactions and the implications for overall GHG emission reductions and costs. • Despite State Spending, There Is No Spending on Capped Sources Likely Has No Additional Decrease in Emissions. The net Net Effect on Overall Emissions. At first glance, effect of subsidizing an emission reduction subsidizing emission reductions from capped from Company C is that Company D will sources might appear to encourage additional obtain the allowance and continue to emit emission reductions. However, as long as the cap is instead of Company C. limiting emissions from these sources, spending on As long as the cap is limiting emissions, activities that reduce emissions from these sources subsidizing an emission reduction from one capped will likely have no net effect on overall emissions. source will simply free-up allowances for other Figure 6 builds on the example in Figure 5 and emitters to use. The end result is a change in the illustrates how subsidizing reductions from capped sources of emissions, but no change in the overall sources results in no net change in emissions. level of emissions. Specifically, as shown in Figure 6: In contrast to spending on reductions • Without Subsidy, Company D Reduces from capped sources, spending on reductions Emission and Others Purchase from uncapped sources—such as agriculture, Allowances. As shown in Figure 6, landfill methane emissions, and emissions from without state spending on GHG refrigerants—is likely to reduce overall emissions. emission reductions, Company D will Net reductions could occur in the uncapped sectors reduce emissions for a cost of $10. because there would be no trading of allowances Companies A, B, and C will purchase that would allow the subsidized emission reduction allowances and continue to emit. 14 Legislative Analyst’s Office www.lao.ca.gov AN LAO REPORT to be offset by an increase in emissions from a reductions would likely be more costly. For different source. example, the overall emission reduction costs in Spending on GHG Reductions From Capped Figure 6 are $10 without the state subsidy. The Sources Likely Increases Overall Costs. As overall emission reduction costs with the state Graphic Sign Off discussed above, the cap-and-trade regulation subsidy—including both state spending and private generally creates a financial incentive for producers spending—are $15. Secretary and consumers to find the least costly mix of In some limited circumstances, tAhen ianlcyesnttives emission reductions. Therefore, using state funds provided by cap-and-trade might failM toP eAncourage to encourage a different mix of GHG emission cost-effective emission reduction actiDvietipesu. tIyn such Figure 6 Spending Has No Effect on Overall Emissions 1 2 3 With Cap State Provides Subsidy With Cap and State Subsidy Company A Company A AAlllloowwaannccee AAlllloowwaannccee Company B Company B AAlllloowwaannccee AAlllloowwaannccee $10 Subsidy to Reduce Company C Company C Emissions From Company C Cost $15 - $10 = $5 AAlllloowwaannccee Sells Allowance to Company D Company D Company D Cost $10 AAlllloowwaannccee Emissions: 3 Emissions: 3 Emission Reduced: 1 Emission Reduced: 1 Cost of Reduction: $10 Cost of Reduction: $15 Template_LAOReport_fullpage.ait ARTWORK #150638 www.lao.ca.gov Legislative Analyst’s Office 15 AN LAO REPORT instances, targeting auction revenue to certain could use auction revenue to provide an annual GHG reduction activities in the capped sector rebate check to California households and/or might be able to improve overall cost-effectiveness, businesses affected by cap-and-trade. The amount as we discuss in more detail later in this report. of the rebate could be a lump sum amount not dependent on the household’s energy use. This Limits Flexibility to Efficiently would maintain the financial incentive to use Achieve Other Legislative Goals less GHG-intensive products and meet the state’s The Legislature has a wide variety of goals and climate change goal. In addition, the Legislature priorities, in addition to reducing GHG emissions. would have the flexibility to determine the Programs funded with auction revenue are, in amount of the rebate going to each household to part, intended to promote some of these other ensure that low-income households do not bear a goals and priorities (such as improving air quality disproportionate amount of the costs. and limiting costs for low-income households). A similar approach is currently being However, under current law (and potentially under implemented by the state’s IOUs. State law and future court decisions), the state can only fund regulation directs the IOUs to use revenue raised projects that provide those benefits if those projects from selling their free allowances to provide a also reduce GHGs. This limits the state’s flexibility semiannual “Climate Credit” on customers’ bills. to achieve non-GHG benefits as efficiently as The Climate Credit is intended to offset the higher possible. costs of electricity associated with cap-and-trade. Limits Flexibility to Reduce Costs for Energy However, it is unclear if such an approach would be Users. As noted earlier, AB 32 directs ARB to practical or legal to implement more broadly. The design regulations in a way that minimizes costs IOUs present a somewhat unique situation because and ensures activities undertaken to comply the state has substantial regulatory authority with the regulations do not disproportionately over IOUs. As a result, it can direct IOUs to use impact low-income communities. Currently, the revenue to offset customer costs. In addition, some programs funded with auction revenue since the revenue is collected by the IOUs, it is not provide financial benefits to households, but such technically state revenue and might not have the benefits only go to the small portion of households same potential legal restrictions associated with that participate in the program. For example, state regulatory fees. in 2014-15, the ARB’s Clean Vehicle Rebate Limits Flexibility to Achieve Climate-Related Project provided $111 million in rebates to 52,000 Policy Goals. The current requirement to spend individuals that purchased electric vehicles. These auction revenue on activities that reduce GHGs households represent less than one-half of 1 percent limits the state’s flexibility to use the funds in a of the nearly 13 million households in California. way that maximizes the state’s ability to lessen In addition, any financial benefits provided to the effects of climate change. For example, many households through many of the other programs of the activities that might be needed to prepare that receive significant amounts of funding (such as for the effects of climate change—such as public transit and high-speed rail) are relatively indirect health strategies to prevent heat illnesses, enhanced and difficult to measure. emergency management activities, and protecting Ideally, there would be more direct ways to infrastructure from rising sea levels—likely do not reduce costs for households. For example, the state reduce GHG emissions. 16 Legislative Analyst’s Office www.lao.ca.gov AN LAO REPORT In addition, auction revenue currently is being Legislature has many other goals and priorities, used to fund a variety of activities that are intended in addition to those identified in climate-related to improve air quality (as well as reduce GHGs), legislation. For example, at the time this report was such as rebates for electric vehicles and funding prepared, the Legislature was in a special session for public transit. The state could be missing to identify a permanent and sustainable increase opportunities to fund activities that produce in funding for transportation. Improving the significant local air quality benefits but that have state’s transportation infrastructure could provide no significant effect on GHGs. For example, using significant economic and social benefits. The the funds to encourage companies to upgrade current requirement potentially limits flexibility air pollution control technologies that reduce to fund certain projects from auction revenues nitrous oxides or particulate matter might provide that have the greatest mobility benefits if the GHG substantial air quality benefits, but such activities effects associated with such projects are unclear. might have little or no GHG benefit. Moreover, The requirement also limits flexibility to address to the extent the Legislature is interested in other legislative priorities, which could include: maximizing air quality benefits for disadvantaged (1) tax reductions; (2) greater fiscal stability; and/or communities, the current requirement potentially (3) spending on other priority programs, such as limits flexibility to fund the most effective air improved health care services, education facilities, quality projects in these communities. or public safety programs. Limits Flexibility to Promote Legislative Priorities Unrelated to Climate Policy. The POST-2020 UNCERTAINTY CREATES ADDITIONAL CHALLENGES As discussed above, there is currently some that is not ultimately needed to comply with dispute about the ARB’s current statutory authority state regulations, it would face increased costs to: (1) enforce regulations to achieve a more unnecessarily. Alternatively, if the company does stringent post-2020 GHG target and (2) extend the not purchase the more efficient technology and cap-and-trade program beyond 2020. Below, we the state subsequently adopts more stringent GHG discuss some of the potential problems created by reduction requirements, then the company might this legal uncertainty. have to find more expensive ways to comply in the Costly Private Investment Decisions. future. Regulatory uncertainty about long-term GHG Difficulty Evaluating State Spending limits and regulations can make it difficult for Options. If cap-and-trade is extended beyond covered entities today to make cost-effective 2020, then spending auction revenues now on long-term investments. For example, a company activities that reduce emissions from capped might have an opportunity to purchase a more sources will likely have no net effect on long-term expensive, but more efficient, technology that emissions. If the program is not extended, then reduces GHGs reductions beyond 2020. If the spending on post-2020 emission reductions company purchases the more expensive technology from capped sources could reduce long-term www.lao.ca.gov Legislative Analyst’s Office 17 AN LAO REPORT emissions. Clarifying whether cap-and-trade near-term spending decisions will affect GHG will be extended beyond 2020 would give the emissions in the long run. Legislature a better understanding of how its OPTIONS FOR LEGISLATIVE CONSIDERATION As long as the Legislature has GHG reduction associated with each option. In general, the more goals, we think relying heavily on market-based the funds are being used for things other than the regulatory approaches, such as a cap-and-trade primary purpose of AB 32—achieving the 1990 program, would help achieve such goals in a GHG limit—or on projects that have less certain cost-effective manner. Although a well-designed GHG benefits, the greater the risk of violating cap-and-trade program generally includes future court restrictions on the use of the funds. auctioning at least some allowances, generating We continue to recommend the Legislature consult revenue is not a primary goal of the program. with Legislative Counsel about the legal risks Further, spending billions of dollars of auction associated with different spending options. revenue on GHG reductions from capped sources is Spend in Uncapped Sector to Achieve Net not necessary to accomplish GHG goals, and doing GHG Reductions. The ARB projects that existing so limits flexibility to limit costs for households and regulations will encourage enough emission businesses and achieve other legislative priorities. reductions—from capped and uncapped sources— In our view, these findings have significant to meet the state’s overall 2020 GHG target. To the implications for how the Legislature might want extent additional GHG reductions are a priority, to approach cap-and-trade and the expenditure the Legislature could target funds to achieve GHG of auction revenue. Below, we provide strategies emission reductions from uncapped sources. As designed to help the Legislature promote its discussed above, spending on emission reductions priorities more efficiently under two alternative from uncapped sources would likely result in net scenarios: (1) under a legal framework that requires emission reductions. In addition, there is limited cap-and-trade revenue be spent on GHG reductions legal risk associated with this option because the and (2) removal of the legal requirement to spend funds would be targeted to GHG reductions that revenue on GHG reductions by reauthorizing the would not otherwise occur. To ensure funds are cap-and-trade program with a two-thirds vote. being used to maximize emission reductions, the Legislature should target funds to projects and Under a Requirement to Spend programs with the greatest emission reduction per on GHG Reductions dollar spent. We first discuss strategies for using auction Target Spending to Reduce Overall Costs. To revenue assuming the Legislature continues to the extent reducing the overall costs of emission operate under a legal framework for cap-and-trade reduction activities is a priority, the Legislature which requires the funds be spent on activities could target spending to cost-effective emission that facilitate the reduction of GHGs. The extent reduction activities that cap-and-trade and other to which the Legislature relies on each of these existing regulations and programs do not already strategies depends on: (1) legislative policy encourage. For example, cap-and-trade might priorities and (2) an assessment of the legal risk not provide adequate incentive in the private 18 Legislative Analyst’s Office www.lao.ca.gov AN LAO REPORT sector for research and development activities on guidance on identifying market conditions GHG-reducing technologies because the benefits of in which current federal and state programs such activities can “spill over” to other companies fail to provide adequate incentives for energy that can profit by implementing developments technologies. This information could then be used made by others in their own products. As a result, to: (1) target auction revenues to programs that best private companies do not always invest in research address these market conditions and (2) direct state and development activities at a level that is socially agencies to evaluate project applicants based on optimal. Thus, there could be a rationale for their ability to address these market conditions. providing some state funding in this area. Prioritize Other Legislative Goals. If the Using auction revenue to encourage more priority is to address other climate-related goals, cost-effective emission reductions should be based the Legislature may want to consider directing on an analysis of (1) gaps in other regulations and the administration to give greater weight to some programs and (2) how state funds can be best of these other benefits when allocating funds. For targeted to address these gaps. State law currently example, GHG reductions are one of the primary requires the administration to provide such an evaluation criteria used to evaluate Transit and analysis as part of its Three-Year Investment Plan. Intercity Rail Capital Program applications. However, in our view, the administration’s analysis Benefits to disadvantaged communities, such as to date has been lacking. The administration’s reduced air pollution, are a secondary evaluation draft investment plan released in December criteria. The Legislature could direct state 2015 provides limited data or analysis that can agencies to give greater weight to other goals be used to identify gaps in existing programs when evaluating applications for funding, such as and regulations, the extent to which additional air quality or preparing for the effects of climate state funding is needed, or how funding could be change in disadvantaged communities. The targeted to address these gaps in a cost-effective Legislature would have to balance the potential manner. (For more information on the ways in benefits of achieving greater non-GHG benefits which the administration’s approach to the Second against the potential greater legal risk of targeting Investment Plan is lacking, see our September the money less towards GHG reductions. 2015 online report Framework for Cap-and-Trade Offset Other Types of State Spending to Enable Investment Plan Needs Further Development.) Greater Budget Flexibility. If the priority is to The Legislature could consider requiring the achieve greater flexibility, the Legislature could administration to provide a more robust analysis use auction revenue to offset spending from other of the ways in which existing regulations and sources of state funds, including special funds and programs do not provide adequate incentive for the General Fund, that are currently being used for consumers and businesses to make cost-effective GHG reduction-related activities. Using revenues to reductions. Such an analysis can be difficult offset other state spending could free up state funds because it relies on a strong understanding of to be used for other legislative priorities, which complex economic market conditions that exist could include reducing fees or taxes. For example, for different types of emissions. To help ensure the Legislature could consider using the additional a robust analysis, the Legislature could require revenue to offset special fund spending on certain the administration to establish an expert panel of climate related activities, such as the Alternative economists and other outside experts to provide and Renewable Fuels and Vehicle Technology www.lao.ca.gov Legislative Analyst’s Office 19 AN LAO REPORT Program. Similarly, using auction revenue to offset households. It would be important to provide General Fund spending on activities such as energy the rebates or tax reductions in a way that does conservation activities in state buildings would not interfere with the price signal provided by make additional General Fund dollars available the cap-and-trade program. This could be done for other legislative priorities. The current amount by issuing a rebate check directly to California of potential General Fund offsets is unclear. Our households and businesses in an amount not tied past efforts have found limited General Fund to their energy consumption or GHG production, expenditures on activities that reduce GHGs. which is similar in concept to the Climate Credit provided to IOU customers. An alternative Removal of Requirements to Spend approach would be to use the funds to reduce on GHG Reductions by Reauthorizing taxes. For example, the funds could be used to Cap-and-Trade With Two-Thirds Vote reduce the state sales tax rate which would provide Alternatively, the Legislature could reauthorize financial benefits to all California households. The the cap-and-trade program with a two-thirds vote Legislature could also use the funds to expand and clarify that ARB has the authority to conduct the state’s Earned Income Tax Credit (EITC). (For auctions. It could reauthorize the program only more details on the considerations of structuring a through 2020 or, to the extent the Legislature state EITC, please see our 2014 report Options for a determines it would like to use cap-and-trade State Earned Income Tax Credit.) This would have to achieve post-2020 GHG reductions, it could the benefit of minimizing costs for low-income authorize the program beyond 2020. In either case, households, as well as the potential policy benefit authorizing the program with a two-thirds vote of increasing incentives for full-time labor force would (1) give the Legislature greater flexibility participation. to return the revenue directly to households and Flexibility to Use Revenue to Promote Highest businesses and/or use the funds to address its Legislative Priorities. To the extent the Legislature highest priorities and (2) reduce legal uncertainty determines additional revenue is needed to achieve about the future of the program. Under this other policy priorities, reauthorizing cap-and approach, the state would still meet its GHG trade with a two-thirds vote would provide greater emissions target from capped sources for as long flexibility to use the funds in a way that efficiently as a well-designed cap-and-trade regulation was in promote its highest priorities whether those are place. climate change-related or not. For example, the Flexibility to Return Funds Directly to Legislature could use the revenue to fund the Households and/or Businesses. Since generating highest priority transportation infrastructure revenue for other state programs is not the primary projects or increase rates for certain health care goal of a cap-and-trade program, the Legislature services. might want to consider returning most or all of If additional climate-related activities are a the revenue to households and businesses in the high priority, the Legislature would also have the form of rebates or tax reductions. This option flexibility to target some revenue to achieve these is likely unavailable under the current legal benefits. For example, the Legislature could target framework because it has no clear connection to the funds to activities that provide the greatest air GHG reductions. However, it would help promote quality benefits for disadvantaged communities the Legislature’s goal of minimizing costs for or best prepare the state for the effects of climate 20 Legislative Analyst’s Office www.lao.ca.gov AN LAO REPORT change. It could also use a portion of the funds post-2020 GHG goals, it should consider relying on for GHG reductions, such as reductions from market-based approaches such as a cap-and-trade uncapped sources or cost-effective GHG reductions regulation (or a carbon tax) to achieve a significant that other regulations are not achieving. portion of the GHG reductions. Market-based We note that not all projected auction revenues approaches are generally the most cost-effective have been appropriated by the Legislature. strategies for reducing emissions. Therefore, absent any adverse court rulings against If the Legislature determines that it wants to the state, a significant amount of revenue collected provide ARB authority to operate cap-and-trade under the current cap-and-trade authority will be beyond 2020, it is unclear whether providing such available for GHG reduction activities. We estimate authority would require a simple majority vote, that roughly $1.6 billion in auction revenue will be or whether a two-thirds vote would be needed. available by the end of 2015-16. As indicated earlier, In 2010, voters approved Proposition 26, which the Governor’s proposed budget includes a plan to required a two-thirds vote of the Legislature to spend these funds, as well as additional cap-and- pass some state charges that previously could be trade auction revenues collected in 2016-17. passed with a majority vote. It is unclear whether Might Be Needed to Remove Post-2020 Legal cap-and-trade auction revenue is one of the types of Uncertainty. As discussed above, uncertainty about charges that now requires a two-thirds vote. If the ARB’s current authority to operate a cap-and-trade Legislature authorized the program beyond 2020 program beyond 2020 can lead to problems, such with only a majority vote, it is possible the courts as costly investment decisions. Therefore, the would determine this a violation of Proposition 26. Legislature should consider clarifying whether The Legislature could remove legal uncertainty ARB has the authority to continue to operate about the ability to operate cap-and-trade beyond a cap-and-trade program beyond 2020 or not. 2020 if it extended the program with a two-thirds In our view, to the extent the Legislature has vote. CONCLUSION With regard to the Legislature’s GHG emission reauthorizing the cap-and-trade with a two-thirds goals (including post-2020 goals), we believe that vote. Removing the legal requirement that all relying heavily on market-based approaches such resulting auction revenue be spent on activities as cap-and-trade would help to achieve GHG that reduce GHGs would provide the Legislature reductions in a cost-effective manner. Market- maximum flexibility to (1) return the revenue to based approaches generally result in additional households and businesses in California to offset state revenue, even though that is typically not the costs associated with higher energy prices under primary goal of the program. In this report, we the program and/or (2) use the revenue to address present strategies for using the revenue under two other policy priorities. Moreover, as long as a alternative scenarios: (1) under a legal framework well-designed cap-and-trade program is in place, that requires the state to spend auction revenue the state will likely meet its GHG emission targets on GHG reduction activities and (2) removing the from major sources of emissions. legal requirement to spend on GHG reductions by www.lao.ca.gov Legislative Analyst’s Office 21 AN LAO REPORT 22 Legislative Analyst’s Office www.lao.ca.gov AN LAO REPORT www.lao.ca.gov Legislative Analyst’s Office 23 AN LAO REPORT LAO Publications This report was prepared by Ross Brown and reviewed by Brian Brown. The Legislative Analyst’s Office (LAO) is a nonpartisan office that provides fiscal and policy information and advice to the Legislature. To request publications call (916) 445-4656. This report and others, as well as an e-mail subscription service, are available on the LAO’s website at www.lao.ca.gov. The LAO is located at 925 L Street, Suite 1000, Sacramento, CA 95814. 24 Legislative Analyst’s Office www.lao.ca.gov