The 2017-18 Budget: Cap-and-Trade

The 2017-18 Budget: Cap-and-Trade MAC TAYLOR • L E G I S L A T I V E A N A L Y S T • FEBRUARY 2017 2017-18 BUDGET 2 Legislative Analyst’s Office www.lao.ca.gov 2017-18 BUDGET EXECUTIVE SUMMARY California’s Cap-and-Trade Program SB 32 Established 2030 Greenhouse Gas (GHG) Target. The Global Warming Solutions Act of 2006 (Chapter 488 [AB 32, Núñez/Pavley]) established the goal of limiting statewide GHG emissions to 1990 levels by 2020. The legislation directed the Air Resources Board (ARB) to adopt regulations to achieve the maximum technologically feasible and cost-effective GHG emission reductions by 2020. In 2016, Chapter 249 (SB 32, Pavley) established an additional target of reducing emissions by at least 40 percent below 1990 levels by 2030. Cap-and-Trade Aims to Limit Emissions and Encourage Cost-Effective Reductions. Assembly Bill 32 authorized ARB to implement a market-based mechanism—known as a cap-and-trade program—through 2020. Under the cap-and-trade program, ARB issues a limited number of “allowances” (essentially, emission permits), which large GHG emitters can purchase at a state-run auction or on the private market. (ARB also gives some allowances away for free.) From an economic perspective, the primary advantage of a cap-and-trade program is that the market sets a price for GHG emissions, which creates a financial incentive for businesses and households to implement the least costly emission reduction activities. Legal Uncertainty Around Cap-and-Trade. Currently, there is a court case challenging ARB’s authority to auction allowances and raise revenue through 2020. There is also legal uncertainty whether ARB has the authority to operate the cap-and-trade program beyond 2020 and whether extending the authority to auction allowances beyond 2020 would require a two-thirds vote of the Legislature given changes to the definition of taxes and fees under Proposition 26 (2010). Governor Proposes Extending Cap-and-Trade With Two-Thirds Vote The Governor’s 2017-18 budget proposes to spend $2.2 billion in cap-and-trade auction revenue on activities intended to reduce GHGs. However, $1.3 billion would only be spent after the Legislature enacted—with a two-thirds urgency vote—new legislation extending the ARB’s authority to operate a cap-and-trade program beyond 2020. Under the Governor’s proposal, the Department of Finance (DOF) would have authority to select the specific programs within each category of activities that would receive funding. In addition, under the Governor’s proposal, DOF would have the authority to adjust downward allocations to discretionary programs proportionally based on available funds. LAO Recommendations In this report, we make recommendations in response to three critical questions raised by the Governor’s proposal: • Should cap-and-trade be authorized beyond 2020? • Is a two-thirds vote needed to extend cap-and-trade? • How should the Legislature use cap-and-trade revenue? www.lao.ca.gov Legislative Analyst’s Office 3 2017-18 BUDGET Authorize Cap-and-Trade Beyond 2020 Because Likely Most Cost-Effective Approach. We recommend the Legislature authorize cap-and-trade (or a carbon tax) beyond 2020 because it is likely the most cost-effective approach to achieving the state’s 2030 GHG emissions target. If the Legislature approves cap-and-trade, we recommend the Legislature (1) strengthen the allowance price ceiling because there is potential for substantial price volatility associated with the lower cap and (2) provide clearer direction to ARB regarding the criteria that the board should use to determine whether complementary policies should be adopted. We also recommend the Legislature continue to take steps to ensure oversight and evaluation of major climate policies by establishing an independent expert committee. Approve With a Two-Thirds Vote to Ensure Ability to Design Effective Program. Although cap-and-trade could be extended with a simple majority vote, we recommend the Legislature approve cap-and-trade (or carbon tax) with a two-thirds vote because it would provide greater legal certainty and ensure ARB has the ability to design an effective program. For example, a two-thirds vote would provide legal certainty regarding ARB’s authority to auction allowances—a method for distributing allowances that is generally recommended by economists. A two-thirds vote would also allow the Legislature to remove the current requirement that cap-and-trade auction revenues can only be used on activities that reduce GHG emissions. Broaden Allowable Uses of Revenue to Include Other Legislative Priorities. With a two-thirds vote, we recommend the Legislature broaden the allowable uses of auction revenue because it would give the Legislature flexibility to use the funds on its highest priorities. The Legislature could use the funds to (1) offset higher energy costs for households and businesses by providing tax reductions or rebates; (2) promote other climate-related policy goals, such as climate adaptation activities; and/or (3) support other legislative priorities unrelated to climate policy. In our view, returning the revenue to businesses and consumers by reducing taxes or providing rebates could become a particularly important option if allowance prices—and, consequently energy costs for households and businesses—increase substantially in the future. When finalizing its 2017-18 cap-and-trade spending plan, we also recommend the Legislature (1) reject the administration’s proposed language making spending contingent on future legislation, (2) consider alternative strategies for dealing with revenue uncertainty, and (3) allocate funds to specific programs rather than providing DOF that authority. 4 Legislative Analyst’s Office www.lao.ca.gov 2017-18 BUDGET INTRODUCTION The Global Warming Solutions Act of 2006 proposes a $2.2 billion cap-and-trade expenditure (Chapter 488 [AB 32, Núñez/Pavley]), commonly plan, contingent on the Legislature extending the referred to as AB 32, established the goal of limiting authority for ARB to operate cap-and-trade beyond statewide greenhouse gas (GHG) emissions to 2020 with a two-thirds urgency vote. In this report, 1990 levels by 2020. One of the policies the state we provide background information on California’s adopted to achieve this goal was a cap-and-trade GHG policies and the role of cap-and-trade. We program. The program is meant to establish a limit also provide comments and recommendations on emissions from major sources and provide related to three critical questions that merit incentives for cost-effective emission reductions. legislative consideration: Chapter 249 of 2016 (SB 32, Pavley) established an • Should cap-and-trade be authorized additional GHG target of at least 40 percent below beyond 2020? 1990 levels by 2030. However, it is unclear whether the Air Resources Board (ARB) has the legal • Is a two-thirds vote needed? authority to operate cap-and-trade beyond 2020. • How should the Legislature use cap-and- The cap-and-trade program generates revenue trade revenue? which is used to support programs intended to reduce GHGs. The Governor’s 2017-18 budget BACKGROUND State GHG Targets and Policies • Ensure that activities complement efforts to achieve regional air quality standards. AB 32 and the Scoping Plan. Assembly Bill 32 established the goal of limiting GHG • Minimize the extent to which emissions emissions statewide to 1990 levels by 2020. The are shifted out of state because companies legislation directed ARB to adopt regulations to move the production of goods due to achieve the maximum technologically feasible higher costs associated with regulations and cost-effective GHG emission reductions by (referred to as “leakage”). 2020. Assembly Bill 32 further authorized ARB ARB is required to develop a Scoping Plan to to implement a market-based declining annual achieve the emission targets and update the plan emissions limit through 2020. In addition, to the periodically. The first Scoping Plan was approved extent feasible, ARB must: by ARB in 2008, and the first update to the • Design regulations in a manner that is Scoping Plan was approved in 2014. These scoping equitable, minimizes costs, and maximizes plans included a wide variety of regulations benefits to California. intended to help the state meet its GHG goal, • Ensure that activities undertaken to comply including cap-and-trade, a low carbon fuel with regulations do not disproportionately standard (LCFS) intended to reduce the carbon impact low-income communities. intensity of transportation fuels, energy efficiency www.lao.ca.gov Legislative Analyst’s Office 5 2017-18 BUDGET programs, and the 33 percent renewable portfolio authorized to establish a panel of experts to provide standard (RPS) for retail electricity sales. In order an independent analysis of the state’s policies. to meet the 1990 target, the 2014 Scoping Plan The Legislature has adopted additional update projected that the regulations would reduce policies intended to help achieve the 2030 GHG emissions by 78 million metric tons of carbon target. For example, Chapter 547 of 2015 (SB 350, dioxide equivalent (MMtCO2e) in 2020—roughly de León) requires a 50 percent RPS and doubling 15 percent below what annual emissions are energy efficiency savings in electricity and estimated to have been without the regulations. natural gas by 2030. In addition, Chapter 395 of Recent Legislation Established 2030 GHG 2016 (SB 1383, Lara) requires ARB to implement Targets and Policy Direction. Senate Bill 32 a strategy to reduce methane emissions by established an additional GHG target of at least 40 percent, hydrofluorocarbon gases by 40 percent, 40 percent below 1990 levels by 2030, as shown and anthropogenic black carbon by 50 percent in Figure 1. In addition, Chapter 250 of 2016 below 2013 levels by 2030. These types of emissions (AB 197, E. Garcia) directs ARB to prioritize are also known as short-lived climate pollutants. regulations that result in direct GHG emission ARB is currently in the process of updating its reductions, including emission reductions at Scoping Plan to identify the policies that will be large stationary sources and from mobile sources. used to achieve the additional reductions needed to Assembly Bill 197 also establishes a Joint Legislative meet the 2030 GHG target. Committee on Climate Change Policies. The Cap-and-Trade committee is tasked with collecting facts and making recommendations to the Legislature on Purpose of Market-Based Mechanisms. state policies related to climate change and is Cap-and-trade is one commonly discussed market-based approach to reducing GHG emissions. Figure 1 SB 32a Requires More (The other market-based Greenhouse Gas Reductions by 2030 approach most commonly discussed is a carbon tax.) MMtCO2e Cap-and-trade differs from Actual Emissions 500 other regulatory approaches, 450 2020 Target such as traditional command- 400 and-control regulations. 350 Projectionb Under traditional regulations 300 2030 Target for reducing emissions, 250 government requires 200 150 businesses to install a certain 100 type of emission reduction 50 technology or meet a 1990 1995 2000 2005 2010 2015 2020 2025 2030 certain minimum emissions standard. When discussed a Chapter 249 of 2016 (SB 32, Pavley). b Projection from Air Resources Board based on actions that have been taken to achieve the 2020 target. in relation to market-based MMtCO2e = million metric tons of carbon dioxide equivalent. approaches, these regulatory 6 Legislative Analyst’s Office www.lao.ca.gov 2017-18 BUDGET approaches are sometimes referred to as direct the state. As long as GHG emissions are accurately regulations or complementary policies. In contrast, measured and the regulation is adequately a market-based approach like cap-and-trade enforced, the number of emissions cannot exceed adds a financial cost to producing GHGs, which the number of allowances (or the cap). Figure 2 (see provides a financial incentive for private businesses next page) shows a simplified example of how the and consumers to reduce emissions. The private cap ensures emissions do not exceed the number of sector has flexibility to determine which emission allowances issued by the state. Without establishing reduction activities are least costly and whether the a cap, Companies A, B, C, and D would each have costs of the activities are less than the financial cost one emission. To establish a cap, the state issues of continuing to emit GHGs. three allowances. As a result, only three companies Description of Cap-and-Trade. The cap-and- can obtain an allowance and continue to emit, trade regulation places a “cap” on aggregate while one company is forced to reduce its emission. GHG emissions from large GHG emitters, such Allowance Price Provides Incentive for as large industrial facilities, electricity generators Cost-Effective Emission Reductions. From an and importers, and transportation fuel suppliers. economic perspective, the primary advantage of a Capped sources of emissions are responsible for cap-and-trade program is that it creates a financial roughly 80 percent of the state’s GHG emissions. incentive to identify the least costly emission The cap declines over time, ultimately arriving at reduction activities. The supply and demand of the target emission level in 2020. To implement allowances in a trading market generally determine the cap-and-trade program, ARB issues carbon the price of an allowance. In our example, each allowances equal to the cap, and each allowance company would only purchase an allowance if the is essentially a permit to emit one ton of carbon allowance price (in this case, $11) is lower than dioxide equivalent. Entities can also “trade” (buy their cost to reduce their emission. As shown in the and sell on the open market) the allowances example in Figure 2, some emitters (Company D in order to obtain enough to cover their total in this case) will reduce emissions because it is less emissions. Some entities will end up reducing their costly ($10) for them to do so than purchase an emissions if the number of allowances available allowance. Remaining emitters will purchase an is less than the number of emissions that would allowance and continue to emit because allowances otherwise occur. Entities can also purchase are cheaper than reducing emissions. In theory, the “offsets” to cover their emissions. Offsets are GHG level of overall emission reductions is achieved at emission reduction projects undertaken by entities the lowest cost possible—$10 in our example. This is not subject to the state’s cap-and-trade program because the allowance price provides an economic (uncapped sources), such as forestry projects that incentive to find the mix of emission reductions and reduce GHGs. Covered entities can use offsets— allowance purchases that minimize costs. rather than allowances—to cover up to 8 percent of It is important to note that, while covered their emissions. entities (such as electricity generators and Cap Intended to Provide Emissions Certainty. transportation fuel suppliers) pay the direct From a GHG emissions perspective, one of the costs of purchasing allowances, at least a portion primary advantages of a cap-and-trade regulation is of the costs are passed on to customers and that the cap ensures total GHGs from major sources other businesses in the form of higher product of emissions do not exceed the limit established by prices. As a result, a wide variety of businesses www.lao.ca.gov Legislative Analyst’s Office 7 2017-18 BUDGET and households have a financial incentive to are key to ensuring that businesses and consumers use less GHG-intensive products. For example, have an incentive to consume fewer GHG-intensive transportation fuel suppliers must purchase products. However, it also means that households allowances associated with the emissions from and businesses that continue to consume these gasoline consumption, but those costs are generally products, such as gasoline, will pay more for those passed on to consumers in the form of higher goods and services. gasoline prices. As gasoline prices increase, ARB Designed Cap-and-Trade to Be a businesses and households have an incentive to Backstop to Ensure State Meets GHG Target. The reduce gasoline consumption. The higher prices mix of measures in the Scoping Plan—including Figure 2 Cap-and-Trade Designed to Limit Emissions at Lowest Cost 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 8 Legislative Analyst’s Office www.lao.ca.gov 2017-18 BUDGET both cap-and-trade and complementary As shown in Figure 3, ARB offered 46 percent of regulations—are intended to achieve the aggregate 2016 allowances at auctions and gave 50 percent emission reduction target by 2020. In the Scoping away for free. (Four percent of allowances are Plan update in 2014, about 70 percent of emission made available at predetermined prices—a strategy reductions in 2020 were expected to result from intended to moderate potential spikes in allowance complementary measures. Only the remaining prices.) Of the 50 percent of allowances given away 30 percent of the projected GHG emission for free, most were given to investor-owned utilities reductions were projected to come from the ARB’s (IOUs) (16 percent), certain industrial emitters cap-and-trade regulation. The actual emissions (14 percent), natural gas suppliers (12 percent), and reductions achieved under the cap-and-trade publicly owned utilities (8 percent). State law and program, however, could be significantly different regulation require IOUs to auction their allowances than those estimates. That is because the cap serves and most of the resulting revenue must be credited as a “backstop” to achieve GHG emissions targets to their industrial, small businesses, and residential in the covered sectors, regardless of programmatic electricity customers. ARB allocates free allowances or economic changes that affect emissions. For to certain energy-intensive trade-exposed example, if energy efficiency programs fail to meet industries based on how much of their product their planned emissions targets, the cap would (not GHG emissions) they produce in California. encourage additional GHG reductions from other The more they produce in California, the more free sources to ensure overall emissions do not exceed allowances they receive. This strategy is intended to the specified limit. Alternatively, if technological prevent emissions leakage. advancements or slow economic growth result in lower than projected emissions, the cap is needed Figure 3 to reduce fewer emissions in Some Allowances Auctioned by the State, Some Allowances Given Away for Free order to stay below the limit. Some Allowances 2016 Allowances Auctioned, Some Given Away for Free. One important aspect of implementing a cap-and-trade program State Auction is determining how to Free Allocation distribute allowances. In theory, allowances can be issued in one of three general ways: (1) they can be given away for free, (2) they can Othera be auctioned by the state, Total = 382 Million Allowances or (3) some portion can be freely allocated while the a Four percent of allowances were made available at predetermined prices—a strategy intended to moderate potential spikes in allowance prices. other portion is auctioned. www.lao.ca.gov Legislative Analyst’s Office 9 2017-18 BUDGET Cap-and-Trade Auction Revenue • Directing investment toward the most disadvantaged communities and Auctions Have Generated $4.4 Billion in State households in the state. Revenue. ARB has conducted 17 quarterly cap-and- trade auctions since November 2012—generating To address this last goal, Chapter 830 of 2012 roughly $4.4 billion in state revenue. Beginning (SB 535, de León), as amended by Chapter 369 January 1, 2015, transportation and natural gas fuel of 2016 (AB 1550, Gomez), requires that at suppliers were required to obtain allowances for least 25 percent of auction revenue be allocated the GHG emissions associated with the combustion to projects that are located in disadvantaged of their fuels. Since transportation fuel suppliers communities and benefiting low-income are not given free allowances, the number of state- individuals living in disadvantaged communities auctioned allowances increased substantially in (as determined by the Office of Environmental 2015—resulting in auctions raising significantly Health Hazard Assessment). higher amounts of state revenue. However, as we How Auction Revenue Has Been Spent so Far. discuss later in this report, there was a substantial The state has used auction revenue to fund various reduction in demand for allowances offered at programs and projects. For revenue collected quarterly auctions in 2016. This drop in demand in 2015-16 and beyond, statute continuously was likely due, at least in part, to an oversupply of appropriates (1) 25 percent for the state’s high-speed allowances and legal uncertainty about the future rail project, (2) 20 percent for affordable housing of the program. As a result, quarterly state revenue and sustainable communities grants (with at has been volatile. least half of this amount for affordable housing), State Law Requires Auction Revenue Be Used (3) 10 percent for intercity rail capital projects, and to Reduce GHGs. Statutes enacted in 2012 direct (4) 5 percent for low carbon transit operations. the use of auction revenue to GHG reduction The remaining 40 percent is available for annual activities. For example, Chapter 807 of 2012 appropriation by the Legislature. Statute also (AB 1532, Perez) requires auction revenues be used requires that an outstanding loan of $400 million to further the purposes of AB 32. Revenues must in auction revenues to the General Fund be repaid be used to facilitate GHG emission reductions in to the high-speed rail project when needed by the California. In addition to reducing GHGs, to the project. As illustrated in Figure 4, the state will extent feasible, funds must be used to achieve other have spent about $3.8 billion from auction revenues goals, such as: through 2016-17. • Maximizing overall economic, Legal Uncertainty Around Cap-and-Trade environmental, and public health benefits to the state. Current Authority to Auction Allowances Challenged in Court. There is currently a court • Complementing efforts to improve air case challenging whether the state can continue quality. collecting revenue from cap-and-trade auctions. In a lawsuit against ARB, plaintiffs argue that AB 32 • Lessening the effects of climate change did not provide ARB the authority to auction on the state (also known as climate allowances and collect state revenue. (Plaintiffs do adaptation). not dispute ARB’s authority to operate a cap-and- trade program and give allowances away for free.) 10 Legislative Analyst’s Office www.lao.ca.gov 2017-18 BUDGET They further argue that even if the Legislature Authority to Operate Program Beyond 2020. gave ARB the authority to collect auction revenue, The administration indicates that it believes it such revenue constitutes an illegal tax. The currently has authority to extend cap-and-trade California Constitution requires that any increases beyond 2020. However, an opinion provided by in state taxes be approved by a two-thirds vote Legislative Counsel released last year stated its view of the Legislature. Previous court decisions have that current law does not provide such authority determined that certain types of “charges,” such because AB 32 only explicitly authorizes cap-and- as regulatory fees, are not considered taxes and trade through 2020. require only a simple majority vote. The plaintiffs Vote Threshold Needed to Authorize Auctions argue that auction revenues are tax revenues and, Beyond 2020. Even if the courts rule that current since AB 32 was not passed with a two-thirds vote, auctions are not a tax, the vote threshold needed to the state is collecting auction revenues illegally. In pass new legislation that provides ARB authority November 2013, the superior court ruled that the to auction allowances is unclear. This is because charges from the auction have characteristics of a the current case challenges whether the auctions tax as well as a fee, but that, on balance, the charges authorized by legislation passed in 2006 are a tax constitute legal regulatory fees. This ruling has under Proposition 13 (1978). In 2010 (after the been appealed and a decision from the state’s third enactment of AB 32), voters passed Proposition 26, appellate court is expected in the next couple of which changed the definition of a tax in a way months. that could change whether auction revenues are Figure 4 Cap-and-Trade Spending Through 2016-17 (In Millions) Program Agency 2013‑14 2014‑15 2015‑16 2016‑17 Total High-speed raila High-Speed Rail Authority — $250 $458 $250b $958 Affordable housing/sustainable communities Strategic Growth Council — 130 366 200b 696 Low carbon vehicles Air Resources Board $30 200 95 363 688 Transit and intercity rail capital Transportation Agency — 25 183 235b 443 Low-income weatherization and solar CSD — 75 79 20 174 Transit operations Caltrans — 25 92 50b 167 Transformational Climate Communities Strategic Growth Council — — — 140 140 Agricultural energy and efficiency Food and Agriculture 10 25 40 65 140 Sustainable forests and urban forestry Forestry and Fire Protection — 42 — 40 82 Green infrastructure Natural Resources Agency — — — 80 80 Waste diversion CalRecycle — 25 6 40 71 Water efficiency DWR 30 20 20 — 70 Wetlands and watershed restoration Fish and Wildlife — 25 2 — 27 Active transportation Caltrans — — — 10 10 Black carbon woodsmoke Air Resources Board — — — 5 5 Other technical assistance and administration Various 2 10 14 24 50 Totals $70 $852 $1,354 $1,522 $3,800 a Does not include $400 million loan repayment from General Fund that is allocated to high-speed rail in future years under current law. b Estimated continuous appropriation based on $1 billion 2016-17 revenue estimate in Governor’s budget. CSD = Community Services and Development; Caltrans = Department of Transportation; and DWR = Department of Water Resources. www.lao.ca.gov Legislative Analyst’s Office 11 2017-18 BUDGET considered a tax or not. Therefore, even if the the auctions would be evaluated under the courts ruled that the current auctions are not a requirements of Proposition 26. tax under Proposition 13, any new law authorizing GOVERNOR’S PROPOSAL As shown in Figure 5, the budget proposes In addition to the continuously appropriated to spend $2.2 billion in cap-and-trade revenue in programs, the budget would provide $500 million 2017-18. This would be supported from $1.5 billion in auction revenues to support the Governor’s in auction revenue assumed to be collected in transportation funding package. The remaining 2017-18 and almost $700 million in unallocated $755 million would be allocated for other prior-year collections. Consistent with current categories of activities—rather than provided to law, 60 percent ($900 million) of projected 2017-18 specific departments and programs—designed revenue would be continuously appropriated. to reduce GHG emissions. Under the Governor’s Under the Governor’s proposal, the remaining proposal, the Department of Finance (DOF) $1.3 billion in proposed discretionary spending would have authority to select the specific would be spent only after the Legislature enacted— programs within each category that would receive with a two-thirds urgency vote—new legislation funding. In addition, under the Governor’s extending the ARB’s authority to operate a proposal, DOF would have the authority to adjust cap-and-trade program beyond 2020. downward allocations to discretionary programs proportionally based on available funds. LAO ASSESSMENT In this section, we provide our comments and Should Cap-and-Trade Be recommendations related to three critical questions Authorized Beyond 2020? that the Governor’s proposal raises: The first key decision facing the Legislature is • Should cap-and-trade be authorized whether to authorize cap-and-trade beyond 2020. beyond 2020? In making this decision, the Legislature will want to consider the following issues: (1) the role of the • Is a two-thirds vote needed to extend cap-and-trade program so far, (2) the different cap-and-trade? options and key considerations for achieving the • How should the Legislature use cap-and- state’s 2030 GHG targets, (3) the merits of market- trade revenue? based mechanisms—such as cap-and-trade or a carbon tax—as a tool for achieving state GHG Figure 6 provides a summary of our main targets cost-effectively, and (4) the significance of recommendations. a one specific design feature—an allowance price 12 Legislative Analyst’s Office www.lao.ca.gov 2017-18 BUDGET ceiling—in the cap-and- Figure 5 trade program. Below, Proposed 2017-18 Cap-and-Trade Expenditure Plan we assess each of these (In Millions) issues and make specific Program Amount recommendations based Continuous Appropriations on our assessment. High-speed rail $375 Affordable housing and sustainable communities 300 Emissions Below Transit and intercity rail capital 150 Cap During Initial Transit operations 75 Years of Program Subtotal, Continuous Appropriations ($900) Discretionary Spending As the Legislature Public transit and active transportation projects $500 considers the proposal Clean transportation and petroleum use reduction 363 to extend cap-and- Transformative Climate Communities 142 Carbon sequestration 128 trade beyond 2020, Short-lived climate pollutants 95 understanding the Energy efficiency and renewable energy 28 outcomes of the program Subtotal, Discretionary Spending ($1,255a) Total $2,155 so far can provide valuable a Does not total due to rounding. information about the potential effects of program so far has not been conducted. Such a extending the program. study would be complex and the data available to Different aspects of the cap-and-trade program have complete the study might be somewhat limited. been the subject of much research and analysis. For example, advanced statistical techniques However, to our knowledge, a robust study of would be needed to determine which activities to the overall statewide effects of the cap-and-trade reduce emissions were the result of cap-and-trade, Figure 6 Summary of LAO Recommendations 9 Should Cap-and-Trade Be Authorized Beyond 2020? • Authorize cap-and-trade (or a carbon tax) beyond 2020 because it is likely most cost-effective approach to achieving 2030 GHG target. • If the Legislature approves cap-and-trade, we also recommend the Legislature (1) strengthen the allowance price ceiling because there is potential for substantial price volatility and (2) provide clearer direction to ARB regarding the criteria that will be used to determine whether a direct regulation should be adopted. • Ensure oversight and evaluation of major climate policies. 9 Is a Two-Thirds Vote Needed? • Approve cap-and-trade (or carbon tax) with a two-thirds vote because it would give greater legal certainty and ensure ability to design an effective program. 9 How Should Cap-and-Trade Revenue Be Used? • With a two-thirds vote, broaden allowable uses of revenue because it would give Legislature flexibility to use funds on highest priorities, including offsetting higher costs for households and businesses. • If adopting a spending plan, then (1) reject language making spending contingent on future legislation, (2) consider alternative strategies for dealing with revenue uncertainty, and (3) allocate funds to specific programs. www.lao.ca.gov Legislative Analyst’s Office 13 2017-18 BUDGET rather than other policies or changes in economic demand for allowances at recent auctions also conditions. In addition, emissions data is only suggests emissions are below the cap. The reasons available for the first three years of the program. why emissions might be lower than previously As a result, the overall effects of the program are anticipated are not entirely clear, but two likely still somewhat uncertain. Based on the information contributing factors are (1) lower-than-expected and analysis that we have reviewed, we provide our economic growth due to the 2008 recession and assessment of the likely effects of the program so far. (2) the presence of a wide variety of complementary GHG Emissions Likely Below the Cap in Early policies. All else equal, lower economic Years Due to Other Factors. The cap is likely not activity results in fewer emissions. In addition, having much, if any, effect on overall emissions in complementary policies reduce emissions from the first several years of the program. As shown covered entities and reduce the level of emission in Figure 7, emissions have actually been below reductions needed from the cap as a backstop to the cap for the first few years of the program meet the state’s established target. To the extent (2013 through 2015) suggesting, therefore, that these are the primary contributing factors, it means the cap has not had to contain total emissions. emissions are likely below the cap for reasons other Furthermore, future projections—including ARB’s than the cap-and-trade regulation itself. emissions projections and studies conducted Minimum Allowance Price Likely Having by academic economists—suggest emissions Some Effect on Emissions. In theory, the level of the could remain below the cap through 2020. Low cap is the most important factor affecting overall emissions. However, since the cap has likely Figure 7 not been limiting ARB Data Suggest Emissions Below the Cap emissions in the early MMtC02e stages of the program, 450 other aspects of the Cap program have likely 400 had a more significant 350 effect on emissions 300 so far. The minimum ARB Projected 2020 Emissions price for allowances 250 Actual Emissions established by ARB 200 is one such program feature. The current 150 market price for 100 trading allowances— over $13 per ton—is 50 likely driven by ARB’s minimum 2013 2014 2015 2016 2017 2018 2019 2020 price ($13.57 in a Beginning January 2015, transportation and natural gas fuel supplies were included in the program. the February 2017 ARB = Air Resources Board and MMtC02e = million metric tons of carbon dioxide equivalent. auction). The 14 Legislative Analyst’s Office www.lao.ca.gov 2017-18 BUDGET $13 allowance price provides some incentive for the limited role the cap has had on GHG GHG reductions. For example, if current allowance emissions so far, it is unlikely that the prices are fully passed on to consumers, they result regulation has had a major effect on in about a 12-cent increase in gasoline prices. co-pollutants. As we have discussed in This higher price likely encourages some minor other reports, the effects of programs reductions in fuel consumption and GHGs relative receiving cap-and-trade expenditures on to what would have occurred without the program. co-pollutants are also unclear at this time. However, the price is not high enough to incentivize • Emissions Leakage. Research on the effects the types of changes in investments decisions that of the regulation on overall emissions are likely needed to meet the state’s more aggressive leakage is also limited. So far, ARB has 2030 GHG goals, such as a substantial shift away allocated a relatively high share of free from purchasing gasoline powered vehicles to allowances to energy-intensive trade exposed electric vehicles. industries. Combined with relatively modest Benefits and Costs Vary Across Households, allowance prices, this approach has likely Businesses, and Regions. The program has had mitigated large-scale statewide leakage distributional effects because certain households concerns. It is possible that certain industries and businesses have benefitted while others or businesses have been affected—either have been adversely affected. For example, many positively or negatively—by the ARB’s households and businesses are paying higher prices strategy for allocating free allowances. for energy—such as gasoline and electricity. This is how the program is intended to operate. It also It is important to note that our findings do means these households and businesses have less not imply cap-and-trade has been a failure (or money to spend on other things. On the other a success). Rather, our key takeaway from the hand, some businesses and/or households benefit existing literature and discussions with program from receiving free allowances or some of the experts is that the overall effects of the program so auction revenue that is collected by the state. For far are somewhat unclear, but, most likely, the effect example, major utilities use auction revenue to on GHGs has been limited because the cap has provide customer bill credits and the Legislature not yet been put in a position to reduce emissions. allocates state auction revenue to programs. These In addition, it is worth noting that the effects of programs provide various benefits to California other complementary GHG policies that have been households and businesses. The overall net effect of implemented so far are similarly unclear. these different effects are unclear and likely vary by Legislature Has Different Options for household, business, and region. Achieving 2030 Target Effects on Other Legislative Goals Unclear. Information on the effect of the regulation on The Legislature has different policy options to other, non-GHG legislative goals is also limited. For meet the 2030 GHG target. In January, the ARB example: staff released its 2017 Scoping Plan update that included five potential approaches to achieving the • Local and Regional Air Quality. Based 2030 target. In our view, the document provides a on our review of the literature, there is good starting point for discussions about potential limited evidence of the effects of cap-and- approaches. Our office has not had an opportunity trade regulation on co-pollutants. Given www.lao.ca.gov Legislative Analyst’s Office 15 2017-18 BUDGET to conduct a detailed review of ARB’s methods and would need to achieve relatively few reductions assumptions used to estimate emission reductions because emissions would be decreasing even in the and costs. As a result, at this time, we caution the absence of state actions. Conversely, in a high BAU Legislature against placing too much emphasis on scenario, state policies would need to achieve many the details of the emissions and costs estimates more emission reductions than projected. included in the plan. Below, we (1) describe the There is also significant uncertainty about the significant uncertainty around the GHG reductions overall costs of meeting the state’s GHG goals. and costs needed to achieve the 2030 target and First, the overall cost depends on the number of (2) describe the policy options ARB identifies for emission reductions the state would need to achieve achieving the target. to meet its goal, which, as discussed above, is GHG Reductions and Costs Needed to Meet uncertain. Second, even if the state could predict 2030 Target Are Highly Uncertain. The state’s BAU emissions perfectly, the costs of different 2030 GHG target is 40 percent lower than the 2020 policies needed to reduce emissions are difficult to target. Consequently, it could be substantially more predict. For example, the future costs of policies difficult for the state to meet the new target. The meant to reduce gasoline consumption depend on emissions reductions from state policies—including such factors as future gasoline prices and costs for cap-and-trade and/or other policies—needed alternative vehicle technologies—both of which are to meet the target are highly uncertain. This is difficult to predict. because the level of reductions needed depends ARB Scoping Plan Identifies Alternative on what emissions would be without additional Approaches to Achieve 2030 Target. The five state action—otherwise known as business as alternatives presented in the January 2017 Scoping usual (BAU) emissions. Under ARB’s current Plan are summarized in Figure 9. Under all projections, state policies—including those that alternatives, ARB assumes emission reductions have already been adopted by the Legislature—will Figure 8 have to reduce emissions by Wide Range of BAU Emissionsa Are Possible 132 MMtCO2e (33 percent) MMtC02e below BAU emissions in 600 2030. BAU emissions are BAU Scenarios highly uncertain and depend 500 High on a variety of other factors 400 Actual that are difficult to predict, Baseline including economic growth 300 and technological advances. Low 200 For example, Figure 8 shows 2030 Target one projection of the potential 100 range of BAU emissions that is based on preliminary 1990 2000 2010 2020 2030 modeling done by ARB’s economic advisors. In a low a Emissions from entities covered by the cap-and-trade program. BAU = business as usual and MMtC02e = million metric tons of carbon dioxide equivalent. BAU scenario, state policies 16 Legislative Analyst’s Office www.lao.ca.gov 2017-18 BUDGET from implementing policies that have already been pollutants) and the administration’s Sustainable adopted—such as a achieving a 50 percent RPS, Freight Action Plan (to improve and make more doubling energy efficiency, and implementing efficient the state’s system for transporting goods). SB 1383 to reduce short-lived climate pollutants. Below, we describe the main differences between the Each alternative approach also assumes reductions ARB’s proposed approach and the four alternatives from implementing ARB’s Mobile Source Strategy identified in the Scoping Plan. (to meet federal air quality standards for criteria Figure 9 January Scoping Plan Alternatives to Achieve 2030 Goal Options For Meeting 2030 Goals Proposal: Alternative 1: Cap‑and‑ No Market‑ Alternative 2: Alternative 3: Alternative 4: Trade + Based Carbon Tax + Cap‑and‑Trade Cap‑and‑Tax Estimated Others Mechanism Others Only + Others Cost Per Ton Policies Enacted by the Legislature 50 percent RPS 9 9 9 9 9 $100 to $300 Double energy efficiency 9 9 9 9 9 -550 to -$300 Reduce SLCPs 9 9 9 9 9 N/A Demand response 9 9 9 9 9 -200 Additional Scoping Plan Measures Market‑based approaches Extend cap-and-trade 9 9 25 to 85 Carbon tax 9 50 Complementary Policies Mobile Source Strategy and Sustainable Freight 9 9 9 9 9 Less than 50 Initiative Reduce refinery emissions 9 9 9 9 70 to 200 by 20 percent Reduce refinery emissions 9 70 to 200 by 30 percent Increase LCFS to 18 percent 9 9 9 9 250 Increase LCFS to 25 percent 9 400 Increase RPS to 60 percent 9 300 to 450 Reduce emissions from oil 9 70 to 200 production by 25 percent Reduce other industrial 9 70 to 200 emissions by 25 percent Increase renewable natural 9 300 to 1500 gas by 5 percent ZEVs and vehicle retirement 9 -150 to 200 incentivesa Energy efficiencyb 9 100 to 200 Other Cap-and-tax 9 N/A a In addition to what is included in the Mobile Source Strategy and Sustainable Freight Initiative. b In addition to doubling energy efficiency savings, as required by Chapter 547 of 2015 (SB 350, de León). RPS = renewable portfolio standard; SLCPs = short-lived climate pollutants; N/A = not available; LCFS = low carbon fuel standard; and ZEVs = zero emission vehicles. www.lao.ca.gov Legislative Analyst’s Office 17 2017-18 BUDGET • Proposed Approach: Cap-and-Trade, Plus need to reduce GHG emissions by 132 MMtCO2e Other Selected Measures. The approach to meet the 2030 target. Figure 10 provides the recommended by ARB staff includes estimated emission reductions associated with (1) extending cap-and-trade, (2) increasing each of the basic measures included in ARB’s the LCFS carbon intensity reduction from proposed approach. ARB staff proposes to extend the current goal of 10 percent to 18 percent, cap-and-trade, in part, because it provides entities and (3) implementing a new regulation compliance flexibility to identify the least costly that requires refineries to reduce GHG emission reduction opportunities. Other benefits emissions by 20 percent by 2030 (the ARB cites are (1) certainty that the state meets its 20 percent refinery measure). GHG targets by establishing an overall limit on emissions, (2) flexibility to allocate free allowances • Alternative 1: No Market-Based to help prevent emissions leakage, and (3) ability to Mechanism. Instead of a cap-and-trade link with other programs and encourage emission program, this approach includes a wide reductions in other jurisdictions. variety of direct regulations and incentive The primary rationale ARB provides for programs that would focus on specific including the 20 percent refinery measure is to be industries and sources of emissions. responsive to AB 197 direction to prioritize direct emission reductions. ARB also indicates that it may • Alternative 2: Carbon Tax, Plus Other reduce co-pollutants in some of the most polluted Selected Measures. This approach is and disadvantaged communities in the state. Based similar to the ARB’s proposed approach, on our initial review of the plan, the rationale except a carbon tax would be implemented for including a more stringent LCFS is less clear, instead of cap-and-trade. but ARB indicates that this proposal is part of its • Alternative 3: Cap-and-Trade Only. This Mobile Source Strategy intended to help the state approach would only involve extending meet its federal regional air quality standards. cap-and-trade. Market-Based Approaches • Alternative 4: Cap-and-Tax, Plus Other Likely Most Cost-Effective Selected Measures. Instead of cap-and- Below, we discuss why market-based trade, ARB would implement a policy it mechanisms are likely the most cost-effective describes as “cap-and-tax.” Under this approach to achieving the state’s GHG reduction approach, each entity currently covered goals. In our view, achieving these goals in a under cap-and-trade would be required cost-effective manner becomes increasingly to reduce its emissions by a set amount important as the state seeks to achieve more each year (without allowance trading) and aggressive—and potentially more costly—2030 also pay a tax for each metric ton of GHG GHG reduction targets. We also discuss the limited emissions it releases each year. information available on how effective different ARB Staff Proposes Cap-and-Trade policies would be at achieving other legislative Extension, Plus Other Direct Measures. As goals—such as reducing local air pollutants or discussed earlier, ARB estimates that the additional preventing leakage. policies in its Scoping Plan update will collectively 18 Legislative Analyst’s Office www.lao.ca.gov 2017-18 BUDGET Figure 10 ARB Staff Proposed Scoping Plan Estimated Emission Reductions MMtCO2e Range of 2030 GHG Reductionsa Policies Enacted by Legislature RPS to 50 percent 13-15 Double energy efficiency 12-14 Short-Lived Climate Pollutant Strategy 17-35 Demand response 2 Plans Developed by Administration Sustainable Freight Action Plan and Mobile Source Strategy 12-14 Additional Scoping Plan Measures LCFS Stringency increased to 18 percent 4 New 20 percent refinery measure 2-5 Cap-and-trade extension 45-100 Total Needed to Meet 2030 Target 132 a Compared to ARB’s business as usual projection for 2030. ARB = Air Resources Board; MMtCO2e = million metric tons of carbon dioxide equivalent; GHG = greenhouse gas; RPS = renewable portfolio standard; and LCFS = low carbon fuel standard. Market-Based Mechanisms Less Costly Than costs by choosing not to reduce their emissions, Other Measures. In the most recent Scoping Plan instead deciding to buy allowances (under cap-and- update, ARB estimates cap-and-trade would be trade) or pay the tax (under the carbon tax). one of the least costly approaches to meeting the Emissions sources that can reduce their emissions 2030 goals. According to the ARB’s estimates, the relatively cheaply are given an economic incentive refinery regulation ($70 to $200 per ton of emission to do so, as an alternative to buying allowances or reduction) and the more stringent LCFS ($250 paying the tax. per ton) would be much more costly than either Carbon Tax and Cap-and-Trade Address cap-and-trade ($25 to $85 per ton) or a carbon tax Different Types of Uncertainty. Although carbon ($50 per ton). taxes and cap-and-trade are both designed to As noted above, we caution the Legislature encourage cost-effective reductions, there are about giving too much weight to these specific trade-offs between these two approaches. A carbon estimates. However, there is a large body of tax provides relative certainty about the maximum academic literature—including both theoretical cost of reductions because the per-ton cost of and empirical studies—that indicates market-based emitting is, by definition, the dollar amount of the mechanisms are more cost-effective strategies per-ton emissions tax. However, there is less certainty to reducing emissions than direct regulatory about the quantity of emissions reductions that will measures. The potential for lower costs stems result. Should regulators set the emissions tax too from the fact that the regulated emissions sources low, emissions may exceed targets. If regulators set generally have better information about which the emissions tax too high, then regulated emissions compliance strategies minimize costs for them sources may act to reduce emissions beyond what than even the best-informed regulator could have. is required to meet the targets. In contrast to a Emissions sources facing relatively high costs to carbon tax, a cap-and-trade program provides reduce emissions can potentially minimize their relative certainty to the regulator that over the life www.lao.ca.gov Legislative Analyst’s Office 19 2017-18 BUDGET of the program GHG emissions will not exceed the With respect to emissions leakage, it is limit. However, because the price of an allowance is unclear whether market-based mechanisms or determined by market forces, the cost of compliance direct regulations would be preferred. In large for an emitter is less certain under a cap-and-trade part, the effects depend on the specific design program. The preferred approach between the of the program. For example, cap-and-trade has two depends, in large part, on the extent to which the potential to drive significant leakage, but the policy makers are more concerned about emissions allocation of free allowances to certain industries certainty or cost certainty. can potentially minimize such leakage. It is less It is also possible to design programs in ways clear how the state would prevent leakage under that combine aspects of cap-and-trade and a carbon alternative direct regulations that target trade- tax. For example, a cap-and-trade program that exposed industries. includes price floors (minimum allowance prices) Cap-and-Trade Design Features and price ceilings (maximum allowance prices) can Warrant Legislative Consideration provide greater price certainty, but somewhat less emissions certainty. (We discuss price ceilings in The potential benefits and costs of a cap-and- more detail below.) Alternatively, a carbon tax rate trade program depend, in large part, on the design could be adjusted upward or downward in future of the program. (As discussed above, we think both years if statewide emissions are above or below types of market-based mechanisms—cap-and-trade certain thresholds. This would enhance emission and a carbon tax—merit legislative consideration. certainty and reduce price certainty. However, for the remainder of this report, we focus Effects of Market-Based Mechanisms and on cap-and-trade because that is the proposal Direct Regulations on Other Goals Are Less currently before the Legislature.) If the Legislature Clear. Based on our initial review, there is limited extends cap-and-trade, it will want to ensure the evidence about how different GHG reduction program is designed in a way that is consistent policies would affect other goals the Legislature with legislative goals and priorities. There is no one has identified, such as reducing pollution that “right” way to design a cap-and-trade program. The contributes to regional and local air quality. specific design involves many different technical Assembly Bill 197 requires ARB to estimate decisions, as well as some key policy choices. In our the reductions in co-pollutants associated with view, ARB has made a reasonable effort to balance different measures proposed in the Scoping the various policy trade-offs in the particular Plan. The estimates provided by ARB assume design of the cap-and-trade program so far. Under that the level of GHG reductions from each the Governor’s proposal, ARB would continue to policy will result in a proportional reduction in have broad authority to design the program. co-pollutants. However, as ARB acknowledges, Given the inherent policy trade-offs involved, it is unclear whether such a relationship exists in there are a number of key design features that all cases. Further, the design and implementation warrant review and potentially additional direction of each policy could have a significant effect on from the Legislature. These include strategies co-pollutants. For example, choices about the for allocating allowances, the use of offsets, and extent to which out-of-state offsets can be used for linking the program with other jurisdictions. We compliance or how auction revenue is used could discussed many of these key design features and the affect the level of co-pollutants in California. major trade-offs in our 2012 report, Evaluating the 20 Legislative Analyst’s Office www.lao.ca.gov 2017-18 BUDGET Policy Trade-Offs in ARB’s Cap-and-Trade Program. near the minimum price established by ARB Below, we highlight one key issue that we think or the soft price ceiling, but not as likely to be the Legislature should make a high priority as it in the intermediate range (for example, $30). In considers the Governor’s proposal to extend the addition, it is possible that future prices could program: price volatility, particularly extreme price exceed the current soft price ceiling. Some of the increases. factors that contribute to potential price volatility Options for Reducing Extreme Price Increases. are (1) BAU emissions uncertainty and (2) the The basic options for limiting the potential presence of complementary policies. In light of this that prices in a cap-and-trade market exceed a volatility, the economic advisors recommended predetermined level are: strengthening the price ceiling by issuing additional (perhaps unlimited) allowances at some • Hard Price Ceiling. The state could set an predetermined price. upper limit on allowance prices and allow Trade-Offs Associated With Establishing businesses to buy an unlimited number of Stronger Price Ceiling. High allowance prices are allowances at the predetermined maximum not an inherently bad outcome and, in fact, might price. This would ensure that market prices be necessary to encourage the types of activities do not exceed the maximum price, but the that are needed to reach the state’s GHG goals. level of emissions would exceed the cap However, a stronger price ceiling has several if businesses purchased these additional advantages. First, it ensures more predictable allowances. allowance prices, which helps businesses and • Soft Price Ceiling. The government could households make more effective decisions about make available a small share of allowances potential long-term GHG reduction investments. at a specified price. This could moderate Second, a strong price ceiling could serve as a potential price spikes while also ensuring more effective cost-containment mechanism by emissions do not exceed the cap. The ensuring prices, and thereby GHG reduction costs, specified price is considered a “soft” ceiling do not exceed a threshold that policy makers deem because it is still possible for market prices unreasonable. Finally, according to the economic for allowances to exceed the ceiling if all of advisors, a stronger price ceiling would help reduce the additional allowances are purchased. the risk of market price manipulation because, if ARB has adopted this approach by prices cannot exceed a certain level, it limits the depositing a limited number of allowances potential for market participants to obtain a large in its Allowance Price Containment share of allowances to drive up market prices. Reserve and making them available at three The primary downside to a hard price ceiling different price tiers (currently $51 to $63). is that there is less certainty that emissions will remain below the cap because the state would have Economic Advisors Suggest Potential Price to issue additional allowances if market prices Volatility, Recommend Stronger Price Ceiling. exceeded the ceiling. This is an important trade-off Based on modeling on cap-and-trade through 2020 for the Legislature to consider. However, there may done by a group of economic advisors to ARB, be other ways to reduce the additional emissions there is potential for significant price volatility that could result from the hard price ceiling. For in the cap-and-trade market. The researchers example, the state could potentially use some of found that allowance prices are likely to be either www.lao.ca.gov Legislative Analyst’s Office 21 2017-18 BUDGET the auction revenue from the sale of the additional or direct, measures in the Scoping Plan only allowances to purchase less costly allowances in if it can adequately demonstrate that they other jurisdictions. would achieve a specific legislative goal more effectively than market-based approaches. LAO Recommendations Complementary policies are generally much Authorize Cap-and-Trade Beyond 2020. We more costly approaches to reducing GHGs. It is recommend the Legislature authorize a market- possible that these policies achieve other legislative based mechanism to meet its 2030 GHG goals. goals—such as reducing more co-pollutants This could be either a cap-and-trade program, in disadvantaged communities—or provide as proposed by the Governor, or a carbon tax. more efficient incentives for GHG reduction Either approach is likely to be a cost-effective activities in certain circumstances. However, way to achieve the state’s GHG targets. Without ARB provides limited evidence that the proposed a market-based approach, the state would likely complementary policies present such trade-offs have to implement more costly policies. Given the and, thus, why they would be preferred to market- advantages of such an approach, the Legislature based approaches. Alternatively, instead of might want to direct the administration to implementing complementary policies targeted at implement cap-and-trade (or a carbon tax), GHG reductions, the Legislature could establish rather than simply providing it the option of new policies or expand existing policies that more implementing it as is the case under current law. directly target these other goals. Strengthen the Price Ceiling. We recommend Ensure Oversight and Evaluation of Major the Legislature direct ARB to strengthen the Climate Policies. We recommend the Legislature allowance price ceiling. This is consistent with take steps to ensure there is adequate oversight a recommendation from ARB’s own economic and evaluation of state climate policies. To date, advisors. This approach creates some risk there have been no robust evaluations of the that overall emissions would exceed the limit overall statewide effects—including on GHG established by ARB. However, it would reduce price reductions, costs, and co-benefits—of most of volatility and potentially help limit the overall the state’s major climate policies and spending costs of the program. This is especially important programs. As we have recommended in previous given the significant uncertainty around the future reports, the Legislature should consider creating costs of meeting the state’s more aggressive 2030 an independent committee of outside experts, GHG goals. The Legislature should also consider including academic researchers and economists, specifying the level of the price ceiling. This price to provide ongoing guidance to the administration ceiling could be higher or lower than the current and the Legislature and help evaluate California’s one. The Legislature would want to set the price climate policies. Such a committee appears to be ceiling at a level at which any higher market prices consistent with the authority AB 197 provided would be deemed to be too costly to businesses and to establish the Joint Legislative Committee on households. Climate Change Policies to create an independent Provide Clearer Direction on Role of panel of experts. Complementary Policies. We recommend the Legislature direct ARB to include complementary, 22 Legislative Analyst’s Office www.lao.ca.gov 2017-18 BUDGET Is a Two-Thirds Vote Needed to allowances has no direct effect on the overall level Extend Cap-and-Trade? of emissions or cost of emission reductions. This is because the overall level of emissions cannot exceed The Governor proposes to extend the cap-and- the number of allowances issued, regardless of how trade program beyond 2020 with a two-thirds the allowances are initially distributed. Also, each vote. The Governor states that the rationale for company still has an incentive to reduce emissions requesting a two-thirds vote for an extension is to if doing so is less than the price of an allowance in enact the measure immediately with an urgency the market. However, the distribution of allowances clause in order to provide greater certainty to can have significant indirect effects, such as effects the market regarding the ongoing nature of the on leakage of emissions to outside of California cap-and-trade program. While providing greater and how the costs and benefits of the program are market certainty would be beneficial, we find that distributed. the two-thirds vote raises larger legal and policy In general, economists recommend auctioning questions. Below, we compare a cap-and-trade allowances rather than giving them away for program with a two-thirds vote to one that is free. This is because auctions are considered a authorized with a simple majority vote. more transparent, equitable, and efficient method Two-Thirds Vote Would Provide of distributing allowances. (For more detailed More Certainty and Flexibility information on the potential benefits of auctioning allowances, please see the box on the next page.) Cap-and-Trade Could Be Extended With a The primary exception to this recommendation Simple Majority Vote. The Legislature could is giving away allowances for free to certain authorize cap-and-trade beyond 2020 with a industries to prevent leakage. Free allocations to simple majority vote. This would eliminate the prevent leakage can help ensure the program is legal uncertainty about ARB’s ability to operate reducing overall emissions by ensuring emissions the program beyond 2020. However, there would are not simply shifted to other states or countries. continue to be legal uncertainty about ARB’s ability In addition, even if the courts determined to auction allowances. It is important to note that ARB could auction allowances beyond 2020 the legal uncertainty would likely continue even under legislation passed with a simple majority if the courts ruled in favor of the state in the case vote, the Legislature would likely be required to challenging ARB’s authority to auction allowances. spend the revenue on activities that reduce GHG This is because the plaintiffs are challenging ARB’s reductions. This is because the state would have to current authority provided under Proposition 13. maintain a nexus between the fee paid and how However, new legislation authorizing auctions the resulting revenue is used, as required under would be subject to Proposition 26 requirements. Proposition 26. As we discuss in more detail below, The ability to auction allowances is an this requirement limits the Legislature’s flexibility important design feature of a cap-and-trade to use the funds on its highest priorities. program. If the courts determined that ARB could Two-Thirds Vote Would Give Greater Ability not auction allowances, the ARB would have to give to Design an Effective Program. Extending the all of the allowances away for free. This would limit cap-and-trade program with a two-thirds vote the state’s flexibility to design the most effective would remove legal uncertainty about ARB’s program. In theory, the method of distributing authority to auction allowances. The ability to www.lao.ca.gov Legislative Analyst’s Office 23 2017-18 BUDGET Economic Advisory Committee Recommended Auctioning Allowances Economists generally recommend auctioning 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. This reduces the incentive for consumers to buy less greenhouse gas (GHG)-intensive products. If consumers no longer have a financial incentive to purchase less GHG-intensive products then other, more expensive, reduction activities might need to be undertaken. • 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 do not occur under auctions. • Opportunities to Reduce Taxes. Auction revenue can be used to provide economic benefits. For example, in theory 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. For example, the state could use the revenue to provide targeted tax breaks to certain industries. 24 Legislative Analyst’s Office www.lao.ca.gov 2017-18 BUDGET auction allowances would allow the state to operate auction revenue. From an economic perspective, a more effective program for the reasons discussed auction revenues are often thought of as a above. In addition, a two-thirds vote would allow by-product of cap-and-trade programs, not the the Legislature to remove the requirement that goal of the program. Below, we discuss (1) the cap-and-trade auction revenues be limited to use administration’s revenue assumptions and how on activities that reduce GHG emissions. Instead, various factors could affect future revenue, as we discuss in more detail below, the Legislature (2) potential options for using revenue if the could authorize a broader set of allowable uses for program is approved with a two-thirds vote, and those revenues based on its priorities. (3) our concerns about the Governor’s proposed approach to spending auction revenue. LAO Recommendations Revenue Projections Plausible, but Approve Cap-and-Trade With a Two-Thirds Significant Uncertainty Remains Vote. We recommend the Legislature approve cap-and-trade (or a carbon tax) with a two-thirds The Governor’s budget assumes $1 billion vote. Extending cap-and-trade with a two-thirds in auction revenue in 2016-17 and $1.5 billion vote would remove legal uncertainty about in 2017-18. In our view, the administration’s the ARB’s ability to auction allowances, which revenue assumptions are plausible, but there is generally seen as an important feature of a is substantial uncertainty. Figure 11 shows the well-design cap-and-trade program. Also, with volatility in quarterly auction revenue over the a two-thirds vote, the Legislature could broaden last couple of years since fuel suppliers were the allowable uses of the funds and have greater required to obtain allowances. Notably, there was flexibility to use the revenue on its highest a substantial decrease in revenue collected at the priorities. Figure 11 How Should Recent Cap-and-Trade Auction Revenue Volatile Cap-and-Trade Revenue Be Used? (In Millions) As the Legislature $700 considers how to use cap-and- 600 trade auction revenue, it is important to keep in 500 mind that the primary goal of a cap-and-trade 400 program is to provide an 300 economy-wide incentive for businesses and consumers 200 to undertake cost-effective 100 emission reductions. This is accomplished through establishing a price on February May August November February May August November 2015 2015 2015 2015 2016 2016 2016 2016 emissions, not spending www.lao.ca.gov Legislative Analyst’s Office 25 2017-18 BUDGET May and August 2016 auctions. Several factors reductions. However, as we discussed in our likely contribute to this volatility, including (1) an 2016 report Cap-and-Trade Revenue: Strategies to oversupply of allowances because emissions Promote Legislative Priorities, this requirement are below the cap, (2) uncertainty related to the creates some significant policy challenges. First, ongoing court case challenging the legality of if a cap-and-trade program is in place, spending state-auctioned allowances, and (3) uncertainty auction revenue only on GHG reductions is not about ARB’s legal authority to continue cap-and- necessary to meet the state’s GHG goals and likely trade beyond 2020. Results from the next two increases the overall costs of emission reduction auctions will be available by June and provide some activities. This is because, if the cap is limiting additional revenue clarity before the Legislature emissions, spending on GHG reductions interacts adopts a budget for 2017-18. However, estimates with the regulation in a way that changes the of 2017-18 revenue will continue to be subject to types of emission reduction activities, but not the substantial uncertainty. overall level of emission reductions. Second, the Actions by the courts or the Legislature requirement to spend on GHG reductions limits the that provide legal clarity about the future of the Legislature’s flexibility to use the revenue in a ways program could have significant effects on future that could achieve other goals. auction revenue. For example, the Legislature Authorizing the program with a two-thirds extending the program with a two-thirds vote vote would give the Legislature ability to remove would provide greater certainty that the program the requirement that auction revenue be used only would exist beyond 2020. We note that ARB has on activities that reduce GHGs. The Legislature proposed regulatory changes to extend the program could use the funds to (1) offset higher costs for beyond 2020. Under these proposed changes, households and businesses associated with higher allowances can be banked and used for post-2020 energy prices by providing tax reductions or compliance. If the cap is expected to limit rebates, (2) promote other climate-related policy emissions beyond 2020, a statutory extension of goals, such as climate adaptation activities, and/or the program would very likely increase demand for (3) promote other legislative priorities unrelated to allowances and state revenue. The change in market climate policy. Returning the revenue by reducing conditions could happen almost immediately after other taxes or providing rebates could become the Legislature takes action, or possibly even before. even more important if allowance prices increase In light of some of the potential price volatility in the future—thereby increasing energy costs for explained earlier, and the more substantial role households and businesses. cap-and-trade might play in the future, annual Broadening the allowable uses of the revenue state revenue could be billions of dollars higher would almost certainly make the auctions a tax than assumed in the Governor’s budget. under Proposition 26. As such, it raises some questions about what additional constitutional Two-Thirds Vote Gives Flexibility to requirements might affect the state’s collection Broaden Potential Uses of Revenue and use of cap-and-trade revenues. For example, Under current law (and potentially under if auction proceeds are tax revenues, they would future court decisions), the state can only spend count towards the state’s appropriations limit auction revenue on activities that facilitate GHG established by Proposition 4 in 1979. 26 Legislative Analyst’s Office www.lao.ca.gov 2017-18 BUDGET Governor’s Proposal Limits revenue in light of the revenue uncertainty. In our Legislative Authority view, the administration’s concern about potential revenue uncertainty is reasonable. However, the Governor’s Proposal Unnecessarily Restricts Legislature has other options to address revenue Legislature’s Spending Authority. The issues of uncertainty. For example, the Legislature could ongoing authority for cap-and-trade and how allocate the funds that are available at the end to spend auction revenues are related, and it is of 2016-17, plus a small portion of expected reasonable to consider them together. For example, 2017-18 revenue. Another option would be for the as described above, extending cap-and-trade Legislature to use funding “buckets” that designate with a two-thirds vote would give the Legislature which programs receive allocations first, and which a much wider range of spending options to programs receive allocations only if sufficient consider. However, the Governor’s proposal revenue is collected. unnecessarily restricts Legislative spending authority. The Legislature does not have to make LAO Recommendations budget allocations in 2017-18 contingent on future Broaden Allowable Uses of Revenue. We legislation to extend cap-and-trade. It currently has recommend that the Legislature broaden the the authority to appropriate this funding regardless potential uses of auction revenue by removing of whether it adopts the Governor’s proposed policy the requirement that auction revenue be spent change to extend cap-and-trade. on GHG reduction activities. This would give Proposed Control Section Gives Too Much the Legislature flexibility to use the revenue to Spending Authority to Administration. The offset higher costs for households or business or Governor’s budget allocates $1.3 billion in spend the auction revenue on its highest priorities. discretionary funding through what is known This approach would almost certainly require a as a control section. As currently proposed, the two-thirds vote of the Legislature. We suggest control section specifies the amount that would the Legislature make a high priority spending go to general types of activities—such as carbon strategies that would offset higher future energy sequestration, energy efficiency, or short-lived costs associated with the program, such as reducing climate pollutants—but it would give DOF other taxes or providing rebates to households and the authority to allocate the funds to specific businesses. This is because collecting revenue for departments and programs. It is not clear which state programs is not a goal of the program and departments or programs would receive the funds extending the program to 2030 could result in a or whether the allocations made by DOF would significant increase in energy costs. In addition, be consistent with the Legislature’s priorities. if the Legislature broadens the potential uses of According to DOF, the administration anticipates the funds, we recommend that it consider how revising the proposal to allocate funds to more all revenue should be prioritized—including specific programs based on discussions with the the portion of revenue that is that is currently Legislature. continuously appropriated—because there could be The control section also directs DOF to make higher priority uses that are not allowed under the quarterly allocations on a proportional basis to current legal requirements. the different categories based on the amount of Reject Language Making Spending Contingent available funds. According to DOF, this provision on Future Legislation. We recommend rejecting was included to ensure allocations did not exceed www.lao.ca.gov Legislative Analyst’s Office 27 2017-18 BUDGET the proposed budget bill language that would to adjust allocations proportionally addresses a make cap-and-trade allocations contingent on reasonable concern, but the Legislature might legislation extending the cap-and-trade program. want to prioritize certain programs over others. It is reasonable to consider how to spend auction Accordingly, we recommend the Legislature revenue in the context of a broader discussion consider various options, such as using funding about the long-term future of the cap-and-trade buckets to ensure the highest priority programs program. However, the proposed language receive allocations first. unnecessarily restricts legislative spending Allocate Funds to Specific Programs. We authority. If a decision is not made about the future recommend the Legislature allocate funds to of cap-and-trade by the time the 2017-18 budget specific departments and programs, rather than is passed, the Legislature should still consider allocating to general categories of programs allocating auction revenues based on its spending and providing DOF authority to select specific priorities. programs (as proposed by the Governor). The Consider Alternative Strategies for Dealing current proposal delegates to DOF spending With Revenue Uncertainty. We recommend the authority that is more appropriately the Legislature consider alternative approaches to Legislature’s. Making this modification would dealing with auction revenue uncertainty. The ensure the allocations are consistent with legislative administration’s proposal to give DOF authority goals and priorities. CONCLUSION The Governor’s proposal raises a wide variety additional direction to ARB intended to improve of important policy and oversight issues for the the design of the program and ensure the polices Legislature to consider. Based on our review of it implements are consistent with legislative goals the available information, we recommend the and priorities, and broaden the potential uses Legislature authorize cap-and-trade (or a carbon of the revenue so it can be used to promote the tax) beyond 2020 with a two-thirds vote, provide Legislature’s highest priorities. 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. 28 Legislative Analyst’s Office www.lao.ca.gov