California’s Cap-and-Trade Program: Frequently Asked Questions

AN LAO REPORT California’s Cap-and-Trade Program: Frequently Asked Questions GABRIEL PETEK | LEGISLATIVE ANALYST | OCTOBER 2023 This brief answers commonly asked questio ns The state has taken a number of steps towards about California’s cap-and-trade program and meeting these GHG reduction goals, such the revenues it generates, which are deposited as establishing new policies, programs, and and spent through the Greenhouse Gas regulations—including the cap-and-trade program. Reduction Fund. What Is the Cap-and-Trade Program? Cap-and-trade is one of the state’s key policies The Cap-and-Trade Program intended to reduce statewide GHG emissions. What Are California’s Greenhouse Gas (GHG) Under the program, the California Air Resources Emissions Goals? Board (CARB) is tasked with setting a declining, GHG emissions are the main drivers of global aggregate cap on the amount of GHGs allowed to climate change. To try to reduce California’s be emitted in the state each year. Entities covered contributions to climate change—and encourage under the program represent roughly 75 percent innovations that influence actions in other states of the state’s GHG emissions and include oil and countries—the Legislature has adopted various statewide GHG emissions targets. These goals are summarized in Figure 1 Figure 1. Specifically: Summary of Statewide GHG Targets • 2020. Chapter 488 of 2006 Millions of Metric Tons of Carbon Dioxide Equivalent (AB 32, Núñez) established the target of limiting GHG 600 emissions statewide to the 1990 level by 2020. • 2030. Chapter 249 of 2016 500 (SB 32, Pavley) extended the Actual Emissions 1990 emissions limit to at least 40 percent by 2020 below the 1990 level by 2030. 400 • 2045. Chapter 337 of 2022 (AB 1279, Muratsuchi) 300 extended the limit to at least 85 percent below the 1990 40 percent below 1990 level by 2030 level by 2045. Assembly Bill 200 1279 also established a goal of attaining zero net carbon emissions by 2045, commonly 100 known as carbon neutrality. 85 percent below To meet this objective, the 1990 level by 2045 state will need to adopt practices such as carbon 2010 2015 2020 2025 2030 2035 2040 2045 capture and storage to offset GHG = greenhouse gas. remaining GHG emissions. www.lao.ca.gov 1 AN LAO REPORT refineries, electricity generators and importers, and (that is, to keep companies from moving their manufacturing facilities. These covered entities operations outside of California to avoid the need can comply with program requirements in three to comply with the program). The program does not ways: (1) reduce their GHG emissions, (2) obtain establish individual GHG emission caps for each allowances (essentially a permit to emit one ton of covered entity or facility. Rather, the total number carbon dioxide equivalent) to cover their emissions, of allowances sold and given away statewide in a and/or (3) purchase “offsets” (paying to support a given year is equal to the aggregate statewide cap GHG reduction project elsewhere) to cover their on GHG emissions that CARB sets each year. emissions. Figure 2 provides an illustration of What Is the History of the Program? these options. The cap-and-trade program was first authorized CARB issues a set number of allowances each through AB 32 in 2006, which—along with year equal to the annual cap that entities can establishing the state’s first major GHG reduction purchase and sell on an open market—this is the goal—allowed CARB to develop a market-based “trade” component of the program. Some of these mechanism to reduce GHG emissions from large allowances are auctioned, and some are given emitters. Since then, CARB has adopted numerous away for free to utilities, natural gas suppliers, regulations governing the program and its and industrial facilities. These free allowances are implementation. The Legislature also has adopted intended to protect consumers from significant subsequent legislation governing the program’s rate increases and prevent emissions leakage operations. For example, Chapter 39 of 2012 (SB 1018, Committee on Budget) established criteria that must be Figure 2 met before CARB links California’s cap-and-trade market to other Ways Entities Can Comply With the carbon markets (as described Cap-and-Trade Programª below). More recently, Chapter 135 of 2017 (AB 398, Garcia) authorized the program through 2030 and modified certain aspects of the Reduce Emissions CO Entities can reduce their emissions. ² program design, including placing new limits on the use of offsets and making some changes to the Obtain Allowances distribution of free allowances. Entities can buy allowances—essentially permits—to cover their emissions.b What Are the Program’s Key Goals and Objectives? The cap-and-trade program’s Buy Offsets primary goal is to reduce statewide Entities can purchase offsets, which are investments in projects intended to GHG emissions at the lowest cost. counter-balance their emissions. Other major goals of the program include encouraging investments into cleaner, more efficient technologies that reduce emissions and establishing California as a global leader on climate issues. a “Covered entities” subject to the cap include large GHG emitters such as oil refineries, electricity generators and How Do Auctions Work? importers, and manufacturing facilities. CARB hosts four auctions of b Some covered entities receive free allowances, such as some utilities, natural gas suppliers, and industrial facilities. cap-and-trade allowances each GHG = greenhouse gas and CO2 = carbon dioxide. year, in February, May, August, and November. CARB sets a “floor 2 LEGISLATIVE ANALYST’S OFFICE AN LAO REPORT price” (minimum price) for which an allowance can importers, natural gas suppliers, and transportation be sold, but historically allowances frequently have fuel suppliers. However, within these sectors, sold above that price due to buyer interest. For CARB establishes (1) the types of emissions that example, in the August 2023 auction, CARB set the are covered and (2) GHG emission threshold per-allowance floor price at $22.21 but allowances requirements focusing on larger facilities. As a ultimately sold for $35.22 each. In addition to result, not all emissions from industrial processes covered entities, outside investors also are able are covered by the cap-and-trade requirements. to purchase allowances at auctions to resell to For example, although emissions from the energy covered entities or other investors at a future date. used to power dairy product manufacturing Covered entities need not use the allowances they facilities are covered by cap-and-trade, the have purchased towards covering their emissions methane emissions that come from the dairy cows in that year; as discussed below, they also can that produce the milk are not covered. Moreover, “bank” them and choose to apply them towards smaller businesses within a covered sector—such compliance in a future year. as individual gas stations—often are exempt from How Do Offsets Work? meeting the requirements because their emissions are below the established threshold. In addition to obtaining allowances to emit GHGs, CARB allows covered entities to continue emitting How Does Cap-And-Trade Fit in With Other GHGs by purchasing offsets. Offsets are designed State Efforts to Reduce GHGs? to counter-balance the impacts of an entity’s As noted, the cap-and-trade program is just one emissions by reducing emissions or preventing of a collection of activities the state is undertaking increased emissions elsewhere. In one common to meet its GHG reduction goals. Other key example, an entity covered under cap-and-trade in efforts include regulations to increase adoption of California—such as an oil refinery—can purchase an zero-emissions vehicles, requirements to shift the offset through a private company that works directly state’s electricity to rely on renewable sources, and with forest owners to preserve forest growth. standards to encourage the use of lower-carbon (Preserving forestlands is intended to have a net transportation fuels. Historically, cap-and-trade positive long-term effect on GHG emissions as has been considered as a “backstop” to ensure the compared to if they were cut down because forests state meets its targets. That is, CARB has explicitly can sequester carbon.) Statute requires that at stated that to the degree other policies collectively least half of claimed offsets—and assumed impacts fall short of meeting the state’s GHG reduction on GHG emissions—provide direct environmental goals, the cap-and-trade program is intended to benefits in California, but the remainder could be for reduce emissions further to make up the difference. projects undertaken in other states that do not have How Effective and Cost-Effective Is direct environmental benefits in California. CARB the Program? maintains a number of eligibility requirements for Since the cap-and-trade program began, offset projects to be used as credits for program California’s overall GHG emissions have declined compliance. Currently, covered entities may use by 14 percent. However, this is not solely due to offset credits to meet up to 4 percent of their the impacts of the program. Other state programs, compliance obligations under cap-and-trade; such as requirements and incentives to transition to they must either directly reduce emissions or greater use of renewable sources of electricity, also purchase allowances for the remainder of their have contributed to these reductions. The complex compliance requirements. interactions between cap-and-trade and other What Entities Are Covered Under state climate change efforts—as well as the many the Program? technological and economic factors that affect Cap-and-trade program requirements generally emissions in California—make it difficult to quantify apply to entities located within California that the level of emissions reductions attributable to emit significant amounts of GHGs, such as large the program alone. To our knowledge, no studies industrial facilities, electricity generators and have produced a reliable estimate of the emission www.lao.ca.gov 3 AN LAO REPORT reductions achieved by the cap-and-trade program unused allowances. That is, they have purchased— so far. While the cap-and-trade program likely also and, thus far, not yet used—excess permits that has made some progress in spurring market-based they can use to allow for additional emissions climate policies outside of California, data are in future years. Accordingly, under the current similarly unavailable to quantify the extent of structure of the program, covered entities likely this influence. will have more than enough banked allowances to While cap-and-trade is just one component comply with program requirements even as they of the state’s suite of climate change mitigation continue to emit at levels exceeding the 2030 cap, efforts, evidence suggests it reduces emissions as illustrated in Figure 3. This program shortcoming more cost-effectively than most other state-funded may keep cap-and-trade from helping the state programs. Specifically, based on auction prices, achieve its near-term GHG goals. In the long term, cap-and-trade has an associated cost of about CARB likely will need to adjust the cap downward to $30 per ton of carbon dioxide equivalent reduced. put the state on track to meet its 2045 GHG goal. In contrast, a large state program that subsidizes How Does California’s Program Relate to zero-emission vehicle replacements has an Other Cap-and-Trade Programs? estimated cost per ton of $193. As noted above, in 2012 SB 1018 authorized However, questions have been raised about CARB to join California with similar programs whether certain components of the current cap-and in other states and/or countries, creating a trade program—such as the option for covered unified carbon market that hosts joint auctions of entities to purchase offsets to comply while allowances that can be applied in all participating continuing to emit GHGs—are effective at meeting jurisdictions. In 2014, CARB linked the state’s the state’s goals. Specifically, in recent years, academic Figure 3 researchers have questioned the quality of the offsets in the Example of How Cap-and-Trade Allowances carbon market, with some studies Banked in Earlier Years Can Be Used in Later Years finding a marginal or nonexistent Millions of Metric Tons of Carbon Dioxide Equivalent climate benefit. Is the Program 450 Well-Positioned to Help the State Unused Allowances Banked From Earlier Years Achieve Its GHG Goals? 400 While the state depends on a wide variety of activities to 350 Program Caps Banked Allowances Used to meet its GHG reduction goals, Comply in Later Years 300 cap-and-trade is a key component Emissions to make up the difference to 250 the degree other policies and programs fall short of achieving 200 desired reductions on their own. 40 Percent Below 1990 Level by 2030 However, cap-and-trade currently 150 is not stringent enough to drive the additional emissions reductions 100 needed to meet the state’s 2030 50 GHG emissions reduction goal. This is because, over the past several years, covered entities and 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 2029 2030 outside investors have accumulated and banked a significant number of 4 LEGISLATIVE ANALYST’S OFFICE AN LAO REPORT program with the Canadian province of Quebec’s cap-and-trade and local air pollution. A 2022 study smaller carbon market. California’s carbon market from the University of Southern California found that was also linked with Ontario’s market from 2017 to the program did not improve local air quality and 2018, before that province’s cap-and-trade program in some cases contributed to greater disparities shuttered. As of this writing, CARB was considering in exposure to air pollution near covered facilities. the possibility of linking California to Washington Another study from University of California, Santa state’s new program. Barbara published in 2023 found air pollution How Are Changes Made to the Program? disparities across California from facilities covered under cap-and-trade narrowed as a result of As noted above, in the history of the program, the program. the state has made a number of changes to cap-and-trade through both regulations and How Does the Program Affect Gas Prices? legislation. CARB conducts a formal rulemaking As of this writing, CARB estimates that the process to make changes to the program. For cap-and-trade program adds about 27 cents to example, the board is expected to initiate a process each gallon of retail gasoline sold in California. in 2024 which may include potential changes This assumes transportation fuel suppliers pass related to program stringency and the allocation of their compliance costs on to consumers in the form allowances to certain industrial entities. CARB has of higher retail gas prices, which economists have made numerous changes to the program in past found to be the case. years, including adjusting the supply of allowances What Are Some Ways in Which the and establishing the linkage with Quebec’s carbon Cap-and-Trade Program Impacts Lower-Income market. The Legislature can also direct changes Populations? to the cap-and-trade program. For example, in Certain covered facilities are more likely to be 2017, AB 398 added the requirement that half of located in communities with higher proportions of eligible offsets for the program be from projects that people of color and those earning lower incomes, provide direct environmental benefits in California. fitting with the pattern of historic marginalization What Will Happen to the Program After 2030? of these communities to areas closer to heavy There is uncertainty regarding the program’s industry. As noted above, cap-and trade is not operations past 2030. When the program last designed to address these localized impacts and neared its original expiration date of 2020, the research is inconclusive about whether the program Legislature passed legislation to authorize its has resulted in better, neutral, or even worse air extension to 2030. Whether CARB has the authority pollution disparities for vulnerable communities to continue the program beyond that date without located near certain covered facilities. legislative action or whether the Legislature must As noted above, cap-and-trade increases the authorize a further extension currently is an area of price of purchasing gasoline in California. Higher some legal uncertainty. Should the program expire gas prices disproportionately impact lower-income in 2030, the state likely would need to identify households, which tend to pay a larger share of activities and policies to attain additional emissions their income towards transportation costs. This is reductions in order to meet its 2045 GHG goals. due in part to lower-income residents having moved How Does Cap-and-Trade Impact Local further from places of employment in recent years Air Pollution? in response to rising housing costs in California’s Cap-and-trade is designed to address GHG metropolitan centers, forcing them to spend more emissions, not local air pollution. However, certain on gas due to longer commutes. entities covered under the program—such as oil Additionally, as described below, the state refineries—emit air pollutants alongside GHGs requires that a certain portion of cap-and-trade that historically have worsened air quality and auction revenues be spent on activities that benefit contributed to air pollution in certain parts of the low-income and disadvantaged communities. state. Academic researchers have reached different conclusions about the relationship between www.lao.ca.gov 5 AN LAO REPORT The Greenhouse Gas Reduction Fund that at least 35 percent of GGRF expenditures benefit “priority populations,” which include What Is the Greenhouse Gas Reduction Fund disadvantaged and lower-income communities. (GGRF) and How Much Revenue Does It Receive? (Senate Bill 535 required the California Environmental GGRF is the depository for revenues generated Protection Agency to develop a data tool to identify from the sale of cap-and-trade allowances. In recent these target communities, based on the degree years, cap-and-trade auctions have raised between to which they are disproportionately affected $3 billion and $4.3 billion per year. Multiple factors by environmental pollution and/or have higher influence revenues—including interest in purchasing concentrations of people with lower incomes or allowances from outside investors, confidence greater rates of unemployment. That tool is now in the longevity of the program, and the balance known as CalEnviroScreen.) Many specific spending of supply versus demand for allowances. These requirements originated with the 2014-15 budget, dynamics make it difficult to predict with certainty which established a number of standard annual how much revenue will be generated for GGRF in allocations for GGRF, as described next. a given year. Figure 4 displays the fluctuations in What Types of Activities Do GGRF Funds auction revenues over the past few years. (Due Support? to economic slowdowns related to the COVID-19 pandemic, entities purchased very few allowances in Figure 5 displays the programs and associated May 2020, resulting in a sharp drop in revenue from amounts stipulated in statute for annual GGRF that auction.) allocations. These statutory requirements largely have stayed the same since the cap-and-trade What Requirements Govern How GGRF Funds program was established, though the forest health Can Be Spent? and drinking water spending amounts were added The Legislature has established a number of more recently (2022 and 2019, respectively). About requirements for how GGRF monies can be spent. 65 percent of annual GGRF revenues is dedicated to Assembly Bill 32, the legislation that created the these statutory spending requirements. For the most program in 2006, required that revenues be spent part, these statutory GGRF spending commitments on activities that reduce GHG emissions and/or are continuously appropriated, meaning they are not address the impacts of climate change. In addition, subject to appropriation by the Legislature through Chapter 830 of 2012 (SB 535, de León) required the annual budget act or other legislation. After accounting for these statutory spending commitments, the remainder Figure 4 of annual GGRF revenues are available Quarterly Cap-and-Trade Auction Revenue for the state to spend on other activities, Has Fluctuated Over Time at its discretion (and pursuant to other (In Millions) statutory requirements). The Legislature typically appropriates GGRF funds as a part of the annual budget process, $1,400 and spending priorities for these 1,200 “discretionary” revenues can vary each 1,000 year. Past expenditures have focused 800 on low-carbon transportation programs, 600 community-based air protection, 400 and agriculture programs. Figure 6 200 provides a summary of how the state MayAug Nov FebMay Aug Nov FebMay Aug Nov FebMay Aug Nov Feb May AugNov Feb MayAug has spent GGRF revenues since the 2018 2019 2020 2021 2022 2023 cap-and-trade program began. This link provides a summary of GGRF spending in the most recent state budget package. 6 LEGISLATIVE ANALYST’S OFFICE AN LAO REPORT How Does the State Set Its Figure 5 Annual GGRF Spending Level? Statutorily Required GGRF Appropriations As part of developing the annual state budget package, Program Department Appropriation Amount the Legislature and Governor High-Speed Rail HSRA 25 percent of annual revenues base the annual GGRF spending Affordable Housing and SGC 20 percent of annual revenues plan on estimates for how much Sustainable Communities Transit and Intercity Rail CalSTA 10 percent of annual revenues revenue the cap-and-trade Low Carbon Transit Operations Caltrans 5 percent of annual revenues auctions might generate in the Healthy and Resilient Forests CalFire $200 milliona coming year. If revenues ultimately Safe and Affordable Drinking Water SWRCB $130 milliona come in significantly lower than Manufacturing Tax Credit Other Roughly $70-$90 million SRA Backfill CalFire/CCC Roughly $70-$90 million expected, the Legislature may a Allocation may be reduced proportionally if annual revenues are not sufficient to support intended need to make midyear reductions amount. to some authorized expenditures. GGRF = Greenhouse Gas Reduction Fund; HSRA = High Speed Rail Authority; SGC = Strategic If revenues come in higher than Growth Council; CalSTA = California State Transportation Agency; Caltrans = California Department of Transportation; CalFire = California Department of Forestry and Fire Protection; expectations, the Legislature can SWRCB = State Water Resources Control Board; SRA = State Responsibility Area; and CCC = California Conservation Corps. allocate the additional funding through a subsequent budget action. The funding levels for the Figure 6 programs identified in Figure 5 that Cumulative Cap-and-Trade Spending by Area receive a statutorily established percentage of annual GGRF 2013 Through 2023 revenues adjust without the need for legislative action. Total: $26.4 Billion Transformative Climate Communities Waste Diversion Safe and Affordable Drinking Water Other Various Agriculture and Food Production Clean Energy Programs Other Transportation High-Speed Rail Project Community Air Protection Forest Health Affordable Housing and Sustainable Communities Transit and Intercity Rail Capital Low Carbon Transportation www.lao.ca.gov 7 AN LAO REPORT LAO PUBLICATIONS This report was prepared by Sarah Cornett, and reviewed by Rachel Ehlers and Anthony Simbol. 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, California 95814. 8 LEGISLATIVE ANALYST’S OFFICE