Assessing California’s Climate Policies—Cap-and-Trade Reauthorization

AN LAO REPORT Assessing California’s Climate Policies: Cap-and-Trade Reauthorization GABRIEL PETEK | LEGISLATIVE ANALYST | MAY 2025 SUMMARY Legislature Faces Important Decisions Related to Reauthorization of Cap-and-Trade Program. As the 2030 statutory sunset date approaches, the Legislature faces choices about whether and how to extend the cap-and-trade program. These decisions are particularly important given that reauthorization could shape the program for many years to come. Also, in light of the dollar amounts at stake, these choices could have significant implications for various legislative priorities, such as greenhouse gas (GHG) reductions and affordability. Cap-and-Trade Plays Important Role in Helping State Reduce GHGs Cost-Effectively. Since its creation, the cap-and-trade program has served an important role in helping the state ensure that it meets its GHG reduction goals in a relatively cost-effective manner. Fundamentally, the cap-and-trade program works by making polluters pay a price for each unit of GHGs they emit. This price provides a financial incentive for households and businesses to undertake low-cost emission reductions (similar in many ways to a carbon tax). Should the program expire in 2030, the state would need to identify other—likely less cost-effective—activities and policies to attain additional emissions reductions in order to meet its GHG-reduction goals. Reauthorization Decisions Will Have Significant Financial Implications for Households, Businesses, and the State. If the program were to be extended for 15 years (until 2045), we estimate that emitters could potentially pay a couple of hundred billion dollars for allowances during this period. Many of these charges likely would be passed on to California households and businesses in the form of higher prices, such as for gasoline and diesel fuel. Notably, however, the revenue from these charges also can be directed to meet legislative priorities, such as offsetting the costs of the program to consumers, further reducing GHG emissions, or supporting other policy priorities. As a result, decisions about both the design of the program and how the revenue is used will have important implications for households and businesses, as well as on funding levels for various state programs. Legislature Faces Various Options, Each With Key Trade-Offs. To help inform the Legislature’s decisions, in this report we summarize some options available to the Legislature to help achieve its policy priorities through reauthorization. For example, the Legislature may want to focus on improving affordability, particularly given that the extension of the program could put upward pressure on allowance prices and result in higher associated costs to emitters and consumers. If affordability were the Legislature’s focus, some options for addressing it include: (1) lowering the price ceiling to prevent the potential for high allowance prices; (2) using cap-and-trade revenues to offset consumer costs, such as by providing rebates to households; and/or (3) increasing the number of free allowances dedicated to offsetting consumer costs. These options would all come with notable trade-offs. Important for Reauthorization to Reflect Legislative Priorities. Whichever approaches the Legislature chooses to adopt, we encourage it to ensure that its key policy priorities are reflected in the design and operation of the program going forward, including providing clear statutory direction when applicable. www.lao.ca.gov 1 AN LAO REPORT INTRODUCTION Legislature Faces Decisions Related to cap-and-trade program. Second, we discuss some Reauthorization of Cap-and-Trade Program. reasons why decisions about reauthorization of the Since the cap-and-trade program was created program are important. Third, we summarize some through the passage of Chapter 488 of 2006 options for addressing key potential legislative (AB 32, Núñez), it has served as one of the state’s priorities for the program—GHG reductions, primary policies intended to help it achieve its affordability, and various other policy goals—as ambitious GHG reduction goals. Chapter 135 part of reauthorization. Finally, we discuss the of 2017 (AB 398, Garcia) extended the statutory importance of the Legislature providing clear authorization for the program from 2020 through statutory authorization and direction for the 2030. As the 2030 statutory sunset date program in priority areas. approaches, the Legislature faces important Report Meets Statutory Requirement. choices about whether and how to extend This report is submitted pursuant to AB 398, the program. which requires our office to report annually on Report Is Intended to Help Inform Decisions the economic impacts and benefits of the state’s on Reauthorization. This report is intended to GHG emissions reduction targets. Consistent help inform legislative decision-making around with the statutory direction, this report discusses reauthorization of the cap-and-trade program. the potential economic impacts and benefits The report has four main sections. First, we begin of the state’s GHG targets, focusing on the by providing background on various aspects of the cap-and-trade program. BACKGROUND In this section, we provide background on Figure 1 California’s existing cap-and-trade program. State Met 2020 GHG Targets Early, But Cap-and-Trade Program Overview 2030 and 2045 Targets Are More Ambitious California Has Adopted Ambitious GHG Million Metric Tons of GHGs Emitted Reduction Goals. GHG emissions are the main drivers of global climate change. To try to reduce 600 California’s contributions to climate change and encourage innovations that influence actions in 500 Target other states and countries, the Legislature has adopted three successive statewide GHG emission 2020 400 Electricity reduction goals (also known as targets) for 2020, 2030, and 2045. As shown in Figure 1, the state 300 met its 2020 goal several years ahead of schedule. Target Transportation However, emissions will need to decline at a much 2030 faster rate in order to meet the 2030 and 2045 200 targets, which are significantly more ambitious. State Is Implementing Various Programs to 100 Industry, Heating, Target Agriculture Reduce GHGs. In order to meet its GHG-reduction 2045 goals, the state has implemented various programs and policies. For example, in 2006, the Legislature 2006 2010 2014 2018 2022 2026 2030 2034 2038 2042 adopted AB 32, which authorized the California Air GHG = greenhouse gas. 2 LEGISLATIVE ANALYST’S OFFICE AN LAO REPORT Resources Board (CARB) to create a market-based amount of GHGs per unit of fuel sold in the state— mechanism to reduce GHG emissions from large through regulation. emitters through 2020. Under this authority, CARB Cap-and-Trade Program Aims to Limit adopted the cap-and-trade program as the state’s the Overall Level of Emissions From Large market-based mechanism. (In the nearby box, we Emitters. Under the cap-and-trade program, discuss how cap-and-trade compares to another CARB issues a limited number of allowances each main market-based approach: carbon taxes.) The year—sometimes known as the “cap” on emissions. program first took effect in 2012. Subsequently, Entities covered under the program represent in 2017, the Legislature enacted AB 398 to extend roughly three-quarters of the state’s GHG emissions the explicit statutory authorization for the program and include oil refineries, electricity generators through 2030 and modify certain aspects of the and importers, and manufacturing facilities. These program design. The state also has developed “covered entities” can meet compliance obligations various other programs to reduce GHGs. Some under the program through a combination of the of these programs were established by the following actions: Legislature in statute, such as the Renewable • Reducing their GHG emissions. Portfolio Standard, which requires a growing share • Obtaining allowances (essentially a permit to of electricity generation to come from renewable emit one ton of carbon dioxide equivalent) to sources. In other cases, CARB has developed cover their emissions. programs under the broad authority it received through AB 32. For example, CARB created the • Purchasing “offsets” (paying to support a Low-Carbon Fuel Standard (LCFS) program—which GHG reduction project outside of the capped requires transportation fuel suppliers to reduce the sectors) to cover their emissions. Cap-and-Trade and Carbon Taxes Are Both Market-Based Policies Both Policies Rely on Financial Incentives to Reduce Emissions. The two main market-based policies for reducing emissions are cap-and-trade and carbon taxes. Market-based approaches differ in a few key ways from other potential regulatory approaches such as traditional command-and-control regulations. Under traditional regulations for reducing emissions, the government requires every affected business to install a certain type of emission reduction technology or meet a certain minimum emissions standard. In contrast, a market-based approach adds a financial cost to producing greenhouse gases (GHGs), which provides a financial incentive for private businesses and consumers to reduce emissions. Policies Differ in Some Key Ways. A carbon tax sets a price on GHG emissions and allows the market to determine the quantity of those emissions. In contrast, a cap-and-trade program sets the quantity of GHG emissions allowed and lets the market determine the price. Thus, in concept, cap-and-trade generally provides more certainty regarding emissions while carbon taxes generally provide more certainty regarding the price of emissions (and thereby on the price effects on consumers and businesses). Notably, California’s cap-and-trade program has some design features that make it more similar to a carbon tax than the most basic stylized version of a cap-and-trade program would suggest. For example, California’s cap-and-trade program has a price floor and price ceiling, which limit the ability of carbon prices to fluctuate outside of a defined range. Also, notably, in California’s program, if allowance prices were to reach the price ceiling, the California Air Resources Board would sell an unlimited number of permits to emit at that price level. (Under current regulations, the proceeds from the sale of those permits must be used to pay for mitigation activities outside of the capped sectors, such as those funded by offsets.) In effect, this would allow additional emissions beyond the program’s cap, but it also would help ensure that the effects on prices did not exceed a certain threshold. www.lao.ca.gov 3 AN LAO REPORT By limiting the number of allowances and offsets less “work” the cap-and-trade program must do that can be used, the program requires that, in to ensure emissions stay within the cap, which can aggregate, these major sources of emissions do lower allowance demand.) As shown in Figure 3, for not exceed a certain level. Covered entities—as well most of the program’s history, allowance prices have as certain other qualifying entities—can buy and been at or near the price floor. While allowance prices sell (“trade”) allowances, thereby creating a market generally have increased since 2020, they have been price for the allowances. As discussed in more detail somewhat lower in the last few auctions compared below, this market price for allowances provides a to late 2023 and early 2024. Thus far, however, financial incentive for emitters to identify low-cost allowance prices have never gotten close to the price opportunities to reduce emissions. ceiling (roughly $95 per allowance in 2025). Allocation and Sale of Allowances State Gives Away Roughly Half of the Figure 2 Allowances. As shown in Figure 2, currently Allocation of Free and Auctioned the state gives away about half of the program’s Cap-and-Trade Allowances in 2025 allowances for free to industrial facilities, electric utilities, and natural gas suppliers. The free allowances to industry are intended to keep Free Allowances for Industry Free Allowances to Various Other Entities (Leakage Protection) companies from moving their operations outside of California to avoid the need to comply with the Free Allowances to program (known as emissions “leakage”). The free Natural Gas Utilities (Ratepayer Benefits) allowances for electric utilities and natural gas suppliers are intended to protect consumers from Auctioned Allowances (Revenues Deposited significant cost increases. To that end, many of these Into GGRF) free allowances are used to provide regular—annual Free Allowances to Electric Utilities or twice annual—rebates to customers, known as (Ratepayer Benefits) the “California Climate Credit.” The remaining free allowances provided to electric and natural gas utilities are used to support other purposes that are generally intended to benefit ratepayers, such Total: 259 Million Allowances as activities that reduce the utilities’ emissions and GGRF = Greenhouse Gas Reduction Fund. thereby reduce their compliance costs. For example, some of these allowances support energy efficiency programs and solar energy programs. Figure 3 CARB Sells the Remaining Allowances at Quarterly Auctions. CARB sells the remaining Cap-and-Trade Allowance Prices half of allowances at quarterly auctions and the Generally Have Been Close to the Price Floor revenues are deposited into the state’s Greenhouse Gas Reduction Fund (GGRF). CARB sets a $45 minimum and maximum price at which allowances 40 Allowance Price can be sold (known as a “price floor” and “price 35 30 ceiling”) at its auctions. Multiple factors affect the 25 relative supply and demand for allowances and thus 20 allowance prices. For example, some dynamics Price Floor 15 that can affect prices include the program’s specific 10 design features (such as the number of allowances 5 issued), confidence in the longevity of the program, and the level of GHG reductions achieved by other Q4 Q4 Q4 Q4 Q4 Q4 Q4 Q4 Q4 Q4 Q4 2014 2015 2016 2017 2018 2019 2020 2021 2022 2023 2024 state policies. (The greater the level of reductions achieved by other programs and policies, the 4 LEGISLATIVE ANALYST’S OFFICE AN LAO REPORT Auctions Generate Billions of Dollars, Which appropriations for forest health and safe and State Has Mostly Used to Further Climate Goals. affordable drinking water are scheduled to expire From its inception through 2023-24, cap-and-trade at the end of the 2028-29 and 2029-30 fiscal years, auctions have provided roughly $31 billion for GGRF. respectively. (Should the cap-and-trade program As shown in Figure 4, these revenues have been fail to be extended, revenues would cease, thereby used to support a wide range of programs, many of effectively sunsetting all the statutory allocations.) which are aimed at reducing GHG emissions. Initially, the program’s Figure 4 emphasis on supporting GHG Cumulative Cap-and-Trade Spending by Area reductions with GGRF was due in part to legal uncertainty regarding 2013-14 through 2023-24 the allowable use of the funds. However, from a legal perspective, Total: $30.6 Billion since the passage of AB 398, which Clean Energy Programs was adopted with a two-thirds vote Other Transportation of both houses of the Legislature, Agriculture and Food GGRF funds have been considered Production Programs akin to tax revenues, so they can be Low Carbon Transit Operations used for any purpose. Most GGRF Spending Directed by Statute. As shown in Figure 5, by Community High-Speed Rail Project statute, roughly two-thirds of auction Air Protection revenues are dedicated for certain purposes. Most of these statutory GGRF spending commitments are Wildfire Resilience continuously appropriated, meaning they are not subject to appropriation Affordable Housing and Transit and Intercity Sustainable Communities by the Legislature through the annual Rail Capital budget act. The remaining revenues that are not statutorily directed are available for appropriation by the Other Low Carbon Legislature for other discretionary Transportation spending programs. Some of the existing statutory allocations do have sunset dates. For example, under current law, the continuous Figure 5 Continuous Appropriations and Other Statutorily Required GGRF Appropriations Program Department Appropriation Amount High-speed rail project HSRA 25 percent of annual revenues Affordable Housing and Sustainable Communities Program SGC 20 percent of annual revenues TIRCP CalSTA 10 percent of annual revenues Low Carbon Transit Operations Program Caltrans 5 percent of annual revenues Healthy and resilient forest activities CalFire $200 million Safe and Affordable Drinking Water Program SWRCB 5 percent of annual revenues (up to $130 million) Manufacturing tax credit N/A Roughly $100-$140 million State Responsibility Area fee backfill CalFire Roughly $70-$90 million GGRF = Greenhouse Gas Reduction Fund; HSRA = High-Speed Rail Authority; SGC = Strategic Growth Council; TIRCP = Transit and Intercity Rail Capital Program; CalSTA = California State Transportation Agency; Caltrans = California Department of Transportation; CalFire = California Department of Forestry and Fire Prevention; SWRCB = State Water Resources and Control Board; and N/A = not applicable. www.lao.ca.gov 5 AN LAO REPORT LEGISLATURE’S REAUTHORIZATION CHOICES HAVE SIGNIFICANT IMPLICATIONS Whether the Legislature decides to extend the to consumers in the form of higher retail prices for cap-and-trade program and—if it does proceed those products. For example, transportation fuel with reauthorization—its decisions regarding how suppliers must purchase allowances associated to do so could have significant implications for the with the emissions from gasoline consumption and state’s climate policies, affordability, and other the costs generally are passed on to consumers policy priorities for many years to come. In this in the form of higher gasoline prices. As these section, we discuss some of the main impacts prices increase, households and businesses have of these decisions. Specifically, reauthorization an incentive to reduce their gasoline consumption. decisions will have important implications for: By sending these price signals to emitters and (1) the costs of reducing GHG emissions; (2) the consumers, cap-and-trade likely is among the financial costs paid by households and businesses most cost-effective approaches to reducing GHG that continue to produce and use GHG-intensive emissions the state can consider; it generally is products; and (3) revenue generated from the more cost-effective than direct industry regulations, program, which can be used to offset costs to other narrower market-based mechanisms (like households and businesses or achieve other LCFS), or expenditures on programs aimed at policy priorities. reducing GHGs. …Allowing the State to Meet Its Goals at Program Can Help State Lower Cost Than Many Other Options. To Meet GHG Goals Cost-Effectively the extent that the state relies more heavily on Cap-and-Trade Can Provide Greater other climate programs—which generally are Certainty for State to Meet Its GHG Reduction less cost-effective than cap-and-trade—emitters Goals. By limiting emissions to a designated level, likely would face higher overall costs to reduce the cap-and-trade program has sometimes been emissions and meet the state’s climate goals as considered a “backstop” to help make sure the compared to depending more on cap-and-trade. state meets its targets. That is, to the degree other Moreover, if the program were to cease operating policies collectively fall short of meeting the state’s after 2030, the state would need to identify other— GHG reduction goals, the cap-and-trade program likely more costly—activities and policies to attain can ensure that covered entities reduce emissions additional emissions reductions in order to meet further to make up the difference. As a result, were its 2045 GHG-reduction goals. We note that the program not to operate beyond 2030, the state cost-effectiveness considerations could become would have less certainty that it will be able to meet increasingly important as the state’s GHG-reduction its 2045 GHG-reduction goals. goals become more ambitious and the costs of Cap-and-Trade Reduces GHGs Relatively achieving them grow. Cost-Effectively… Another important attribute Program Imposes Costs on Households of the cap-and-trade program is that it provides and Businesses That Continue to Emit the private sector with the flexibility to determine which emission reduction activities are least costly Cap-and-Trade Program Imposes Costs on and provides a monetary incentive for undertaking Emitters and, Ultimately, Consumers. While the those relatively low-cost activities. By adding a cost cap-and-trade program is a relatively cost-effective to activities that produce emissions, the program approach to reducing GHG-emissions, it still provides businesses with a financial incentive to imposes notable costs on entities that continue emit fewer GHGs when producing their goods to emit and must pay to purchase allowances. and services. Also, in many cases, the additional Many of these costs are in turn passed along costs of GHG-intensive products are passed on to consumers in the form of higher prices for 6 LEGISLATIVE ANALYST’S OFFICE AN LAO REPORT the associated products. These financial costs 23 cents per gallon based on February 2025 for businesses and consumers are largely a allowance prices. (We estimate that the average byproduct of the way the program is designed household would pay about $700 per year as to incentivize the emission reductions—not the a result of the program if the program were primary goal of the program. However, many to contribute 74 cents per gallon to gasoline households and businesses still pay higher costs prices and gasoline use remained stable.) Such under the program. For example, based on current higher costs would be particularly burdensome allowance prices (which are near the price floor), for lower-income households, as they tend to we estimate that the cap-and-trade program adds spend a relatively high share of their incomes about 23 cents to each gallon of retail gasoline on transportation fuels compared to wealthier sold in California. Consumers that continue to use households. These potential increases come at a gasoline—for example, because they may not have time when the state is implementing changes to the resources to purchase an electric vehicle—have other programs and policies—such as updates to to pay these costs. LCFS—that also are expected to raise consumer Amount Consumers Would Pay in the Future costs, including for transportation fuels. Depends on Allowance Prices. Future allowance Program Generates Revenue That Can prices are highly uncertain. For illustrative Be Used to Offset Costs and/or Achieve purposes, Figure 6 highlights three example scenarios for potential impacts of various allowance Legislative Priorities prices, including if (1) allowance prices were to fall Allocating Allowances Is Similar to Allocating to the current price floor of about $26, (2) allowance Tax Revenues. CARB issues a set number of prices were to stay at the level of the February 2025 allowances each year equal to the annual cap. auction, and (3) allowance prices were to reach the Emitters pay for allowances, similar to the way they current price ceiling of roughly $95. would pay a tax on their GHG emissions. A key If Allowance Prices Were to Reach the Price difference between allowances and taxes is how Ceiling, Consumer Impacts Would Be Much the revenues are allocated. In the case of taxes, Larger. Some recent modeling suggests that all of the revenues come directly to the state. In reauthorization likely will put upward pressure contrast, in the case of allowances, the revenues on prices and potentially lead to them reaching go to whichever entity is provided the allowances. the price ceiling over the next several years. As a result, in concept, the decision about who gets As highlighted in the figure, in the hypothetical the allowances essentially determines where the scenario of allowance prices reaching the price revenue from the charges paid by emitters will go, ceiling, we estimate that cap-and-trade would including which entities will receive these revenues contribute roughly 74 cents per gallon to gasoline and for what purposes. For example, under the prices, compared to the current level of roughly current program structure established through Figure 6 Illustrative Example of Relationship Between Cap-and-Trade Allowance Prices, Gasoline Cost Increases, and Allowance Values Floor and Ceiling Prices and Allowance Allocations Reflect 2025 Levels Total Value of All Price Per Per Gallon Retail GGRF Revenues Allowancesa Hypothetical Price Scenario Allowance Gasoline Price Impact (Annual) (Annual) Price Floor $25.87 $0.20 $3.2 billion $6.9 billion February 2025 Actual Price 29.27 0.23 3.6 billion 7.8 billion Price Ceiling 94.92 0.74 11.6 billion 25.4 billion a Includes combined value of both free and auctioned allowances. GGRF = Greenhouse Gas Reduction Fund. www.lao.ca.gov 7 AN LAO REPORT CARB regulations, the value of allowances goes to of the program is a key distinction of cap-and the entities that receive free allocations (such as trade as compared to alternative approaches for utilities and some industries) and to the state (in reducing GHG emissions—such as direct industry the case of allowance revenues sold for deposit regulations or the LCFS program—which do not into GGRF). generate discretionary revenues that the state can Allowance Value Could Be Used to Reduce direct to offset costs or meet its policy goals. Consumer Costs or Address Other Priorities. Allowances Could Be Worth a Couple Another important aspect of the cap-and-trade Hundred Billion Dollars Under Reauthorization. program is that the significant value of these The decisions around the allocation of allowances can be directed by the Legislature to cap-and-trade allowances are akin those around reduce the financial costs to households the use of tax revenues. These decisions are and/or meet its other policy priorities, such as particularly important given the dollar amounts those discussed further below. For example, involved, both in terms of the potential price currently, some of the allowances are allocated impacts to consumers discussed above as well as to utilities for free. These utilities are required to the potential value of future allowances. Specifically, consign most of these free allowances to auction if the Legislature were to extend the program from and use the resulting revenues to provide customer 2030 through 2045, we estimate that the total value rebates. Specifically, the California Climate Credit of allowances issued over that 15-year period could that is provided to electricity customers generally be in the range of roughly $70 billion to $260 billion offsets the costs that are passed along to them as (in 2025 dollars). (This estimate is based on a result of the cap-and-trade program. California allowance scenarios CARB has identified as part natural gas customers also receive similar credits of its forthcoming rulemaking and assumes that aimed at mitigating much of their costs. Also, allowance prices remain between the current price roughly half of the allowances are sold by the state, floor and ceiling, adjusted by 5 percent annually, deposited in the GGRF, and used to fund a variety consistent with current CARB regulations.) of state environmental programs. This aspect ADDRESSING POTENTIAL LEGISLATIVE PRIORITIES In this section, we highlight three potential recognizing that more significant reductions will legislative priority areas for the future of be necessary to meet legislatively established cap-and-trade: GHG emission reductions, GHG reduction targets, and (2) how to achieve its affordability, and other various goals. We also preferred level of GHG reductions. We discuss highlight some key decision points—and policy some potential approaches for achieving greater options—that the Legislature might want to GHG reductions through the program below. In the consider, depending on how it weighs its different box on page 10, we discuss an approach that— policy priorities. Figure 7 provides a summary of while it may not reduce overall GHG emissions— these policy options. could also play a role in supporting the state’s climate goals. GHG Emission Reductions Main Way to Drive GHG Reductions Is One of the Clear Goals for Reauthorization Through Design of Cap-and-Trade Program. Is Promoting GHG Reductions. One obvious Generally, the best way to reduce GHGs using a legislative priority is pursuing GHG reductions, cap-and-trade program is through the program which traditionally has been the main purpose of design. (This is largely more impactful than the cap-and-trade program. The Legislature faces directing spending from the revenues it generates important decisions about (1) the level of GHG because the cap already ensures GHG reductions reductions it wants to achieve through the program, take place in covered sectors regardless of how 8 LEGISLATIVE ANALYST’S OFFICE AN LAO REPORT would be to drop the cap Figure 7 on emissions even lower, Summary of Some Options for Addressing Potential which could be done through Legislative Priorities in Cap-and-Trade regulations or by statute. Taking such a step would Category Options result in allowing fewer GHGs Policy Priority: Greenhouse Gas Reductions to be emitted in the capped 9 sectors. A key trade-off of a Program Design Lower cap on emissions. lower cap is that allowances 9 Modify treatment of offsets, such as by putting would become more scarce, offsets “under the cap” or strengthening thus driving up allowance requirements for their use. prices. This, in turn, would 9 Use of Allowance Value Spend GGRF revenues on cost-effective activities result in higher costs to to reduce emissions in uncapped sectors. emitters, and ultimately to Policy Priority: Affordability households and businesses, 9 as discussed previously. Program Design Lower price ceiling to prevent potential for high allowance prices. • Modify Treatment of 9 Offsets. Changing how Use of Allowance Value Spend GGRF revenues to offset or reduce costs offsets are handled under of the program, such as by providing rebates to households. the program could affect GHG emissions in various 9 Increase number of free allowances dedicated ways, depending upon what to offsetting costs, such as by increasing the modifications are made. amount of electricity rebates or paying for utility wildfire mitigation costs. For example, one potential Other Policy Priorities change could be to remove 9 an allowance from the Use of Allowance Value Reduce number of free allowances to sell more program for each offset that and thereby generate additional funding for GGRF to spend on other priorities. is used to meet a compliance obligation. (This approach 9 Modify current GGRF spending, such as by often is referred to colloquially eliminating some continuous appropriations or reducing some statutory funding levels, and as placing offsets “under direct funding for other priorities. the cap.”) In practice, this GGRF = Greenhouse Gas Reduction Fund. would lower the effective cap relative to what it would GGRF spending is directed, as discussed in the box otherwise be, which would on page 10.) Some examples of program design reduce the amount of allowable emissions and modifications that could strengthen the program’s thereby likely increase the scarcity and costs ability to reduce GHGs include: of remaining allowances. Accordingly, the key • Lower Cap on Emissions. CARB’s existing trade-off would be lower emissions but higher regulations include planned annual reductions consumer cost impacts. Another potential in the program’s cap (and associated number change would be to enhance requirements for of allowances). The board has indicated offset projects, such as by adopting stronger that it plans to propose new regulations that standards to ensure that offsets result in will further tighten the emissions cap by permanent emissions reductions that would removing a greater number of allowances not otherwise have occurred. A trade-off of from the program in 2026 through 2030 this option is that it likely would increase the than would currently be the case. The most price of offsets and decrease their use, which straightforward way to modify the program’s would increase overall compliance costs for design to further reduce GHG emissions emitters (and associated costs to consumers). www.lao.ca.gov 9 AN LAO REPORT Changes to Utility Allowances Could Also Support Climate Goals As we discuss in our January 2025 report, Assessing California’s Climate Policies— Residential Electricity Rates in California, a barrier to achieving the state’s goals for electrification—which is an important step in meeting the state’s greenhouse gas (GHG)-reduction goals—is the high volumetric cost of electricity in the state. This is because high volumetric rates reduce the financial incentives for consumers to pursue electrification through switching out their fossil fuel-powered cars and appliances. Currently, a significant share of the free cap-and-trade allowances provided to electric and natural gas utilities are used to provide rebates of fixed dollar amounts to ratepayers. The Legislature could consider various modifications to this approach with the goal of reducing volumetric electricity rates and thereby increasing incentives for electrification. For example, the Legislature could require that utilities structure electricity rebates to offset volumetric rates rather than providing them as fixed amounts. Additionally, shifting some allowances from other existing purposes—such as natural gas utility rebates and programs—to electric utilities could result in a greater number available for lowering electricity rates. We note that such changes would have associated trade-offs. For instance, these changes would have distributional impacts, with some customers receiving bigger or smaller rebates than under current practices. If the Legislature were concerned about such distributional impacts, it could consider focusing volumetric rebates for certain vulnerable groups of customers, such as households in hotter areas (which tend to have higher electricity usage) and/or those with lower incomes. Spending Revenues in Capped Sectors Generally Does Not Reduce GHGs In a well-functioning cap-and-trade program, the cap will ensure that greenhouse gases (GHGs) are reduced, regardless of how revenues generated from allowance sales are spent. At first glance, using cap-and-trade revenues to subsidize GHG reductions from capped sources might appear to encourage additional emission reductions. However, as long as the cap is already limiting emissions from these emitters, spending on activities to reduce emissions from these same entities likely will have no net effect on overall emissions. This is because subsidizing an emission reduction from one capped source will simply free-up allowances for other covered emitters to use. The end result is a change in the sources of emissions under the cap, but no change in the overall level of emissions. In contrast, spending on reductions from uncapped sources—that is, entities that are not subject to the cap-and-trade program, such as agriculture, landfill methane emissions, and emissions from refrigerants—is likely to reduce overall emissions. Net reductions would occur in the non-covered sectors because it would not result in a trading of allowances that simply change the source of emissions, as such entities are not required to purchase allowances or comply with the cap. For more detail, please see our 2016 report, Cap-and-Trade Revenues: Strategies to Promote Legislative Priorities. In Some Limited Cases, GGRF Revenues revenues. In general, the best way to do so would Can Also Be Used to Reduce GHG Emissions. be to fund GHG-reduction activities that are outside While adjusting the program design generally is of the capped sectors, such as related to natural the most impactful and cost-effective approach and working lands and landfills. This is because to reducing GHGs, the state could achieve some the cap does not otherwise limit emissions from additional GHG reductions with the use of GGRF these sources. 10 LEGISLATIVE ANALYST’S OFFICE AN LAO REPORT We note that to the extent the Legislature would allowances available for other purposes, like to direct additional spending toward reducing such as for leakage protection or generating GHGs, such as by funding GHG reductions outside revenue for GGRF. of the capped sectors, it would be important to • Use GGRF Revenues to Offset or Reduce consider factors such as (1) the cost-effectiveness Costs. The state also could consider of this spending; (2) how this spending interacts dedicating GGRF revenues to support with other programs besides cap-and-trade; (3) any rebates—potentially focused on low- and co-benefits beyond GHG reductions that might middle-income consumers—for energy be achieved through the proposed spending; cost growth that might result from program and (4) whether the timing of the funding needs changes. Alternatively, it could consider using align with the availability of GGRF funding, as the GGRF revenues to reduce other existing costs volatility of auction revenues mean that GGRF is not for consumers, such as by paying for activities well-suited to securitization. that otherwise would be funded by electricity ratepayers, including for wildfire mitigation Affordability activities or energy efficiency programs. A Potential Legislative Goal for Cap-and-Trade Design Features—Like Reauthorization Is Mitigating Impacts on a Lower Price Ceiling—Can Also Promote Affordability. Affordability is an important policy Affordability. The design of the cap-and-trade priority, particularly in the context of cap-and-trade program also can be modified to mitigate potential reauthorization. This is because a lower cap on impacts on affordability. A straightforward example GHG emissions likely will increase consumer costs of this would be to set a lower price ceiling for notably, particularly for gasoline and diesel fuel, as the program. This is because the effect of the discussed previously. cap-and-trade program on consumer costs largely Revenues From Allowances Can Play Key is driven by allowance prices. Accordingly, setting a Role in Helping Preserve Affordability. The value lower upper bound for allowance prices can thereby of allowances—both those that are given away constrain potential associated costs for consumers. for free and those that are sold to generate GGRF The Legislature could set a price ceiling at whatever revenue—can play an important role in mitigating level it deems appropriate given its policy priorities. the program’s impacts on affordability. Some A key trade-off of this option is that a relatively options for using the value of allowances to mitigate low price ceiling would limit the program’s ability costs to consumers include: to reduce GHGs because once the price ceiling • Increase Number of Free Allowances is reached, CARB issues an unlimited amount of Dedicated to Offsetting Costs. The state permits to emit at the level of the price ceiling. could consider altering how it currently This, in turn, means that the cap would no longer allocates allowances to certain covered be binding and emissions beyond the capped levels entities. For example, it could increase would be allowed. It would therefore require the the number of free allowances it provides state to rely more on other programs—which likely to electric utilities to sell on the market, are less cost effective—to meet its climate goals. enabling them to generate more revenue for customer bill credits such as the California Other Legislative Goals Climate Credit. Additionally, the Legislature Various Other Legislative Goals for could modify how these credits are provided Reauthorization. The Legislature may have various to help achieve other goals—such as other goals for the program besides GHG emission reducing volumetric electricity rates to help reductions and affordability. For example, in the encourage electrification or providing targeted past, the Legislature has prioritized GGRF funding assistance to those who are most vulnerable. for various programs—such as high-speed rail, safe A key trade-off of this option is that such drinking water, and community air protection— an approach would reduce the number of because they met other policy goals, such as www.lao.ca.gov 11 AN LAO REPORT improving transportation mobility and supporting • Eliminate Some Continuous access to clean water and air, particularly in Appropriations. The Legislature could disadvantaged communities. eliminate existing continuous appropriations Revenues From Allowances Can Support for certain programs if they no longer reflect Other Priorities. The Legislature could assess its highest priorities for multiyear funding. whether the current allocations of allowances and This would free up additional funding for GGRF revenues still are consistent with its most discretionary purposes, better allowing pressing policy goals. To the extent the Legislature the Legislature to respond to its evolving identifies other policy goals beyond GHG emission policy priorities. Eliminating continuous reductions and affordability—such as related to appropriations also could enhance legislative environmental quality, transportation mobility, or oversight by creating a natural opportunity climate change adaptation—it could structure the to more regularly review and revisit the program to support those goals. Some examples allocations of cap-and-trade revenues through of ways to use the value of allowances to support the annual budget process. However, a other policy goals include: key trade-off to consider is that taking this step would provide less funding certainty • Change Allowance Allocation. The state to the affected programs, as they would could consider altering its current allowance then be subject to annual funding decisions allocation to reduce the number of free alongside other priority programs through the allowances (such as those provided to certain budget process. industrial emitters that may be at lower risk • Reduce Some Statutory Funding Levels. for leakage), thereby making more available to Even if some or all of the existing statutory be sold at auction and generating additional appropriations remain among its highest GGRF revenues for spending on legislative priorities for continued funding from GGRF, policy priorities. A key trade-off of this option the Legislature could consider adjusting would be that fewer free allowances would their current funding levels. For example, the mean less support for the purposes for which Legislature could establish fixed annual GGRF they are currently being used, potentially appropriation amounts for certain programs including mitigating affordability impacts rather than providing them with percentages through the California Climate Credits or for of auction revenues. In years where auction protection against leakage. revenues are comparatively high, this would • Modify Activities Funded by GGRF. The free up additional GGRF for spending on Legislature also could consider various other legislative priorities while still providing options for modifying the activities that are certain and consistent funding streams to the funded by GGRF to ensure that they most existing programs. closely align with current legislative goals. For example, the Legislature could: LEGISLATURE PLAYS IMPORTANT ROLE IN REAUTHORIZATION OF PROGRAM In this final section, we discuss the importance program design, where appropriate, to help ensure of the Legislature weighing in on the cap-and-trade legislative policy priorities are achieved. program through (1) reauthorizing the program Explicit Statutory Authority Provides Greater to provide more certainty and flexibility and Program Certainty and Flexibility. As mentioned (2) providing additional statutory direction on the previously, the explicit statutory authority for 12 LEGISLATIVE ANALYST’S OFFICE AN LAO REPORT the cap-and-trade program sunsets at the end statutory allocations and selecting discretionary of 2030. Whether the Legislature must explicitly allocations on an annual basis. Through AB 398, authorize a further extension or CARB already the Legislature opted to provide more specific could continue the program beyond 2030 under direction about certain program design features— its existing broad statutory authority is an area such as specifying the share of compliance of some legal uncertainty. To the extent CARB obligations that can be met with offsets. However, were able to continue a cap-and-trade program AB 398 still granted CARB broad authority to make absent explicit additional statutory authority, it decisions about many aspects of the program, such could face limitations around how it structures as related to setting the number of allowances, the the program and how GGRF revenues could be price floor and ceiling, and the share of allowances used, particularly in light of the requirements of directed for different purposes (such as for GGRF Proposition 26 of 2010. (Proposition 26 expanded and the various allocations of free allowances). the definition of a tax under the State Constitution.) If It Reauthorizes Program, Providing Accordingly, to the extent the Legislature would Greater Direction in Key Areas Would Ensure like the program to continue, providing explicit Legislative Priorities Are Reflected. As part of statutory authority passed with a two-thirds vote reauthorization, the Legislature faces important of both legislative houses would be important to decisions about which choices to defer to CARB— increasing program certainty and flexibility. Such allowing the agency the discretion to weigh the certainty would help businesses make long-term trade-offs associated with various policy options investment decisions and facilitate the state’s plans and make program design choices consistent for how it can pursue its GHG goals and support with its statutory mandates—and which to direct high-priority programs. through statute. In general, particularly in light of Historically, Legislature Has Delegated Many the high stakes involved, we advise the Legislature Decisions on Cap-and-Trade to CARB. Assembly to weigh in—through providing additional statutory Bill 32 gave CARB almost complete discretion direction to CARB—on any areas it deems to be of over how to design the cap-and-trade program. particular importance and for which it has specific Since the program’s establishment, much of the preferences. Providing such additional direction in Legislature’s role has revolved around how to spend key areas would ensure that the decisions on those GGRF revenues, including establishing ongoing components reflect legislative policy priorities. www.lao.ca.gov 13 AN LAO REPORT 14 LEGISLATIVE ANALYST’S OFFICE AN LAO REPORT www.lao.ca.gov 15 AN LAO REPORT LAO PUBLICATIONS This report was prepared by Helen Kerstein, and reviewed by Rachel Ehlers and Ross 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, California 95814. 16 LEGISLATIVE ANALYST’S OFFICE