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California Inaugurates Country’s First Carbon Credit Auction Under Cap-and-Trade

December 3, 2012

On November 14, 2012, the California Air Resources Board (“CARB”) took a big step to implement AB 32 – the state’s landmark climate change legislation – by conducting its long-anticipated first auction of tradable carbon allowances under a market-oriented cap-and-trade system for controlling statewide greenhouse gas (“GHG”) emissions.

AB 32 (formally known as the Global Warming Solutions Act of 2006, Cal. Health & Safety Code § 38500, et seq.) envisioned a cap-and-trade system as one of the ways in which California could meet the law’s goal of reducing statewide GHG emissions to 1990 levels by the year 2020. On October 24, 2011, CARB adopted a final cap-and-trade regulation that covers major GHG emission sources (such as refineries, power plants, industrial facilities, and transportation fuels) and includes an enforceable emissions cap that will decline over time. Under the regulation, CARB has authority to distribute tradable allowances equal to the emissions permitted under the cap.

To get started, CARB is to give away some 90 percent of available allowances to market participants and distribute the remaining 10 percent by auction.[1] As the program ramps up, the percentage of credits given away will decrease in favor of increased auctioning.[2] The auction is intended to play the important function of setting an initial price for individual carbon allowances, on the theory that the higher the price allowances can command, the greater the incentive emitters will have to reduce their emissions overall.

In the November 14 auction, CARB offered 23.1 million carbon allowances – each representing the right to emit one ton of carbon - for the first phase beginning January 1, 2013 and 39.5 million for the second phase starting in 2015.[3] When phase one begins, California’s carbon market will be the world’s second largest, behind only the European Union Emissions Trading Scheme.[4] With a set reserve price of $10, phase one allowances initially were expected to clear between $12 and $15 per allowance.[5] In fact, while all the allowances for phase one made available at the initial auction were sold out, the actual clearing price was just $10.09, barely above the reserve price.[6]

The Impact of Market Uncertainty

The lower than expected price obtained for auctioned allowances likely reflects, in part, uncertainties over the legal viability of the auction process. Fueling that uncertainty is a last-minute challenge to the process brought by the California Chamber of Commerce (“CalChamber”), which filed a lawsuit in Sacramento County Superior Court against CARB, CARB Chairman Mary Nichols, and several other CARB officials, questioning (among other things) whether the auction was technically authorized by AB 32.[7] (The complaint is available here.)

AB 32 explicitly provides CARB with significant discretion to meet California’s emission goals.[8] The California Legislature likely understood that any cap-and-trade system would necessarily involve difficult design decisions, and it accordingly did not expressly restrict how such a system would function.[9] Indeed, it did not specify whether an auction procedure could be part of CARB’s scheme, and instead merely provided authority to create a “system of market-based declining annual aggregate emission limits.”[10]

In its lawsuit, CalChamber claims that by instituting an auction procedure, CARB exceeds its authorization under AB 32, because the money raised from it will be as a result of a tax, not a fee.[11] As discussed in more depth below, AB 32 only authorizes a “schedule of fees,” not a tax.[12] CalChamber also asserts that while CARB perhaps could create a system where it gave away all allowances, AB 32 does not permit it to allocate allowances to itself, to conduct an auction, or even to promulgate regulations to this effect.[13] Moreover, even if AB 32 did authorize the auction, CalChamber contends that the auction effectively entails the imposition of a tax that could only be enacted by a two-thirds vote in each house of the California Legislature (which AB 32 did not receive), as required by article XIII A, section 3 of the California Constitution.[14] The lawsuit does not include a request for injunctive relief to stop the auction, but theoretically could still affect the market for carbon allowances.[15]

Because jurisdictions outside California generally have not agreed to participate in the state’s cap-and-trade program (only the Canadian province of Quebec is currently planning to do so), CalChamber and other business entities warn that California’s system goes too far and will lead to businesses leaving the state. CalChamber also contends that cap-and-trade may cost taxpayers $70 billion or more, is not cost effective, and will discourage other states from joining California’s efforts to reduce carbon emissions.[16]

Fees v. Taxes

The tax versus fee issue raised by CalChamber has been hotly debated. CalChamber asserts that the auction process will generate up to $70 billion in new taxes the state will use to plug budget shortfalls.[17] CARB has maintained that the money generated by auction constitutes a fee because it will be used to further the goals of AB 32.[18] In effect, the state would shuffle funding so programs with a clear nexus to curbing carbon emissions previously funded from California’s general fund may become funded by the AB 32 fee.[19] Likely uses of the revenue include greenhouse gas mitigation activities and investment in clean technologies, public transportation, and energy efficiency.

In 1978, California voters approved Proposition 13, an initiative constitutional amendment, which imposed a requirement of a two-thirds vote of the legislature for “any changes in State taxes enacted for the purpose of increasing revenues. . . .”[20] In 2010, California voters amended Proposition 13 by passing Proposition 26, which expanded the term “taxes” to include regulatory fees.[21] However, given AB 32 had already been on the books for four years when Proposition 26 was passed, it is unlikely that it could be applied retroactively to AB 32, especially because the proposition’s specified effective date is January 1, 2010.[22]

Because the 90 percent of allowances given away to the regulated parties clearly do not represent a tax, it is only the auctioned allowances that raise the tax versus fee issue.[23] Conceivably, at least initially, certain emitters may not need to buy any of the remaining 10 percent of allowances auctioned by the state, as they could instead rely on the free allowances and could employ new technologies to decrease their emissions as necessary.[24] However, as free allowances diminish, many, if not all, regulated entities may find their financial interests are best served by purchasing allowances. Regardless of whether an entity complies by purchasing allowances or by reducing emissions, the effect of the diminishing free allowances will be increased cost of compliance.

The courts are likely to consider at least three factors in addressing the tax versus fee issue: (1) whether the total amount of money raised by the fee is limited to the reasonable costs of the regulatory scheme; (2) whether the money generated is used for purposes unrelated to the purpose of the regulation; and (3) whether the burden of compliance is reasonably allocated between regulated entities.[25] There is an emerging consensus in the California legal community that for the auction proceeds to be considered a fee and not an invalid tax, the auction proceeds may need to be spent on programs that reduce or mitigate greenhouse gas emissions.[26] Although use of the auction proceeds for non-greenhouse gas mitigation purposes may be defensible,[27] such spending would make AB 32’s fee more susceptible to a court holding it to be an illegal tax.

Prospects for the Future

As cap-and-trade proceeds, CARB will auction a growing number of the allowances, leading to more revenue for the Air Pollution Control Fund. In this case and future likely cases, the court will have to determine whether the legislature intended fees on the scale generated by auction and whether the funds are being properly allocated to carrying out the purposes of AB 32.

California Governor Jerry Brown recently signed into law two bills passed by the legislature directing the Department of Finance and CARB to develop an investment plan for the funds generated by the cap-and-trade’s auction, with a focus on using revenue to protect disadvantaged communities.[28] Although this was not the same legislature that passed AB 32, the bills are nonetheless a strong signal that AB 32 included authorization for an auction procedure.

Regardless of how CalChamber’s lawsuit is resolved, one can assume it will not be the last of its kind. Cap-and-trade and the use of an auctioning procedure have been controversial since they were first considered, and with so much riding on the fate of the program, it is clear that the controversy will not go away soon. As California again ventures into unchartered waters, the energy and environmental world will be watching to see how its innovative climate change program unfolds.

For more information on California’s cap and trade law (AB32), and its implementation, please contact Kevin Haroff or any other member of Marten Law’s Climate Change or Energy practice groups.

[1] Lynn Doan, California Carbon Price Drop 2% as State Auctions First Permits, the Washington Post (Nov. 14, 2012).

[2] Id.

[3] Id.

[4] California greening: the biggest effects of California’s cap-and-trade law may be felt elsewhere, the Economist (Nov. 24, 2012).

[5] Supra note 1.

[6] Lynn Doan, California Carbon Allowances Sold Out at $10.09 in Auction, Bloomberg (Nov. 19, 2012).

[7] CalChamber Sues to Invalidate CARB’s Cap and Trade Auction, CalChamber (Nov. 13, 2012).

[8] See Cal. Health & Safety Code § 38562.

[9] See id.

[10] Cal. Health & Safety Code § 38562(c).

[11] Complaint ¶ 14.

[12] Cal. Health & Safety Code § 38597 (“The state board may adopt by regulation, after a public workshop, a schedule of fees to be paid by the sources of greenhouse gas emissions regulated pursuant to this division, consistent with Section 57001. The revenues collected pursuant to this section, shall be deposited into the Air Pollution Control Fund and are available upon appropriation, by the Legislature, for purposes of carrying out this division.”)

[13] See Complaint ¶¶ 16, 18.

[14] Complaint ¶ 20.

[15] Complaint ¶¶ 15-22.

[16] Supra note 7.

[17] Id.

[18] AB 32 Cost of Implementation Fee Regulation (HSC 38597), California Environmental Protection Agency: Air Resources Board, last reviewed Nov. 14, 2012.

[19] Deborah Lambe & Daniel Farber, California’s Cap-and-Trade Auction Proceeds: Taxes, Fees, or Something Else? University of California, Berkeley, School of Law, Center for Law, Energy & the Environment (May 2012).

[20] Cal. Const. art. XIIIA §3 (prior to 2010).

[21] Supra note 19.

[22] Id.

[23] Ann Carlson, Breaking News: California Chamber of Commerce Sues over AB 32 Auction, Legal Planet (Nov. 13, 2012).

[24] Id.

[25] See Sinclair Paint Co. v. State Bd. of Equalization, 15 Cal. 4th 866, 876-78 (1997).

[26] Supra note 19.

[27] Id.

[28] Rory Carroll, California governor signs cap-and-trade revenue bills, Reuters (Oct. 2 2012).

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