Source: https://elq.typepad.com/currents/2017/11/the-case-for-cap-and-trade-californias-battle-for-market-based-environmentalism.html
Timestamp: 2019-04-22 06:42:33+00:00

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The California Cap-and-Trade Program (“CAT”) is derived from the California Global Warming Solutions Act of 2006 (“Global Warming Act”), which requires the State to reduce its greenhouse gas (“GHG”) emissions to 1990 levels by 2020. The California Air Resource Board (“CARB”) is the State regulatory agency responsible for the project. In 2011, the CARB adopted cap-and-trade regulations and created the CAT to set limits on GHG emissions. The first auctions for the CAT were held in 2012, and the program went into full effect on January 1, 2013.
The CAT operates in two phases each year. First, a number of emission allowances are freely distributed to entities that fall under the purview of the program. Second, the remaining allowances are auctioned off on a quarterly basis. The free distributions are reduced annually, and eventually all the allowances will be distributed via auctions. The program also permits carbon offsets to satisfy up to eight percent of an entity’s compliance obligations. The ultimate objective is to create incentives for businesses to craft environmentally friendly industrial practices as the number of yearly allowances decreases over time.
The CAT also has an enormous scope, and it is the world’s second largest market-based mechanism designed to reduce GHG emissions. This size makes the successful implementation of the program especially impressive. The success is due largely to a design structure that draws upon the shortcomings of previous cap-and-trade initiatives, such as the Regional Greenhouse Gas Initiative (“RGGI”) in the northeastern United States and the Emissions Trading System (“ETS”) in the European Union.
The CAT was not the first emissions marketplace in the United States. In 2009, the RGGI went into effect as a cap-and-trade marketplace for CO2 emissions in the following nine states: Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire, New York, Rhode Island, and Vermont. However, the RGGI has been plagued with numerous shortcomings that have frustrated the performance of the initiative and which impart several lessons on how to more effectively design a cap-and-trade system.
The second significant failing of the RGGI was that it overestimated the amount of CO2 emissions among the member states. In fact, the RGGI set an initial emissions cap that was above actual emissions levels. This was a gross oversight that stemmed from two key defects in the RGGI’s design.
First, the RGGI emission limits for the first cap period, which ran from 2009–2013, were based on emission estimations made in 2005. Between 2005 and 2009, the amount of electricity generation in the member states decreased by thirty-six percent due to energy efficiency improvements and structural changes in energy generation portfolios. Second, the RGGI distorted its emission forecasts by including all electrical power plants that had the capacity to generate twenty-five or more megawatts in its estimates. Limiting the emission calculations to power plants that actually generated twenty-five or more megawatts would have produced more accurate projections.
These errors have been catastrophic for the initiative. The initial regulations had no effect on most businesses, which were already emitting below the inflated emissions cap. Participation in the RGGI was therefore minimal, since many of the targeted businesses had no need to reduce emissions, purchase allowances, or generate offset credits. Furthermore, because the RGGI does not limit the amount of allowances that can be “banked” and used in subsequent years, many companies have stored substantial amounts of these initial surplus allowances for future use.
The administrators of the RGGI have taken extreme measures to try and remedy these miscalculations. Most notably, they implemented a “revised emissions cap,” running from 2014–2020, that slashes the emission limits by forty-five percent in an effort to match actual emission levels. Such radical action would not have been necessary if the initial emissions cap had been more precise.
A final pitfall of the RGGI is its undervalued price floor for auctions. The reserve price has hovered around two dollars per allowance, despite being scheduled to increase according to the Consumer Price Index (“CPI”). But the fact that auctioned allowances have been sold at prices exceeding five dollars indicates that businesses are willing to pay more. The program therefore severely underappreciated the corporate demand for allowances and forfeited substantial potential earnings. Moreover, by greatly undervaluing the price floor, the RGGI administrators neglected to protect against suboptimal years when allowance prices have plummeted. A higher reserve price would have preserved the revenue generation capacity of the program, even during these off years.
There are also numerous lessons to be learned from the deficiencies of the European Union’s ETS, which is the world’s largest market-based mechanism for reducing GHG emissions.
At the conclusion of Phase I of the ETS, the “Learning Phase” that ran from 2005–2007, it was apparent that the initial targets for emission reductions were far too lenient. Indeed, the lax regulations during Phase I only produced GHG reductions of three percent. The EU was forced to compensate by crafting extreme targets for Phases II and III of the program, setting emissions goals of six percent below 2005 levels for Phase II and twenty-one percent below 2005 levels for Phase III. If the EU had formulated a more ambitious target for Phase I rather than over-prioritizing the transition of members into the program, it would have avoided the need for these drastic adjustments.
Similar to the RGGI, the ETS grossly over-allocated emission allowances. In fact, ETS allowances initially exceeded the amount of actual emissions by four percent. This miscalculation was devastating for Phase I of the ETS, as it enabled European businesses to emit 130 million tons more in GHGs than they had emitted prior to the implementation of the program. This surplus destroyed the demand for allowances in the ETS marketplace, and auction prices fell precipitously. The EU was forced to heavily reconfigure ETS allowance allocations to try and mitigate the damage caused by these initial overestimations, and it is still attempting to normalize the ETS marketplace.
The ETS has also been hamstrung by its inferior market design. Phase I of the program did not permit any allowances to be banked for future use. Coupled with the initial over-allocation of allowances, this meant that most regulated entities possessed surplus allowances they had to expend by the year-end. This resulted in extreme downward price volatility at the conclusion of trading periods, as many companies attempted to dump the remainder of their emission allowances into the auctions. The EU was once again forced to implement significant revisions to correct this oversight. And while the ETS now permits allowances to be banked, the initial trading instability across Europe nearly destroyed the program.
The EU also does not set a reserve price for ETS auctions, meaning there is no price protection for emission allowances. This remains a gross oversight by the EU, as the lack of a price floor fails to account for the inevitable fluctuation of allowance prices due to changes in weather or energy price cuts. As a consequence, the ETS has lost significant revenue during periods of low auction demand where allowances have sold for pennies on the dollar, and the program will continue to be financially vulnerable until this design flaw is remedied.
Administrative inefficiencies have also plagued the ETS. The most glaring hole was the initial lack of a single registry for ETS participants. Prior to 2012, each nation participating in the ETS had its own registry, which resulted in inconsistent regulation across the system. The Danish registry, for example, failed to vet its registrants for two years. The registry ultimately became so saturated with fraudulent companies that over ninety percent of account holders had to be deleted in 2010. Even after the EU moved all participants into a single registry, the credibility lost among consumers during these initial years continues to plague the reputation of the program.
The final shortcoming of the ETS is that its cyber-security has been extremely assailable. “Phishing” has been one particularly vexing problem. The scam involves the creation and promotion of fake registries that solicit users to reveal their ETS identification codes. The “phishers” then use this information to carry out carbon trading transactions in legitimate registries. These deceptions have had severe economic ramifications, and as much as three million euros have been stolen in a single month.
Hacking has been another key cyber-security issue for the ETS. Hackers have been able to infiltrate users’ computer systems and sell off all their allowances for immediate cash payments on the “spot market.” Numerous companies have been crippled by this scam, and hackers have defrauded certain businesses of more than seven million euros worth of emission allowances.
When considering the numerous oversights of the RGGI and ETS programs, the success of the CAT is doubly impressive. This success is due to the balanced design of the CAT, which incorporates the strengths of the RGGI and ETS while mitigating their weaknesses.
Both the RGGI and ETS erred by overestimating actual emission levels and allocating excessive allowances. The CARB avoided this mistake by crafting a precise allocation methodology that prevented surplus allowances from derailing the auction marketplace. Foremost, the CARB calculated California emission levels for the years immediately preceding the creation of the CAT to more accurately forecast future emissions. The CARB also narrowed the variability of its emissions estimates by only including emitters who had actually emitted 25,000 or more metric tons of CO2 or equivalents. Emitters who merely had the capacity to emit beyond the 25,000 metric ton threshold were not included in the calculations. The greater accuracy of the CAT estimates was evidenced during the program’s first quarterly auction in 2012, where all twenty-three million allowances offered at the auction were purchased above the reserve price.
Another common error of the RGGI and ETS was that their design strategies over-prioritized transitioning members into their systems. The programs initially neglected to implement substantive emission reduction targets for fear of overwhelming participants, and they have subsequently instituted dramatic reforms to compensate. By contrast, the CARB recognized the need to balance the transition of members into the program against regulatory efficacy, lest one derail the other.
The CARB facilitated the transition of participants into the CAT by narrowing the scope of the first compliance period to only cover electrical and industrial sectors. It waited until the second compliance period to expand into the transportation and heating fuel sectors to provide companies time to adjust their business practices. Yet the CARB also implemented considerable GHG reduction targets. The CARB initially set a 2020 reduction goal of seventeen percent below 2013 levels, which still eclipses the target of the RGGI. Due to these ambitious benchmarks, the CAT has already produced “non-negligible” emission reductions and economic gains, with 2013 alone seeing GHG reductions of over a million and a half metric tons and statewide economic growth of two percent. The CAT has benefitted greatly from such a stable infrastructure, and it remains on track to reach its ultimate emission reduction target by 2020.
The CARB also built off the mistakes of the RGGI by broadening the regulatory scope of the CAT. Because it only regulates CO2 emissions, the RGGI covers less than twenty percent of the GHG emissions generated across its nine participating states. By contrast, the CAT emulates the ETS by also covering CO2 equivalents such as CH4, N2O and other fluorinated GHGs, resulting in more effective emission restrictions. The CARB also recognized that the RGGI erred in solely regulating electrical power plants. Accordingly, the CARB extended CAT regulations into other sectors heavy in GHG emissions, such as industrial, transportation, and heating fuel sectors. Because of this broader scope, the CAT already covers over 600 facilities in California, whereas the RGGI only reaches 163 facilities across nine states. The CAT also covers more than eighty-five percent of California’s GHG emissions, which is almost four times the amount of GHG coverage under the RGGI.
The CAT also avoided the severe design blunders of the RGGI and ETS. Rather than undervaluing or ignoring auction price floors, the CARB instituted a strong reserve price of ten dollars in 2012, which has been set to increase each year thereafter by five percent (in addition to increases for inflation). Allowances have consistently sold above these amounts, but the price floor has provided steady protection against downward price volatility during poor trading periods. Moreover, the built-in mechanism for annual increases to the reserve price has ensured that the price floor continues to increase irrespective of CPI circumstances.
The CAT further protects against precarious price drops by permitting allowances to be banked. This avoids the price instability problems of the ETS by discouraging businesses from dumping surplus allowances into auctions at the end of trading periods. Nevertheless, the CAT imposes limits on the maximum amount of allowances that can be held by a business. This circumvents the design flaw of the RGGI that allows businesses to bank an inordinate amount of allowances and eliminate any need to subsequently reduce emissions.
The revenues generated by the CAT best demonstrate the success of its market design. The first auction raised more than $289 million, and the first compliance period generated $969 million in revenue for California. Projections estimate that the CAT will generate two billion dollars or more per year as the program’s regulatory scope continues to scale upwards.
The CAT has also benefitted immensely from its efficient administration and strong security practices. Foremost, the CAT keeps a single registry for all its regulated entities, ensuring vigilant and orderly monitoring of all participants. The cyber-security protocols of the CAT have been extremely successful as well. To prevent hackers and phishers from infiltrating the program, CAT auctions take place over a four-hour window that is constantly supervised by state employees. The bidders and supervisors remain undisclosed to the public, and all parties must surrender their electronic devices during the auction. This “sealed bid” approach to the auctions has protected the CAT from the fraud and counterfeiting issues that tormented the RGGI and ETS.
V. A Recent Legal Challenge: Are Cap-and-Trade Auctions Tax Programs?
Despite the success of the CAT, the program has faced serious legal obstacles. The principal challenge took place in the recent Morning Star Packing Company v. California Air Resources Board case, where the plaintiffs alleged that the auctions were unconstitutional and violated California law. The chief contention was that the CAT constituted a tax on companies for emitting GHGs. The plaintiffs argued that the statutory authorization of the CAT, the Global Warming Act, therefore fell under the purview of California’s Proposition 13, which requires legislators to pass by two-thirds vote “any act to increase state taxes for the purpose of increasing revenue.” Because the Global Warming Act was not passed by a two-thirds vote, the plaintiffs asserted that the CARB exceeded its regulatory authority when it created the CAT.
The dispositive issue in the case was whether the auctions were unconstitutional taxes or whether they were permissible regulatory fees placed on tradable commodities. The Sacramento superior court ultimately upheld the CAT, concluding that emission allowances were tradable commodities in a marketplace. The court considered several distinctions between taxes and regulatory fees, but the chief difference seemed to be that whereas the government sets tax prices, the market determined the auction price of the emission allowances. Thus, the fact that the allowances had no value independent of the California regulatory scheme did not transform the auctions into a tax program, and the allowances remained tradable commodities.
Yet the superior court ruling did not mark the end of the contentious litigation. The Morning Star decision was appealed to the Sacramento appeals court, which affirmed the lower court judgment by a two-to-one majority decision. In turn, the appellate court ruling was appealed to the California Supreme Court, which ultimately declined to hear the case in June of 2017. What should have been a resounding victory, however, was diminished by the fact that the State Supreme Court did not issue a written opinion on the program itself. Nevertheless, the affirmation of the CAT provided market-based environmentalism with a new lease on life and has galvanized California policymakers and legislators.
The ramifications of the Morning Star have already been substantial in California. State legislators quickly capitalized on the State Supreme Court’s dismissal of the case by voting to extend the CAT an additional ten years through 2030. The extension produced newfound confidence in environmentalism and revitalized the market economy surrounding the CAT – whereas previous quarterly auction sales had dropped sharply, the California government sold every emission permit offered in the August 2017 auction.
Yet these successes have not been replicated on a national scale. This is somewhat perplexing, as the CAT provides a workable model upon which to base the creation of a federal cap-and-trade program. In particular, Congress could convincingly argue that the Morning Star case supports the notion that cap-and-trade programs deal with tradable commodities and do not constitute tax programs. Congress could therefore avoid having to rely on the Taxing and Spending Clause of the Constitution to justify the creation of an auction program and, instead, could derive its authority from the broader powers of the Commerce Clause.
Despite the reasoning provided by Morning Star, recent federal policy has demonstrated a marked shift away from the environmentalist approach espoused by the Obama Administration. The recent withdrawal of the Clean Power Plan, the Obama-era rule regulating greenhouse gas emissions, best evinces this change in protocol. Indeed, with the Environmental Protection Agency consistently the choice target of President Trump’s proposed budget cuts, environmentalism on a national level has been placed in a precarious position.
It remains to be seen whether this federal paradigm shift will take a toll on the CAT. It is certain, however, that the demise of the CAT would be the death knell for market-based environmentalism in the United States. Fortunately, the CAT has several contingency protocols to counteract market volatility. In particular, the CARB can hold unsold allowances off the market for at least nine months to compress the supply and force participants back to the auctions. This foresight proved to be invaluable in the wake caused by the initial Morning Star appeal in 2016, during which time the May 2016 and August 2016 auctions only sold eleven percent and thirty-five percent, respectively, of the allowances offered. The remedial mechanisms built into the CAT allowed administrators to re-stabilize the market, and the November 2016 auction resulted in the successful sale of eighty-nine percent of the offered allowances. Nevertheless, these contingencies are merely stopgap solutions, and hesitation among market participants will likely resurface as Californian and national policy progress along their collision course. Until a clear and unified path towards environmentalism is forged across the nation, an ominous shadow will remain cast over the CAT.
The CAT has been a landmark initiative for environmentalism in the United States. Incorporating lessons from the RGGI and ETS, the program has struck a masterful balance in its market design and has produced significant environmental and financial gains for California. The affirming decision of the California judiciary and recent expansion of the program by the California legislature have been beacons of hope for cap-and-trade. Despite these successes, the future of the CAT remains in doubt, plagued by an uncertain socio-political climate where federal support for environmentalism has recently waned. And while the CAT has withstood previous legal and economic challenges, it is undeniable that the decisive battle for market-based environmentalism across the United States has begun.
* J.D. 2017, University of Virginia School of Law. I would like to thank Alisha Mehta for her advice and comments and Pamela Lim for her tireless support, without which this article would not be possible.
 Morning Star Packing Co., et al. v. California Air Resources Board, et al., Sacramento Appellate Court, Case No. 34-2012-80001313 [hereinafter Morning Star Appellate Decision], http://documents.latimes.com/appeals-court-upholds-californias-cap-and-trade-program/.
 California Environmental Protection Agency, Assembly Bill 32 Overview, http://www.arb.ca.gov/cc/ab32/ab32.htm.
 California Cap-and-Trade Program Summary, Center for Climate and Energy Solutions (Jan. 2014), https://www.c2es.org/docUploads/calif-cap-trade-01-14.pdf.
 Id. From 2013–2015, the program covered electrical and industrial power plants that emitted 25,000 or more metric tons of CO2 or equivalent gases per year. Since 2015, fuel distributors have also been covered.
 Id. Carbon offsets are greenhouse gas emission reductions that are credited to a company that funds or participates in an activity that reduces carbon footprints in the environment.
 Lucas Bifera, Regional Greenhouse Gas Initiative, Center for Climate and Energy Solutions 1 (Dec. 2013), https://www.c2es.org/docUploads/rggi-brief-12-18-13-updated.pdf.
 Jonathan Ramseur, The Regional Greenhouse Gas Initiative: Lessons Learned and Issues for Congress, Congressional Research Service 2 (Apr. 27, 2016), https://www.fas.org/sgp/crs/misc/R41836.pdf.
 Overview of RGGI CO2 Budget Trading Program, Regional Greenhouse Gas Initiative 6 (Dec. 2007), http://www.rggi.org/docs/program_summary_10_07.pdf.
 Ramseur, supra note 12 at 7–8.
 Emissions Trading in the European Union: Its Brief History, Pew Center on Global Climate Change 1–2 (Mar. 2009), https://www.c2es.org/docUploads/emissions-trading-in-the-EU.pdf.
 Tamra Gilbertson, Fraud and Scams in Europe’s Emissions Trading Systems, Climate & Capitalism, May 5, 2011, http://climateandcapitalism.com/2011/05/05/fraud-and-scams-in-europes-emissions-trading-system/.
 Emissions Trading in the European Union, supra note 28 at 1–2.
 Flawed Application of the Auction Reserve Price in the EU ETS, Emissions-EUETS.com (Feb. 23, 2013), http://www.emissions-euets.com/auctionsco2allowances/153-flawed-application-of-the-auction-reserve-price-in-the-eu-ets.
 Id.; Union Registry, European Commission, https://ec.europa.eu/clima/policies/ets/registry_en (last visited Feb. 17, 2017).
 California Cap-and-Trade Program Summary, supra note 4.
 Dana Hull, 13 Things to Know About California’s Cap-and-Trade Program, San Jose Mercury News (Feb. 22, 2013), http://www.mercurynews.com/ci_22092533/13-things-know-about-california-cap-trade-program.
 Dave Clegern, California greenhouse gas inventory shows state is on track to achieve 2020 AB 32 target, California Environmental Protection Agency (June 30, 2015), http://www.arb.ca.gov/newsrel/newsrelease.php?id=740.
 Id.; Michael Hiltzik, California’s cap-and-trade program has cut pollution. So why do critics keep calling it a failure?, L.A. Times (July 29, 2016), http://www.latimes.com/business/hiltzik/la-fi-hiltzik-captrade-20160728-snap-story.html.
 Ramseur, supra note 12 at 2.
 Id.; Emily Reyna, Four Reasons California Cap and Trade Had an Extraordinary First Year, Forbes (Jan. 14, 2014), http://www.forbes.com/sites/edfenergyexchange/2014/01/08/four-reasons-california-cap-and-trade-had-an-extraordinary-first-year/#58ffab0e4dfc.
 Archived Auction Information and Results, California Environmental Protection Agency, http://www.arb.ca.gov/cc/capandtrade/auction/auction_archive.htm.
 Archived Auction Information and Results, supra note 60.
 Hull, supra note 47; Michael Hiltzik, Emissions cap-and-trade program is working well in California, L.A. Times (June 12, 2015), http://www.latimes.com/business/hiltzik/la-fi-hiltzik-20150613-column.html.
 Laurel Rosenhall, Why hasn’t California’s cap and trade pollution program been the model for the U.S.?, L.A. Daily News (July 31, 2015), http://www.dailynews.com/environment-and-nature/20150731/why-hasnt-californias-cap-and-trade-pollution-program-been-a-model-for-us.
 Id.; Gilbertson, supra note 31.
 Morning Star Packing Co., et al. v. California Air Resources Board, et al., Sacramento Superior Court, Case No. 34-2013-80001464 [hereinafter Morning Star Superior Court Ruling]. The case was consolidated and decided jointly with California Chamber of Commerce, et al. v. California Air Resources Board, et al., Sacramento Superior Court, Case No. 34- 2012-80001313. The joint decision is available at: http://www.edf.org/sites/default/files/content/decisionchambermorningstar.pdf.
 Id.; Allie Goldstein, Cap-and-Trade Is Not A Tax, California Court Says, Ecosystem Marketplace (Nov. 18, 2013), http://www.ecosystemmarketplace.com/articles/cap-and-trade-is-not-a-tax-california-court-says/.
 See generally Morning Star Appellate Decision.
 Dan Whitcomb, California Supreme Court Upholds Cap-and-Trade Law, CNBC (June 28, 2017), https://www.cnbc.com/2017/06/28/reuters-america-california-supreme-court-upholds-cap-and-trade-law.html.
 Id.; Chris Megerian, California Supreme Court Leaves in Place Decision Upholding Cap-and-Trade System, L.A. Times (June 28, 2017), http://www.latimes.com/politics/essential/la-pol-ca-essential-politics-updates-cap-and-trade-supreme-1498684764-htmlstory.html.
 Melanie Mason & Chris Megerian, California Legislature Extends State’s Cap-and-Trade Program in Rare Bipartisan Effort to Address Climate Change, L.A. Times (July 17, 2017), http://www.latimes.com/politics/la-pol-ca-california-climate-change-vote-republicans-20170717-story.html.
 California Cap-and-Trade Program: Summary of Joint Auction Settlement Prices and Results, California Air Resources Board (Aug. 2017), https://www.arb.ca.gov/cc/capandtrade/auction/results_summary.pdf.; Chris Megerian, California Cap-and-Trade Program Gets Shot in the Arm with Strong Permit Auction, L.A. Times (Aug. 23, 2017), http://www.latimes.com/politics/la-pol-sac-cap-trade-auction-results-20170823-story.html.
 CFTC Glossary, United Statutes Commodity Futures Trading Commission, http://www.cftc.gov/ConsumerProtection/EducationCenter/CFTCGlossary/glossary_p.
 See generally Morning Star Superior Court Ruling.
 See, e.g., 7 U.S.C. § 1a(47)(B)(ii) (2012) (excluding from the definition of “swap” “any sale of a nonfinancial commodity or security for deferred shipment or delivery, so long as the transaction is intended to be physically settled”).
 Daniella Diaz et al., EPA Administrator Scott Pruitt Announces Withdrawal of Clean Power Plan, CNN (Oct. 10, 2017), http://www.cnn.com/2017/10/09/politics/environmental-protection-agency-scott-pruitt-clean-power-plan/index.html.
 Brady Dennis & Juliet Eilperin, EPA Remains Top Target with Trump Administration Proposing a 31 Percent Budget Cut, Washington Post (May 23, 2017), https://www.washingtonpost.com/news/energy-environment/wp/2017/05/22/epa-remains-top-target-with-trump-administration-proposing-31-percent-budget-cut/?utm_term=.c5889f6eca1d.
 Summary of Joint Auction Settlement Prices and Results, supra note 84.
Copyright 2017 Theodore McDowell. All rights reserved.

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