Calif. Cap-and-Trade: Bull or Bear Market?

The California Air Resources Board (CARB) recently kicked off a new era in its cap-and-trade program designed to reduce greenhouse gases (GHG) when it held its first GHG emissions allowance auction on November 14. While CARB pronounced the auction a success, the low price and lukewarm demand for allowances evidences market reticence to fully embrace the program.

As a procedural matter, the auction was a success. It had no electronic glitches, and there was no evidence of tampering or interfering with the market. A brief analysis of the results, however, shows that the auction did not generate the enthusiasm that CARB expected.

Wide Participation But at a Low Price

As a key part of California’s Global Warming Act, or AB 32, the cap-and-trade program relies on allowances as permission for entities to emit CO₂ and other GHGs. The program sets a cap on total emissions that reduces yearly. Emitters must surrender one allowance per metric ton of CO₂ (or CO₂ equivalent). The program anticipates a secondary market in which emitters and others can buy and sell extra allowances. Those looking to trade in this secondary market will closely watch the allowance price from this and future quarterly auctions.

The first auction’s results indicate its “success” may be less than suggested by CARB’s press release. First, the sale price for allowances was not as high as anticipated. While all of the available 2013 allowances (23,126,110) were sold, the sales price was $10.09, barely above the $10 minimum reserve price. Many expected the allowances to sell for $12 to $13 each. Second, the auction also included 2015 vintage allowances, of which only about 15% sold at the minimum reserve price of $10.

These results indicate that market participants are taking seriously the obligation to obtain allowances but are uncertain of the program’s future. The low prices and the minimal number of 2015 allowances purchased may indicate wariness. In essence, participants seem to be dipping their toes in the water, but they are not ready to take the plunge by purchasing large quantities of allowances.

Challenges to the Cap-and-Trade Program

Market participants’ cautious responses may be motivated by ongoing uncertainties caused by various court challenges to the cap-and-trade program. Today’s prices for 2015 allowances may be inexpensive, but if the courts delay, narrow, or totally reject CARB’s cap-and-trade program, today’s bargain price could be tomorrow’s regulatory lemon.

Most recently, the California Chamber of Commerce filed suit in state court to enjoin CARB from allocating to itself GHG allowances and then selling them through an auction process to raise revenue. This auction earned the state over $230 million. CARB has reserved for sale approximately 10% of GHG emission allowances. The Chamber asserted that CARB should allocate all GHG emission allowances to business at no cost, and companies exceeding their allowance should be able to purchase GHG emission allowances from other companies. The Chamber concluded that this interpretation of AB 32 would fulfill the state’s goal of reducing emissions while keeping GHG compliance costs low for businesses and consumers.

The Chamber’s complaint characterizes CARB’s allowance auction as both an unconstitutional tax and a violation of AB 32. The complaint alleges that AB 32 only authorized CARB to impose a “minor administrative fee” but did not authorize CARB to raise revenue by selling GHG emission allowances. Because a two-thirds majority of the California legislature is needed to increase taxes, the Chamber contends that requiring businesses to purchase GHG emission allowances sold by CARB imposes an unconstitutional tax. The Chamber did not seek to enjoin this first auction, but its suit threatens future auctions. CARB must respond to the Chamber’s allegations prior to the next auction in February 2013.

In addition to the Chamber’s lawsuit, other pending litigation may potentially delay or restrict California’s climate change initiatives:

• Environmental groups filed a state suit in 2012 challenging the use of offsets (GHG emissions’ reductions in certain areas that can be used as allowances) for compliance under the cap-and-trade program.
• Environmental groups also filed a complaint last year at the Environmental Protection Agency, asserting that CARB’s AB 32 regulatory program violates the federal Civil Rights Act of 1964 by not focusing on emissions reduction from specific local emission sources to the detriment of disadvantaged communities.
• An appeal is pending before the Ninth Circuit of an injunction issued against CARB’s enforcement of the Low Carbon Fuel Standard (LCFS) regulations. So far, the LCFS litigation is the only challenge based on the Interstate Commerce Clause in the U.S. Constitution. The Ninth Circuit has suspended the injunction pending its decision.

So although CARB’s claimed “success” of its first auction can be construed as a positive first step in California’s GHG regulation through cap and trade, the auction results suggest reluctance by market participants, who remain unconvinced of its regulatory future. California must battle the lawsuits challenging the use of the auction proceeds, the application of offsets, and the viability of the program as a whole. The participation levels and prices associated with the next auction scheduled for February 2013 will provide more evidence as to market participants’ confidence that California will proceed with a robust cap-and-trade GHG regulation.

— Allison Davis ([email protected]) and Kerry Shea ([email protected]) are partners in Davis Wright Tremaine’s Energy Practice Group.