California is about to revolutionize climate policy … again.

Source: Daily Climate

California’s ambition on climate change policy has become dizzying to track. A few months ago, the leader of the senate introduced a bill that would commit the state to 100 percent renewable energy — and that’s not even the biggest California climate policy story of 2017.

The biggest story broke yesterday, though it didn’t make much of a splash and will likely sneak under the public’s radar. Unlike “100 percent clean energy,” which is very sexy, “cap and trade” is … not.

But cap and trade is the focus of a crucially important new bill, released yesterday by State Sen. Bob Wieckowski (D-Fremont) and Senate President pro Tempore Kevin de León (D-Los Angeles).

The changes that SB 775 proposes for the state’s carbon trading program are dramatic — and, to my eyes, amazingly thoughtful. I know some environmental groups have reservations (on which more later), but in my opinion, if it passes in anything close to its current form, it will represent the most important advance in carbon-pricing policy in the US in a decade. Maybe ever. Yeah, really.

I’ll tell you all about the changes and you can tell me if you agree. First, though, we have to take a little detour, a mini-history of California climate policy. (There’s more extensive backgrounder here if you’re interested.)

Why California has to fix its cap-and-trade system

California recently put in place some of the most ambitious carbon targets of any jurisdiction in the world. Already aiming to return to 1990 levels of carbon dioxide emissions by 2020, last year the state passed into law SB 32, which would mandate an additional 40 percent reduction by 2030.

California’s historical emissions and targets under AB 32 and SB 32. (Adapted from Greenblatt, 2015)

To hit that target, the state will need to amp up its entire suite of climate policies. Most notably, it will have to do something about its weak, flawed, and beleaguered carbon cap-and-trade program.

Back in 2006, under Republican Gov. Arnold Schwarzenegger, California passed AB 32, its groundbreaking climate law, which put in place the 1990-levels-by-2020 target. The law (a mere 15 pages) put the California Air Resources Board (CARB) in charge of achieving the goal, giving it incredible power and autonomy to partner with other state agencies and develop the necessary tools.

Since then, CARB has implemented or overseen a wide array of policies meant to reduce the state’s emissions. Somewhat contrary to conventional wisdom, the price on carbon (the cap-and-trade system) is only a small part of that array, initially expected to account for about a quarter of the state’s reductions. The other three-quarters would come from the state’s Low Carbon Fuel Standard, efficiency standards, renewable energy portfolio standard, and various and sundry other regulations.

SAN FRANCISCO - JUNE 05: California governor Arnold Schwarzenegger delivers a speech to business and community leaders June 5, 2007 in San Francisco, California. Schwarzenegger addressed local leaders outlining his vision for the future of California Stat

SAN FRANCISCO - JUNE 05: California governor Arnold Schwarzenegger delivers a speech to business and community leaders June 5, 2007 in San Francisco, California. Schwarzenegger addressed local leaders outlining his vision for the future of California Stat

Your climate hero, in 2007. (Photo by Justin Sullivan/Getty Images)

Regulations, not carbon pricing, have been the main driver of California’s carbon reductions to date. In fact, they have been so effective, and carbon reductions so much cheaper than expected, that there hasn’t been much work left for the cap-and-trade program to do. Near-term emission goals are being reached without its help.

For this and other reasons, carbon allowances in the system have been dirt cheap; since 2014, they’ve been sitting on the “price floor” of around $12 a ton. Suffice to say, a price that low doesn’t do much to drive emission reductions.

What’s more, a price that low doesn’t produce much revenue — and programs that depend on revenue from allowance sales (among them the governor’s beloved high-speed rail project) have been starving lately.

This has led critics to dismiss the program as a failure. And it also faces serious charges that “leakage” — emissions simply moving over the border to a different state to escape the price on carbon — is poorly regulated and badly weakening the program.

To make matters worse, the program recently came under new legal scrutiny, regarding whether allowance auctions (which raise state revenue) violate the state’s Prop. 13, which requires a two-thirds vote in the legislature to raise taxes.

Whether or not they trigger Prop. 13, auctions almost certainly trigger the more recently passed Prop. 26, which requires a two-thirds vote in the legislature to raise revenue of almost any kind — fees, auctions, charges, whatever. Even if the current cap-and-trade system proves legally sound through 2020 (when its authorization ends), there is considerable doubt that it could be reauthorized without a two-thirds vote.

This is a long, tangled story (told more fully here), but the net result is that California now badly needs a legally sound, politically salable post-2020 extension of its cap-and-trade program.

LOS ANGELES, CA - APRIL 29: California Governor Jerry Brown closes his eyes to concentrate on the words of a another speaker during a panel discussion at the 18th annual Milken Institute Global Conference where spoke about new efforts to cope with climate

LOS ANGELES, CA - APRIL 29: California Governor Jerry Brown closes his eyes to concentrate on the words of a another speaker during a panel discussion at the 18th annual Milken Institute Global Conference where spoke about new efforts to cope with climate

Gov. Jerry Brown, contemplating what a giant headache his cap-and-trade system has become. (Photo by David McNew/Getty Images)

And here’s another wrinkle: The legislature cannot simply reauthorize and extend the existing program. If it does, all the piles of cheap allowances laying around (the current system allows unlimited “banking,” i.e., hoarding of allowances from year to year) will suddenly be worth much, much more, as the market prices compliance costs through 2030 into the value of today’s allowances. Danny Cullenward, a Stanford researcher who advised the bill’s co-sponsors, says that simple reauthorization could send the value of existing permits shooting up to $50, or in some studies even $100.

That would, among other things, add $0.40 (or up to $0.80) to the price of a gallon of gasoline, more or less overnight. And that’s in a state that just went through a bruising battle over raising the gas tax. And there would be no revenue to soften the blow, because all revenue in the current system is already allocated. It would be a political nightmare. That reality has focused lawmakers on crafting a new system.

Whatever the post-2020 cap-and-trade system is, it has to accomplish all of the following:

  • increase the predictability and stability of carbon prices, to comfort business and conservatives;
  • increase the level of carbon prices, to achieve the state’s ambitious carbon targets and…
  • …generate more revenue to fund dependent programs;
  • solve the leakage problem and protect in-state business;
  • keep existing constituencies happy, while garnering enough support from less-liberal legislators to…
  • …pass the bill through the legislature with a two-thirds vote, insulating the program from legal challenge.

Easy, right?

But this is California, where all things are possible. And that brings us to SB 775.

The elegant new cap-and-trade system proposed in the California senate

The system proposed in the new bill reflects the fact that policymakers expect cap-and-trade to take over as the primary instrument of carbon reductions in the state. It’s easy to achieve low-hanging emission reductions with a suite of regulations. To really dig in to the more difficult reductions, you need a more predictable and powerful instrument. That’s what this system is designed to be.

It has the following features, almost every one of which will cause a tingle in the toes of carbon wonks:

1) It is entirely new.

“Any problems in the current market (like oversupply) would infect the post-2020 market,” Jessica Green of NYU, an expert on carbon pricing policies, told me. “A clean break will prevent this from happening.”

And so a clean break it is: This would be an entirely new trading system, starting in 2020. Allowances and offsets from the old program would not transfer over. New allowances would be issued in 2020 and trading would begin anew.

This solves the reauthorization problem — no big spike in prices. And it neatly walls off the new program from the flaws of the old.

2) It includes a price collar.

All allowances in the system will be auctioned (none allocated for free). Prices for allowances will be contained by a “price collar” that establishes both a floor and a ceiling.

Some environmental groups are leery about the ceiling. There is an eternal debate in carbon wonk circles about the relative merits of a carbon tax versus a cap-and-trade system. A well-designed version of the former gives you price certainty; a well-designed version of the latter gives you emissions certainty. Environmental groups, naturally, prefer the latter. Business and conservatives tend to prefer the former.

By keeping allowance prices within a bounded range, a price collar creates a hybrid of the two. It provides some price certainty while also offering enough flexibility to allow prices to vary with emissions.

This does open at least the theoretical possibility that the ceiling won’t be high enough to ensure the necessary emission reductions. (Though, as we will see, the ceiling gets pretty high pretty quick.) But it is also a savvy way to reach out to more conservative legislators without compromising too much.

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A different, much cuter kind of collar. (Shutterstock)

3) Prices start low and rise, predictably, in perpetuity.

In 2020, the price floor begins at $20, just a little higher than the price floor of the system it replaces. The price ceiling begins at $30. Both rise in predictable increments, though at different rates.

The price ceiling rises at $10 per year, plus inflation. The price floor rises at $5 per year, plus inflation, “after a one-year delay, such that there is a $20/tCO2e spread between the floor and ceiling after one year of market operation and a $60/tCO2e spread between the floor and the ceiling in 2030.”

This keeps prices within a tightly bounded range at first, as people and businesses adjust to the system, while gradually increasing price flexibility over time. It also starts with reasonably low prices, while increasing them fast enough that the ceiling hits $100 before 2030. In this way, the system neatly balances the twin imperatives of predictability and stringency.

It is worth noting that the program’s architects expect, given California’s incredibly ambitious carbon targets, that allowance prices will start at the ceiling and stay there. If that happens, the price will operate more or less exactly like a carbon tax.

Finally, note that the program, as proposed, operates in perpetuity. (The price ceiling will be well over $200 by 2040, over $300 by 2050.) There is no statutory finish line at which point it needs to be reauthorized. Obviously future legislatures can do whatever they want, but at least structurally, the program is about as simple and long-term predictable as it could possibly get.

4) It has a border-adjustment tax.

All carbon trading systems face the problem of how to prevent “leakage.” If it costs more to operate in California, why shouldn’t a plant or factory simply move to an adjacent state and ship its products back to California? That way it could undercut in-state competitors.

To prevent that, the system would implement a border-adjustment tax, levied on imports according to their carbon intensity (much like the LCFS taxes imported fuels according to carbon intensity). In effect, this amounts to levying a carbon tax on imports. That way everyone competes within the state on a level playing field.

The border tax will be administered by a newly created Economic Competitiveness Assurance Program, which is tasked with making sure that in-state industry isn’t unduly impacted.

There are some important-but-boring technicalities here. The tax has to be designed to weather both “dormant commerce clause” lawsuits domestically and possible WTO judgments internationally. I will do you the favor of mostly passing over these technicalities; suffice to say, the authors have scrutinized the issue and believe they have a legally resilient solution.

Unlike various baroque solutions to leakage attempted by other cap-and-trade programs, a well-administered border tax is simple and transparent. If it passes legal muster, it can serve as a model to other jurisdictions.

5) In includes zero (0) offsets.

One of the most controversial features of most cap-and-trade programs is the inclusion of carbon offsets, which amount to complying with a carbon cap by paying someone else to reduce carbon. On the upside, this allows the system to achieve emission reductions even in sectors that aren’t covered by the carbon cap. On the downside, it introduces lots of opportunities for shenanigans.

I am of the unpopular opinion that offsets, especially in the case of California’s current system, get a worse rap than they deserve. Happily, there’s no need to rehash those old arguments, because the proposed system includes no offsets at all.

Unsurprisingly, this has upset the constituencies that have grown up around the offset trade.

But offsets are anathema to environmental justice groups, who don’t want polluting facilities in their communities to be able to buy their way out of emission reductions. And they are widely viewed with suspicion inside and outside of environmental groups.

Others will disagree, but in my judgment, being free of the taint and complication of offsets, especially if it attracts other constituencies, is worth the loss of whatever benefits they add.

6) Most of the revenue will go to per-capita dividends.

The proposal does not specify exactly how revenue will be allocated. The details are inevitably going to be hashed out among stakeholders during the legislative process.

(Interesting side note: The vote to raise carbon revenue triggers Prop. 26 and must get a two-thirds majority. Votes on how to allocate revenue do not trigger Prop. 26, and so can be won with a simple majority. That means, politically speaking, that it is probably wise to leave revenue allocation specifics for another, later vote.)

The bill does, however, establish a broad revenue structure. Specifically, the revenue will go into three buckets.

The first and largest is the California Climate Dividend Program, which will rebate revenue on a per-capita basis. The bill also establishes a Climate Dividend Access Board (CDAB) that will work with low-income and immigration groups to make sure the dividends reach everyone, even in vulnerable communities.

Several people connected to the process stressed that dividends are key to the bill’s political viability and will likely receive the bulk of the revenue, anywhere from 50 to 90 percent. It will be a quarterly benefit — some sort of check or credit every constituent receives four times a year.

If, as expected, carbon prices rise and stick to the ceiling, dividends will rise to keep up, cushioning the consumer (and political) impact. And, it is hoped, the idea of returning most revenue directly to constituents, bypassing nefarious Big Government, will attract more conservative Democrats and perhaps even a few Republicans.

The second bucket is for “public infrastructure investments and investments in disadvantaged communities.” (Vulnerable communities receive roughly 40 percent of current carbon revenue.) The third is for “climate and clean energy research and development.”

Faithful readers will recall that fights over revenue sank a carbon-tax proposal in Washington last year. California wonks and legislators are intensely cognizant of that fiasco and eager to avoid it. The hope is that rising carbon revenue will channel investment into those communities and pay substantial dividends.

7) California is going to leave other states behind.

California’s trading system is currently linked with Quebec’s, and there’s been talk of other West Coast states joining as well.

That probably won’t happen anytime soon. Starting in 2020, the new system will not link to any other jurisdiction (including Quebec) until it “has a minimum carbon price that is equal to or greater than California’s” and the governor determines that the linkage won’t do any damage to California dividends.

By year three or four of this program, the set of potential linkees will include basically no one, unless other states/provinces get really ambitious, really fast.

California is way out ahead and it isn’t waiting around for you slackers to catch up.

It’s a long road to passage, but this proposal is state of the art

SB 775 will go to the Committee on Environmental Quality (of which Wieckowski is chair), then to the full Senate, then over to the Assembly, then back for reconciliation. That’s a long road and there are sure to be tussles, surprises, and compromises along the way.

But the governor has asked for cap-and-trade reauthorization by July and Wieckowski is confident that it can get done in that time frame.

I gotta say, if this thing passes, it will be close to a miracle. To my eye, it elegantly balances technical and political considerations in a system that is simple, reliable, and sturdy.

For economists and investors, it has prices that increase steadily and predictably. For in-state industry, it offers the protection of a border tax. For carbon hawks, it promises rising carbon prices as far as the eye can see — an unmistakable signal to utilities, big consumers, energy companies, and entrepreneurs.

For low-income and vulnerable populations, it eliminates offsets and promises more and steadier funding for resilience and adaptation projects in their communities. (Initial reaction from the state environmental-justice community is highly positive. Those groups are also supporting a companion bill, AB 378, which would focus on criteria-pollutant reductions at facilities in vulnerable communities.)

And for every Californian, it provides rising dividends that offset the pocketbook impacts of carbon prices. The higher the carbon price gets, the higher the dividend checks get (and the more fond recipients become of the program). And of course the whole state benefits from investments in clean energy RD&D.

It’s like some Hegelian synthesis of every proposal in carbon-pricing history!

“California is less than 1 percent of the world’s emissions,” said political scientist David Victor of UC-San Diego, when I asked him about the proposal’s impact. “What we do on emissions doesn’t matter. What we do on leadership, to influence other jurisdictions — that matters.”

The significance of SB 775 is not just that it would rationalize and accelerate carbon reductions in California, but that it would show other jurisdictions what ambitious, state-of-the-art carbon-pricing policy looks like. It might even — ironically given the state’s heavily blue politics — chart a course toward bipartisan carbon policy. It is, after all, California, where all things are possible.

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