Selina Lee-Andersen

On July 17, 2017, the California legislature passed legislation to extend the state’s cap-and-trade program to 2030 (the program was originally set to expire in 2020). Bill AB 398 received broad bi-partisan support and was passed with a two-thirds majority vote, which is the threshold required to pass tax laws in California. With a super-majority vote, California’s cap-and-trade program will be harder to challenge in court, thus providing policy certainty to market participants and partner jurisdictions including Québec and Ontario. AB 398 was accompanied by two bills: (1) AB 617, which seeks to address local air quality concerns by requiring increased monitoring, mandating upgrades of outdated equipment and technology, and imposing stricter penalties for noncompliance with regulations; and (2) ACA 1, which establishes the Greenhouse Gas Reduction Fund, into which all revenue from the auction or sale of allowances will be deposited (a 2/3 vote of each house will be required to appropriate the funds). The passage of AB 617 was key to winning over the support of key environmental groups.

By way of background, California Governor Jerry Brown signed SB 32 in September 2016, which requires the state to cut greenhouse gas emissions to 40% below 2020 levels by 2030 (the previous goal was achieving 1990 levels by 2020). However, SB 32 did not provide any details on how California would achieve this goal, casting a shadow of uncertainty over California’s cap-and-trade program beyond 2020. Following SB 32, Governor Brown, legislators and a broad range of stakeholders squabbled over the future of the cap-and-trade program, and various proposal were put forward to either extend the program or overhaul it.

While the nuts and bolts of California’s cap-and-trade program remain the same, several changes have been made to the program, which will likely have impacts for the cap-and-trade programs in Québec and Ontario. These changes include:

  • Price ceiling: AB 398 establishes a price ceiling for emission allowances, which will be determined by the California Air Resources Board (ARB). Under the current system, there is a reserve of allowances (known as the Allowance Price Containment Reserve or APCR) that can be made available for auction once the price of allowances reaches a specified threshold; this is a mechanism to slow down price increases with an additional supply of allowances. While this reserve has not yet been used, there were some policy concerns about the upward trajectory of allowance prices if the APCR was exhausted, which is a more likely scenario with a more stringent cap after 2020. The price ceiling seeks to address these concerns by containing compliance costs. AB 398 also requires the ARB to take into consideration the social cost of carbon in setting the price ceiling, and allows ARB to transfer current vintages unsold for more than 24 months to the APCR. Analysts have forecast that the ceiling price could reach US $111 by 2030.
  • Pricing Speed Bumps: AB 398 establishes intermediate price steps or “speed bumps”, which are set at various points between the price floor and price ceiling.  Once the allowance price hits any of these speed bumps, an additional supply of allowances (taken from the unused APCR pool) will be released to soften price hikes.
  • Offsets: AB 398 allows capped emitters to purchase offsets to meet up to 4% of their compliance obligation (down from 8%). This will ratchet up to 6% after 2025.  The legislation also requires an increase in offset projects with “direct environmental benefits” in the state, which are defined as the reduction or avoidance of any pollutant that could have an adverse impact on the waters of California. AB 398 also establishes a Compliance Offsets Protocol Task Force that will provide guidance on new offset protocols – the priority will be those projects that increase benefits for disadvantaged communities, Native American or tribal lands, and rural and agricultural regions. It has been reported that California’s offset supply is expected to be well short of future demand, potentially placing upward pressure on offset prices. With more stringent emission reduction targets on the horizon in California, Canadian entities could benefit from this new legislation as suppliers of offsets into the secondary market.

Given the higher cost of abatement in Canada, the price ceiling under AB 398 is important to the Québec and Ontario markets because it will help to contain compliance costs for regulated entities in those jurisdictions. At the same time, the higher price will likely lead to greater abatement action in Canada. In addition, the continued free allocation of allowances to certain capped emitters in California will take the pressure off Québec and Ontario to move to a full auction scenario, which may also help to bolster industry support for cap-and-trade policy.

As California lawmakers work to finalize specific details of the cap-and-trade program, the passage of AB 398 appears to have stabilized the carbon market following a period of volatility. At the ARB’s July 2017 board meeting, the linkage with Ontario was approved, along with provisions to address economic and emission leakages. Upcoming workshops and board meeting will focus on how ARB will address the overall cap beyond 2020, as well as provide further clarity over the use of offsets.