California tilts towards cap and refund

February 16, 2010


— John Kemp is a Reuters columnist. The views expressed are his own —

California is set to auction all or almost all allowances under its emissions trading programme, and rebate up to 75 percent of the proceeds to households through a lump sum payment or reductions in income and sales taxes.
The proposals, contained in a draft recommendation from the Economic and Allocation Advisory Committee (EAAC) to the California Air Resources Board (CARB), are in sharp contrast to the proposed federal programme, stalled in Congress, which would give away most permits to utilities and other energy intensive industries.
Since California’s proposed programme is one of the most advanced, and would be the largest and most comprehensive in the country, with links to other states through the Western Climate Initiative (WCI), the decision gives significant impetus to proponents of the cap and refund approach, now emerging as a credible alternative in Congress.

California’s Global Warming Solutions Act 2006 (AB 32) requires the state to reduce its greenhouse gas emissions back to 1990 levels by 2020. CARB has developed a “Scoping Plan” detailing how the state will achieve this using a mix of direct regulations and an over-arching cap and trade programme.
In May 2009, CARB established an Advisory Committee, consisting of technical experts, to make recommendations on two key elements: (a) how to put allowances into circulation (via auctions, free distributions, or some combination of the two); and (b) how to allocate free allowances or the revenues from permit auctions.

In making recommendations, the Advisory Committee must take account of various statutory objectives, among them to “ensure no disproportionate impact on low-income communities” and design the regulations “in a manner that is equitable, seeks to minimise costs and maximise the total benefits to California”. The draft recommendations therefore carry weight as an expert opinion of which system best meets both equity and efficiency criteria.


The Committee reviewed a range of auction designs (single or multiple rounds, uniform or discriminating price) as well as mechanisms for free distributions (fixed allocations based on historical emissions, or allocations updated in line with changes in relative output).

In the end it recommended all or almost all permits be sold through uniform price, single round (sealed bid) auctions. Permits would be given free only to energy-intensive and trade-exposed industries at risk of a real competitive disadvantage, and only where the problem of “emissions leakage” cannot be addressed by other means such as a border adjustment.
The Committee admitted free allocations have some advantages. They compensate emitters for compliance costs in the most direct and expedient manner.

Free allocation returns allowance values directly to emitters and links them to the cost of making reductions. If the cost of compliance rises, so does the value of the allowances.

An auction system can also provide compensation by distributing revenues. But it involves two steps (auctioning and revenue distribution) rather than one (simple allocation of free allowances). “Because the auction process involves two steps, [emitters] might feel that obtaining allowance value through the recycling of auction revenue carries greater risk than obtaining value in one step through the receipt of free allowances.”

In the end, the Committee decided auctions were superior because they bring “price discovery in the market and transparency in the assignment of allowance value”. They would also make it easier to deal with sources entering and exiting the market, creating a level playing field, and avoiding giving incumbents monopoly power. The Committee noted nearly every objective of free allocation can be achieved through an appropriate distribution of auction proceeds.

Its recommendations would establish the boldest environmental market yet. The Environmental Protection Agency’s (EPA) pioneering Acid Rain Program, which is often cited as a model for carbon markets, auctioned only a small number of allowances at first, distributing most to emitters on a historic basis.

The European Union’s Emissions Trading Scheme (ETS) has so far allocated more than 95 percent of allowances free, giving recipients massive windfall profits, though the share auctioned will rise sharply from 2013.


No one knows for certain how much revenue auctions would raise. Based on a literature review, the Committee indicates allowance prices “are most often estimated to be in the range of $20 to $60 per metric ton of emissions in 2020″ (in 2007 dollars). But it admits the full range is from $8 to $214 (depending on assumptions about the availability of offsets and other design features).

Under most scenarios, however, the programme will produce a substantial pool of revenues. Assuming real prices of $35 in 2020 (about the middle of the range) auction revenues would rise from $4.4 billion (2012) to $11 billion (2016) and $12.8 billion (2020).

The Committee examined three main options for using these revenues: (a) financing investments especially in clean technologies and to create jobs for disadvantaged communities; (b) returning the proceeds to the public through a rebate programme; (c) or cutting other state taxes.


There are complex legal issues surrounding how revenues from the programme may be used; the State Legislature may need to approve further changes to the law, possibly by a difficult-to-achieve two-thirds supermajority, to comply with the State Supreme Court’s ruling in “Sinclair Paint Co v State Board of Equalization”.

But abstracting from the legal problems, the Committee recommends foregoing a small share to give free allowances to firms at risk from leakage; placing another small share in a contingency fund for environmental remediation and clean up; and reserving another one to finance transfers to low income households most affected by rising energy prices.

The Committee cites estimates showing emissions pricing will be regressive, raising costs for households in the lowest income decile by 2.09 percent of their income, sliding to 0.66 percent of income for households in the highest category. Direct transfers to low income households would meet the statutory objective of avoiding a “disproportionate impact” on these communities.

But the lion’s share of auction revenues would be devoted to financing investments related to emissions reduction, or returned to households through lump-sum payments or cuts in individual income or states sales taxes. The proportions would vary over time; the Committee shows a strong preference for investments in the early years. Ultimately the Committee recommends distributing 75 percent of the revenues as rebates/tax cuts and 25 percent for investment projects.

The Committee specifically recommends against using proceeds to prop up profits in industries hit hardest by rising energy costs, or to subsidise rising electricity bills for businesses and households, to avoid blunting the incentive for curbing energy use and reducing emissions.

The Committee’s recommendations remain provisional and subject to change. There is no guarantee they will be adopted by CARB, and there are doubts about whether a trading programme will be introduced at all.
But this is a detailed report prepared under the direction of 16 influential experts and consultants from economics, finance and environmental policy; consummate insiders in the debate. The proposals therefore carry a lot of weight, adding intellectual respectability and political momentum to the cap and refund proposal at national level.

(1) EAAC Allocation Report
(2) EAAC Presentation

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