The first auction under California’s cap-and-trade program kicked off today as expected despite a last-minute lawsuit filed on the eve of the auction by the California Chamber of Commerce.

The Chamber of Commerce filed suit in state superior court in Sacramento alleging that the California Air Resources Board, known as CARB, lacks the authority to allocate percentages of each year’s allowances to itself (as opposed to private and public emitters of greenhouse gases) to sell at auction or reserve.

Each allowance permits a covered entity to emit one metric ton of greenhouse gases.

The Chamber of Commerce did not try to block the auction by asking for an injunction. However, the suit tries to invalidate the CARB auction regulations. According to the Chamber of Commerce, the underlying legislation, AB 32, setting up the cap-and-trade program requires that revenues from auctions of allowances be designated for use in regulating greenhouse gas emissions instead of being added to the general revenue. The Chamber of Commerce argues that, even if the court interprets the existing regulations to allow CARB to reserve allowances for sale and the state legislature to appropriate the collected revenue, those regulations violate the California Constitution as a tax that was not enacted by two-thirds vote of each house of the state legislature as required by the California constitution.

The cap-and-trade program caps the amount of CO2 and other greenhouse gases that power plants, refineries, chemical companies, cement plants and other affected emitters in California are allowed to release each year. Greenhouse gas emitters covered by the program are required to submit allowances for each metric ton of greenhouse gas emitted. The program is market based because anyone who can reduce his emissions more efficiently or less expensively can earn income by selling unneeded allowances to those whose emissions are harder or more expensive to control. As the cap on overall permitted emissions ratchets down over time, the value of the allowances is expected to rise and the overall level of greenhouse gases entering the atmosphere should fall.

The program also creates a domestic offset market. Covered entities can meet, or “offset,” up to 8% of their compliance obligations by surrendering valid greenhouse gas offset credits. An offset credit represents greenhouse gas emission reductions or sequestered carbon that meets certain regulatory criteria. To qualify under AB 32, the offset credits may only be obtained in three ways. First, certain “early action offset credits” generated between 2005 and 2014 pursuant to the protocols of the Climate Action Reserve may be converted into credits that CARB will issue. Second, CARB expects to issue its own offset protocols. Third, CARB expects to allow use of credits registered under some third-party offset project registries.

Initially the program covers only the power and manufacturing sectors (including refineries, but only for their “direct emissions”). By 2015, the program will expand eventually to reach 85% of the California economy, including not only electricity generation and manufacturing, but also such sources as refineries, pipelines and fuel distributors.

The program will also have an effect beyond California by imposing compliance obligations on emissions associated with electricity, natural gas and other fuels imported from other states into California. This is the first regulatory program to regulate suppliers of power and fuels in other states who sell into the California market.

The new rules cover “first deliverers of electricity,” who include not only in-state electricity generating facilities, but also “electricity importers.” “Electricity importers” are defined as “facilities physically located outside the state of California with the first point of interconnection to a California balancing authority’s transmission and distribution system.” Thus, even facilities located entirely outside California may be required to comply if their energy is sold in the state. California receives nearly a quarter of its power from out-of-state sources.

The program may also apply to out-of-state suppliers of natural gas and other fuels whose products sold in California reach an annual threshold of 25,000 metric tons or more of CO2-equivalent from emissions from combustion or oxidation of the fuels.

CARB included a number of provisions designed to limit wild swings in allowance prices and increase market stability. To prevent prices from falling too low, the early auctions will have a price floor of $10 per allowance, adjusted over time. Unsold allowances are returned to the state’s “auction holding account” and will be re-sold at later auctions, subject to the limitation that only 25% of an auction’s total volume may include such re-auctioned allowances.

To prevent prices from rising too high too quickly, initially most allowances beyond the share reserved and sold at auction by CARB will be given to covered entities for free. Over time, as auctions account for greater distribution of allowances, there will be an allowance price containment reserve. This reserve acts as a soft price collar by offering allowances for sale six weeks after each auction at set price tiers ranging from $40 to $50 a ton at first, adjusted over time.

Now that the Chamber of Commerce filed its lawsuit, there is more uncertainty about the program and many speculate that this first auction will have fewer participants than expected and the status of future auctions will remain unclear until this lawsuit is resolved. CARB will release statistics about the number of auction participants, the number of allowances sold and the settlement price on November 19, 2012.