California continues to blaze a climate change policy trail in pursuit of a state-of-the-art carbon pricing mechanism. Bill SB 775 (California Global Warming Solutions Act of 2006: Market-based Compliance Mechanisms) was introduced into the California Senate on May 2, 2017, and follows the introduction in February 2017 of SB 584 (which would require 100% of the state’s electricity to come from renewable sources by 2045) and the passage of SB 32 in 2016 (which, beyond the current emissions reduction target of returning to 1990 emission levels by 2020, mandates a reduction of an additional 40% in emissions by 2030). Although it was introduced with little fanfare, SB 775 is significant because if passed, the bill will overhaul California’s cap-and-trade system after 2020 when the current cap-and-trade program expires. The changes proposed by SB 775 are dramatic and would have implications for the cap-and-trade programs currently operating in both Québec and Ontario. Among the changes being considered:

  • A new start: California’s cap-and-trade program would be an entirely new trading system starting on January 1, 2021 with the issuance of new allowances, i.e. allowances and offsets from the current system would not be transferred over.
  • No free allowances: All allowances under the proposed new program would be auctioned, i.e. no allowances will be allocated for free. The cost of allowances would be contained by a price collar, which would establish both a price floor and ceiling (discussed in further detail below).
  • Prohibition on offsets: As currently proposed, the new cap-and-trade system will prohibit the use of offsets as a compliance mechanism.
  • Allocation of revenue: The bill proposes a broad revenue structure, with revenue to be allocated into three areas: (1) California Climate Dividend Program, which will rebate revenue on a per-capita basis (in addition, a Climate Dividend Access Board will be established to work with low-income groups to ensure that dividends are delivered to those in vulnerable communities); (2) public infrastructure investments and investments in disadvantaged communities; and (3) climate and clean energy research and development. Further details around the allocation of revenue are expected to be developed during the legislative process.
  • Linking: The new cap-and-trade program will not link to any other jurisdiction until such jurisdiction has a minimum carbon price that is equal to or greater than California’s and the governor is satisfied that the linkage will not adversely impact California dividends.
  • Border adjustment tax: In order to address carbon leakage, the new cap-and-trade program would levy a border adjustment tax on imports based on their carbon intensity. The border adjustment tax would be administered by a newly created Economic Competitiveness Assurance Program, which would be given a mandate of ensuring that in-state industry is not unduly impacted by California’s carbon pricing regime. In the event that a border adjustment tax is reduced or eliminated following a legal decision, SB 775 provides a safety net for California businesses in the form of free allowances, which would be made available to eligible entities for the purpose of maintaining economic parity between producers of carbon intensive goods that are subject to the cap-and-trade system and those who produce or sell similar products that are not.
  • No statutory time limit on program: The proposed cap-and-trade program is designed to operate in perpetuity, meaning that it will not need to be reauthorized at a later date.

Current State of Affairs

By setting ambitious emission reduction targets, California has raised its game on climate change policy. As a result, California will need to dig deeper and ensure that innovative climate change policies are in place so it can meet its climate goals. In 2006, under then Governor Arnold Schwarzenegger, California introduced AB 32, the state’s groundbreaking climate change law, which established the current emission reduction target of 1990 levels by 2020 and gave the California Air Resources Board (CARB) power to develop the necessary tools to achieve this target. In partnership with various state agencies, CARB has since overseen the implementation of a number of climate policies, including the cap-and-trade program, low carbon fuel standard (LCFS), efficiency standards, renewable energy portfolio standard and other emission reduction initiatives.

From the outset, the cap-and-trade program was expected to play a small role in the state’s emission reduction efforts; the majority of emissions were expected to come from the LCFS, energy efficiency and other initiatives. To date, regulations have been quite effective in reducing California’s emissions, so the state is on track to meet its 2020 target (as indicated by CARB). Since regulations have been driving meaningful emission reductions in the state, the value of the cap-and-trade program has come under scrutiny. The perceived weaknesses of the cap-and-trade program (which range from the low pricing of allowances and resulting low level of revenues, to claims of carbon leakage and the political and legal challenges in extending the program beyond 2020) are the main driver for creating a new, politically viable, cap-and-trade system. Under SB 775, the new cap-and-trade system is being envisioned as the primary tool for reducing emissions in the state, particularly now that the low-hanging emission reductions have been achieved through regulations.

The Art of Carbon Pricing

As noted above, all allowances in the new system would be auctioned and none would be allocated for free. This would aim to address the oversupply and low pricing of allowances. In 2021, the price floor would begin at US $20 with a price ceiling of US $30 (the initial auction price will be set at US $30 per allowance). Both will rise in fixed increments, although at different rates. In particular, the price ceiling would rise at US $10 per year, plus inflation. The price floor would rise at $5 per year, plus inflation. The price floor is designed to increase after a one-year delay in order to provide a US $20 per tonne of carbon dioxide equivalent (CO2e) spread between the floor and ceiling after one year of market operation and a US $60 per tonne of CO2e spread between the floor and ceiling in 2030. The price collar will keep the cost of allowances within a smaller range at first (in order to allow businesses and consumers to adjust to the system), while gradually increasing the price range over time. It should be noted that the proposed program will operate in perpetuity, meaning that the price ceiling could continue to increase to over US $300 by 2050 in the absence of changes to the program.

Keeping Up With the Joneses

Since 2014, California’s cap-and-trade program has been linked to the one in Québec and Ontario is expected to link to both California and Québec’s cap-and-trade programs in 2018. If California’s new cap-and-trade program proceeds as currently envisioned under SB 775, any jurisdiction looking to link with California will first need to match the state’s level of carbon pricing. As a result, Québec and Ontario may have little incentive to link to California post-2020, since California’s minimum carbon price in 2021 will already be close to or exceed the carbon pricing requirements of the Canadian federal government (starting in 2018, provinces and territories are expected to implement a carbon price of CAD $10, which will increase by $10 per year until it reaches CAD $50 in 2022). With a key North American carbon market player steaming ahead on its own, the passage of SB 775 may incentivize other jurisdictions to consider implementing a carbon tax rather than cap-and-trade. That said, SB 775 has a number of hurdles to clear before it is passed into law. SB 775 will now go to the Committee on Environmental Quality and then on the state Senate, after which it will be sent to the state Assembly before it is sent back fro reconciliation. California governor Jerry Brown has asked for cap-and-trade reauthorization by July 2017.