Cap-and-trade appears to be dead for now at the federal level but it is alive and well in California. Under California’s landmark Global Warming Solutions Act (AB 32), California has committed to reducing greenhouse gas (GHG) emissions to 1990 levels by 2020. Cap-and-trade is one of the key measures that California will use to achieve that goal.

Under regulations proposed by the Air Resources Board (ARB) today, the proposed cap-and-trade program would cap GHG emissions from the largest sources and allow trading of allowances in an attempt to minimize compliance costs. Due to the deadlines imposed by AB 32, the proposed regulations are scheduled for adoption at a December 16 Board hearing and will go into effect in 2012.

The cap-and-trade program will cover the major sources of GHG emissions in the state, including refineries and power plants, large industrial facilities, and transportation fuels. Beginning in 2012, the program will impose an enforceable emissions cap on the electrical sector and large industrial sources (over 25,000 MT CO2e/year). In 2015 the cap will be expanded to include transportation fuels and natural gas distributors, among others, regulating not only small industrial users but commercial and residential customers as well. Each year, the cap for the covered sectors will decline.

The State will distribute allowances, which are tradable permits, equal to the year’s cap. An allowance will be equal to one metric ton of CO2 equivalent or MTCO2e. Individual facilities will receive a share of their sector’s cap in the form of allowances. In addition to the allowances received from the state, covered entities will be able to buy allowances at auction, purchase allowances from others, or purchase offset credits.

In the early stage of the program, the ARB is proposing that most allowances will be distributed for free to provide what they hope will be a smooth transition into the program. The ARB has stated that “transition assistance provides free allocation to the industrial sector at the outset of the program to avoid sudden or undue short-term economic impacts and promote a transition to a low-carbon economy.”

The amount of allowances distributed to each facility will be determined following program adoption and the allowances may not be equal to an individual facility’s current CO2 emissions. The details regarding the distribution of allowances to individual facilities are likely to be among the most controversial aspects of the proposed regulation. ARB has stated that the allowances “will be based on an emissions efficiency benchmarking approach. Under this approach, more efficient facilities will receive a greater amount of free allowances relative to their actual emissions.” Proposed efficiency benchmarks for each sector are described in the regulation.

It is extremely important to California’s economy that the ARB gets this program right. California businesses are already deeply concerned with their ability to compete with rivals in states with lower energy costs. This concern has lead to a ballot proposition designed to postpone implementation of AB 32 until the economy improves. Limited polling appears to show the ballot measure headed for defeat. If defeated, AB 32 and the other GHG reducing measures adopted by the state will further increase the already higher costs of electricity, natural gas and transportation fuels paid by California businesses. While some cost savings will undoubtedly be realized from greater energy efficiency, for some businesses it may not be possible to remain competitive. Such companies may be forced to leave the state.

The ARB is keenly aware of this issue and has proposed a number of ways to minimize what they refer to as “leakage” or production shifts from California to other states. That is one of the major reasons they are proposing free allocation of allowances for most industries in the early years (over the vehement objections of the environmental community) and why they believe linkage to other state programs and provisions for allowing the use of offsets are essential to minimize leakage. They have said that “for as long as ARB assesses that the risk of leakage persists, allowances will be allocated for free to those at risk”. However, it is very clear that the ARB intends the amount of free allowances to decrease over time and that many companies will be required to pay for some of all of their allowances in the future.

One big issue to be resolved is what will be done with the money generated by auctioning allowances. The staff report states that “some allowances will be auctioned directly by ARB; the proceeds will be placed into the Air Pollution Control Fund and made available for appropriation by the Governor and the Legislature for the purposes outlined in AB 32. How the Governor and Legislature apportion this portion of total allowance value will be important to the legacy of the cap-and-trade program. Staff recommends that these revenues be used primarily for the protection of California’s consumers and to further the goals of AB 32.” Given California’s on-going budget issues, ARB appears to be rightly concerned about this issue.