Did the Air Resources Board just approve an illegal regulation while transferring hundreds of millions of dollars to the oil industry?

Last week the California Air Resources Board (ARB) held a board meeting to discuss the future of California’s cap-and-trade program. By a voice vote, the Board approved Resolution 17-21, a far-reaching directive that extended California’s cap-and-trade program. It also set up a process for sending hundreds of millions of dollars to the oil industry—above and beyond what policymakers agreed to in AB 398, a bill with major concessions that some environmental groups labeled a “bitter pill” necessary to secure its passage.

Given that Governor Brown just signed AB 398 into law to provide ARB with the authority to continue its cap-and-trade program through 2030, one might think that Resolution 17-21 is the next obvious step. But AB 398 doesn’t hand ARB a blank check to do as the board wishes. Rather, AB 398 requires that if ARB adopts a cap-and-trade program that applies after 2020, then that program must reflect the changed market design that the bill’s supporters negotiated over the last few months.

Here’s what AB 398 says in modifying Cal. Health & Safety Code § 38562(c)(2):

The state board may adopt a regulation that establishes a system of market-based declining annual aggregate emissions limits for sources or categories of sources that emit greenhouse gases, applicable from January 1, 2012, to December 31, 2030, inclusive, that the state board determines will achieve the maximum technologically feasible and cost-effective reductions in greenhouse gas emissions, in the aggregate, from those sources or categories of sources. In adopting a regulation applicable from January 1, 2021, to December 31, 2030, inclusive, pursuant to this subdivision, the state board shall do all of the following: […] (Emphasis added.)

The provisions that follow describe the new market design features required by AB 398: reduced carbon offset limits, a hard price ceiling, and so-called price containment points, to name only a few changes the new state law requires in any post-2020 cap-and-trade regulation. ARB’s current market design lacks these features and is inconsistent with the plain text of the new statute, which is why it can’t be adopted without reform to apply to the post-2020 period.

Nevertheless, ARB appears to have ignored the clear direction of the legislature and adopted a regulation it had proposed in August 2016—well before AB 398—that retains the current market design without the modifications required by AB 398. At last week’s Board meeting, ARB staff and board members correctly indicated that a future rulemaking would be needed to comply with AB 398. That didn’t stop the board, however, from approving a regulation that appears to violate the new statute, not merely to defer its proper execution to a later date. Indeed, the official agenda notice for last week’s board meeting explicitly included a mandate to adopt a post-2020 regulation, apparently in violation of AB 398:

The Board will consider approving proposed amendments to the Cap-and-Trade Regulation. The proposed amendments would enhance current Program implementation and oversight; link the Program with the Ontario, Canada program; and provide that the Program extends beyond 2020. (Emphasis added.)

I say that the outcome appears to violate the statute because no one actually knows for sure. Neither Resolution 17-21 nor the final regulation it purportedly approved is available online. You can watch video of the board meeting and hear the unanimous voice vote approving Resolution 17-21, but as of this writing, you won’t find the resolution or final regulation on ARB’s website.

A rushed process

It’s clear that something was approved, but what? Per an advance copy of the proposed version of Resolution 17-21:

BE IT FURTHER RESOLVED that the Board adopts the amendments to the California Cap on Greenhouse Gas Emissions and Market-Based Compliance Mechanisms set forth in Attachment A to this Resolution.

Yesterday I spoke by phone with ARB’s Clerk of the Board, who helpfully informed me that Resolution 17-21 is still being finalized, presumably as a result of an oral amendment introduced during the board’s deliberations last week. It will be posted online when that process is complete. The entire regulatory package is subject to an August 4 deadline as imposed by the Office of Administrative Law (OAL), so the public will learn soon enough what just happened. When I asked whether ARB would publish the attachments to Resolution 17-21—including the final regulation order that was approved last week—the clerk said that they were already online. However, we confirmed together that in fact these documents were not online. The clerk promised to upload them soon. 

If ARB adopted a regulation—as the proposed text of Resolution 17-21 suggests—then one of two things appears to have happened:

  • If the regulation applies in the period 2021-2030, it must comply with the provisions of AB 398. Given that ARB’s proposed post-2020 cap-and-trade regulation did not include the market design changes required by AB 398, any decision to adopt the current market design into the post-2020 period is inconsistent with the legislature’s clear directive in AB 398.
     
  • Alternatively, perhaps the new regulations apply only to the pre-2020 period, during which time ARB retains discretion in implementing the requirements of AB 32. In that case, however, one might question the adequacy of the public process. The proposed regulation before the board last week would have extended the cap-and-trade program through 2031, so it would have needed to be modified in order to limit its temporal scope; yet if it were modified to avoid inconsistency with AB 398, there was no public notice of that change and no opportunity for public comment, contrary to the basic principles of state administrative law.

Until ARB releases text of Resolution 17-21 and the final regulation it approved, however, public stakeholders cannot verify whether or not ARB respected public notice and comment process requirements or the requirements of AB 398.

Another $300 million windfall to the refining industry

Meanwhile, buried in last week’s deliberations and the text of Resolution 17-21 is another handout to the fossil fuel industry, which successfully negotiated a significant transfer of wealth under AB 398 earlier this summer.

Under AB 32, ARB is required to “minimize leakage” of emissions (H&S Code § 38562(b)(8)). In the cap-and-trade program, ARB minimizes leakage from energy-intensive, trade-exposed industries (EITIs) by providing free allocation of allowances to certain industries, which are classified as high, medium, or low leakage risk. Free allocation starts at generous levels in the first (2013-14) and second (2015-17) compliance periods, but under the regulations that applied as of last week, was set to step down in the third compliance period (2018-2020) for medium and low risk industries (see Table 8-1 on page 144 of the current market rules).

The complete formulas are somewhat complicated, but all one needs to understand the deal given to industry in AB 398 and Resolution 17-21 is that the level of free allocation is multiplied by a so-called industry assistance factor (IAF). Currently, all industries receive a 100% IAF. Beginning in 2018, however, medium and low risk industries are scheduled instead to receive a 75% IAF—a 25% reduction from current levels. These planned reductions are based on careful studies conducted by ARB and external experts that concluded perpetual free allocation at a 100% IAF was not necessary to protect against leakage. Indeed, ARB had initially considered reducing the IAFs to much lower levels for some industries in the post-2020 period, perhaps as low as 44% for oil refiners (see Table 8-3 on page 169 of the December 2016 NODA).

The biggest giveaway to industry in AB 398 is the requirement that ARB retain the IAFs applicable in the second compliance period for the entire market in 2021 through 2030. In other words, beginning in 2021, ARB must roll back the scheduled reductions in free allocations and give industry a 100% IAF, no matter whether or not these generous levels are actually necessary to protect against leakage. Here’s AB 398 again (see H&S Code § 38562(c)(2)(G)), which requires ARB to:

Set industry assistance factors for allowance allocation commencing in 2021 at the levels applicable in the compliance period of 2015 to 2017, inclusive. The state board shall apply a declining cap adjustment factor to the industry allocation equivalent to the overall statewide emissions declining cap using the methodology from the compliance period of 2015 to 2017, inclusive. (Emphasis added.)

Now don’t get me wrong: leakage is a legitimate risk that requires an effective solution. Many of California’s industries could be put at a disadvantage relative to their competitors who don’t face a carbon price. That could lead to lower economic growth, job loss, and leakage of emissions as California consumers buy more products produced outside the reach of the state carbon pricing policy. But don’t be confused about how free allocation operates in practice. The oil and gas industry received 72% of the free allowances given to EITIs in 2016—about 50% to the midstream refining industry and another 22% to upstream oil and gas producers. That means that only 28% of the free allowances given to industry went to the kinds of firms most people think of when they worry about competitiveness and leakage—manufacturers, dairies, and food processing industries.

Where AB 398 requires ARB to perpetuate generous levels of free allocation—worth many billions of dollars over the next decade—its predecessor, AB 32, gave ARB discretion to set free allocation levels in the pre-2020 period using evidence-based decision-making. Instead of relying on the expert judgment of staff analysis and outside experts, however, ARB last week directed staff to propose regulations to increase the IAFs to 100% in the third compliance period without any reasoning whatsoever:

BE IT FURTHER RESOLVED that the Board directs the Executive Officer to propose subsequent regulatory amendments to provide a quantity of allocation, for the purposes of minimizing emissions leakage, to industrial entities for 2018 through 2020 by using the same assistance factors in place for 2013 through 2017.

Let me be crystal clear on this point. ARB is now required under AB 398 to hand out a massive number of free allowances to the oil and gas industry from 2021-2030, a concession that industry extracted from the Brown Administration in exchange for a 2/3 vote on cap-and-trade. That was a political deal—the “bitter pill”—and now it’s the law. But by law ARB is also required to exercise its independent judgment about how many free allowances are needed to protect against leakage risks in the three years leading up to AB 398’s new market era. Instead of exercising that judgment, however, ARB instructed its staff to achieve a pre-determined political outcome that transfers public wealth to special interests.

So what’s the cost of ARB’s new handout? Let’s take a look at the refining industry, which received 50% of the free allocations in 2016. The refining industry is classified as a medium risk industry, which means it is scheduled to receive a 75% IAF in 2018-2020, instead of the 100% IAF it receives today. Resolution 17-21 would increase the IAF to 100% in 2018-2020. For simplicity I will assume that refinery production remains constant at 2016 levels over the 2018-2020 period, while accounting for the declining cap adjustment factor, such that I vary only the industry assistance factor to illustrate the differences.

Extra free allowances given to refineries under ARB Resolution 17-21

Extra free allowances given to refineries under ARB Resolution 17-21

Bottom line: Resolution 17-21 would give the refining industry an extra $300 million over three years, resulting in significantly more free allocation than what ARB staff and outside experts concluded was necessary to satisfy the requirements of AB 32 and protect California businesses against leakage. That money that could instead be going to the unfunded AB 617 local air pollution mandates, returned to California taxpayers via climate rebates, or spent on infrastructure that creates public value. Instead, it’s going to the refining industry via a side deal. One has to wonder: when it comes to important decisions at ARB, do special interests call the shots?

An inauspicious beginning

ARB’s side deal with the oil industry is cause for concern because AB 398 delegates most key market design questions to ARB. This means that whether the program delivers on its environmental goals or not depends on how ARB implements a very flexible statutory framework. Unfortunately, last week's resolution is not a good sign. 

Perhaps the most important issue in the AB 398 implementation process is ARB’s oversupply problem: there are far too many allowances in circulation, which is why the 2016 auctions crashed and the independent Legislative Analyst’s Office concluded that the program is “likely not having much, if any, effect on overall emissions” so far. Getting rid of market oversupply will be necessary if the program is going to deliver on the state's 2030 climate goals. 

Instead of requiring ARB to eliminate market oversupply—such that emissions actually fall in line with the state’s climate goals, with the program serving as a “backstop” per the standard line from some national environmental groups—AB 398 merely directs ARB to “[e]valuate and address concerns related to overallocation … as appropriate” (H&S Code § 38562(c)(2)(D)). You can imagine what ARB will determine is “appropriate” if they ask the oil industry for the answer. It certainly won’t be a backstop that delivers on California's climate targets.

To my friends who supported AB 398, I have to ask: how big will that bitter pill get before you have trouble swallowing? For all of the talk of how AB 398 offers a framework that can be improved over time—and in theory, it does—this episode is not a great start.

We can and we must do better.

Update (Aug. 16, 2017): 

ARB Resolution 17-21 and the post-2020 cap-and-trade regulations are now online. The post-2020 cap-and-trade regulations do not account for AB 398, as suggested in my original post above, but will instead be modified by a future rulemaking. 

Hot air and offsets in California's post-2020 carbon market

California policymakers need to carefully balance supply and demand in a post-2020 carbon market in order to address cost containment and environmental outcomes at the same time. Two critical issues are (1) what to do with the significant supply of excess allowances in the pre-2020 system and (2) what role carbon offsets should play in the post-2020 program.

To explain these concepts and provide quantitative context for their impact on market design, I prepared a short policy brief. Both offsets and excess allowances have the potential to independently overwhelm the supply/demand balance in the post-2020 period and therefore require careful study. 

Supply of carbon offsets, pre-2020 hot air allowances, and post-2020 demand Units: million compliance instruments (MMtCO2e)

Supply of carbon offsets, pre-2020 hot air allowances, and post-2020 demand

Units: million compliance instruments (MMtCO2e)

Allowing covered entities to use today's oversupplied allowances in tomorrow's program introduces the problem of "hot air": because these excess permits aren't needed with emissions today falling below program caps, their future use increases total emissions. If allowed, these allowances would enable covered entities to comply with the program on paper without actually reducing their emissions—hence the term "hot air." Unfortunately, the estimated size of current market oversupply is comparable to the role ARB projects for the post-2020 cap-and-trade program. 

Carbon offsets generate credits for emission reductions that take place outside of the cap-and-trade program. At current limits—8% of total emissions—offsets could generate more credits in the post-2020 program than ARB projects the cap-and-trade program will need to deliver. 

As an aside, ARB assumes perfect foresight in its calculations of the emission reductions required to reach the SB 32 target for 2030 and in the role cap-and-trade will need to play in achieving those reductions. This is not the right way to think about a fundamentally uncertain future; we could need significantly more or less mitigation depending on economic growth, oil prices, technological change, and a host of other factors we can't know in advance. For the purposes of illustrating the importance of hot air and carbon offsets, however, it is reasonable to compare the size of these two issues against ARB's calculations. 

Linking, Banking, and Offsets

As the California climate policy conversation begins to focus on the design of a post-2020 carbon market, one of the issues that has drawn the most criticism—and frankly, the most inaccurate criticism—is how SB 775 contemplates California's approach to linking its carbon market with similar programs in other jurisdictions.

Critics have alleged that SB 775 makes it impossible for California to develop new market links, typically with an argument in one of three flavors:

  • Linking. Some have suggested that SB 775’s new requirements for linking are unduly burdensome and would frustrate future market links.
  • Banking. Some have argued that SB 775’s limited banking provisions render its market design incompatible with other jurisdictions’ choices.
  • Offsets. Because SB 775 prohibits carbon offsets in the post-2020 market, others have suggested this makes it impossible to link with other jurisdictions that don’t ban offsets.

Each of these concerns is misplaced, as I’ll explain below. I agree with constructive critics that the conversation around banking merits additional discussion; even though I don’t believe the current proposal would complicate future market links, any independent movement on the banking conversation will make linking even easier than what is presently contained in SB 775.

Contrary to critics’ claims, SB 775 proposes a market that is just as open to new market links as the current program. 

Linking

California’s carbon market is currently linked to a similar but smaller market in Québec, and Governor Brown recently made the necessary findings to begin a market link with another program in Ontario. Notably, however, neither of these jurisdictions has a post-2020 carbon market at this time—and nor does California. 

SB 775 would create a new trading program in the post-2020 period that does not begin as linked to any external market. This is a sensible starting position because nobody actually has a post-2020 market to link to at this time. Nevertheless, SB 775 remains open to future market links. The proposal would require new conditions on links to protect the political sustainability of the new market design, building on existing rules governing market links.  

Current state law requires the Governor to make four affirmative findings before the Air Resources Board is allowed to finalize regulations to link its carbon market to an external program. These requirements were established by SB 1018 in 2012 and are codified in California Government Code § 12894.

SB 775 would leave these standards in place and require the Governor to make two additional findings:

  • First, that the prospective linked market has minimum carbon prices that are equal to or greater than those in the California market.
  • Second, that the prospective market link wouldn’t threaten the performance or purpose of the climate dividend established by SB 775.

These new conditions clarify the general requirement under SB 1018 that the prospective linked program have program requirements that are “equivalent to or stricter than” California’s system (Cal. Gov. Code § 12894(f)(1)). In essence, the new requirements merely ask the Governor to confirm that the revenue recycling provisions in SB 775 aren’t disrupted because the Air Resources Board decides to link with an external jurisdiction with much lower market prices. In that instance, significant revenue could flow from regulated companies in California to out-of-state actors, rather than back to California residents via the dividend.

If Québec, Ontario, or other jurisdictions adopt comparable minimum carbon pricing trajectories, SB 775 would enable the Air Resources Board to link its post-2020 market to these external programs. Again, however, none of these governments has established a post-2020 market.

If California policymakers have signaled to the state’s partners that the current market design will continue without modification, they have erred: AB 32 clearly does not provide the authority to continue the program without legislative re-authorization. Thus, the question of whether or not there will be a carbon market in California depends on the legislature providing the Air Resources Board with that authority. There will be no links without a new bill. As the first comprehensive proposal designed to deal with practical political constraints in the legislature, SB 775 provides a clear path for future market links, including continued market links with our current linked partner, Québec, and with our proposed linking partner, Ontario.

SB 775's new linking requirements are clarifications of the existing rules as those rules would apply in the context of the post-2020 market design. In other words, SB 775 is a step forward for those who want to see continued market links, not the end of the line.

Banking

SB 775 has limited banking provisions in the post-2020 period, requiring regulated entities to demonstrate compliance every year and limiting the compliance validity of allowances to the year in which they are sold at auction. This limited banking is a departure from the current market, which features unlimited banking. Although no one has specified exactly how these changes would pose a problem to market links, some respected voices—like Resources for the Future's Dr. Dallas Burtraw—have criticized SB 775’s banking provisions as posing a potential barrier to future market links.

Personally, I am not convinced that limited banking provisions are a barrier because there is no reason a program along the lines of SB 775 couldn’t be linked with an external market that features unlimited banking. But in any case, the reason for limited banking in SB 775 is to address a key challenge that follows from the inclusion of a rapidly rising price ceiling, and that problem needs to be managed independent from the linking process.

With a hard price ceiling, the regulator is obliged to issue unlimited permits at a specified carbon price—in this case, the world’s most ambitious carbon trajectory, not some modest safety valve that excuses industry from the program.

A price ceiling is necessary to contain costs and provide certainty that the Governor won’t face political pressure to suspend the program, as is his or her right under current law (Cal. Health & Safety Code § 38599). But it also poses a problem: if companies can buy unlimited allowances at a price ceiling that rises rapidly every year, they will have an incentive to buy extra allowances in the early years (at low prices) and bank these allowances for use in later years (at high prices). In this case, companies could effectively avoid the rising carbon price and therefore frustrate the core purpose of the program—producing a credible incentive to reduce climate pollution.

To date, there has been precious little discussion of how to manage the negative consequences of unlimited banking under a rising price ceiling. After the release of SB 775, however, some thoughtful economists have begun to share ideas on how this problem could be overcome—including Dr. Burtraw. I am optimistic that this technical conversation will bear fruit and could potentially allow the legislature accomplish its goals under a less restrictive banking rule.

Again, the SB 775 market design not require other markets to copy its banking rules as a precondition of linking. It is entirely possible to link a program with limited banking to a program that has unlimited banking, so critics' concerns are misplaced. As a result, SB 775 has no impact on the choices other jurisdictions make with respect to their domestic market rules on banking. 

And even if I am wrong, there remains room to solve the underlying problem of how to control the negative consequences of banking under a rising price ceiling. If that conversation proceeds, it could have the effect of removing any hypothetical barrier to future market links.

Offsets

Finally, I want to address a common misconception about SB 775’s prohibition on the use of controversial carbon offsets in the post-2020 period. Some have suggested that this prohibition would block California’s ability to link with markets that retain some use of carbon offsets. But this is neither the purpose of SB 775 nor the actual requirement of the proposal.

Those expressing this concern are presumably referring to one of the findings the Governor must make under SB 1018 before affecting a new market link:

The jurisdiction with which the state agency proposes to link has adopted program requirements for greenhouse gas reductions, including, but not limited to, requirements for offsets, that are equivalent to or stricter than those required by Division 25.5 (commencing with Section 38500) of the Health and Safety Code. (Cal. Gov. Code § 12894(f)(1).)

It could be argued that because SB 775 bans offsets, the Governor would be unable to make this finding where a proposed linking partner allows for carbon offsets. In this case, one might argue that the proposed linking partner does not have offset requirements that are "equivalent to or stricter than" California's. In legal terms, however, this argument is wrong for two reasons.

First, the more appropriate reading of the current linking standards is to compare the provisions governing the standards that would apply to carbon offsets under state law. In his findings approving market links with Québec and Ontario, Governor Brown compared these program’s offsets standards to California’s own requirements that market-based measures like carbon offsets produce emission reductions that are “real, permanent, quantifiable, verifiable, and enforceable” (Cal. Health & Safety Code § 38562(d)(1)) (see findings here and here).

Under SB 775, a future Governor could approve market links to programs that include carbon offsets using a similar comparison. Current law requires our partners to maintain minimum carbon offset standards, and that is good policy. Any post-2020 carbon market should maintain this standard even if it precludes the use of these instruments for compliance in California. After all, the environmental integrity of each linked market affects that of all others, so minimum standards will always be required to continue market links.  

Second, it is important to recognize that the SB 1018 linkage findings are not judicially reviewable (Cal. Gov. Code § 12894(g)). In other words, the only recourse for someone who disputes the Governor’s findings is through the political process, not the courts. A court cannot and will not review the Governor’s standards, which gives the Governor significant leeway in interpreting the linking requirements.

As a result, SB 775 should not be read to preclude market links with jurisdictions that retain the use of responsible carbon offsets. In my view the bill would benefit from an amendment to clarify this outcome, but in any case, nothing about current state law or its proposed modification under SB 775 would prohibit market links with jurisdictions that retain the well regulated use of carbon offsets.

Conclusion

Contrary to some concerns, SB 775 does not frustrate the prospect of future carbon market links. In fact, it is a step forward because future links are possible if and only if the legislature re-authorizes cap-and-trade with a 2/3 vote.

Under SB 775, jurisdictions that match California’s climate ambitions are welcome to join the new trading period. The state’s partners would remain free to choose their own market designs as they see fit—including on banking and carbon offsets. Governor Brown has already concluded that the market designs in Québec and Ontario are consistent with California standards in terms of their minimum treatment of offsets; he or his successor would presumably do so again.