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.