California’s safest option for guarding against lawsuits over how it spends the billions anticipated from its landmark cap-and-trade program is to channel the auction revenue toward reducing greenhouse gas pollution and furthering the goals of its Global Warming Solutions Act (AB32), according to a recent analysis.

The conclusion by the UCLA School of Law’s Emmett Center on Climate Change and Environment may put the brakes on some of the wide-ranging suggestions for using the state’s fee revenue.

“Although the auctions are not primarily aimed at generating revenue, the amount of money at stake is significant, with projections on the order of a billion dollars in the program’s first year and anywhere from $2 billion to $10 billion annually or more as the program expands,” according to the paper entitled “Spending California’s Cap-And-Trade Auction Revenue: Understanding the Sinclair Paint Risk Spectrum.”

“As legislators, stakeholders and advocates develop their positions about how these monies should be spent, they may face legal constraints in determining how to allocate the proceeds generated from these auctions.”

The Emmett Center paper, which analyzes California’s constitutional restrictions on the use of regulatory fees as applied to AB 32 auction revenue, concludes the safest auction revenue proposals “from a litigation risk perspective” would be those receiving “yes” answers from the following questions:

  • Will the project permanently, verifiably reduce greenhouse gas emissions?
  • Will the project advance other explicit AB 32 goals, such as directing investment to disadvantaged communities, maximizing economic and environmental benefits, or allowing opportunities for community institutions to participate in and benefit from emissions reductions?
  • Has the state built a strong record showing how the revenue use will achieve the purposes of AB 32?
  • Does the project avoid direct allocation of money for revenue purposes unrelated to AB 32?

“The further the state strays from these principles in spending auction money, the more it risks a litigation loss that could set back its cap-and-trade program,” the study authors write.

AB 32 does not directly address how to use the auction revenue, and with California facing a $9 billion deficit, General Fund relief is among the proposals on the table, which also include providing backstop funding for the proposed high speed bullet train, job training, investment in technology research and development, infrastructure planning and construction, energy efficiency programs, consumer rebates, and numerous other areas.

The UCLA study identifies General Fund uses as particularly risky, concluding that it would be “high risk” to direct auction revenue toward augmenting the state’s General Fund without restrictions and notes that even if it is limited to pre-existing projects that reduce GHGs “courts have repeatedly flagged funneling revenue into the General Fund as indicative of a tax, not a fee, because the monies are being used for unrelated revenue purposes. It may be hard to overcome the sense that General Fund monies are fungible.”

The study says that a better approach would be to put the money in the separate Air Pollution Control Fund or to create a Greenhouse Gas Reduction Account, and shift payments for preexisting GHG projects over to this specialized fund.

The tax vs. fee issue is important because cap-and-trade opponents contend the program imposes an unlawful tax as AB 32 did not pass with the two-thirds supermajority required for tax increases in California. The paper notes such legal challenges will give rise to questions about the reach of the California Supreme Court’s landmark Sinclair Paint ruling, which established a charge could be a valid regulatory fee, not a tax, if it met certain criteria, such as “a causal connection or nexus between the product [regulated] and its adverse effects.”

While the Emmett study authors said they could not predict whether the courts would reach the same conclusion regarding cap-and-trade, the program does raise state money as part of a program to regulate and reduce pollution so “it is arguable that the cap-and-trade program imposes something akin to a regulatory fee.” 

California’s non-partisan Legislative Analyst’s Office (LAO), meanwhile, recently issued a report noting it had received an opinion from the state’s Office of Legislative Counsel that auction revenues would constitute mitigation fees subject to the Sinclair nexus test.

“Therefore, in order for their use to be valid as mitigation fees, revenues from the cap-and-trade auctions must be used only to mitigate GHG emissions or the harms caused by GHG emissions,” the LAO said, adding that it believes there may be only $100 million worth of such programs currently funded by the General Fund rather than the $500 million in savings assumed under the Governor’s budget. 

Under AB 32, California’s Air Resources Board (CARB) was directed to develop clean energy measures to return the state’s greenhouse gas emissions to 1990 levels by the year 2020. Integral to the larger strategy ARB developed is the nation’s first cap-and-trade program to limit GHG emissions from the industrial, utility and transportation fuel sectors, which together account for about 85% of California’s greenhouse gas pollution. (Read more about the design of the program here).

The program sets a “cap” on covered sectors’ aggregate carbon dioxide pollution, but allows individual firms to buy and sell (“trade”) pollution credits, known as “allowances,” in order to comply. The first of the state’s planned quarterly auctions is scheduled for November in advance of the program’s initial compliance phase in 2013. As the cap steadily declines, along with the number of allowances, the program will expand to about 350 businesses representing 600 mostly large industrial facilities that must reduce emissions or pay increasingly higher prices for allowances to account for their carbon pollution.