Other Legal Issues
SCPPA argues that the deliverer approach is inconsistent with the legislative intent expressed in AB 32. More specifically SCPPA refers to Health & Safety Code § 38530, contained in Part 2 of AB 32 dealing with GHG reporting and provides in pertinent part:
38530. (a) On or before January 1, 2008, the state board [ARB] shall adopt regulations to require the reporting and verification of statewide greenhouse gas emissions and to monitor and enforce compliance with this program.
(b) The regulations shall do all of the following:
. . .
(2) Account for greenhouse gas emissions from all electricity consumed in the state, including transmission and distribution line losses from electricity generated within the state or imported from outside the state. This requirement applies to all retail sellers of electricity, including load-serving entities as defined in subdivision (j) of Section 380 of the Public Utilities Code and local publicly owned electric utilities as defined in Section 9604 of the Public Utilities Code.
ARB has already adopted these regulations, and they do provide for reporting by all load-serving entities and local publicly owned utilities. We are now in the process of recommending to ARB how it ought to implement a different portion of AB 32, Part 4 of AB 32 dealing with GHG reductions. The fact that the Legislature required reporting by retail providers does not mean that retail providers must be the point of regulation for achieving the required reductions in GHG emissions.31
As described in the preceding subsections, the deliverer point of regulation best meets the first four criteria that we find to be most important. We also find that the deliverer method can be supported on legal grounds. For these reasons, we choose the deliverer point of regulation as the recommended approach for a GHG cap-and-trade program as it applies to the electricity sector.
3.4. Allowance Distribution in a Cap-and-Trade System with Deliverer Point of Regulation
Because we recommend a deliverer-based point of regulation, in this section we limit our consideration of methods for distributing GHG emission allowances to those that are appropriate for a deliverer system.
Under a cap-and-trade system, two basic options exist for distribution of emission allowances: they may be auctioned or they may be allocated administratively. A third option is some combination of the two, whereby some emission allowances are auctioned and the rest allocated administratively. There may also be a transition from predominantly administrative allocations to greater reliance on auctions.
In addition to considering the method for distributing emission allowances, we also address the manner in which auction proceeds should be used and the manner in which any free allowances should be allocated.
Parties that favor auctions submit that, because auctions should create a least-cost, multi-sector clearing price, they should reduce the societal cost of avoiding environmental damage while rewarding early action. These parties assert variously that auctions would allow new suppliers to enter the market (AES); avoid the windfall profits to historical emitters seen in the European Union (CPC, DRA); promote allowance market liquidity (Morgan Stanley); provide revenues to invest in further carbon reductions or to compensate consumers (CPC, DRA, TURN, NRDC/UCS); set a precedent for a national auction policy that would benefit California with its lower carbon footprint (NRDC/UCS); and change the relative prices among higher- and lower-GHG emitting power plants and technologies, thus advantaging cleaner plants and technologies (TURN). Other arguments include that auctions would be simpler than an administrative allocation scheme; that auctions would reward early adoption through the market mechanism while avoiding the need to determine administrative credits for early adopters; and that auctioning emissions allowances would follow the basic environmental principle of "polluter pays" (TURN).
Most parties that support auctions recommend some form of transition from predominantly administrative allocations to greater reliance on auctions as California gains experience with an auction methodology. In their view, such a transition over a period of time would better allow entities to deal with legacy contracts, recover existing investments, and determine their best emission reduction options (AES, IEP, DRA, WPTF, AREM).
Among parties that oppose auctions, some claim that they or their customers would suffer from facing the full and uncertain cost of auctioned allowances or that system reliability would suffer if producers fail to invest in generation for California (Calpine, EPUC/CAC, LADWP). Other parties are concerned that sole or heavy reliance on auctions is untested and that the State lacks experience to administer auctions (Calpine, El Paso, EPUC/CAC). Dynegy opposes auctions due to the mixed nature of the California market and argues that, if auctions are chosen, they should be used only for regulated entities. Calpine argues that auctions would increase volatility in the short term because there are few options to lower carbon through retrofit investments and generators would have no basis on which to set bids. Some parties are concerned that auction proceeds might be used for some purpose other than benefiting electricity ratepayers. NCPA submits that, without return of revenues, customers would have to pay both for the allocations and for the future emission reductions required to avoid buying additional allowances. While most parties appear to believe that ARB has the legal authority to require auctions, some contest ARB's ability to auction emission allowances without new State law (LADWP, SCPPA, EPUC, El Paso, PG&E).
An important issue regarding auctions is what to do with the proceeds. SDG&E/SoCalGas recommend that, if auctions are used, proceeds should benefit customers by being used for cost-effective contributions to climate change mitigation, or should be used to offset price impacts to price-regulated entities and their customers and to entities subject to competition from uncapped entities. NRDC/UCS state that auction proceeds should be returned to the electricity sector and used in the public interest and to further the goals of AB 32. NCPA recommends that revenues be returned to electric retail providers that will bear the costs of emissions reduction programs.
All parties, including those that support auctions, are in agreement that there are many difficult issues in designing an effective, transparent, and enforceable auction process. Several recommend that the State hire experts on auction design for assistance in developing the best auction mechanism for California.
The alternative to selling emission allowances through auction is administrative allocation, either to deliverers or potentially to other entities such as retail providers. Emission allowances could be allocated free of charge, or rights to purchase allowances at a set fee could be distributed. Some parties believe that deliverer-based systems should rely exclusively on auctions and, therefore, limit their recommendations regarding administrative distributions to their use in retail provider-based systems.
EPUC/CAC support administrative distribution and strongly oppose full auction. Caithness and Dynegy favor administrative distribution of allowances to those who will need them based on historical emissions. They argue that this approach is appropriate because it would take years to recover current investment costs. Calpine favors an administrative, output-based, updated method of allocation regardless of the point of regulation. WPTF favors initial administrative allocations with a gradual transition to an auction, in order to give entities time to plan their emission reduction strategies.
POUs generally prefer administrative allocation (LADWP, MID, SCPPA, NCPA). They believe that the chances of auction revenues not being returned to their customers would be high. These entities fear that, if they do not receive auction revenues, they would have to pay both for current emissions and for the new investments needed in low carbon infrastructure and energy efficiency. LADWP prefers that it spend its dollars directly on investments in its own infrastructure and community rather than participate in a statewide program.
Some parties are concerned that, should regulators over-estimate the number of allowances needed, the administrative distribution of allowances would inadvertently provide windfall profits to those entities whose allocations exceed their needs, as happened to many generators in Europe (Calpine, LADWP, SCE).
The parties make important points regarding both auctions and administrative allocations of emission allowances for the cap-and-trade market.
Regardless of the initial emission allowance distribution methodology, we expect that there would be active secondary trading of emission allowances. Even with initial administrative allocations, a secondary market would develop because administrative allocations would not perfectly meet the entities' actual needs. Entities with insufficient allowances to cover their needs would need to purchase allowances, and those with excess allowances would either hold them or sell them. Additionally, to the extent allowed by ARB rules, entities without compliance obligations themselves may also want to participate in the market.
As Morgan Stanley points out, auctioning rather than initial administrative allocation of allowances would promote allowance market liquidity. The increased trading opportunities would assist in finding least-cost emission reduction investments and improve incentives for investing in energy efficiency and low-GHG technologies and fuels. Because of the increased pursuit of lower-cost emission reductions, open, transparent, fair, and enforceable auctioning would promote the accurate reflection in allowance prices of the true cost of marginal emission reduction measures. These benefits due to allowing more parties to seek the least-cost reductions from whichever sector of the economy can produce them would tend to reduce allowance prices and the cost of GHG emission reductions across all participating sectors.
Regardless of the initial allowance distribution mechanism, entities that retire allowances rather than pursue low-cost emission reduction opportunities would lose the opportunity cost of selling the allowances. As a result, we expect that the power market would tend to reflect the value of allowances, regardless of whether allowances are distributed via auctions or administrative allocations.
However, many parties point out that auction design is a new field for the State and an auction would take several years to develop. Careful design, a learning period, and effective enforcement would be needed. In addition, there are lessons to be learned from the experiences of others with auction design.
Many parties concerned about auctions are most concerned that the proceeds from auctions could be used for purposes other than benefitting the customers who will pay the costs. In addition, some entities who are both deliverers and retail providers are concerned that there may be an added impact on their customers, who may have to pay both for the purchase of emissions allowances and the costs of direct programs to reduce emissions such as renewables and energy efficiency. Impacts on entities with compliance obligations and on customers will depend in large part on the use that is made of auction proceeds.
Auction proceeds could be used to benefit consumers directly by rate mitigation or indirectly by providing funds for investments that would reduce GHG emissions and avoid the need for future allowances. By contrast, free or below-market value administrative allocations could result in windfall profits to deliverers in cases where those deliverers are not also retail providers of electricity to consumers. For these reasons, and in light of the potential benefits of increased market liquidity on allowance prices, we conclude that initially auctioning of a portion of the allowances is superior to relying solely on administrative allocations in terms of reducing costs to consumers of achieving GHG emission reductions. We also conclude that California may need a development and learning period before a full multi-sector auction would be viable.
Entities with potential compliance obligations are concerned that auctioning could make them more vulnerable to volatility in allowance prices, since they would have to purchase needed allowances. This is a valid concern and one that can be addressed by having flexible compliance mechanisms in place. Our final recommendations to ARB will include more information on the potential role of flexible compliance.
One issue of particular concern is how new entities with compliance obligations would obtain allowances.32 A beneficial aspect of auctions is that new entrants would have the same access to allowances as other market participants, with no need for administrators to anticipate new entrants' need for administrative allocations. On a broader scale, auctions would avoid the complex and imprecise task of establishing and maintaining an administrative allocation scheme. Instead, purchasers would determine how many allowances to buy and how to minimize their costs of buying allowances. Finally, auctioning rewards early action automatically, because entities who have reduced their emissions will not need to purchase as many allowances.
Because of the benefits, we conclude that some portion of the allowances available to the electricity sector should be auctioned. As an integral part of this recommendation, we conclude that the proceeds from the auction of allowances for the electricity sector should be used primarily to benefit electricity consumers in California in some manner, in order to minimize costs of GHG emission reductions to consumers and assist with emissions reduction opportunities. Possibilities include use to augment investments in energy efficiency and renewable power or to maintain affordable electricity rates. Allocating the value of allowances and/or auction revenues primarily to benefit consumers recognizes the importance of electricity as a vital commodity. Thus, we believe that reservation of allowances or allowance value for consumers in this sector is warranted regardless of what may be done for other sectors.
Another option available for distributing the value of allowances to consumers, even under an auction scenario, is to allocate auction revenue rights to consumer purposes and/or to allocate allowances to retail providers directly, with the provision that they must offer up those allowances in a centralized auction and receive the proceeds. We will examine these and other available options for the treatment of any available auction proceeds in more detail in the remainder of this proceeding and may make further recommendations to ARB in this regard in a later decision.
Parties disagree as to whether ARB has authority under current statutes to conduct auctions of allowances.33 This is not an issue that we should, or need to, resolve. If ARB concludes that it needs additional authority in order to conduct auctions and distribute auction proceeds consistent with our recommendations, we recommend that ARB seek additional legislation. We would support ARB in this endeavor.
Based on the current record, we are not able to determine the proper relative roles of auctions and administrative allocation of allowances in a deliverer-based system. Several parties recommend that there be a gradual transition over several years from relatively more administrative allocations initially to relatively greater reliance on allowance distribution via auctions. Distributing some amount of allocations administratively in the early years of the program could reduce the immediate impact on entities that would bear the costs of obtaining allowances, and would give them more time to develop emission reduction strategies. Based on the current record, it may be reasonable to provide a transition from small amounts of auctioning in the early years to greater amounts in later years. However, we require more analysis before making a determination on this issue.
Other parties raise concerns with any administrative allowance allocations to deliverers, including the potential for windfall profits in cases where the deliverer is not also a retail provider, and uncertainties regarding how the value of the allowances would be returned to consumers or other affected entities. If auctions are to be phased in, the transition period should be specified well in advance so that parties can plan their investment strategies. We plan to seek additional comments on this issue in the context of the deliverer-based cap-and-trade system which we recommend to ARB.
If any allowances are to be distributed administratively, the manner of the administrative allocation must be determined. Options recommended by parties for determining allowance allocations range from use of historical emissions to output-based metrics. In addition, as mentioned above, some parties recommend direct distribution of allowances to retail providers, which would then be required to sell the allowances at auction and would receive the proceeds. Many of the parties' comments on this issue were couched in terms of a retail provider-based approach rather than the deliverer-based approach that we recommend to ARB. There has been little development of the record on the relative impacts of the various administrative allocation approaches in the context of a deliverer point of regulation. Nor have complications in estimating needed allowances due to fluctuations in emissions due to temperature, hydro conditions, and business cycles been explored adequately.
Now that we have determined that a cap-and-trade system should be implemented, with deliverers bearing the compliance responsibility and with some allowances auctioned for the electricity sector, parties should be given the opportunity for further comment and recommendations on these and any other remaining allowance distribution issues. We reiterate our openness to considering all reasonable options for allocation policy that take into account the circumstances of differently-situated entities in the electricity sector, to ensure that all obligated entities have a path for compliance at reasonable cost, consistent with the general principles outlined here.34 The modeling analysis that is being undertaken by staff and consultants should also provide additional insight on some of these issues.
We plan to address further in this proceeding the allowance-related issues that we identify but do not resolve in this decision. The ALJs may request comments and/or schedule additional workshops or other follow-up activities as appropriate. We plan to address these additional issues related to the distribution of emission allowances in a subsequent decision.
31 SCPPA also expresses concern that this point of regulation will result in the regulation of transactions where power is merely wheeled through California, but generated and consumed in other states or countries. However, as discussed in Section 3, our recommended deliverer point of regulation would not cover power that is merely wheeled through California.
32 In its comments on the proposed decision, LADWP argues that the auctioning of allowances would violate its right of home rule. While, LADWP claims that an auction structure would financially undermine its renewable procurement program, it has not substantiated this claim. We are not convinced that a conflict exists between the use of auctions under AB 32 and LADWP's home-rule authority to operate its municipal utility. The courts have stated that "[t]o the extent difficult choices between competing claims of municipal and state governments can be forestalled in this sensitive area of constitutional law, they ought to be; courts can avoid making such unnecessary choices by carefully insuring that the purported conflict is in fact a genuine one, unresolvable short of choosing between one enactment and the other." (California Fed. Sav. & Loan Assn. v. City of Los Angeles (1991) 54 Cal.3d 1, 16-17.) LADWP has not shown that any purported conflict is unresolvable short of choosing between one enactment and the other.
LADWP also argues that in a pure auction system it would be required to purchase allowances for coal-fired generation it was forced to purchase decades ago due to a now repealed federal law. We note that this decision does not recommend a pure auction system.
33 LADWP argues that AB 32 does not authorize auctions and that auctions would be an illegal tax if it did.
34 We acknowledge the arguments made by various entities, including POUs and SCE, that the method of distribution of allowances can have a significant effect on costs to consumers.
