California strikes back

“In the face of devastating attacks from Donald Trump, escalating threats from wildfire and national economic turmoil, California is standing strong to grow jobs and our economy, make life more affordable and protect our leading climate policies.” - Mike McGuire, California's Senate Majority Leader

In January I penned an article warning investors that they should be concerned about more than just regulatory delays: the future of California's cap-and-trade program beyond 2030 was in doubt.

"One of the most important, yet hitherto unappreciated risks investors face going into 2025 is that the states cap-and-trade program is currently set to expire in 2030, and it’s future beyond 2030 is far from guaranteed."

Specifically, the risk was that the bar for approval could also be high, if as Danny Cullenward, Policy Director at CarbonPlan, spelt out, “policymakers determine that new statutory authority would be necessary or otherwise useful to resolve potential legal uncertainty — as they did before, with the passage of Assembly Bill 398 in 2017”. If this is the case then “they will need to determine whether such authority requires a simple majority or two-thirds supermajority vote.”

On Wednesday evening Governor Newsom and California's legislative leaders announced that an agreement had been reached reauthorising the Cap-and-Invest Program (previously known as Cap-and-Trade), and so extending its role in helping to decarbonise the state all the way through to 2045 (see What's in a [carbon market] name? Why governments should adopt the 'Cap-and-Invest' nomenclature).

In the final hours of the legislative session on Saturday the state Senate passed AB 1207 (29-6, 5 abstentions), before the state Assembly also voted in favour (55-10, 15 abstentions). AB 1207 (along with a separate bill, SB 840, that spells out how auction revenues will be spent) will now advance to Governor Newsom, who now has until 12th October to sign or veto the bill.

Futures prices had already rebounded from the $26 floor price in recent weeks as traders anticipated the bill being signed, surging above $30 following the announcement on Wednesday evening. Further upside to the California Carbon Allowance (CCA) price is now expected as the final hurdles to reauthorisation have been overcome.

Long-term commitment to decarbonisation

Up until now legislators have only ever extended the program end date by 10 years. The 2017 reauthorisation (AB 398) moved the program's end date from 2020 to 2030, setting a target of 40% below 1990 emissions, while also introducing a price ceiling and an allowance price containment reserve (APCR). Although reauthorisation set the foundations for the subsequent bull market in the CCA price, the knowledge that the program's future would always come up for debate at some point is likely to have deterred investment.

Meanwhile, recent low prices, as market participants weighed the chances that the program will be scrapped or not, has hit state revenues. This resulted in less funds available for reinvestment in environmental programs and support for disadvantaged communities. The recent regulatory uncertainty illustrates just how significant this can be. The state has missed out on nearly $3 billion in revenue from its carbon market due to the tumbling carbon price since February 2024, according to Clean & Prosperous California (see Cap and fade, or golden opportunity? It's crunch time for California's cap-and-trade program).

By extending the program by 15 years this time, to 2045, bill AB 1207 delivers a powerful signal that the Californian state government is committed to decarbonising over the long-term. As most, if not all, of the low-hanging decarbonisation solutions have already been implemented, attention now turns to the more challenging, more expensive, longer-term investments required to move the state towards net zero.

AB 1207 also explicitly links the program to the states climate targets for the first time. The state is currently required to cut GHG emissions by 40% relative to 1990 by 2030 (potentially rising to 48% by 2030 if earlier proposals come into effect), before reaching net zero by 2045. With companies likely to require multi-decade policy support, the states commitment is a welcome signal of intent.

Offsets are no free lunch

The use of offsets has been a perennial bugbear for critics of the Californian carbon market concerned about the integrity of many of the projects. Although the bill doesn't propose any specific integrity reforms, it does include a significant change in how offset credits will be accounted for. Going forward CCA's equivalent to the total number of offset credits used for compliance in any one year will be removed from the subsequent year’s annual allowance budget and retired. To that end the AB 1207 reforms mirror the approach used in the Washington Cap-and-Invest Program.

Up until the end of 2025, a max 4% of a covered entity’s compliance obligation can be met by surrendering offset credits. Of the credits surrendered, no more than half could be sourced from projects not providing direct environmental benefits in California. From 2026 until 2045 offsets can now meet up to 6% of an individual obligation, while the state maintains the focus on Californian environmental benefits.

This part of the bill is probably the most bullish aspect of the whole document, resulting in "significant depletion" of the allowance bank. ClearBlue Markets estimate "offset use for California entities to be around 203 million between 2031 and 2045 compliance years." However, under the proposed rules, this would result in a reduction to the allowance supply. As a comparison, their analysts estimate that the current allowance bank "stands at 370 million allowances (for California and Quebec)."

Tighter protections for consumers and industry

As always it isn't all good news for long-only carbon investors. The bill also includes options to manage price spikes. AB 1207 maintains the current APCR and price ceiling structure first introduced in the 2017 reauthorisation bill. However, the bill allows the Californian Air Resources Board (CARB) regulatory discretion to adjust "the allowance price containment reserve or the price ceiling, or both”, if they feel the CCA price is rising too fast. As per AB 1207, in the case CARB, “finds that the price containment reserve or the price ceiling or both the price containment reserve and price ceiling do not adequately protect California consumers, the state board shall consider additional actions to ensure consumers are protected."

Residential energy customers currently receive a refund on their electricity bills two times a year (April and October), with natural gas customers getting a refund in April. The CA Climate Credit is funded by revenues from the auctioning of CCAs via the Cap-and-Invest Program. In the future the refund in electricity bills will receive a boost (supported by the diversion of free allowance allocations from natural gas suppliers to electrical distribution utilities), with relief concentrated during the summer. By lowering the cost of electricity relative to natural gas, the boost to the CA Climate Credit will help to incentivise electrification (e.g. EV's, heat pumps, induction stoves).

Previously, free CCAs were granted to industry regardless of their respective risk of carbon leakage, the likelihood that industry will move out of the state to take advantage of less onerous environmental regulations. Excessive free allocation resulted in less revenue from auctions, and less funds available to direct to state priorities. From 2031 AB 1207 requires there to be an assessment of each industry's risk of carbon leakage, distributing free allowances in a manner that minimises the risk. The bill also asks that a "border carbon adjustment" be considered as a tool to reduce leakage.

Setting the stage for a comeback

Looking forward the most important factors will be further implementation of CARBs Program Review and the 2027 Scoping Plan. Here there is widespread support, even among businesses not directly affected by the Cap-and-Invest Program. In August, 40 businesses entities with operations in California called for the legislature to extend the program as soon as possible, while also urging them to resume its rulemaking immediately thereafter. The group argue that the program needs to be strengthened, to "drive clean investments into California and uphold the state as a global economic powerhouse." (see California's emissionary zeal begins to crack: Carbon market tumbles as climate policies are delayed).

Finally, it's worth reflecting on California's response to Trump's tirades. Almost six months ago it appeared that America's carbon markets were under siege with no way to escape. To recap, one of the four four executive orders signed by President Trump on Tuesday 8th April - PROTECTING AMERICAN ENERGY FROM STATE OVERREACH - sought to block the enforcement of state laws that reduce the consumption of fossil fuels. Trump ordered Attorney General Pam Bondi to look for ways to “stop the enforcement”, giving her a deadline of 7th June to issue a report on potential actions. The deadline has come and gone and all you can hear is tumbleweed. The inference is that no actions were uncovered that could derail individual states support for carbon markets, and hence no report is forthcoming.

The reauthorisation of California's Cap-and-Invest Program represents a decisive response to the Trump administrations aggressions, and one that may have implications well beyond the state's borders. Now that uncertainty over California's future has lifted, lawmakers in Quebec - whose carbon market has been linked to California via the Western Climate Initiative (WCI) since 2014 - may now also seek to extend to 2045. Amendments to the WCI will then give Washington State confidence to move forward with establishing a link to its carbon market with California. Lastly, with industrial carbon pricing elsewhere in Canada in a state of flux, other provinces may decide to follow Quebec's lead.