Same Emissions Budget, Different Program Revenues: Revenue Implications from California Cap-and-Trade Amendments

The California Air Resources Board is considering three different emissions budget pathways for upcoming rulemaking that would achieve the same cumulative emissions reductions by 2045. We analyzed each budget’s impact on revenues and how an emissions containment reserve (ECR) could be used to bolster revenues. We find the following:

• Over the next five years, CARB’s identified Smoothed Option 1 which would have a slower reduction in the emissions budget before 2030 would yield about $100 million dollars more revenue to the Greenhouse Gas Reduction Fund (GGRF) in 2026, rising to nearly $1 billion more revenue in 2030 than the other options. In the long term through 2045, cumulative revenues from Smoothed Option 2 and the original Standardized Regulatory Impact Assessment (SRIA) budget are larger than Smoothed Option 1. However, near-term revenues may be more important to fund investments to accelerate the energy transformation, especially given California’s current budget deficit. Smoothed Option 1 would also sustain a decline each year in the annual emissions budget, although initially at a slower rate than the alternatives.
• The addition of an Emissions Containment Reserve (ECR) would support allowance prices when they are low and increase and stabilize revenues for the GGRF. In the low allowance demand scenario, we find the ECR could boost cumulative GGRF revenues by $3.5 billion over the rest of this decade. Through 2045, GGRF revenues could increase by over $21 billion.

The California Air Resources Board (CARB) is considering an update to the state’s cap-and-trade program to align it with the 2022 Scoping Plan (CARB 2022) and AB 1279 (Muratsuchi 2022). The former sets a target for 2030 emissions to be 48 percent below 2005 levels; the latter mandates an 85 percent reduction (net zero) in greenhouse gases from 2005 level by 2045. CARB began a rulemaking process in 2023 to consider a comprehensive set of changes to the program. Many details of the program are being considered, and CARB has emphasized that the update must occur in the context of overall program stability and the need for a steadily increasing price signal. Nevertheless, core to all decisions is the updated emissions budget. CARB is updating the budget with two goals in mind: aligning with the most recent state climate targets for net zero and adjusting for an emissions accounting error in the past years of the program.

In a previous report, we analyzed the various budgets CARB has proposed throughout this process (Roy et al. 2024). We also discussed other policies and market designs that engaged stakeholders have proposed, such as an emissions containment reserve (ECR) and facility-specific emissions caps. Since the release of the report, CARB has hosted two more workshops narrowing focus to a 48 percent emissions reduction target by 2030 (CARB 2024b), the emissions pathway laid out by CARB in the April 2024 Standardized Regulatory Impact Assessment (SRIA) (CARB 2024d). Figure 1 illustrates the derivation of that pathway in two steps. The reduction in the annual budget from the 2018 (Current Budget) to the Simple Target reflects increased ambition. The reduction from the Simple Target to the SRIA 48 percent pathway reflects an additional reduction in the budgets from 2025–2030, referred to as the emissions inventory adjustment, which addresses the aforementioned emissions accounting error.

The implementation of the emissions inventory adjustment by 2030 as reflected in the SRIA 48 percent pathway would yield a jump up in the emissions budget from 2030 to 2031 after the adjustment is complete. This is illustrated as the SRIA Proposal A in Figure 1. In the May 2024 workshop, CARB highlighted some implementation issues that could arise from this irregularity (CARB 2024b). Concerns from CARB in conjunction with stakeholder input (Munnings and Robinson 2024; Lubowski, Bernasconi, and Lee 2024; Hoekstra 2024) on the matter led CARB to propose two “smoother” emissions budget trajectories in their July 2024 workshop (CARB 2024a). These two smoother budgets, visualized as Smoothed Option 1 and Smoothed Option 2 in Figure 1, have equivalent cumulative allowance supply through 2045 as the SRIA 48 percent Scenario A pathway but with different schedules that never increase (“jump up”) from the previous year. Budget pathways are estimated using CARB’s annual cap-adjustment factors and descriptions of emissions pathways post-2030. These budgets also take effect in 2026, one year after the original SRIA scenario, which was to take effect in 2025. CARB further narrowed its focus regarding how to strengthen the emissions budget by removing allowances from future allocations and auctions without changing the volume of allowances in the allowance price containment reserves (APCRs).

Most findings from our previous report (Roy et al. 2024) about the SRIA scenario apply to CARB’s two smoothed emissions budget scenarios (Smoothed Option 1 and Smoothed Option 2), because they share identical cumulative allowance supply. For example, the price paths and annual emissions outcomes are identical in our modeling of these three proposed budgets. This equivalence is attributable to the perfect foresight nature of our model and the assumption that compliance entities rationally minimize compliance costs over the entire program horizon. Accounting for uncertainty, financial constraints on investors, or market psychology could change this outcome. Nonetheless, because the smoothed budgets shift the allowance supply schedule over time, they shift annual program revenues from the allowance auction that accrue to the GGRF. The budget alternatives also result in different patterns of allowance banking, which we illustrate in the appendix.

This issue brief compares these smoothed budgets to the original SRIA budget and quantifies potential revenue impacts and banking behavior. We also reevaluate the impact of an emissions containment reserve (ECR) under these different proposed budgets and demonstrate how the ECR raises revenue in low emissions demand scenarios. We also discuss important considerations about policy sequencing and market phenomena that may lead to different outcomes.

CARB is expected to complete a rulemaking and update to the cap-and-trade program by early 2025.

In this issue brief, we employ the Resources for the Future (RFF) Haiku emissions market model, as we did in our previous report (Roy et al. 2024), to simulate two different allowance demand scenarios and identify market equilibria given three different allowance budgets pathways (SRIA Proposal A, Smoothed Option 1, and Smoothed Option 2). One demand scenario uses projections of energy demand and resulting allowance demand from the 2022 Scoping Plan. The second demand scenario, which we refer to as the Delayed Scoping Plan scenario, assumes higher energy and allowance demand resulting from delays in the implementation of technologies including carbon capture and storage for refineries and building electrification, as well as a failure to achieve reductions in vehicle miles traveled that were detailed in the 2022 Scoping Plan. The model also identifies additional abatement that can occur based on the incentives created by changes in the carbon price. We use these two demand scenarios—the Scoping Plan and Delayed Scoping Plan scenarios—to illustrate lower and upper bounds for this analysis. For more details on methodology, refer to the previous report on California’s carbon market.

3.1. Revenue Impacts

Proceeds from auctioned allowances under the cap-and-trade program accrue to the GGRF and are appropriated by the legislature and the governor, largely for investments to support California’s energy transformation. The GGRF supports investments in high-speed rail, intercity and low-carbon transit, affordable housing, sustainable agriculture, electric vehicle rebates, and numerous community-level investments. At least 35 percent of investments funded by the GGRF must go to the benefit of disadvantaged communities as described in SB535 (De León 2012); CARB estimates that 76 percent of investments have benefited priority populations to date (CCI 2024). California is also currently facing budget deficits that have threatened cuts to decarbonization spending (Lazo 2024b; 2024a), with some of those priorities shifted to the GGRF. This makes the impacts on the GGRF particularly salient when discussing CARB’s decision on which allowance budget path to take.

The differences between the three emissions budgets we examine are most evident through the end of the decade, after which the emissions budgets begin to realign. Under the Smoothed Option 1 budget, there are more allowances through the remainder of the 2020s than in the original SRIA or Smoothed Option 2 budgets. Because cumulative allowance supply determines the allowance price path Price paths are set by cumulative allowance supply following what is known as a Hotelling path, where shadow prices from cap-and-trade constraints are summed, discounted, and set to increase at the assumed opportunity cost of capital of 6 percent. The path deviates temporarily from the Hotelling path when APCR allowances are used to contain costs. and these three supply schedules have equivalent cumulative totals, the price path is the same. Therefore, if the price is the same across these scenarios but more allowances are made available earlier in Smoothed Option 1 budget, that budget will have greater annual revenues for the rest of the 2020s than either of the other two options. The estimated ranges of annual revenues are reported in Figure 2.

In Figure 2, each year between 2026–2030 has three bars representing each allowance budget option. The lower part of the bar indicates revenues under the Scoping Plan allowance demand scenario, and the higher range of the bar indicates allowance demand under the Delayed Scoping Plan allowance demand scenario. In 2026, we note that both smoothed options raise over $100 million more from the allowance auction than the SRIA scenario. In 2028, Smoothed Option 1 raises approximately $200 million more than the other two budgets. In 2030, the difference between the two smoothed options is about half a billion dollars under Scoping Plan allowance demand and over a billion dollars under Delayed Scoping Plan demand. Through 2030, Smoothed Option 2 cumulatively raises the least revenue, totaling $13.4 billion under the Scoping Plan demand scenario and $27.4 billion under Delayed Scoping Plan demand scenario. The SRIA scenario raises $100 million more under Scoping Plan demand and $200 million more under Delayed Scoping Plan demand. Smoothed Option 1 raises the most revenue, totaling $14.6 billion from 2026–2030 under the Scoping Plan demand scenario and $29.8 billion under the Delayed Scoping Plan.

After 2030, the ranking of scenarios in terms of GGRF revenues changes. Cumulative revenues across these scenarios converge in the late 2030s, and by 2045, Smoothed Option 2 raises the most cumulative revenue at $71.7 billion under Scoping Plan demand and $147.1 billion under the Delayed Scoping Plan demand. Option 1 raises the least total revenue by 2045, ranging from $68 billion to $140 billion .

Since emissions and price outcomes should be identical for scenarios with identical cumulative allowance supply, the primary trade-off for the regulator to consider may be changes in revenues from different allowance schedules. Scenarios that will raise more revenue in the short run will raise less revenue by the later years of the program. Near-term revenues may be more important to fund investments to accelerate the energy transformation, especially given California’s current budget deficit.

3.2. Emissions Containment Reserve

In our previous report, we detailed how an emissions containment reserve (ECR) provides additional flexibility in supply. This type of flexibility results in preserving emissions reductions and revenues in low allowance demand scenarios by slightly reducing the allowance supply when the carbon price is below a specific trigger-price level. At the July 2024 workshop, CARB referred to the price floor as a mechanism that maintains emissions reductions at low prices (CARB 2024c). However, the purpose of adding an ECR is meaningfully different from the price floor. For instance, it allows for prices above and below it. The additional flexibility between the price floor and APCRs that CARB already has in place reduces uncertainty in price and emissions outcomes in the long run.

Figure 3 shows how the price path in the low emissions allowance demand (Scoping Plan) scenario shifts from the black to the green line. In orange, we can see the reductions in cumulative emissions reductions that further California’s progress toward mitigating emissions. The ECR trigger-price path is noted with the blue dashed lines and is set by assumption at the midpoint of the price floor and APCR tier 1 allowances price level. Coincidentally, this is also the price level CARB described in the SRIA for the 48 percent target scenario. Our modeling finds that this price path will not materialize if emissions are at the Scoping Plan allowance demand levels, but with an ECR, they will. In the higher emissions allowance demand cases such as the Delayed Scoping Plan scenario, the ECR has no effect. In our model, the ECR only has an effect if the auction price would be at or below the ECR price level without an ECR in place. However, conceptual and experimental evidence describes how the ECR can change expectations about market performance and support allowance prices even if the ECR is not binding. (Salant et al. 2022; Burtraw et al. 2010)

In Figure 4 we show how the ECR reduces uncertainty around revenues. Figure 4 is identical to Figure 2 except for the gray bars which indicate additional revenue raised in the Scoping Plan demand scenario. For example, under the SRIA scenario in 2026, the lower bound of revenue under Scoping Plan assumptions about the emissions would be $4 billion (Figure 4) instead of $3 billion (Figure 2). We see that the ECR raises revenues by at least $900 million in every scenario in 2025 and annually will increase revenues by at least $500 million each year. By 2030, the introduction of the ECR raises cumulative GGRF revenues by over $3.5 billion in all the proposed budget pathways. By 2045, it raises over $21 billion for any of the budget scenarios.

Affordability has been identified by the Independent Emissions Market Advisory Committee (Burtraw et al. 2021) and the Environmental Justice Advisory Committee (Argüello et al. 2022) as an important concern for California’s climate policies. Although the ECR supports prices and raises prices in the carbon market, it only does so when prices would otherwise be low. Moreover, low carbon prices are a signal of additional low-cost emissions reductions that could be achieved in the market. The Legislative Analyst’s Office has expressed concern that regulatory programs may have costs that are multiple times that of emissions reductions available in the carbon market (Petek 2020). Hence, when prices are low, the ECR would harvest additional reduction, reducing the burden placed on regulatory programs, and contribute to overall climate program affordability.

The described outcomes stem from an economic model that assumes perfect information, foresight, and no further changes to the policy. Although we did not relax these assumptions in this analysis, we can discuss what distortions in the market might lead to different outcomes. One example would be if the opportunity cost of capital changes over time, which would lead to a realignment of the price path. Another variable is the market psychology underpinned by investors and regulated entities. These types of behavioral distortions are known but difficult to represent in modeling. We also do not model the larger affordability implications from these decisions, which is an important consideration alongside emissions reductions and GGRF revenues.

When charting the path to net zero, it is necessary to motivate private sector investments to achieve an energy transformation. One important factor policymakers may consider in selecting an allowance supply budget is its effect on regulatory certainty and program credibility (Dolphin et al. 2023). Irregular allowance supply budgets may influence perceptions about program credibility. To reduce uncertainty, CARB could implement an ECR to ensure emissions reductions at low prices, improve the cost-effectiveness and hence affordability of California’s comprehensive climate policy portfolio, stabilize GGRF revenues, and guarantee higher revenues when allowance demand is low. An ECR might also shield the market from volatility driven by behavioral or unpredictable factors. Strengthening expectations about the credibility of achieving long-run goals can motivate greater private sector investment to support these goals.

We have analyzed the current budgets under CARB’s consideration using RFF’s Haiku emissions market model. In the case of emissions reductions and price paths, these budgets lead to very similar or identical outcomes over the next decade. However, the different budgets CARB is proposing materialize varying revenues to the state’s Greenhouse Gas Reduction Fund . We find that Smoothed Option 1 has the highest revenues over the next five years, and the original SRIA budget and Smoothed Option 2 result in higher revenues in the later years of the program. Additional revenues, greater revenue stability, and more cost-effective emissions reductions can result from the introduction of an Emissions Containment Reserve. When considering these budgets, which expand the window of implementation for the emissions inventory adjustment, CARB must maintain the program’s credibility to prevent target backsliding.