By Liz Hardee, Senior Analyst, The Climate Trust

In the wake of the milestone Paris Agreement to limit global greenhouse gas emissions, the eyes of the world are upon jurisdictions that have already taken action. A prime example is California’s cap-and-trade program, which has been heavily promoted as a successful model for mitigation.

The system relies upon a declining cap, which covers 85% of the state’s emission sources. In the California system, covered entities must surrender allowances equal to their annual emissions. Some allowances are provided to covered entities free of charge, but others are sold to emitters by the state at auction. Historically, these auctions have been considered quite successful.

With allowance prices at the high $12 range, each auction typically provides several hundred million dollars in revenue to the state. Revenue is then reinvested in targeted mitigation efforts such as transit improvements, energy efficiency retrofits, and the installation of renewables. According to the California Air Resources Board (ARB), which runs the program, the state has spent $1.44 billion in revenue on such projects to date, with 43% of this funding spent in low income and other disadvantaged communities.

With so much revenue potential, the popular program has enjoyed the political support of the state legislature. However, this support is in danger of eroding without a proper understanding of the program’s design features. The most recent allowance auction sold just 11% of the allowances it offered, resulting in only $10 million in revenue to the state. In market lingo, this is called undersubscription, and its causes are largely political.

First, the allowance market is fundamentally oversupplied, due to free allocations provided to trade-exposed industries whose compliance with the rule could theoretically damage their competitiveness. Oversupply drives down demand.

Secondly, a lawsuit, brought against ARB by the California Chamber of Commerce, alleges that allowance auctions constitute an unlawful tax and should not be allowed to continue, creating uncertainty about the market’s future.

The Wall Street Journal and The Sacramento Bee newspapers have both speculated on the imminent demise of the market in California since the auction. They insist that California is now experiencing the same market dynamics that caused the crash of carbon prices in the European Union several years ago; however, this claim demonstrates a lack of understanding of the two markets’ differing designs. The European Union has no “floor price” for carbon—that is, a price underneath which the system’s allowances will not be sold by the state. In California, allowances sold at auction (referred to as the primary market) must clear the price floor, currently set at $12.73. If prices are lower on the secondary market, where allowances are traded between companies, fewer allowances will be sold at auction. Prices on the secondary market in California began trading slightly lower than the auction floor two months ago, leading to heavier secondary market trading and reduced primary market activity.

ARB has designed their system to adjust for such a dynamic. If at any point allowances are not sold at auction, they are held in a state reserve and cannot be sold until at least two subsequent quarterly auctions clear above ARB’s price floor. In essence, allowance supply becomes artificially constrained until at least the middle of 2017, which should keep prices on the secondary markets hovering near the floor rather than crashing. Indeed, secondary market prices have barely moved since last month’s auction; allowances have traded roughly $0.30 below ARB’s price floor in recent weeks.

This artificial constraint is in addition to the cap’s decline, which sees demand outpace supply and carbon prices rising away from the floor beginning in 2023—assuming post-2020 continuation of the program. A political knee-jerk reaction to this undersubscribed auction would betray the program’s and the legislature’s goals. The cap and trade program is, first and foremost, an emission reduction program, and that goal remains intact—the cap has not changed, and emissions are set to decline regardless of auction performance.

The key question for policymakers is the question of revenue: will they be willing to wait out the market’s natural dynamics in favor of longer-term revenue gains, or will they declare the program a failure, despite the fact that its revenue generation potential is not its primary goal? Time will tell, but one thing is clear: if cap and trade fails in California, it will be due to politics and not to design.

The Climate Trust is a nonprofit carbon financing investor and developer.