April 24, 2017

April 24, 2017

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April 21, 2017

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GHG Allowance Auctions are Not a Tax; Key Element of State’s Cap-and-Trade Program Upheld

California Chamber of Commerce, et al. v. California Air Resources Board, et al., Case No. C075930 (Cal. Ct. App. 3d. Dist., 2017).

On April 6, the California Court of Appeal for the Third District issued its long-awaited decision in the consolidated lawsuits challenging the greenhouse gas (“GHG”) emission allowance auctions, which are a key component of the California Air Resources Board’s (“CARB”) Cap-and-Trade Program.  The court held that CARB has the authority to establish the auctions and that they do not constitute an illegal tax.  The second holding is key and breaks new legal ground; it also was made over a strong dissent.  As the court put it, “the hallmarks of a tax are: 1) that it is compulsory; and 2) that the payor receives nothing of particular value for payment of the tax.”  (Op. at 5.)  The auction system is not a tax because 1) “the purchase of allowances is a voluntary decision driven by business judgments as to whether it is more beneficial to the company to make the purchase than to reduce emissions,” and 2) “the allowances are valuable, tradable commodities, conferring on the holder the privilege to pollute.”  (Id.)  This is a major victory for the Program and the State’s efforts to address climate change by reducing GHG emissions. However, there is a question whether the decision will stand.  There was a strong dissent, and the decision is sure to be appealed to the California Supreme Court.  Meanwhile, the Legislature is currently at work on crafting legislation aimed at determining how the existing ambitious emission reduction mandates will be met.  The court’s decision will factor into those critical legislative deliberations, which will resume later this month after the spring recess.

The Decision

To help achieve the mandate established by the Legislature in the Global Warming Solutions Act of 2006 (better known as “AB 32”) of reducing the State’s total GHG emissions to 1990 levels by 2020, the Cap-and-Trade Program establishes an annual cap on GHG emissions, ratcheting it down each year toward the 2020 goal, and requires large emitters of GHGs to meet specified emission targets.  For each ton of GHGs by which an emitter exceeds its target it must surrender to CARB one compliance instrument, either an allowance or an offset.  Some of the allowances are sold by CARB at quarterly auctions.  Emitters and others purchase them for compliance purposes, for resale or for retirement.  A secondary market has arisen for allowances and offsets; this is the trade side of cap-and-trade.  The idea is to use market forces to maximize the efficiency of emission reductions and to give emitters flexibility in how they comply.

The two lawsuits were brought by the California Chamber of Commerce (“CalChamber”) and Morning Star Packing Company and others.  The National Association of Manufacturers (“NAM”) intervened on the side of CalChamber and the Environmental Defense Fund (“EDF”) on the side of CARB; numerous amici briefs also were filed (including – full disclosure – one by this author on behalf of the International Emissions Trading Association).  The challengers put forward two arguments: 1) the auctions exceed the authority delegated to CARB by the Legislature in AB 32, and 2) the auctions constitute an illegal tax under the California Constitution (art. XIII A, § 3, better known as “Proposition 13”), which requires that the Legislature adopt any taxes by a two-thirds vote.  AB 32 passed by a single vote.

The court upheld the trial court’s decision rejecting both arguments.  The three justices were unanimous with respect to the first challenge, holding that the Legislature’s grant of authority to CARB in AB 32 was very broad.  “The Legislature obviously intended the program to be a creature of the Board, either in deference to the Board’s expertise, or out of pragmatic necessity to secure passage, or for both reasons.”  (Op. at 14.)  This was not a surprise, as two earlier decisions by the Court of Appeal challenging other aspects of the Program had reached similar conclusions.  CARB is now 3-0 in challenges to its authority under AB 32.

The court was divided 2-1 with respect to the Prop. 13 challenge though.  The majority, authored by Justice Duarte and joined by Justice Butz, held that the auctions do not constitute a tax because participation is voluntary and the purchasers of the allowances acquire a “specific thing of value.”  Justice Hull’s dissent took issue with both and also argued that the broad array of uses to which the auction proceeds are put indicates that the auctions are a tax.  Interestingly, the dissent did agree with the majority that the California Supreme Court’s decision in Sinclair Paint Co. v. State Bd. of Equalization (1997) 15 Cal.4th 866, does not control this case.  In short, all three agreed that “Sinclair Paint did not create ‘a binary world’ where every payment to the government must be either a fee or a tax.”  (Op. at 35-36.)  The line between a tax and a fee can be blurry and the auctions at issue here constituted “something else.”

The court found that participating in the auctions was voluntary for three reasons.  First, emitters have a “menu” of compliance options: in addition to purchasing allowances at auction, they can reduce their GHG emissions, purchase allowances on the secondary market, use banked allowances, or purchase offsets.  Second, entities with no  compliance obligations can and do participate, and “[t]axes do not attract volunteers.”  (Op. at 39.)  Third, while the Program “may increase the cost of doing business in California” – just as would command-and-control emission reduction requirements which all agree CARB is empowered to impose – this “unfortunate reality does not translate into a compelled purchase of auction credits.”  (Id. at 41 & 42.)

The heart of the court’s decision is its finding that the purchase of allowances “conveys a valuable asset – the privilege to pollute the air.”  (Op. at 44.)  The fact that the State “previously allowed [emitters] to pollute for free does not change [the] fact” that the “right to pollute is a substantial benefit”; to put it succinctly, “there is no vested right to pollute in the California.”  (Id. at 43.)  Critically, the court went one step further and found that because this valuable asset can be traded, it has the characteristics of property as between the holders of those assets.

Though grounded in citations to precedent, the court here breaks new ground.  The Cap-and-Trade Regulation itself proclaims that an allowance “does not constitute property.”  (Op. at 44 (quoting 17 CCR § 95820(c)).)  The court found that, “when examined in context it becomes clear that this passage refers only to property rights as against the state, not rights as between private parties.”  (Id.)  Because the holders can trade them, they do constitute property – and thus something of value when purchased, and the value of the asset is largely determined by the market, not the state.  The court concluded that the regulation quoted above “preclude[s] an allowance holder from asserting a takings claim against the State, but the free alienability of the allowances means they are of value to the holder.”  (Id. at 47.)  In recognizing the double characteristic of allowances as both compliance instruments vis-à-vis the State and property as between the private parties holding them, the court not only broke free of the binary “tax-or-fee” constraints of Sinclair Paint, it provided a legal foundation for emissions markets.  There have been earlier decisions that, for example, recognized that one could take a security interest in the right to proceeds from a broadcast license purchased at auction from the government, but the license itself did not constitute property in which a security interest could be held.  (See, e.g., In re Cheskey, 9 F.C.C.R. 986, 987 (1994).)  Here the court dispenses with such niceties and recognizes the dual, public/private character of the allowance itself.  It provides a legal foundation for the decades‑old but still legally novel principle at the heart of using market mechanisms to achieve regulatory purposes.  If the decisions stands, it will be very significant.

Observations

Query whether the decision will stand.  The dissent makes a strong argument based on the facts before the court that participation in the auctions is not voluntary.  The record includes an uncontradicted declaration by a Morning Star Packing economist who stated that its “participation in the auction program was ‘voluntary’ only in the sense that [it] could voluntarily cease doing business in California if it did not participate.”  (Dis. at 5.)  The dissent noted that the “trial court at least impliedly accepted Rabo’s declaration” and that, “We are not a trier of fact.”  (Id. at 6 and 8.)  The dissent also declines to recognize the private property aspect of allowances.  “Whatever else these authorizations are, as to Morning Star and others similarly situated, their value as a ‘property right’ is ephemeral and the auction program cannot be said to convey a property right in the nature of a commodity or otherwise when emission authorizations can be limited or terminated by the state at any time.”  (Id. at 10.)  The dissent also took issue with the majority’s “decoupl[ing of ] the issues of generation of revenue from the expenditure thereof.”  (Op. at 50 (emphasis original).)  It stated that that the “use of the revenue from government exactions is a hallmark, probably the most important one, in determining whether that exaction is a tax” (id. at 12), and that here the State’s broad use of the auction proceeds indicates that the auctions serve a general revenue purpose and therefore constitute a tax.

Buoyed by a strong dissent that adheres to a traditional, limited role for the courts and is grounded in the admittedly few facts before the court, the appellants are sure to seek review by the California Supreme Court.  Given the importance of the case to California’s efforts to address climate change (not to mention its finances), and the novelty of the decision, there is a good chance that the Supreme Court will grant review.

That said, the immediate impact of the decision is likely to be upon the Legislature more than the courts.  While the court found that AB 32 authorizes CARB to develop the Cap-and-Trade Program, that authority arguably ends in 2020.  Last year the Legislature passed SB 32, which increases the GHG emission reduction mandate to 40% below 1990 levels by 2030.  However, the bill does not include express authorization for the Program and its companion bill, AB 197, directs CARB to prioritize direct emission reductions.  The Legislature is currently crafting legislation aimed at determining how SB 32’s ambitious emission reduction mandate will be met.  The court’s decision will factor into those critical legislative deliberations, which will resume later this month after the spring recess.

Governor Brown’s proposed budget introduced earlier this year relies on $2 billion in revenue from the auctions and asks the Legislature to expressly authorize the Cap-and-Trade Program, preferably by a two-thirds margin to negate any additional constitutional challenges like the present one.  He’s made this a priority by asking that it be addressed as part of the budget process which must be wrapped-up by June.  (CARB also has teed up for June amendments to the Cap-and-Trade Regulation that would extend the Program post-2020.)  With the Democrats now possessing two-thirds majorities in both houses of the Legislature, that would appear to be achievable.  However, there are deep divisions within the Democrats on this issue.

At the outset of the legislative session in January, there appeared to be consensus amongst the leadership in the Legislature on extending the Cap-and-Trade Program post-2020.  That was a significant show of unity by the State’s political leadership in the face of the news coming out of Washington.  This was especially so as much of the Legislative leadership has been critical of the Program and CARB, faulting it for not adequately addressing the public health issues emphasized by the environmental justice communities.  Significantly, the Western States Petroleum Association and other members of the business community also came out in support of the Program, as they find it preferable to expanded command-and-control regulation.  However, thus far this unity is only with respect to form; the only bills introduced so far are mere placeholders.  A joint committee of the Senate and the Assembly is currently working on draft legislation and sources indicate that major new proposals will be made later this month following the recess.  The content of any new legislative authorization for the Program is very much in debate.  The one thing that is clear is that it is likely to be far more prescriptive than AB 32’s broad grant of authority to CARB.  Regardless of one’s perspective, there are sure to be devils in the details.  Prudence thus calls for engagement.

Also open to debate is whether a two-thirds majority for such a bill can be achieved.  Some are already suggesting that the court’s decision provides sufficient legal basis for the auctions such that there is no longer a need for a two-thirds majority to expressly authorize them.  That may be too sanguine a view.  If the Cap-and-Trade Program with its current auctions is extended post-2020 under the current SB 32, it will be vulnerable to a challenge under Proposition 26, which was adopted by the voters in 2010 and strengthens Prop. 13, making it harder to classify a measure as a fee.  While Prop. 26 does not have retroactive effect and thus does not apply to AB 32 (see op. at 27-29), it will apply to 2016’s SB 32 and any new legislation.  Notably, Prop. 26 shifts the burden of proof from the challengers, which under Prop. 13 must “establish a prima facie case showing that the fee is invalid,” to the state or local government to demonstrate that the measure at issue is not a tax.  (Op. at 30 (citation omitted) and 30 n.22.)  As demonstrated by the court’s dissent here, this issue remains what the trial court called a “close question” and there is no guarantee that a future court would not follow the dissent rather than the majority when considering a challenge to the auctions under Prop. 26.

The Legislature will soon wrestle with the court’s decision.  Thus, while it provides a new and important legal foundation for the Cap-and-Trade Program and emissions trading generally, in California it is likely to fuel the policy debate rather than resolve it.  Stay tuned.

Copyright © 2017, Sheppard Mullin Richter & Hampton LLP.

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About this Author

Nicholas van Aelstyn, Sheppard Mullin Law Firm, Real Estate and Land Use Litigation Attorney
Partner

Nicholas van Aelstyn is a partner in the Real Estate, Land Use and Environmental Practice Group in the firm's San Francisco office.

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