Strengths and limitations of California's cap-and-trade program
Cap-and-trade is one of California's key policies for reducing greenhouse gas emissions. It has been the subject of discussion in recent weeks as the Legislature considers options for reauthorizing the program, which is currently set to expire in 2030. Researchers have emphasized the program as the lowest-cost option to meeting the state's climate goals.
In this blog, we examine the strengths and limitations of cap-and-trade as a climate policy. We find that while the program can generate low-cost emissions reductions, it is markedly insufficient for delivering a statewide net-zero transition in only two decades. This is because a steadily increasing carbon price does little to incentivize key actions including the development of large-scale clean energy infrastructure (electrical transmission, carbon dioxide pipelines, geologic storage) or innovation of presently high-cost technologies in the power, industrial and transportation sectors.
The result is that how cap-and-trade auction proceeds are spent becomes extremely important. Strategic investments in clean energy infrastructure, technology and resilience could address the limitations of cap-and-trade and support the state's climate goals. These investments could also provide affordability benefits by addressing two key drivers of high energy costs in wildfire and investor-owned utility capital spending. The Legislature could also consider expanding annual rebates to ratepayers, although to date these have been very modest. For example, for $2-3 billion in funding the California Climate Credit translates to about $6/month in power bill savings for consumers. Overall, it will be important for policymakers to rigorously assess the trade-offs of alternative revenue expenditure plans.
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California’s cap-and-trade program is one of the state’s key policies for reducing greenhouse gas emissions. The program sets an annual limit (cap) on emissions from regulated entities such as power plants, industrial facilities and fuel producers. This cap then declines over time. Companies must hold allowances for each ton of carbon dioxide they emit, which can be bought and sold between emitters (trade). Covered entities can also meet their obligations by retiring carbon offsets, but there is a limit to how much can be used in a given year. This limit is currently set at 6% from 2026 through 2030.
As the Legislature considers options for reauthorizing the cap-and-trade program, there have been different perspectives shared regarding its role and effectiveness, ranging from it being able to single-handedly drive the state to its climate goals to it providing little benefit compared to other climate policy options. The goal of this blog is to evaluate this issue. We start by briefly stepping back and establishing the nature of the problem that is a transition to a net-zero emissions economy. We then highlight the main strengths and limitations of cap-and-trade policy in this context. We conclude by considering implications of the analysis, notably on the Greenhouse Gas Reduction Fund.
The nature of the problem
In order to assess any climate policy requires a clear understanding of the nature of the problem.
A transition to net-zero emissions is, fundamentally, a technological transition – where an economy is phasing-down carbon-emitting energy and industrial processes while expanding zero-carbon alternatives. It is a physical process – requiring asset decommissioning and deconstruction as well as the deployment of new infrastructure at vast scales. Some of these actions can be minimized with demand reduction, such as energy efficiency and consumer changes. However, even assuming these actions to optimistic levels, the energy supply side overhaul is unprecedented (Figure 1).
Figure 1: This figure shows the major transformation in energy supply to achieve to net-zero emissions by 2045. Source: 2022 Scoping Plan.
The result is that what matters is what it takes to build things – and the need to align various actors to move clean energy projects from conception through development and into operations. This includes: investors, who need to see a viable return to provide capital; developers, who need to navigate siting and permitting as well as secure offtakes; regulators, who need to ensure proposed projects meet high standards such that they are safe, fair and environmentally sound; communities, who need to provide buy-in and support; and researchers and engineers, who need to perform research and development on advanced technologies to help bring down their cost over time. If there is a break in any aspect of this chain for a certain technology, that clean energy option cannot readily be deployed on-the-ground.
The core goal of climate policy, then, is facilitating clean energy deployment. Policy options can range from providing incentives, imposing costs, streamlining processes, and ensuring robust engagement so that projects are durable. With this context, we examine the role of cap-and-trade as a policy option.
Strengths and limitations of cap-and-trade
Cap-and-trade policy is defined by a declining emissions cap and increasing carbon price. The intention is that covered emitters will respond to these pressures (costs) by reducing their emissions in a swap to clean energy. A key goal of program design related to issues including the emissions cap, allowance allocation, allowance banking, trade-exposed industries, carbon offsets, and similar, is to ensure a steady increase in the carbon price. If the price stays too low, there is little incentive to swap to clean energy. If the price rises too quickly, this could have negative consequences on the economy and consumers.
Key strength
The clear strength of cap-and-trade is that it has the ability to identify the lowest-cost emissions reductions in a given year. This follows a key feature of the program, which is that the pool of covered emitters are able to trade allowances to meet their obligations. The result is that emitters should reduce their emissions if it is cheaper than buying an allowance. These entities can then sell their allowances to emitters that are yet to feel the cost pressure to decarbonize. Although it is difficult to disentangle the effect of cap-and-trade as compared to other climate policies, the Legislative Analyst Office (LAO) finds there is evidence that it is driving low-cost emissions reductions in California. The LAO and Independent Emissions Market Advisory Committee identify potential reforms, such as revising allowance allocations and other changes needed to ensure an ambitious program, which could be considered.
Key limitation
The main weakness of cap-and-trade is that the potential of these low-cost emissions reductions in any given year is limited. This stems back to the ‘nature of the problem’ – and the fact that a steadily increasing carbon price does not, in the real-world, easily translate into more clean energy deployment.
It can, in cases where the technology option is mature – implying that investors have experience funding the project, developers have experience executing the project, there is a clear regulatory and permitting regime, etc. – and it is at or below the carbon price. But if there is, for example, a lack of transmission to connect new clean generation (offshore wind, geothermal), an uncertain regulatory environment, community opposition in the region, supply chain constraints, or similar obstacles, developers and investors will be reluctant to advance projects even if – on paper – they appear relatively low-cost.
Another limitation is if the needed technology is relatively high-cost, which is true for multiple clean energy options identified at a substantial scale by 2045, a steadily increasing carbon price will do little to incentivize their deployment and the learning-by-doing needed to push them down the cost curve. This would be less of a problem if the state’s goal was net-zero emissions by, say, 2080, in which case a steadily increasing carbon price may be sufficient. Table 1 provides a rough forecast of technology decarbonization costs on a sectoral basis and shows estimates well in excess of the current cap-and-trade price ($29/ton as of February 2025, with allowances previously selling at $42/ton in February 2024). In general, key high-cost technologies include: clean firm power, long-duration storage, carbon removal, clean hydrogen, sustainable aviation fuel, and various industrial decarbonization.
Table 1: This table (red circle) shows the average annual cost to decarbonize key industries at roughly $100/ton or more between 2022-2035, i.e. well in excess of the current cap-and-trade carbon price of $29/ton. Source: 2022 Scoping Plan.
No climate policy can do everything – and cap-and-trade is no exception. Some of its limitations are by design: in seeking the lowest-cost emissions reductions, it cannot simultaneously address the high-cost options. Others involve acknowledging that there is friction in the translation between a carbon price and real-world project development. Overall, we view cap-and-trade as playing a key role as the ‘floor’ or ‘backstop’ market signal in the state’s climate policy portfolio. Reauthorizing the program could provide much needed market confidence and price stabilization. But the question remains: how can policymakers address program limitations and keep the state on track towards its climate goals?
The importance of auction proceeds
A strategic reallocation of auction proceeds, in particular GGRF, could address the limitations of cap-and-trade while delivering a host of other key benefits, notably long-term energy affordability.
As brief background, cap-and-trade auctions currently generate about $7-8 billion per year for spending on rebates to investor-owned utility customers ($2-3 billion, known as the California Climate Credit) and direct investments in programs such as High-Speed Rail, Affordable Housing and Transit via the GGRF ($4-5 billion) (Figure 2). The main purposes of the Climate Credit and GGRF are to deliver affordability and climate benefits, respectively. However, there is evidence that neither are performing as optimally as they could. For example, for $2-3 billion per year the Climate Credit achieves savings of roughly only $6 per month off of power bills for the three main investor-owned utility customers.[1] In terms of GGRF, the $/ton cost-effectiveness of programs spans a huge range, from $9/ton to over $9,000/ton, with a weighted average of the entire 90 programs at just over $1,000/ton.
Figure 2: This figure highlights total California Climate Credit and GGRF revenues from cap-and-trade auction proceeds since program inception. Recent years have seen revenues of $2-3 billion and $4-5 billion, respectively. Source: CARB.
Key considerations for reform
The Legislature is currently considering options to reform and/or reallocate auction proceeds. As Californians face energy affordability challenges, one option is to enhance rebates to consumers. The current Climate Credit (roughly $6/month) could not be considered meaningful, with average PG&E electricity bills in Q3 of 2024 well over $150/month, with many Central Valley residents likely paying over $300/month. Targeting these revenues to low-income households in climate-stressed regions is one reform option that has been proposed. Overall, should the Legislature look to reform rebates it will be important to calculate how large the monthly savings could be for consumers.
It should be noted, though, that the trade-off of not using that funding in alternative ways is significant. At this stage there is no other option to underwrite essential investments for clean energy and resilience, which are also highly relevant to affordability, as issues including investor-owned utility capital spending and wildfire prevention have been identified as two of the root causes of rate increases.
An alternative option is to pursue a thoughtful reallocation of GGRF. This could include a focus on three priorities: emissions reductions, long-term energy affordability, and climate resilience. To optimize around these priorities, investments could be made in three broad categories:
Infrastructure: For electrical transmission, ZEV chargers, carbon dioxide pipelines and storage, hydrogen infrastructure, and similar investments. Research shows it is important to frontload the development of shared infrastructure to enable upstream projects, such as new generation (offshore wind, geothermal). Public financing of transmission has also been identified as arguably the largest opportunity for long-term ratepayer savings of $3 billion per year (for more information, see also: Senator Padilla; Assemblywoman Petrie-Norris). Lastly, as infrastructure is revenue-generating, there is an opportunity to deploy a low-interest loan revolving fund to scale an initial low-billion dollars' endowment to tens if not hundreds of billions of dollars in clean energy projects.
Technology: For the innovation of presently high-cost decarbonization options identified as needed at scale for state climate goals, such as various clean firm power, long-duration storage, carbon removal, clean hydrogen, sustainable aviation fuel, and other industrial and heavy-duty transport decarbonization. As other states and countries also require these technologies at scale, California’s efforts to innovate them would constitute significant global leadership.
Resilience: For adaptation against growing impacts of climate change, particularly those with a nexus to greenhouse gas emissions, such as wildfire. Initial public funding could help incubate key strategies, including mitigation banks in urban areas that create defensible space as well as a new biomass economy in forested regions – both of which have the potential to substantively cover the cost of wildfire prevention at scale. By reducing the risk of wildfire, GGRF would be leveraged to address what is widely identified as the key cause of high power bills today.
Conclusion
Researchers have emphasized cap-and-trade as a program capable of threading the needle on energy affordability and climate ambition. In this article, we aimed to show that this is not as straightforward as it seems. Specifically, while it is true that cap-and-trade has the potential to identify low-cost emissions reductions, these are limited due to a variety of real-world factors related to project development. The result is that maintaining a broad portfolio of policies is key to state climate goals. A strategic reallocation of cap-and-trade auction proceeds can address key bottlenecks, including a lack of clean energy infrastructure and technology innovation. This approach would also target a key driver of energy price rises in investor-owned utility capital investments. Accompanying climate resilience investments can help to reduce the risk of wildfire, another key and structural cause of recent rate increases. Although there are opportunities to reform consumer rebates, such as by targeting them more towards low-income earners, policymakers should determine how meaningful these rebates could be and rigorously assess the opportunity cost of not investing in clean energy and other affordability strategies. Going forward, policymakers will also need to consider options for recalibrating and transitioning current cap-and-trade expenditures to new allocations that are targeted to achieve climate, affordability and resilience goals.
We hope this blog was useful. For more information or questions, please contact Sam Uden (sam@netzerocalifornia.org) and Amanda DeMarco (amanda@netzerocalifornia.org).
[1] CPUC data shows the 2024 Electric Climate Credit for PG&E, SDG&E and SCE customers as equal to $55, $86 and $78, respectively. An average of these is $73/year or $6.08/month. Source: https://www.cpuc.ca.gov/climatecredit.