California's Cap and Trade Auction Proceeds: Taxes, Fees, or Something Else? - May 2012 - Berkeley Law

 
California’s Cap‐and‐Trade
Auction Proceeds:
Taxes, Fees, or Something Else?

                May 2012

                Deborah Lambe and Daniel Farber
About Berkeley Law’s Center for Law, Energy & the Environment
This report is a product of UC Berkeley School of Law’s Center for Law, Energy & the Environment
(CLEE). The Center develops policy solutions to the most pressing environmental and energy issues at
the state, local, and national levels.

Authors
Daniel Farber is the Sho Sato Professor of Law at Berkeley Law; Faculty Co‐Director of the Center for
Law, Energy & the Environment; and Chair of the Energy and Resources Group at the University of
California, Berkeley.

Deborah Lambe is a Senior Policy Associate at the Center for Law, Energy & the Environment at Berkeley
Law.

Acknowledgements
The authors are grateful to Next 10 for its generous sponsorship of this paper. The authors are also
grateful to numerous reviewers for invaluable support and advice.
Table of Contents
I.          Introduction and Summary……………………………………………………………………………...……….……1
II.         Background: Legal Authorities and Recent Reports………………………………………..….………….3
        A. AB 32: California’s Global Warming Solutions Act…………………………………………….…………….3
        B. Proposition 13 (California Constitution Article XIII A) …………………..……………………….………. 4
        C. Proposition 26………………………………………………………….…………………………………………….……….5
        D. Sinclair Paint in Brief……………………………………………………………………………………………………….7
        E. Recent Reports on Spending the Auction Proceeds…………………………………………………………7
III.        Legal Analysis…………………………………………………………………………..……….……………………………9
       A. AB 32 Will Likely Be Subject to Prop 13, not Prop 26 .......................................................... 9
       B. Prop 13 and the Auction Proceeds ...................................................................................... 9
         1. The “Purpose of Increasing Revenue” Requirement.......................................................... 9
         2. Assessments, Development Fees, and Regulatory Fees……………………………….….……………13
         3. A New Exception? ............................................................................................................. 15
IV.         The Proposition 26 Regime…………………………………………………………….…………………………….17
V.          General Restrictions on State Spending……………………………………………………………………….19
VI.         Analysis of Spending Options Under Different Legal Schemes……………………..……………..20
VII.        Conclusion…………………………………………………………………………………………………………….….…..24
Appendix A: Spending Proposals Risk Chart…………………………………………………...…………….…….….25
Appendix B: Excerpts from AB 32…………………………………………………………………………………..….……28
Endnotes…………………………………………………………………………………………………………………………….…..29
Berkeley Law – Center for Law, Energy & the Environment

                                                      most critical limit on the state. In our view,
                                                      there are three credible arguments that
I. Introduction and Summary                           auctions are not a “tax” under Proposition 13:
                                                      (1) the primary purpose of CARB and AB 32 is
In 2006, California enacted the Global Warming        not fiscal thus Proposition 13 does not apply, (2)
Solutions Act, known as AB 32 (Pavley).1 Under        the allowances constitute a governmental
that legislation, the state must reduce               privilege like a development fee rather than a
greenhouse gas emissions to their 1990 level by       “tax,” and (3) the proceeds are spent in such a
the year 2020.2 AB 32 provided the California         fashion so as to render them a valid “regulatory
Air Resources Board (CARB) with the authority         fee” under the Sinclair Paint regime.8 If AB 32’s
to use a market‐based compliance mechanism            cap‐and‐trade program is challenged in court as
as part of its efforts to reduce greenhouse gas       imposing an illegal tax, the legal questions will
emissions.3 As a result, CARB developed a cap‐        be ones of first impression, and a court’s
and‐trade program, under which allowances to          behavior is difficult if not impossible to predict.
emit greenhouse gases will be sold at auction.4       As a result, the most conservative approach
This paper examines the legal viability of a          would be to use the auction proceeds
range of potential uses of the auction proceeds       consistent with the Sinclair Paint regime
generated by AB 32’s market‐based mechanism.          because that would maximize the number of
The paper first considers the different legal         different arguments in support of the
frameworks under which courts may consider            proposition that the auction proceeds are not a
whether the auction proceeds are a regulatory         “tax” under Proposition 13.
fee, some other fee, an unlawful tax or
something else. Then, the paper looks at 18           Spending Proposals. Under Sinclair Paint, the
different spending proposals, and considers           least risky spending proposals are those that
potential legal risks associated with the             would advance AB 32’s goals, and in particular,
spending proposals under the different legal          AB 32’s primary goal: the reduction and
frameworks.                                           mitigation of greenhouse gas (GHG) emissions.
                                                      Somewhat more risky (but still relatively low
Legal Framework.         California’s Legislative     risk) are costly spending proposals for projects
Analyst recently concluded, based on a                that advance the goals of AB 32, but also
Legislative Counsel opinion, that for the auction     advance other, unrelated goals.          Although
proceeds to be considered a “regulatory fee”          courts generally do not require that the most
(and not an invalid “tax”) the proceeds would         cost‐effective mitigation measures be adopted,
likely need to be spent on programs that reduce       if the cost‐effectiveness of a mitigation measure
or mitigate greenhouse gas emissions.5 UCLA           is very low, there is a possibility that a court
recently released a report agreeing that this         may conclude that the auction proceeds are
would be the least risky approach to revenue          being used in lieu of general funds. The timing
expenditures.6 In general, we agree with other        of the emissions reductions is likely to be
observers about the rankings of key activities in     treated similarly. The emissions cap remains in
terms of their level of risk. However, in terms       place after 2020, so spending proposals that
of the absolute level of risk, we identify some       reduce emissions after that date would further
significant arguments for upholding even the          the purpose of AB 32. At some point, however,
options with a higher level of risk, such as use of   if the emission reductions are projected to
the proceeds in the general fund. We view             occur far into the future, a court may conclude
Proposition 137 (as approved in 1978, not as          that the auction proceeds are being used in lieu
amended by Proposition 26 in 2010) as the             of general funds. Spending proposals that fund

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projects that could reduce General Fund
expenditures would be somewhat more risky,
particularly if the record suggests that the
primary purpose of the expenditures was to
reduce such expenditures rather than to reduce
GHG emissions. Under Sinclair Paint, spending
proposals that provide a rebate to taxpayers
would not advance the purpose of AB 32, and
thus would entail substantial risk. Use of the
auction proceeds for rebates would support an
argument that AB 32 was not enacted “for the
purpose of raising revenues,” however, which
would support a claim that Proposition 13 does
not apply to the auction revenues. Since this is
a novel argument, we conclude that rebates
would be associated with a high level of risk.

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II. Background: Legal                              proceeds for several reasons, including the fact
                                                   that this section is explicitly limited to only
Authorities and Recent Reports                     those revenues “collected pursuant to this
                                                   Section.” Thus, this section of the Health &
There are a number of different legal              Safety Code is unlikely to be found to apply to
authorities that may prove important to a          the auction proceeds, which are authorized by a
court’s review of the AB 32 auction proceeds:      different section.11
the statute itself, Proposition 13, approved by
the voters in 1978, and Proposition 26,            Other Constraints Other sections of AB 32
approved by the voters in 2010.9 There are also    describe the goals and aims of the program, and
two recent reports on this subject, one            direct CARB to structure the program to achieve
prepared by UCLA, the second by the Legislative    those goals. In describing the overall legislative
Analyst. Each of these is briefly described        intent, AB 32 directs CARB to design emissions
below.                                             reductions measures, “in a manner that
                                                   minimizes costs and maximizes benefits for
A. AB 32: California’s Global                      California’s economy, improves and modernizes
Warming Solutions Act                              California’s energy infrastructure and maintains
                                                   electric system reliability, maximizes additional
The language of AB 32 itself imposes constraints   environmental and economic co‐benefits for
on spending auction revenues, both directly, by    California, and complements the state’s efforts
requiring certain spending, and indirectly, by     to improve air quality.12 Another section
directing CARB to achieve certain aims             requires CARB to ensure that programs under
                                                   its jurisdiction, “where applicable and to the
Direct Constraints. AB 32 includes a section       extent feasible, direct public and private
that allows CARB to adopt “a schedule of fees,”    investment toward the most disadvantaged
and requires that the “revenues collected          communities in California and provide an
pursuant to this section” be spent “for the        opportunity for small businesses, schools,
purposes of carrying out this division.” The       affordable housing associations, and other
relevant section, California Health & Safety       community institutions to participate in and
Code §38597 (unless otherwise indicated, all       benefit from statewide efforts to reduce
references are to the California Health and        greenhouse gas emissions.”13
Safety Code) states in full:
                                                   Other sections specifically address the market‐
    The state board may adopt by regulation,       based compliance mechanism. CARB is directed
    after a public workshop, a schedule of fees    to, “[d]esign the [market‐based] regulations . . .
    to be paid by the sources of greenhouse gas    in a manner that is equitable, seeks to minimize
    emissions regulated pursuant to this           costs and maximize the total benefits to
    division, consistent with Section 57001. The   California, and encourages early action to
    revenues collected pursuant to this section,   reduce greenhouse gas emissions. . . . [to]
    shall be deposited into the Air Pollution      [c]onsider overall societal benefits, including
    Control Fund and are available upon            reductions in other air pollutants, diversification
    appropriation, by the Legislature, for the     of energy sources, and other benefits to the
    purposes of carrying out this division.10      economy, environment, and public health. . . .
                                                   [and to] [m]inimize leakage.”14 CARB is also
The UCLA report concludes that this section is     directed to “[c]onsider. . . localized impacts in
unlikely to be found to apply to the auction       communities that are already adversely

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impacted by air pollution,” to “[d]esign any           taxes.” Finally, Sections 5 and 6 concerned the
market‐based compliance mechanism to                   Proposition’s effective date and severability,
prevent any increase in the emissions of toxic         respectively. 17
air contaminants or criteria air pollutants,” and
to “[m]aximize additional environmental and            The full text of Section 3 of Proposition 13, the
economic     benefits    for     California,   as      provision relevant to the AB 32 auction
appropriate.”15                                        proceeds, states:

B. Proposition 13 (California                              From and after the effective date of this
Constitution Article XIII A)                               article, any changes in State taxes enacted
                                                           for the purpose of increasing revenues
In 1978, California voters approved Proposition            collected pursuant thereto whether by
13, an initiative constitutional amendment that            increased rates or changes in methods of
limited taxes. The California Supreme Court                computation must be imposed by an Act
described the four major elements of                       passed by not less than two‐thirds of all
Proposition 13 as:                                         members elected to each of the two houses
                                                           of the Legislature, except that no new ad
    [A] real property tax rate limitation (§1), a          valorem taxes on real property, or sales or
    real property assessment limitation (§2), a            transaction taxes on the sales of real
    restriction on state taxes (§3), and a                 property may be imposed.18
    restriction on local taxes (§4). . . . Since the
    total real property tax is a function of both      Section 4, which courts look to in interpreting
    rate and assessment, section 1 and 2 unite         Section 3, states in part:
    to assure that both variables in the property
    tax equation are subject to control.                   Cities, Counties and special districts, by a
    Moreover, since any tax savings resulting              two‐thirds vote of the qualified electors of
    from the operation of sections 1 and 2                 such district, may impose special taxes on
    could be withdrawn or depleted by                      such district . . . .19
    additional or increased state or local levies
    of other than property taxes, sections 3 and       Courts follow certain rule when interpreting
    4 combine to place restrictions upon the           ballot measures. When the language included
    imposition of such taxes.”16                       in a ballot measure is “uncertain,” “the ballot
                                                       summary and arguments and analysis
More specifically, Section 1 limited the property      presented to the electorate . . . may be helpful
tax rate to one percent of the value of the            in determining the probable meaning . . . .”20 In
property. Section 2 limited the rate at which          the California Voters Pamphlet for the 1978
the value of the property could be increased or        election,      project    proponents,     project
decreased to no more than two percent per              opponents, and the Legislative Analyst all focus
year. Section 3 required a two‐thirds vote of          primarily on the property tax limitations rather
the legislature for “…any changes in State taxes       than on the state and local government tax
enacted for the purpose of increasing revenues.        limitations. The Legislative Analyst, however,
. . .” Section 4 authorized local governments to       noted “[t]his initiative would require a two‐
impose “special taxes” provided they were              thirds vote by the Legislature to increase state
approved “. . .by a two‐thirds vote of the             taxes. . . .”21 All contributors to the California
qualified electors,” but does not include              Voters Pamphlet were silent on the issue of
language about the “purpose” of the “special           what constitutes a “tax” for purposes of Section

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3, although the Legislative Analyst described the             state property, except charges governed by
“special taxes” authorized by Section 4 as                    Section 1655 of Article XI.
“unspecified.”22                                          (5) A fine, penalty, or other monetary charge
                                                              imposed by the judicial branch of government or
                                                              the State, as a result of a violation of law.
C. Proposition 26
                                                              (c) Any tax adopted after January 1, 2010, but
Proposition 26, approved by the voters in 2010,               prior to the effective date of this act, that was
modified Proposition 13 in several important                  not adopted in compliance with the
ways. The modifications are shown below, with                 requirements of this section is void 12 months
deletions shown using strikeout, and additions                after the effective date of this act unless the tax
shown in italics:                                             is reenacted by the Legislature and signed into
                                                              law by the Governor in compliance with the
(a)From and after the effective date of this article,         requirements of this section.
any changes in state taxes enacted for the purpose
of increasing revenues collected pursuant thereto             (d) The State bears the burden of proving by a
Any change in state statute which results in any              preponderance of the evidence that a levy,
taxpayer paying a higher tax whether by increased             charge, or other exaction is not a tax, that the
rates or changes in methods of computation must be            amount is no more than necessary to cover the
imposed by an Act act passed by not less than two‐            reasonable costs of the governmental activity,
thirds of all members elected to each of the two              and that the manner in which those costs are
houses of the Legislature, except that no new ad              allocated to a payor base bear a fair or
valorem taxes on real property, or sales or                   reasonable relationship to the payor’s burdens
transaction taxes on the sales of real property may           on, or benefits received from, the governmental
be imposed.                                                   activity.

(b) As used in this section, “tax” means any levy,        Proposition 26 modified Proposition 13 in at
charge, or exaction of any kind imposed by the State,     least two important ways. First, Proposition 26
except the following:                                     expanded the two‐thirds vote requirement
                                                          from “changes in state taxes enacted for the
(1) A charge imposed for a specific benefit conferred     purpose of increasing revenues” to “[a]ny
    or privilege granted directly to the payor that is
                                                          change in state statute which result in any
    not provided to those not charged, and which
    does not exceed the reasonable costs to the
                                                          taxpayer paying a higher tax.” Thus, under
    State of conferring the benefit or granting the       Proposition 26, the purpose of the statute is not
    privilege to the payor.                               relevant, just the impact. The analysis by the
(2) A charge imposed for a specific government            Legislative Analyst in the Voter Guide for this
    service or product provided directly to the payor     provision stated:
    that is not provided to those not charged, and
    which does not exceed the reasonable costs to             Current Requirement.            The State
    the State of providing the service or product to          Constitution currently specifies that laws
    the payor.                                                enacted ‘for the purpose of increasing
(3) A charge imposed for the reasonable regulatory
                                                              revenues’ must be approved by two‐thirds
    costs to the State incident to issuing licenses and
    permits, performing investigations, inspections,
                                                              of each house of the Legislature. Under
    and audits, enforcing agricultural marketing              current practice, a law that increases the
    orders, and the administrative enforcement and            amount of taxes charged to some taxpayers
    adjudication thereof.                                     but offers an equal (or larger) reduction in
(4) A charge imposed for entrance to or use of state          taxes for other taxpayers has been viewed
    property, for the purchase, rental, or lease of           as not increasing revenue. As such, it can

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    be approved by a majority vote of the             permitting program are actually taxes and
    Legislature.                                      should be subject to the limitations
                                                      applicable to the imposition of taxes.24
    New Approval Requirement. The measure
    specifies that state laws that result in any   The proponents’ ballot arguments in the Voter’s
    taxpayer paying a higher tax must be           Guide, however, do not appear to
    approved by two‐thirds of each house of        unambiguously support this interpretation. It
    the Legislature.23                             states:

This analysis acknowledges that Proposition 13         Proposition 26 . . . PROTECTS LEGITIMATE
was aimed at statutes enacted “for the purpose         FEES SUCH AS THOSE TO CLEAN UP
of increasing revenues,” and not some other            ENVIRONMENTAL OR OCEAN DAMAGE. . .
purpose. Proposition 26 removed the purpose            .Prop. 26 protects legitimate fees and
requirement.                                           WON’T ELIMINATE OR PHASE OUT ANY OF
                                                       CALIFORNIA’S      ENVIRONMENTAL        OR
Second, Proposition 26 expanded what is                CONSUMER PROTECTION LAWS . . . .
considered to be a “tax.” The term “tax” was           ‘Proposition 26 doesn’t change or
not defined in Proposition 13.         In cases        undermine a single law protecting our air,
addressing the question of whether a particular        ocean, waterways or forests – it simply
levy was a tax, courts developed certain               stops the runaway fees politicians pass to
categories of charges that were not considered         fund ineffective programs.’ – Ryan
“taxes,” namely regulatory fees, special               Broddrick, former Director, Department of
assessments, and development fees, each of             Fish and Game.25
which is described in more detail below. There
was nothing in the language of Proposition 13      The Legislative Analyst’s summary in the Voter’s
that would have prevented a court from further     Guide states,
expanding those categories or from recognizing
new categories of charges not considered              Generally, the types of fees and charges
“taxes.” By contrast, Proposition 26 calls any        that would become taxes under the
“levy, charge, or exaction of any kind” a tax         measure are ones that government imposes
unless it falls within one of the five specified      to address health, environmental, or other
exceptions quoted above.                              societal or economic concerns.26

The findings and declarations of Proposition 26    Taken together, the text of the proposition
suggest that it was aimed at the “regulatory       appears to be in conflict with the supporters’
fee” exception to Proposition 13. The relevant     ballot argument, resulting in some ambiguity
provision states,                                  about the application of Proposition 26 to
                                                   environmental laws that existed at the time,
   [T]he Legislature and local governments         such as AB 32.
   have disguised new taxes as ‘fees’ in order
   to extract even more revenue from               D. Sinclair Paint in Brief
   California taxpayers . . . . Fees couched as
   ‘regulatory’ but which exceed the               Of the three types of charges not considered to
   reasonable costs of actual regulations or are   be taxes, one – regulatory fees – is most often
   simply imposed to raise revenue for a new       viewed as applicable to AB 32’s auction
   program and are not part of any licensing of    proceeds. The leading case interpreting what

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charges are “regulatory fees” under Proposition        not affect the state’s Proposition 98 funding
13 is Sinclair Paint. That case concerned the          obligation for K‐12 school and community
Childhood Lead Poisoning Prevention Act, which         college.
provided evaluation, screening and medical
follow‐up services to children at risk of lead         As the auction revenues are deemed to be
poisoning. The program was entirely supported          mitigation fee revenues, we are further
by fees imposed on former and current                  advised that their use would be subject to
manufacturers of lead or products containing           the so‐called Sinclair nexus test, a concept
lead, based on the manufacturers “market‐              which is derived from the Sinclair Paint
share” responsibility for the contamination.           court case referenced above. This test
The court found the program to constitute a            requires that a clear nexus must exist
“regulatory fee” and not a tax because, (1)            between an activity for which a mitigation
there was a causal connection between the              fee is used and the adverse effects related
product regulated and its adverse effects, (2)         to the activity on which that fee is levied.
the money raised was limited to the reasonable         Therefore, in order for their use to be valid
cost of mitigating the adverse effects, and (3)        as mitigation fees, revenues from the cap‐
there was a reasonable relationship between            and‐trade auctions must be used only to
the allocation of costs among payors and the           mitigate GHG emissions or the harms
burdens imposed by the payor.                          caused by GHG emissions.27

E. Recent Reports on Spending the                  The UCLA report describes the cap‐and‐trade
                                                   program and auctions as “novel” and as having
Auction Proceeds                                   “characteristics that make them unlike either a
                                                   traditional tax or a traditional regulatory‐fee
Two recent reports have looked at potential
                                                   mechanism.” The report nonetheless concludes
uses of the cap‐and‐trade auction revenues.
                                                   that in order to minimize the legal
The first report, prepared by California’s
                                                   vulnerabilities of the cap‐and‐trade program, “.
Legislative Analyst’s Office (LAO), cites to an
                                                   . . the state should consider allocation decisions
opinion of the Legislative Counsel when
                                                   as if it may be required to justify those decisions
summarizing the applicable law. The LAO
                                                   under the Sinclair regime.”28 The Sinclair “test”
report describes the law addressing the use of
                                                   is described as having the following four
auction proceeds as follows:
                                                   components, the first three of which are not
                                                   affected by decisions about allocation:
   Based on an opinion that we received from
   Legislative Counsel, the revenues generated
                                                          The nexus requirement: there is a causal
   from ARB’s cap‐and‐trade auctions would
                                                           connection or nexus between the
   constitute “mitigation fee” revenues.
                                                           product regulated and its adverse
   Because AB 32 was enacted by a majority
                                                           effects.
   vote of the Legislature prior to the voter
                                                          The reasonable cost requirement: the
   approval of Proposition 26 – and well
                                                           amount of money raised is limited to
   before its specified retroactive date of
                                                           the “amounts necessary to carry out
   January 1, 2010 – we are told that the
                                                           the regulation’s purpose.”
   provisions of Proposition 26 would not
                                                          The fair allocation requirement: there is
   apply. Also, because the proceeds from the
                                                           a “fair or reasonable” relationship
   auctions are fee revenues and not the
                                                           between the allocation of costs among
   proceeds of taxes, we are also advised that
   the state’s receipt of these monies would

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       payors and the benefits received or the
       burdens imposed by the payor.
      The no unrelated spending requirement:
       the fees may not be used for “unrelated
       revenue purposes.29

The second and fourth components are mirror
images of each other, as noted by UCLA. In
looking at the Sinclair test, combined with AB
32’s stated goals, the report sets forth four
criteria to judge “the relative risks of
expenditure proposals, with ‘yes’ answers
yielding less risk.” The four criteria are:

      Will the project permanently, verifiably
       reduce greenhouse gas emissions?
      Will the project advance other explicit
       AB 32 goals?
      Has the state built a strong record
       showing how the revenue will achieve
       the purposes of AB 32?
      Does the project avoid direct allocation
       of money for revenue purposes
       unrelated to AB 32?30

UCLA then applies its test to seven sample
spending proposals.

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                                                    instruments or allowances could be found to be
III.    Legal Analysis                              development fees or special assessments, since
                                                    they are akin to those types of fees. Third, the
                                                    proceeds may be considered “regulatory fees” if
A. AB 32 Will Likely Be Subject to                  the auction proceeds are used to mitigate GHG
                                                    emissions or the harms caused by GHG emission
Prop 13, not Prop 26                                consistent with the criteria set forth in Sinclair
                                                    Paint, the leading California Supreme Court case
Both the LAO and the UCLA reports concluded         in this area.
that Proposition 26 is unlikely to apply to
revenues generated by AB 32’s market‐based              1. The “Purpose of Increasing
compliance mechanism. This is because AB 32,               Revenue” Requirement
including the provision authorizing a market‐
based compliance mechanism, was enacted             The provision of Proposition 13 relevant here,
prior to voter approval of Proposition26, and       Section 3, applies only to fees “enacted for the
prior to Proposition26’s specified effective date   purpose          of      increasing      revenues.”
of January 1, 2010. In addition, as discussed       Consequently, if the cap‐and‐trade auction
above, the description of Proposition 26 drafted    program was enacted for some other purpose
by supporters and contained in the ballot           (and there is evidence that it was) then the
package states that Proposition 26 will not         auction proceeds should not be viewed as a tax.
apply to any existing environmental statutes.       There are a number of reasons to believe that
Opponents of AB 32 may argue that the cap‐          the AB 32 market‐based mechanism was not
and‐trade regulations were adopted after the        adopted for the purpose of raising revenues.
effective date of Proposition 26, thereby           These reasons are discussed below, and include
making the cap‐and‐trade program subject to         the language of the statute itself, CARB’s
Proposition 26.        The requirements of          purview and the AB 32 planning process, the
Proposition 26, however, are expressly limited      fact that emitters can take steps to avoid
to changes in “state statute,” not changes in       participating in the auctions, evidence that
state regulations.                                  market‐based mechanisms have other benefits,
                                                    and the many benefits to auctioning allowances
B. Prop 13 and the Auction Proceeds                 rather than giving them away. Despite this
                                                    evidence, this is a novel argument and as a
Proposition 13 requires all taxes to be passed by   result it is difficult to predict how it would fare
a two‐thirds majority of each of the two houses     in court.
of the Legislative. Since AB 32 was not passed
by a two‐thirds vote of the Legislature, the cap‐   This section first briefly describes some of the
and‐trade program may be at risk if the auction     many aspects that lead policy makers to prefer
proceeds are found to constitute a “tax.”31 We      market‐based approaches to conventional
believe there are at least three plausible          command‐and‐control approaches. Then, the
arguments that the auction revenues are not         purpose of the AB 32’s cap‐and‐trade program
“taxes” subject to Proposition 13, each of which    is reviewed in light of the statutory language.
is described in more detail below. First, unlike    The purpose of CARB in approving the auctions
other fees, the cap‐and‐trade program was not       is then discussed, followed by a discussion of
“enacted for the purpose of increasing              how covered entities can take steps minimize or
revenues,” and is thus not subject to               eliminate their participation in the auctions.
Proposition 13.       Second, the compliance        Finally, this section discusses why courts, in

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considering whether an exaction is a fee or a         Even if market‐based mechanisms are the most
tax, have not typically focused on the “purpose       efficient way to allocate allowances, if the
of increasing revenues” language. Consistent          statute is not for the purpose of generating
with this view, the Sinclair Paint Court stated, “.   revenues, why not just give the auction
. . if regulation is the primary purpose, the mere    allowances away? There are a number of
fact that revenue is also obtained does not           reasons why an auction is preferable to the free
make the imposition a tax.”32                         distribution of allowances. An auction is the
                                                      most socially and economically efficient way to
Cap‐and‐Trade Compared to Conventional                allocate allowances to the entities that value
Command‐and‐Control Measures                          them most highly because auctions are
                                                      administratively transparent and efficient, and
Market‐based mechanisms such as AB 32’s cap‐          result in allowances being allocated to those
and‐trade program are used principally because        that value them most (the highest bidders).35
they achieve the desired emissions reduction          These and more reasons for preferring auctions
goal at the lowest possible cost, not because         are discussed very briefly below, and include
they may raise revenue. Under a cap‐and‐trade         price discovery, transparency, the treatment of
program, the producers and consumers of               new entrants, efficiency, and the avoidance of
energy choose for themselves the most cost‐           windfall profits.
effective mix of emissions reductions and
allowance purchases.33 Since emitters have the        Price Discovery. Auctions create a clear price
best information about their business processes       signal – one that does not exist if the
and practices, they are much better placed to         compliance instruments are the subject of
make these decisions than are government              private exchanges. For that reason, the price
regulators. If it is cheaper for a regulated entity   signal sent by an auction provides information
to reduce emissions than it is to purchase            that facilitates the smooth functioning of the
allowances, the regulated entity will likely          market.36
reduce emissions. Indeed, regulated entities
could choose to switch fuels, increase energy         Transparency. Auctions are transparent, and
efficiency, or implement other means of GHG           there are two ways in which transparency is
reductions instead of participating in the cap‐       important.        First, with an auction, the
and‐trade program. If the regulated entities          assignment of allowance value is transparent.
choose not to do this, it is because it is cheaper    By contrast, giving away allocations can obscure
for them to meet the pollution control                the true recipients of the value, and the
requirements using the allowances. The ability        magnitude of the value being distributed.37
to trade under AB 32’s cap‐and‐trade program          Second, this transparency helps expose
further enhances the ability of emitters to take      hoarding behavior. Hoarding occurs when an
advantage of the least costly means of meeting        entity obtains compliance instruments that it
their compliance requirements.34 Thus the cost        does not need for its own emissions. There are
of compliance is less for a market‐based              a number of reasons why entities may hoard
approach than with a command‐and‐control              allowance, among them speculation, market
approach, which is the reason market‐based            manipulation (the purchasing of allowances to
approaches are used.                                  raise their price, and then selling them), and
                                                      raising rivals’ costs.38 Exposure through the use
The Reasons Allowances are Auctioned                  of an auction helps minimize this behavior.

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Simple and Fair Treatment of New Entrants.          that pertains to the market‐based mechanism is
Market mechanisms that rely in free allowances      silent on the issue of revenues. Except for the
need to include in the allocation scheme a          provision of AB 32 that imposes fees to fund
process to address sources entering and exiting     implementation of the program, revenues are
the market.39      Allocation formulas involve      not discussed nor mandated by the statute.
controversial issues relating to equity between     The statute does not require the State Board to
emitters and to grandfathering. The use of an       include a market‐based approach, stating that
auction avoids these issues, and allows new         the state board “may include. . . the use of
emitters to face the same cost as existing          market‐based compliance mechanisms. . . .”45 If
competitors.                                        Legislators intended to use an auction to raise
                                                    revenues, AB 32 would likely have required
Most Efficient Method of Allocation. An auction     market‐based mechanisms, and would have
is the method that best allocates allowances to     included a requirement that emission
those who value them most. There are several        allowances be sold or auctioned. Instead, the
reasons for this. First, by relying on businesses   market‐based mechanism is optional, and there
to determine for themselves the worth of the        is no requirement that the allowances be sold
allowances, auctions “. . . extract and use         or used to generate revenues. Indeed, the plan
information unavailable to the government.”40       adopted by CARB initially allocates a majority of
Second, if allowances are distributed freely,       the allowances free of cost to emitters (e.g.,
there is no guarantee a market will efficiently     investor‐owned utilities are initially provided
reallocate them because of friction, and resale     allowances at no charge).46 Throughout AB 32
does not resolve all inefficiencies.41 Auctions     there is language about the purpose of the
reduce transaction costs because rather than        statute, but there is no language suggesting the
buyers and sellers trying to find one other, they   purpose of a market‐based compliance
can buy and sell allowances on a centralized        mechanism is to raise revenues. As the
market, which reduces transaction costs.42          California Supreme Court has stated, “if
                                                    regulation is the primary purpose, the mere fact
Avoidance of Windfall Profits.          The free    that revenue is also obtained does not make the
allocation of compliance instruments would          imposition a tax.”47
result in windfall profits for existing regulated
entities, at the expense of consumers and new       The only language in the section authorizing
entrants.43 Auctions treat new entrants fairly      market‐based compliance mechanisms that
since they compete on the same playing field as     could be said to touch on anything even
older firms, which is not the case if allowances    remotely related to this topic requires the State
are given away. When allowances are given           Board, in designing a market‐based program, to
away, existing companies, and inefficient           “[m]aximize additional environmental and
companies (those who have not taken action to       economic      benefits    for    California,   as
reduce emissions) are rewarded, while new           appropriate.”48 In order to read this provision
companies, and companies that took early            as a requirement that revenues be generated,
action to reduce emissions are penalized.44         the term “maximize economic benefits for
                                                    California” would need to be equated with
Statutory Language and the Design of the            “raising revenues.” It would strain the plain
Program. Both the statutory language and the        language of the statute to read this provision as
design of the cap‐and‐trade program suggest         calling for revenues instead of calling for the
that the AB 32 was not enacted for the purpose      State Board to consider economic concerns,
of increasing revenues. The portion of AB 32        such as leakage or the impact of regulations on

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jobs, in the event a market‐based mechanism is       the fee at issue in Sinclair Paint was imposed on
used. The fact that such considerations need         manufacturers “formerly and/or presently
only be made, “as appropriate” further               engaged in the stream of commerce of lead or
supports this point.                                 products containing lead” and was based on the
                                                     manufacturer’s “past and present responsibility
CARB and the AB 32 Planning Process. The             for environmental lead contaminations, or its
identity of the decision maker and the decision‐     ‘market share’ responsibility for this
making process are also relevant in considering      contamination.”51 Ceasing production might
the purpose of the statute. CARB is not part of      reduce a manufacturer’s payment, but it would
the state’s fiscal apparatus, and its mission does   not eliminate the payment.              Moreover,
not include raising revenue for the state.           manufacturers could not purchase offsets or
Moreover, the lengthy planning process and           allowances from others. Thus, there was no
attendant documentation confirm that CARB’s          way the manufacturers in Sinclair Paint could
concerns were environmental and economic             avoid paying the fee, the primary purpose of
impacts, not state revenue. In the Scoping Plan,     which was to fund a mitigation program.
CARB acknowledges that “emission allowances
represent a significant economic value whether       Why Courts Have Not Focused on the “Purpose”
they are freely allocated or sold through            Requirement in Proposition 13. The statute at
auction,” but goes on to note,                       issue in Sinclair Paint was enacted for the
                                                     purpose of raising revenue to fund a mitigation
    [A] broad set of factors must be considered      program.      In Sinclair Paint, the California
    in evaluating the potential timing of a          Supreme Court asked whether the “fees” at
    transition to a full auction including           issue were, “in legal effect ‘taxes enacted for
    competitiveness, potential for emissions         the purpose of increasing revenues’ . . . and
    leakage, the effect on the regulated vs.         therefore subject to a two‐thirds majority vote.
    unregulated industrial sectors, the overall      . . .”52 Since the Sinclair Paint court “. . . found
    impact on consumers, and the strategic use       no cases that interpret the language of section
    of auction revenues.49                           3 [of Proposition 13],” the Court looked at
                                                     California cases that considered whether
We were unable to locate any language in the         various fees were “special taxes” governed by
planning documents that would support a claim        Section 4. In those cases, courts analyzed
that CARB included a market‐based approach           certain statutes enacted for the purpose of
“for the purpose of increasing revenues.”            raising revenue, but nonetheless found them to
                                                     be fees because they fell into one of three
Emitters Can Avoid Participating in the              categories of exactions that were not
Auctions. “Most taxes are compulsory rather          considered taxes, namely regulatory fees,
than imposed in response to a voluntary              development fees, and special assessments.
decision . . . to seek . . . governmental . . .      The Sinclair Paint Court described the “special
privileges.”50 In contrast, the AB 32 auction is     tax” cases as “. . . helpful, though not
not mandatory. Entities could choose to reduce       conclusive” because “[t]he reasons why
or eliminate their greenhouse gas emissions          particular fees are, or are not, ‘special taxes’
instead of participating in the auction.             under article XIII A, section 4, may apply equally
Alternatively, subject to CARB restrictions,         to section 3 cases.”53 Section 4, unlike Section
emitters could obtain offsets or could purchase      3, however, does not limit the two‐thirds vote
allowances from other emitters rather than           requirement to taxes “enacted for the purpose
purchasing allowances by auction. By contrast,       of increasing revenues,” thus the “special tax”

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cases do not weigh in on that precise language.    Special Assessments. Special assessments “…on
The Section 4 cases do look at the purpose of      property or similar business charges, in
the exaction by considering whether it is aimed    amounts reasonably reflecting the value of the
at generating general revenue but use that as a    benefits conferred by improvements, are not
proxy for the purpose of the statute.              ‘special taxes’ under Article XIII A, section 4.”57
                                                   Examples include “assessments on businesses
In sum, there are many reasons to believe that     for downtown promotion,” “facilities benefit
AB 32’s market‐based compliance mechanism          assessments,” “special assessment on real
was not enacted for the purpose of increasing      property,” and “special assessments for
revenues. Provided “. . . regulation is the        construction of streets.”58 These examples
primary purpose of the fee measure, the mere       share a common trait, which is that the
fact that the measure also generates revenue       assessments are used to fund some type of
does not make the imposition a tax.”54 Relying     improvement – be it infrastructure or
solely on this approach, however, is potentially   downtown beautification. Since GHG emissions
risky as no courts have looked at this precise     are not tied to a particular property, and since
question.                                          emissions reduction more closely resemble a
                                                   mitigation fee than an improvement, the
    2. Assessments, Development Fees,              auction proceeds are unlikely to be found to fall
       and Regulatory Fees                         within this category.

Courts have held that under certain                Development Fees. Development fees “. . .
circumstances statutes enacted in part for the     exacted in return for building permits or other
purpose of increasing revenues are fees, not       governmental privileges are not special taxes if
taxes. As described by the Sinclair Paint Court,   the amount of the fees bears a reasonable
there are three general categories of fees or      relation to the development’s probable costs to
assessments: (1) special assessments, based on     the community and benefits to the
the value of benefits conferred on property; (2)   developer.”59      Examples include “school
development fees, exacted in return for permits    facilities fees,” “fire hydrant fees,” “transit
or other government privileges; and (3)            impact fees,” “new facilities water hookup
regulatory fees, imposed under the police          fees,” “fees as preconditions for building
power.”55 The Court went on to note that the       permits,” “fees for processing subdivision,
three categories may overlap in a particular       zoning and land use applications.”60         Put
case, which may be the case here.56 Spending       differently, development fees “compensate the
the auction proceeds in such a way so as to        state for governmental privileges granted to
allow them to be characterized as falling into     those manufacturers.”61 Traditionally, such fees
one of these exceptions would be the safest        are “imposed on development projects in order
way to move forward since then there would         to finance public improvements or programs
multiple argument that the super‐majority          that bear a ‘reasonable relationship’ to the
requirement does not apply – the cap‐and‐          development at issue.”62
trade program was not enacted for the
purposing of increasing revenue, and even if it    The auction proceeds are similar in some ways
was enacted for the purpose of raising revenue,    to development fees.          An emitter that
the auction proceeds constitute a fee not a tax.   purchases an allowance will have obtained a
Following is a discussion of each of the three     governmental privilege that benefits the
exceptions.                                        emitter – the right to emit a certain quantity of
                                                   greenhouse gas emissions. And, the fee will

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bear a reasonable relation to the benefit              The Sinclair Paint court stated, however, that
provided to the purchaser since an auction will        distinguishing between a tax and a fee can be
be used to determine the price.              If the    difficult.
purchaser did not think the value of the
allowance was greater than the bid, the                    The cases recognize that ‘tax’ has not fixed
purchase would not have been made. Put                     meaning, and that the distinction between
differently, if it was less costly for an emitter to       taxes and fees is frequently ‘blurred,’ taking
reduce emissions than it was to purchase the               on different meanings in different contexts.
allowances at auction, the emitter would                   In general, taxes are imposed for revenue
reduce emissions. Moreover, the price for the              purposes, rather than in return for a specific
allowances will be the lowest price bid by a               benefit conferred or privilege granted.
successful bidder, so all purchasers except for            Most taxes are compulsory rather than
those bidding at that exact price will be paying           imposed in response to a voluntary decision
less than they bid. This suggests that for most            to develop or to seek other government
bidders the value of the allowances is more                benefits or privileges. But compulsory fees
than what they ultimately pay. The fact that               may be deemed legitimate fees rather than
the allowances can be sold and the profit                  taxes.66
retained by the seller also supports a claim that
the auction allowances are tantamount to               The Sinclair Paint Court found statutes that
“development fees” in that the emitter will            shifted the costs of controlling pollution from
have obtained a governmental privilege. If the         the public to the polluters to be consistent with
auction proceeds were used to finance                  the intent of Proposition 13. The “…police
adaptation measures only, that would be even           power is broad enough to include mandatory
closer to the traditional development fee than if      remedial measures to mitigate the past, present
also used to fund GHG emission reduction               or future adverse impact of the fee payer’s
programs. Since no court has looked at this            operations, at least where, as here, the
issue, such an approach would entail some risk.        measure requires a causal connection or nexus
                                                       between the product and its adverse effects.”67
Regulatory Fees. The type of fee that is most          The Court continued, “[i]n our view, the shifting
likely to be found to be applicable here is a          of costs of providing evaluation, screening, and
regulatory fee. Regulatory fees are imposed            medically necessary follow‐up services for
under the police power, rather than the taxing         potential child victims of lead poisoning from
power, and are not taxes provided the fees “. . .      the public to those persons deemed responsible
do not exceed the reasonable cost of providing         for that poisoning is likewise a reasonable
the services necessary to the activity for which       police power decision.”68 Sinclair Paint applied
the fee is charged and which are not levied for        the test set forth in an earlier case, San Diego
unrelated revenue purposes.”63 In order to             Gas & Electric Co. v. San Diego County Air
avoid being called a “tax,” a fee or assessment        Pollution Control District, which described the
must not be “primarily aimed at producing              test for a “regulatory fee” as follows:
revenue.”64 Nonetheless, “if regulation is the
primary purpose of the fee measure, the mere               (1) the fee cannot exceed the cost of the
fact that the measure also generates revenue               service or regulatory activity (i.e., cannot be
does not make the imposition a tax.”65                     primarily aimed at producing revenue), and
                                                           (2) the fee must be fairly or reasonably
                                                           related to the payor’s burdens on or benefit
                                                           from the service provided.69

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                                                         overall cost of the governmental regulation.
Provided the auction proceeds are spent within           They need not be finely calibrated to the
the regulatory fee framework, the cost of the            precise benefits each individual fee payor
allowances may be viewed as a regulatory fee.            might derive. What a fee cannot do is
Part one of the test states, “the fee cannot             exceed the reasonable cost of regulation
exceed the cost of the service or regulatory             with the generated surplus used for general
activity.” As previously discussed, in addition to       revenue collection. An excessive fee that is
the section allowing a market‐based compliance           used to generate general revenue becomes
mechanism, AB 32 also contains a section that            a tax.71
authorizes the imposition of fees on regulated
entities for the purpose of funding AB 32’s          This language is somewhat more restrictive
implementation. Auction proceeds will not be         than the Sinclair Paint language, since it
needed to fund such implementation, so in            suggests that revenue generation, even if not
order to satisfy the first part of the test, the     the primary purpose of the fee measure, would
auction proceeds would need to equal the cost        turn a fee into a tax. Provided the auction
of the service provided, in this case GHG            proceeds are not used for general revenue
emissions reductions and/or mitigation. This is      purposes, however, they may be consistent
somewhat different from a traditional                with this language. The Court also considered
regulatory fee where the fee is imposed in           whether the statutory language “reveals a
order to fund a specific program, but spending       specific intention to avoid imposition of a tax.”72
the cap‐and‐trade proceeds on mitigation and         Since “there is a safeguard in the statute
adaptation would seem fit within the regulatory      authorizing the SWRCB to ‘further adjust the
fee framework. Part two of the test states, “the     annual fees’ if it ‘determines that the revenue
fee must be fairly or reasonably related to the      collected during the preceding year was greater
payor’s burdens on or benefit from the service       than, or less than, the revenue levels set forth
provided.”     Since the allowances will be          in the annual Budget Act…” the Court concluded
auctioned off, the cost of the allowances would      that the charges were regulatory fees, not
seem to be reasonably related to the payor’s         taxes.73 There is no similar provision in AB 32.
benefit from the service provided since
otherwise the payor would not have bid what it       In both cases, the fees were enacted for the
did.                                                 purpose of raising revenues to fund particular
                                                     regulatory programs.           For the auction
Last year, the California Supreme Court issued       allowances, however, the primary purpose of
another opinion on regulatory fees that may          the auction is to reduce the overall cost of
have narrowed the definition of regulatory           compliance, not to fund a regulatory program,
fees.70 That case, California Farm Bureau            so the auctions do not fit neatly in this category.
Federation v. State Water Resources Control          The benefit of the program should be clear,
Board (CFBF), was focused largely on whether         though, since covered entities purchase
the way the fee was imposed was fair, however,       allowances because it is less costly than
the Court described regulatory fees as follows:      installing pollution control equipment.

    A regulatory fee may be imposed under the            3. A New Exception?
    police power when the fee constitutes an
    amount necessary to carry out the purposes       Since the auction proceeds do not fall neatly
    and provisions of the regulation. . . .          into any of the existing exceptions from
    [P]ermissible fees must be related to the        Proposition 13, a court might establish a new

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