The future of California's cap-and-trade program looks a little brighter, thanks to a 2-1 vote of the Court of Appeal for the Third Appellate District on April 6. The decision, which held that the cap-and-trade program is within the California Air Resources Board's (CARB) legislative delegation and that its auction sales program is not a tax, provides at least temporary stability to a key portion of the California Global Warming Solutions Act of 2006, better known as Assembly Bill 32 (AB 32).

The lawsuit was brought by the Pacific Legal Foundation, the California Chamber of Commerce, and the National Association of Manufacturers, among others, who argued that: (1) CARB acted outside its legislative delegation in creating the cap-and-trade program's auction sales program; and (2) the auction sales program constitutes a tax, and therefore the failure of the program to be approved by a two-thirds vote of each house of the Legislature was in violation of California's Proposition 13.

In a 53-page majority opinion, written by Judge Elena Duarte and joined by Judge M. Kathleen Butz, the court affirmed the judgment of the trial court along similar, but not identical, lines as the trial court's opinion. On the legislative delegation question, the majority focused on what it considered the "extremely broad discretion" conferred on CARB by the Legislature to craft a distribution system for cap-and-trade allowances. In particular, the majority noted that AB 32 required CARB to design regulations that include "distribution of emissions allowances," giving CARB what the majority held was "great flexibility" in designing a system — which could rationally include an auction program — for that distribution.

Notwithstanding the broad discretion granted to CARB, the majority held that the regulations surrounding the auction sales program were ratified by the Legislature in 2012. At that time, the Legislature passed four bills that specified how auction sales program proceeds would be spent. As the majority noted, the "legislative will to ratify the Board's auction system by the passage of the 2012 statutes is clear." In so doing, the court rejected an argument by one plaintiff that Proposition 26, which requires any change in a state statute that results in a higher tax be passed by a two-thirds vote of each legislative house, invalidated any attempt by the Legislature to ratify the auction sales program in 2012. In particular, the majority noted that the 2012 legislation did not change the cost of any allowances; rather, it merely "specified how the proceeds of auctions sales would be handled." As a result, there was no increase in any tax that would bring the 2012 legislation within the purview of Proposition 26.

The majority then turned to the second question — whether the auction sales program is a tax subject to (and in violation of) Proposition 13. Here, the court deviated slightly from the trial court in its analysis, though reached the same result — that the auction sales program does not equate to a tax subject to Proposition 13. Where the trial court relied heavily on a Sinclair Paint analysis and determined that the auction sales program's charges were more like regulatory fees than a tax, the majority rejected Sinclair Paint entirely, holding that it did not control this particular case. The majority reasoned that (1) Sinclair Paint did not hold that every payment to the government is either a regulatory fee or a tax, (2) the issue in Sinclair Paint was a regulatory fee, and (3) the auction sales program did not impose a regulatory fee or a tax.

In lieu of applying the Sinclair Paint analysis, the majority applied a two-part test for determining whether a tax was being imposed: first, is participation in the auction sales program compulsory or voluntary; and second, does participation in the auction sales program grant any special benefit to payors?

On the question of voluntariness, the majority held that participation is voluntary because regulated entities can comply with AB 32 without participating in the auction sales program, by reducing emissions, purchasing allowances from other parties, using banked allowances, or purchasing emission offsets. While compliance with AB 32 and/or participation in the auction sales program may increase the cost of doing business, the majority noted that such is a business decision and does not amount to compulsion by the state to participate in the auction sales program.

On the question of special benefit, the majority held that "the purchase of an allowance, whether at the auction or in the secondary market, conveys a valuable asset — the privilege to pollute the air." In other words, the allowances "consist of valuable, tradable, private property rights" that render a special benefit to the regulated entity. Thus, because the auction sales system meets neither of the twin hallmarks of a tax — that it is compulsory, and that it conveys nothing of particular value to the payor — it is not a tax and as a result not subject to Proposition 13.

While the majority found in favor of the auction sales program, Judge Harry Hull drafted a lengthy and detailed partial dissent, concurring in the legislative delegation question but dissenting on the tax question. On voluntariness, Judge Hull asserted that not all companies can voluntarily participate in the auction sales program; for some, it is either participate, shut down or move out of state. For those companies, participation in the auction sales program represents "an increase in costs that businesses ... must bear if they wish to do business in California; an increase in costs that is, in that sense, compulsory."

On whether allowances were properly considered a property right, Judge Hull argued that "it cannot accurately be said that what [businesses] buy at the auctions are commodities carrying property rights." Rather, "[t]he auctions are ... a revenue vehicle for the state, a vehicle by which businesses are compelled to pay the state and obtain, in return only the ability to remain in business in California." Judge Hull concluded that because "the auction program is ... compulsory if [businesses] are to remain in business in California," and does not convey any property right, it is effectively a tax, not passed by a two-thirds vote of the Legislature, and therefore in violation of Proposition 13.

Just one week following the decision, Pacific Legal Foundation announced its intent to appeal the court of appeal ruling to the California Supreme Court. The split court of appeal decision, detailed dissent, and future administrative or legislative attempts to extend the cap-and-trade rules under AB 32 beyond 2020 (its current expiration date) all increase the likelihood that the Supreme Court will hear the appeal, though it has discretion in making that decision.

In the meantime, work in the legislature continues to both reauthorize the program in more-or-less its current form, and also, to introduce bills that would authorize a continued market-based program, while including changes to the program to account for localized pollution. This latter effort is an offshoot of AB 197, passed last year, and which sought to ensure that disadvantaged communities throughout the state also see the benefits of the California's climate change laws and policies.

In short, at least for now, the future of the state's cap-and-trade program is assured.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.