The California dreamers within the Ontario Liberal government got a bit of a wake-up call last week when the Golden State’s cap-and-trade carbon-auction system crashed and nearly burned. At the quarterly auction of emissions permits offered by California and Quebec, only 11 per cent of the permits were bought, leaving giant holes in the revenue plans of both governments. The California government received only a fraction of an anticipated US$500 million while Quebec, anticipating $200 million, will be lucky to see $20 million.

In Ontario, the government of Kathleen Wynne has its green eyes set on $1.9 billion a year in new revenue after it joins the California cap-and-trade auction regime in 2017. Environment Minister Glen Murray, having skillfully leaked the provincial government’s big-spending green-energy plan, is preparing a final version based on the assumption that cap-and-trade will deliver a river of easy cash into which the government will dip. But what if the big California river is dry?

It’s way too early to declare the system a failure, but it is clear that Ontario is set to join an experimental carbon-trading regime that faces severe problems. A Wall Street Journal editorial this week referred to “The California Cap-and-Trade Bubble.” A market analysis circulating in California concludes that “Cap and trade is suffering from a confidence crisis amid significant uncertainty about the future of the program.” In Europe, where the traded price of carbon has collapsed to $9 a tonne, nations are battling over the shape of a new regime.

The uncertainties have a direct bearing on Ontario’s plans to join the California system in 2017 and 2018. In the short run, the California-Quebec market appears to have a massive surplus of previously issued emissions permits that trade on an open market at below the official floor price of US$12.73 a tonne set by the California Air Resources Board (CARB). Some say the surplus exceeds 100 million tonnes, which might explain why many of the usual buyers of emissions permits decided to stay away when the May auction offered up 77 million tonnes in new permits. As many as half the usual energy-consuming buying entities failed to bid.

Among the companies staying away from the May auction in California were Suncor’s Quebec-based operation and Valero Energy, which owns Canada’s second-largest refinery in Levis, Que. Calls to the companies to explain their absence were not returned, and one expert said they would be unlikely to explain their motives since doing so would amount to a breach of the auction rules. “This information is commercially sensitive and, as a rule, we don’t provide comment off the record,” a Suncor spokesperson said in an email.

The auction’s failure caught Pierre-Olivier Pineau, a professor of business management at HEC Montreal, by surprise. With strong growth in sales of SUVs and other gas-consuming vehicles, “there’s been no decrease in gasoline sales” in either Quebec or California, he said. So then why would two major Quebec-based companies stay away from the May auction?

Among the likely structural reasons for sitting out the auction is that the California regime faces longer-term legal and political challenges. First, a California appeals court is set to rule on a case challenging the constitutionality of the cap-and-trade system. The suit, filed by the California Chamber of Commerce and Morning Star Packing Co., hinges on whether cap-and-trade is a tax or a regulatory measure. Under the state constitution, the system would be deemed illegal if the court decides it effectively amounts to a tax.

Since the state of California, like Ontario, plans to use the billions collected from the sale of carbon emissions to build allegedly green projects, cap-and-trade looks like a wealth transfer and smells like a tax. Among the schemes to be funded from cap-and-trade in California is a bullet-train system up and down the state.

Beyond the court challenge, the California system is set to expire in 2020 unless the government renews it. Realistically, the contours of a new set of rules, targets and regulations need to be established within the next couple of years. Seeing uncertainty ahead, carbon-permit buyers may prefer to wait and see what’s coming next.

CARB officials dismiss the May auction failure, and a less-disastrous failure at an earlier auction in February, as nothing more than the usual “ups and downs, as there always are in markets.” Could be, although the European experience with cap-and-trade suggests otherwise.

At HEC Montreal, Pineau says Quebec appears to have no preparations in place to deal with dramatic changes in California’s system or its failure. In the event it fails, he says, Quebec companies would still have to meet emissions targets and would presumably have to do so by trading within Quebec. If Ontario were to join the Quebec system, minus California, the structure would have to be completely revamped, with new targets and new operating and pricing regimes.

Overall, the California-Quebec cap-and-trade connection is still in operation, but now under a cloud of uncertainty. As a result, the Ontario plan to join the California system and collect billions in easy revenues looks even more uncertain and undesirable than it does in Glen Murray’s $7 billion electric-car and natural-gas-reduction strategies.

^{Corcoran, T. (2016, June 3). Terence Corcoran: Ontario's rude awakening from its California carbon dreams. Retrieved June 03, 2016, from http://business.financialpost.com/fp-comment/terence-corcoran-ontarios-rude-awakening-from-its-california-carbon-dreams}