Stay-at-home policies and the economic turmoil caused by the COVID-19 pandemic are reducing demand for fossil fuels in California, and some stakeholders are concerned about what this means for the state's upcoming cap-and-trade auction.

Gasoline production in the state dropped by nearly 48% between the week ending March 20 and the last week of April, according to a report from the California Energy Commission. Jet fuel and diesel production reduced by 68.3% and 33.2%, respectively, as well. All refiners in the state have shrunk the amount of crude oil they're processing to reduce excess gasoline and diesel. And while natural gas demand has increased by around 6%, the average weekday demand for electricity was 9% lower in April as compared to April 2019.

"The issue is, if energy consumption is down — which is what we are seeing in this report —​ then your emissions from the energy sector are therefore also down, which means they have a lower compliance obligation under the cap-and-trade program," Katelyn Roedner Sutter, manager, U.S. climate at the Environmental Defense Fund, told Utility Dive. 

Severin Borenstein, professor at the University of California's Haas School of Business and member of the California Independent System Operator's Board of Governors, concurred.

"I think it's quite possible that demand will be so low that the state will get no revenues at all from the auction, because the state is last in line … among all of the entities auctioning the allowance," he said.

'Weak demand' poses risk to next auction

California's next cap-and-trade auction is scheduled for Wednesday, with summary results due the following Thursday. The last auction raised around $600 million for the state's greenhouse gas reduction fund, and "2020 is off to a strong start in the Western Climate Initiative," Roedner Sutter wrote in a blog post in February.

But low demand for fossil fuels, as outlined in the CEC report, could change that.

In January, California Gov. Gavin Newsom released a budget proposing a $965 million plan for cap-and-trade funds. A revision issued last week, however, noted that with current economic conditions, "there is significant uncertainty surrounding the amount of Cap and Trade proceeds that will be generated in the upcoming auctions, which could result in lower auction proceeds than previously estimated as statewide emissions of greenhouse gases have decreased significantly."

The revision creates a "pay-as-you-go" system where expenditures are based on the actual revenue collected at the quarterly auctions, and air quality, fire prevention and drinking water programs are given priority. 

This quarter's auction could come in with far lower overall sales, both because of overall demand as well as the way the auction is designed, David Weiskopf, senior policy advisor at Nextgen Policy, told Utility Dive. First, entities covered by cap-and-trade rules get a certain number of free allowances, so the number of allowances they need to buy only covers a percentage of actual emissions for that year. 

"In a year where refinery output is down as much as it is this year, or in a quarter like this, it's entirely conceivable that those free allowances may cover 100% or more than 100% of those emissions … so there may not be a need to participate in the auction at all," he said.

There's also an active secondary market for allowances where entities can trade among themselves and potentially purchase additional allowances at a lower cost.

"There's this bigger question this year, with this unprecedented drop in demand, of whether folks will need to buy allowances at all this quarter," he said. 

It's theoretically possible that the state sees no revenue whatsoever from this auction, according to Roedner Sutter —​ but it's "more likely that the revenue is lower than expected," she said in an email. 

Whether future auctions are also impacted depends on the extent of the economic downturn, experts said. And there's also an element of political uncertainty, according to Borenstein —​ other cap-and-trade markets, when prices stayed very low for a long time, decided to adjust the total number of allowances to try and boost the prices up. 

"I certainly wouldn't rule that out," Borenstein said, adding, "I think that we're going to see very weak demand, so it would not surprise me to have that happen here."

Transportation electrification programs could see hit

With lower revenues, there's a real risk that some important clean energy programs, like those that fund low-carbon transportation and heavy-duty vehicle electrification, don't get funded at all or receive a significant haircut, Roedner Sutter said. 

"Those are exactly the kind of programs that reduce emissions, help improve air quality and help create jobs —​ and that's exactly what the state should be doing right now," she said. 

Weiskopf noted that transportation electrification programs are relatively recent and early enough in their life cycle that the loss of cap-and-trade funding could be really consequential. 

"If you think about heavy-duty vehicle electrification, a $100 million plus or minus there could have an important compounding effect over time," he said. "It's hard to say that one or two or three bad auctions really changes that in the long term, but the important thing to remember is that with climate change and with the 2030 emissions reduction targets, we're in a race against time."

That race is complicated by the need to change over long-lived assets, like semi-trucks that may stay on the road for 30 years, he said, "so when you make that equipment, change out matters a lot."

'I strongly prefer a carbon tax'

The pandemic is also throwing light on broader questions regarding the cap-and-trade system's role in California's clean energy transition.

In 2019, Borenstein co-authored a paper identifying potential problems with the mechanism —​ "that there is huge macroeconomic uncertainty with the demand for these emissions and if the economy does badly, it's easy to hit a cap." On the flip side, when the economy does well, you could get an extremely binding cap and skyrocketing prices that probably overstate value, he explained. 

"When I first started working on this, more than a decade ago, I was sort of agnostic between cap-and-trade and a carbon tax, and I'm not anymore —​ I strongly prefer a carbon tax for this reason," he said. 

Even before the pandemic and associated recession, a good number of folks have been questioning how to move beyond cap-and-trade and implement market transformational initiatives, like clean vehicles, building decarbonization and other sectors that are getting off the ground slower than they should, Weiskopf said. 

"What this market crash will potentially do is to make that question more urgent in more people's minds," he noted. "That's the way I'm thinking of it, really ... an environment where more people are going to be aware of the limitations of cap-and-trade funding for these programs. How will that change the political dynamics around that program and clean investment in general?"