Cap and trade — how it will work

Approach uses the power of the marketplace to reduce pollution, in theory doing so at the lowest possible cost.

The basics

In California’s system, government regulators set an annual limit — or cap — on the greenhouse gas emissions produced by the state’s factories, power plants and oil refineries. The cap will decline about 1 percent in the system’s first two years and 3 percent each year after that.

Companies will buy and sell permits — called allowances — to emit carbon dioxide and other heat-trapping gases. Each allowance represents 1 ton of carbon dioxide. The minimum price set by the state starts at $10 per allowance and will slowly increase over time.

The number of allowances each company must hold is determined by the state, based on the standard emissions from their type of business or facility. Companies that cut their emissions quickly will have spare allowances they can sell to other businesses that are having a hard time making reductions.

Who gets what

At first, the state’s electric utilities will get all the allowances they need for free. They will be required to sell those allowances at state-organized auctions that occur four times each year. The money the utilities make must be used to benefit their ratepayers, possibly through a credit on customers’ bills.

Most manufacturers will receive 90 percent of their allowances for free in the system’s first two years, dropping to 75 percent in 2015.

The auction

The first auction happens Wednesday, with 62.6 million allowances up for sale on an electronic trading platform.

Companies and traders who register in advance submit sealed bids specifying how many allowances they want to buy, and at what price. The bids are ranked from highest price to lowest until all the allowances have been allocated. The lowest price at which allowances are allocated becomes the price that all participants pay, regardless of their original bids.

The California Air Resources Board, which created the cap-and-trade system, will report the final price along with the names of all market participants on Nov. 19.

The secondary market

Companies and traders can continue trading outside the auctions. But each allowance has a serial number, and all transactions must be recorded in a central tracking system.

Offsets

Companies can also buy offsets, credits generated by forestry projects and other endeavors that either remove greenhouse gases from the atmosphere or reduce emissions. But the offsets must be generated in the United States and can account for no more than 8 percent of all the allowances that a company needs.

Market manipulation?

The Air Resources Board has set limits on the percentage of available allowances that any individual company or trader can hold, to prevent anyone from cornering the market. Consultants will also monitor the auctions, looking for unusual trading behavior.

Where does the money go?

Amazingly enough, this hasn’t been decided. By law, money the state raises by selling allowances must be used to help reduce greenhouse gas emissions and cannot simply be dumped into California’s general fund as if it were tax revenue. But the Legislature has not yet hammered out the details.