California’s landmark cap-and-trade program for controlling greenhouse gases (GHGs) gets underway this year, with the state’s first public auction slated for November 2012. The state faces crucial questions about how to spend proceeds from its cap-and-trade auctions. Although the auctions are not primarily aimed at generating revenue, the amounts of money at stake are significant, with projections on the order of a billion dollars in the program’s first year and more as the program expands.

As legislators, stakeholders, and advocates develop their positions about how these monies should be spent, it is critical to understand what legal constraints the state is under in its decisions about revenue allocation.

This paper assesses legal constraints on AB 32 auction revenue allocation that derive from the statute itself or from California’s constitutional restrictions on the use of regulatory fees (embodied in Proposition 13). Based on our findings, we make recommendations about the relative risks of approaches to allocating AB 32 state auction proceeds. The aim of our paper is to inform decisionmaking on revenue allocation; as such, we do not address broader questions about the legality of the cap-and-trade program as a whole, but focus on questions that are affected by allocation decisions.

In general, we conclude that the safest proposals, from a litigation risk perspective, are those that are primarily aimed at funding greenhouse gas reductions; those that achieve other goals explicitly endorsed by AB 32; those where these conclusions are supported by a factual record developed by the Legislature or by CARB; and those that avoid direct allocation of money for revenue purposes unrelated to AB 32.

The further the state strays from these principles in spending auction money, the more it risks a litigation loss that could be detrimental to its cap- and-trade program. If a court ultimately concludes that portions of its revenue allocations are illegitimate, the likely potential consequences include invalidation of that revenue choice or of the overall legislative allocation of revenue, though it is possible that a court-ordered remedy would create more significant disruptions of cap and trade.

This paper draws no conclusions and makes no recommendations about the correct way to allocate funds. We recognize that such decisions will reflect policy judgments and goals that are beyond our scope here. Instead, we hope to inform the dialogue on allocation by shedding light on the relative litigation risks of various approaches.

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