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Analysis: Strong start for California carbon market, but challenges loom

By Rory Carroll

SAN FRANCISCO (Reuters) - As the clock winds down on the first year of California's carbon trading market for reducing greenhouse gas emissions, state officials say they have a lot to celebrate.

The state's cap-and-trade program, which could become a model for other U.S. states, sets a limit on the amount of heat-trapping gases businesses can emit and allows them to trade excess permits.

Regulators this year held a series of permit auctions, with strong demand from buyers. The program poured $533 million into state coffers and is expected to raise $1.5 billion next year.

"California has achieved a strong, transparent carbon price, and we have created a model for the world to follow," said state Sen. Fran Pavley, the author of the state's landmark 2006 law designed to combat global warming. "We have shown that sending a strong signal to the marketplace can reduce pollution and spur better investment planning and economic growth."

The success of California's cap-and-trade program could revitalize the policy as a preferred tool for curbing emissions at a low cost, encouraging its expansion across state and international lines.

Still, analysts say the hardest part is yet to come.

The program is supposed to more than double in size in 2015, encompassing the burning of fuels by automobiles as well as home heating fuels like natural gas, meaning that consumers will feel the effects directly and could see gasoline price hikes of 15 cents a gallon or more.

California has also failed to get any other states to join up, raising questions about the political viability of a program that cannot, by itself, claim to have a meaningful impact on global carbon emissions.

Indeed, skeptics had pointed to Congress's rejection of a national cap-and-trade program, as well as ongoing problems with fraud and low prices in the nine-year-old European carbon market, to question the viability of the concept as a means of addressing climate change.

Should California's program unravel, it could sound a death knell for the concept across the United States.

The state has so far sidestepped Europe's biggest mistakes by tracking the output of greenhouse gases from facilities in the state for years prior to the market's launch and by setting a steadily increasing floor price for allowances sold at auction.

From a market standpoint, California's program has worked surprisingly well so far. Carbon prices have hovered in the $11-$16 a ton range throughout the year - high enough to keep traders interested and low enough to keep companies covered by the program from panicking. That's an ideal situation from the point of view of regulators.

Meanwhile trading of allowances on the secondary market has been healthy, with an average of nearly 2 million carbon allowances changing hands every week among environmental credit brokers, power traders and businesses covered by the program.

"The first year of the California market has gone fairly smoothly," said Tony D'Agostino, director of commodity markets for the Royal Bank of Canada. "Trading volumes continue to increase and the auctions have gone off without a hitch for the most part."

Things will get tougher in 2015. Thus far the state has given free allowances to businesses like cement manufacturers and food processors to reduce the program's burden on them, but it's not planning to give any free allowances to fuel distributors to cover the emissions that come from California tailpipes.

Carbon analysts believe a $15 a ton carbon price will translate into an additional 15 cents per gallon of gas in a state that already has some of the nation's highest gasoline prices.

"The very small number of companies that manufacture the fuels we need are going to have to purchase what we roughly calculate to be about $5 billion a year in carbon allowances to meet the requirements that go into effect on January 1, 2015," said Tupper Hull, a spokesman for trade group the Western States Petroleum Association, which represents oil refiners.

"That is an enormous and immediate impact on the price of supplying fuels," he said.

It is possible that the 12-member California Air Resources Board, which is appointed by Governor Jerry Brown, will tinker with the rules and move to give allowances away to cover those emissions. If it doesn't, the program could raise the ire of the public and environmental justice advocates who see higher gas prices as a burden on the working poor.

Another major challenge is finding partners to link with the program to expand its reach and effectiveness. California never intended to go it alone and has long envisioned the state program either being preempted by a federal system or carried out in conjunction with a handful of other large U.S. states.

Instead, governors in states like New Mexico and Utah were unable to convince their legislatures to pass the laws necessary to launch a carbon market.

So far, only the relatively small Canadian province of Quebec is ready to link to the California market next year.

The governors of Oregon and Washington as well as leaders from British Columbia recently met with California Governor Jerry Brown to discuss working toward a low-carbon future together. Despite California's early success, others don't appear to be in any rush to join the carbon market.

Carbon market proponents hope regulations being developed by the Environmental Protection Agency targeting greenhouse gas emissions from existing power plants could persuade some states to link with California's program in the coming years. For now, California looks like a leader without much of a following.

(Reporting by Rory Carroll. Editing by Jonathan Weber and Andrew Hay)

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