California's Cap-and-Invest Overhaul and the Expansion of North America's Largest Carbon Market
North America's largest compliance carbon market is undergoing its most significant structural changes since inception. California's Air Resources Board ("CARB") has adopted sweeping amendments to the state's Cap-and-Invest program (formerly Cap-and-Trade), which took effect on September 1, 2026. California, Québec, and Washington have signed a historic agreement to link their three programs. Once operational, the tri-jurisdictional market will be the world's largest subnational emissions trading system—and will rank among the world's largest carbon markets by allowance volume, behind only China's national ETS, the EU ETS, and South Korea's K-ETS. The three linked programs cover 70–78% of their respective jurisdictions' greenhouse gas emissions—behind only South Korea and well ahead of the EU ETS (38%) and China (32%). These developments—occurring against the backdrop of shifting federal climate and energy policy—offer long-term regulatory certainty for market participants while creating new compliance dynamics, funding opportunities, and transactional considerations for covered entities and investors.
Expanding the Market: The Tri-Jurisdictional Linkage
California launched its Cap-and-Trade program in 2012, and Québec followed in 2013. The two jurisdictions linked their programs on January 1, 2014, creating a joint carbon market in which compliance instruments are fully fungible. Washington established its own Cap-and-Invest Program under the Climate Commitment Act ("CCA") in 2021. The CCA directed the Washington Department of Ecology to pursue linkage with other jurisdictions operating greenhouse gas emissions trading programs, and Washington's program was designed from its inception for compatibility with the California-Québec framework.
On June 25, 2026, the three jurisdictions signed a linkage agreement authorizing each program to accept allowances and offset credits issued by the others. Once operational, the linked market will feature joint allowance auctions and a common carbon price. Each jurisdiction is now undertaking regulatory updates to align its program rules for linkage. Québec has published its updated Cap-and-Trade regulation, effective September 10, 2026, and Washington expects its regulatory updates to take effect in October 2026. After these regulatory updates, additional statutory steps remain before the linked market can launch. In California, the governor must issue linkage findings under Government Code § 12894, followed by a separate CARB rulemaking to approve the linkage. In Québec, the National Assembly must approve the linkage agreement and issue an Order in Council.
Several potential hurdles bear monitoring. Communities for a Better Environment ("CBE") filed a CEQA challenge to CARB's Cap-and-Invest amendments in July 2026, alleging that CARB made substantial revisions during the final stages of the rulemaking process—such as increasing the free allowances available to industrial facilities, including oil refineries—without adequate environmental review. While the lawsuit did not delay the amendments' September 1 effective date, an adverse outcome could have broader implications for both the Cap-and-Invest amendments and the linkage timeline. Additionally, Québec's October 2026 provincial election and California's November 2026 gubernatorial election introduce timing variables for completion of each jurisdiction's remaining statutory processes. Market commentators have suggested that while the jurisdictions target 2027 for commencement of linked operations, the sequence of remaining steps makes mid-to-late 2027 or early 2028 a more realistic timeline.
Linkage is expected to enhance liquidity, stabilize pricing through a larger pool of buyers and sellers, and reduce compliance costs by enabling cost-effective trading across a broader market.
California's Regulatory Overhaul
In September 2025, Governor Newsom signed AB 1207 and SB 840, extending California's Cap-and-Invest program through 2045 and directing CARB to align the program's cap trajectory with the state's targets of 40% reduction from 1990 levels by 2030 and 85% reduction by 2045. CARB released its proposed amendments to the Cap-and-Invest program in January 2026, and following public comment, the Board approved the amendments on May 28–29, 2026. The final package was submitted to the Office of Administrative Law, which approved the amendments on August 31, 2026; the amendments took effect on September 1, 2026.
Budget Tightening. The amendments remove approximately 118 million allowances from the 2027–2030 allowance budgets, producing an approximately 11% year-over-year cap decline through the end of the decade. Post-2030, budgets decline at an average of approximately 7% annually to reach 30.3 million allowances in 2045. In total, the amended budgets contain approximately 2.1 billion allowances from 2027–2045, compared to 3.1 billion under the prior regulation—a reduction of approximately 1 billion allowances.
Manufacturing Decarbonization Incentive. When emissions caps tighten, energy-intensive manufacturers may face pressure to relocate to jurisdictions with less stringent climate policies—shifting emissions elsewhere rather than reducing them (i.e., carbon leakage). This risk is heightened where federal clean-energy incentives that might otherwise offset compliance costs have been curtailed. To address this, the amendments create a new Manufacturing Decarbonization Incentive ("MDI") program, which provides additional allowance support to industrial facilities, such as petroleum and chemical manufacturing, that commit to verified emissions-reduction investments. Eligible facilities that invest in on-site emissions-reduction projects—including electrification, low-carbon hydrogen, renewable energy, CCUS, and biomass-derived fuels—can receive additional allowance allocation for budget years 2028–2035. The Board imposed guardrails requiring staff to evaluate and report on the MDI before issuing any allowances and, by July 2028, propose amendments to ensure that facilities failing to achieve promised reductions return their MDI allocations. The MDI's expansion to include oil refineries drew significant opposition and is a central target of CBE's CEQA challenge.
IMR Compliance Delay. The amendments also include a transitional provision for a subset of the refining sector. Under the program's compliance structure, covered entities must periodically surrender allowances equal to their total emissions for an entire multiyear compliance period. For non-vertically-integrated refineries—which lack the diversification of integrated oil companies and face significant margin pressure—assembling that compliance inventory under tighter allowance budgets and higher carbon prices is challenging on compressed timelines. To address this, the amendments provide qualifying Independent Merchant Refineries (or IMRs)—defined as standalone refineries producing at least one million barrels of motor gasoline blendstock annually, without vertical integration into crude production or branded retail—a one-time deferral of their full compliance-period surrender obligation for the current compliance period. The deferral pushes their deadline to surrender allowances from November 2027 to November 2029, providing additional time to acquire allowances or invest in emissions reductions.
CAG Rule Changes. The amendments strengthen corporate association group ("CAG") rules by adding new triggers based on shared access to market-position information and common registered commodity pool operators or commodity trading advisors. When entities are newly grouped into a CAG, they become subject to a single shared holding limit; if their combined holdings exceed that limit, they must sell excess allowances into the market. CARB estimated that the new triggers would cause a one-time release of approximately 23 million allowances, and delayed the deadline for designating holding-limit shares to December 31, 2027, to allow a gradual release rather than a concentrated market event.
CCUS Framework. The amendments establish a consolidated framework for the future treatment of captured, utilized, or sequestered CO₂ (CCUS). Once CARB adopts a Board-approved quantification methodology—requiring at least a 100-year permanence standard—eligible emitters would for the first time be able to receive a reduction in their compliance obligation for verified sequestration or utilization.
Impacts and Implications
The tighter allowance budgets are expected to produce a meaningfully higher carbon price signal. CARB's economic analysis estimated a weighted-average allowance price of approximately $68 under the amendments, compared with $44 under the baseline. The August 2026 joint California-Québec allowance auction saw current-vintage allowances clear at $32.48, up 12.7% from May’s $28.81—the highest level since November 2024—suggesting that markets are pricing in tighter budgets and greater regulatory certainty. These dynamics may require covered entities to reassess allowance procurement, hedging strategies, emissions-reduction investments, and long-term compliance forecasting. The tighter budgets also accelerate the decline in entity-level holding limits—which are calculated as a function of the annual allowance budget—releasing an estimated 22 million allowances annually into market circulation, compared with approximately 14 million under the prior regulation.
The MDI creates new opportunities for industrial facilities—including manufacturers, refiners, cement plants, and food processors—to secure state funding for facility modernization and on-site emissions-reduction projects, an increasingly significant consideration as federal incentives diminish. For entities evaluating capital investments, due diligence should account for MDI eligibility, application timelines, and the Board's evolving guardrail requirements.
The IMR compliance delay offers near-term flexibility for qualifying refineries, freeing inventory that would otherwise be held for surrender. This may create short-term liquidity and potential monetization opportunities, such as through repos or lending, during the deferral window. Counterparties should evaluate timing risk in carbon-market transactions involving entities that may elect the delay.
More broadly, the amendments reinforce a long-term regulatory framework through 2045. Combined with the tri-jurisdictional linkage, this provides a more predictable policy backdrop for long-term capital investment decisions in decarbonization, energy infrastructure, and clean technology—at a time when the federal policy landscape remains uncertain. Market participants structuring long-term positions across the linked market should also address the possibility of de-linkage—as occurred when Ontario exited the California-Québec system in 2018—noting that such de-linkage gives CARB discretion to limit transfers, modify holding limits, and cancel or issue additional allowances to maintain the program's environmental stringency.
