How California Regulated Itself Into an Energy Crisis

The last few months will likely be remembered as a watershed moment in California’s testy gas price discourse. After years of blaming the state’s eye-watering gasoline prices—the highest in the continental U.S.—on “Big Oil” greed, California’s elected officials have finally started taking seriously the idea that high pump prices are the result of their state’s overly aggressive environmental policies.

The proximate cause for this seems to be Valero’s surprise announcement in April that it would close its Benicia refinery in northern California in 2026, citing regulatory burden. Between the closure of Valero Benicia next spring and Phillips 66 Wilmington this fall—a loss of 20% of the state’s total refining capacity within the year—the state’s supply is set to fall well below demand. A much-publicized study by USC business professor Michael Mische projects that gas will soon shoot up to eight dollars a gallon.

The reckoning triggered by the specter of astronomical consumer prices has been swift and furious. In a tense Assembly Hearing last week at which the state’s top environmental regulators were summoned to sheepishly testify as to the causes of the impending shortage, Assemblyman David Alvarez, a Democrat, concluded: “We have a crisis on our hands that may be self-created.” Assemblywoman Cottie Petrie-Norris, also a Democrat, went further: “I know what climate leadership doesn’t look like and that’s ten dollar gas.”

Even Governor Gavin Newsom, who has spent most of his term accusing refineries of “price gouging” and pushing through legislation to impose profit caps and minimum inventory requirements, has suddenly softened on Big Oil. A week after the Valero announcement, he sent a letter to California Energy Commission (CEC) Vice Chair Siva Gunda instructing him to do everything in his power to keep the state’s remaining refineries in business. (Although even in this letter he astonishingly attributes the refinery closure to “instability” caused by the Trump administration, not California policy.)

For about as long as it has had an environmental regime, the state of California has held that it is possible to pursue climate policy without inflicting economic harm. This line is a fundamentally tough sell, because the market-based solutions California has adopted must raise the price of fossil fuels in order to work. Thus far the state has attempted to mask this reality by reserving its policy sticks for producers (cap-and-trade) and plying consumers with carrots (EV rebates). But ultimately, costs are always passed through.

The impending crisis will force California’s environmental establishment to finally acknowledge—and contend with—the costs of the policies it has pursued. The question now is whether it is too late to preserve affordability for California drivers.

California’s environmental programs (and some mystery) have raised gas prices

How California arrived here can be understood as a story in three acts: the adoption of its boutique fuel requirement in 2003; the implementation of its two signature climate policies in the 2010s; and finally, post-pandemic refinery concentration accelerated by the environmental regime. Over time, the effects of state policy have built upon one another and compounded, resulting in the high and volatile gas prices Californians experience today, about $1.50 higher than the U.S. average:

Less than twenty-five years ago, California gas prices were unremarkable. At the turn of the millennium, California gas retailed for only about thirty-five cents above the national average in today’s money, and that difference was explained mostly by the state’s higher taxes. This changed in 2003 with the phasing in of CARBOB, an ultra-low-sulfur boutique gasoline blend mandated by the California Air Resources Board as part of its campaign to improve air quality.

The CARBOB requirement affected California gas prices in two ways. The first was the addition of about 18 cents per gallon in pass-through costs reflecting the additional expenditure required by the refineries to produce CARBOB. The second, and perhaps more important, was the effective islanding of the California market. CARBOB is only required in California and therefore produced regularly only by California refineries; more than 90% of CARBOB demand is met by in-state producers. Some out-of-state refineries are capable of producing CARBOB, but will do so only when the arbitrage window is favorable. More frequently, refiners facing a supply crunch will import blending components from Asia and blend the CARBOB in-state.

This islanded market is predictably prone to price spikes. When there is a supply crunch—such as when a refinery suddenly goes offline after a fire or equipment failure—it typically takes, at the very least, three weeks for more CARBOB or blending components to be procured. During the time it takes for the replacement fuel to arrive via ship, prices spike as fuel distributors bid up the remaining supply. Such incidents are not uncommon; there was one as recently as early May 2025, when Valero Benicia caught on fire and prices spiked in Northern California. The spike hit just as the region was recovering from high prices due to a February explosion at PBF Martinez that forced the refinery to shut down completely.

California drivers began to incur further environmental costs at the pump in 2015, when the state’s cap-and-trade program finally went into effect after having been authorized by the landmark state climate bill AB32 in 2006. Despite some initial denial by CARB that compliance costs would be fully passed through to consumers, cap-and-trade ended up adding about ten cents to a gallon of gas. Compliance has become more expensive over time as the cap has lowered; today, the per gallon pass-through cost from cap-and-trade is estimated to be around twenty-five cents.

2015 also marked the appearance of an additional California premium not explained by taxes and environmental fees, which Berkeley economist Severin Borenstein has dubbed the“Mystery Gasoline Surcharge” (MGS). The MGS emerged after a major explosion at Exxon’s Torrance refinery in February 2015 put the refinery out of commission for a year and a half. During that time, fuel distributors were forced to import unprecedented quantities of CARBOB from abroad, raising prices substantially. Even after Torrance became fully operational again, however, prices never fell back to a level that could be explained by state taxes and fees. Indeed, this mystery premium has stayed robust, averaging around fifty cents so far this year:

Borenstein’s research has revealed that the MGS occurs not in the refining sector but in the retail sector—that is, somewhere between gasoline being sold to retailers on the spot market and the price you see at the pump. No one is exactly sure why retailers were able to start extracting so much more profit after 2015, although Borenstein suspects there is some degree of market power in the retail sector: branded gasoline stations in California sell gasoline at about 23 cents more than unbranded stations, a gap that is only about 7 cents in the rest of the country. It also doesn’t help that the market is undersupplied: the state has almost twice the number of drivers per gas station as the rest-of-U.S. average. Nor is this shortage likely to be alleviated. A rather circumspect recent CEC study ventures that the EV mandate and various regulatory barriers are likely deterring new competitors from entering the market, as one would expect when retail margins are high.

One working theory for the MGS is that California’s increasingly frequent price spikes are contributing to the longer term problem of elevated prices. Economists have long observed a phenomenon called “rockets and feathers,” in which retail prices shoot up when commodity prices spike but take much longer to return to baseline when commodity prices drop, because retailers do not want to sell their inventory at a loss. It has also been shown that prices will take an even longer time to float down in an environment of local market power, which is plausibly the case in the California retail gasoline market. So it is not unreasonable to theorize that California is having such frequent price spikes that retail prices are never able to float down to what they “should” be.

Both cap-and-trade and the MGS have made California gas prices significantly higher; it is the events of the past few years, however, that set the stage for the impending crisis. Starting with Marathon Martinez in 2020, California refineries have been closing faster than demand for gasoline is falling. The Valero announcement brought the number of refinery closures under the Newsom administration to four (possibly five if Wilmington is shuttered as well)—a third the number of gasoline-producing refineries that were open at the beginning of this decade. When Valero closes, the state’s gasoline supplies will be in chronic deficit, about three times worse than anything it has experienced previously:

California environmental policy hastened refinery exit in a number of ways. Most obvious is the regulatory burden, which Valero called out in its announcement that it would shutter Benicia. The Benicia refinery had been issued a record fine of $82 million last year by the Bay Area Air District and was generally struggling with high costs associated with compliance. Valero was the first refinery to explicitly cite California’s hostile regulatory environment in its exit announcement, but they are far from alone in feeling it. Refiners have long complained about overbearing regulations in excess of any rational standards that make operating a safe refinery unnecessarily expensive.

A more insidious contributor to refinery exit is the Low Carbon Fuel Standard (LCFS), which was adopted in 2011. While the pass-through costs of the LCFS are estimated to only be around 10 cents a gallon currently—although that may change soon if a proposed amendment goes through, with estimates putting increased pass-through at up to 65 cents in the near term—the program has had the much more serious effect of indirectly incentivizing refineries to convert. In just the past few years, the combination of the LCFS with federal subsidies has allowed a product called renewable diesel to rapidly outcompete petrodiesel in California:

The entrance of a highly subsidized competitor has weakened the economics of conventional refineries, which make money by selling every product they can squeeze out of a barrel of crude—including gasoline, jet fuel and diesel. At the same time, the stream of compliance credit money flowing toward biofuels has made it attractive for struggling California refineries to convert to full-time production of renewable diesel. This has happened twice so far with the conversion of Marathon Martinez in 2020 and Phillips 66 Rodeo in 2023.

Finally, there is the decline of the in-state oil extraction industry. Thanks to decades of regulatory pressure and, during Governor Newsom’s reign, an effective moratorium on O&G permitting, California’s abundant oil resources are being left in the ground, with crude output now at about a third of what it was in the 1980s. Up to a point, this is not a problem, as imported crude is very competitive with heavy crude from the San Joaquin Valley, and refiners with marine import facilities do not feel the impact on their margins. Refiners who do not have marine terminals, however, may soon be in danger of going out of business—these refiners rely entirely on pipelines from the Central Valley for their crude, and when in-state extraction has dwindled to a certain level, operation of those pipelines will no longer be economic. Once those pipelines shut down, the refineries will be forced to as well.

The spate of refinery closures California has seen over the past half decade, and the serious prospect of more soon, are about as strong of a refutation of Governor Newsom’s corporate rapaciousness theory of high gas prices as possible: If it were enormously profitable for oil refineries to do business in California, they would not be exiting the state at a record pace.

Ironically enough, this will allow Big Oil to start extracting more profit. The departure of smaller refining enterprises from California has left the state’s remaining CARBOB refining capacity in the hands of just a few big refiners, with three companies—Chevron, Marathon and PBF—set to control over 90% of the state’s refining capacity next year:

With a chronic supply deficit and little competition, California’s remaining refiners will be able to sell CARBOB at unprecedented prices. Rather than protecting citizens from “Big Oil,” the state’s policies have all but guaranteed more consumer harm at its behest.

California can reduce gas prices, but not without compromising on the State’s environmentalist goals

Broadly speaking, California has two options for averting astronomical pump prices in the near term: it can drastically decrease demand or drastically increase supply.

The demand piece is not promising. Between 2023 and 2024, gasoline sales in California fell by only 1.12%. Even if demand falls more quickly this year—which is unlikely, given stalling EV sales—it will not do much to offset the impending 20% decline in refining capacity.

In the absence of any significant demand reduction, the state must take measures to quickly increase supply. It has a few ways it can do this, none of them achievable without compromising on longstanding environmental policy.

The first is to slow the pace of closures by reversing some of the forces contributing to refinery exit. The most obvious way to do this is to immediately reduce the regulatory burden by relaxing air quality standards and enforcement. This would make operating a refinery less expensive, although it is not clear if this intervention alone would be enough for refineries to stay.

Beyond this, the state should consider ending or reforming the Low Carbon Fuel Standard. This would have the effect of improving conventional refinery margins and thus helping the state’s remaining refineries stay in business. Unfortunately, current state policy is going in the opposite direction: three days after the election, CARB voted to tighten the LCFS, which will increase demand for compliance credits and thus biofuels.

The case for the Low Carbon Fuel Standard is extremely underwhelming. A growing body of research suggests that when land use impacts are taken into account, the climate benefits of biofuels are non-existent or net-negative; GTAP, the model CARB uses to “prove” biofuels are climate positive, rests on a number of completely unfounded assumptions about agricultural land use adjustments, and was called out as such during the most recent LCFS amendment process in numerous public comments from prominent economists, as well as

a former CARB chief who has been frozen out by his former colleagues.

Indeed, the only reason for maintaining the LCFS seems to be to ensure that CARB’s goals for reducing the carbon intensity of the transportation fuel pool are met by a specific year – which CARB head Liane Randolph has more or less admitted. Of course, if this reduction in the carbon intensity of the fuel pool has simply diverted or increased emissions elsewhere, the LCFS is not only a massive handout to the biofuels lobby at the expense of California consumers but also a failed policy.

Whether refineries stay or exit, it will become increasingly necessary to rely on imports. If Valero exits as promised next year—which seems very likely—California will have to begin importing unprecedented quantities of fuel. And this is fraught. California port capacity is limited and congestion-prone, as are marine-terminal-to-market fuel pipelines, and there is potential for market power in the latter sector. Any expansions of either ports or finished product pipelines are likely to encounter the classic California obstacles of permitting and NIMBYism as well as stranded asset concerns.

There is also the problem of port emissions. In recent years CARB has ramped its campaign to clean up the state’s ports, particularly those in Southern California. New regulations requiring tankers to use shore power electricity while at berth went into effect earlier this year; if importers face compliance problems on this front it will serve to constrain the flow of imports and inflate pass-through costs.

Relying more heavily on imports also opens up the California gasoline market to vulnerabilities associated with global shipping. One of the bigger contributors to the price spikes of September and October 2022 seems to have been the astronomical cost of freight that summer, which made it uneconomic to import blending components from Asia.

Even if California can succeed in keeping its remaining refineries and optimally managing imports, it is unclear the extent to which supply can be expanded in the short term. If the Governor is really serious about mitigating supply problems, there is further action he might take that would risk truly inflaming the state environmental establishment: ending the CARBOB requirement.

Ceasing to require CARBOB would mitigate California’s islanding problem and allow fuel distributors to buy product from a much greater number of suppliers, improving competition in the refinery space as well as increasing spot market liquidity. It would also have the effect of increasing refinery gasoline output because, all else equal, refiners can get more conventional gasoline than CARBOB out of a barrel of crude. The effectiveness of relaxing gasoline specifications has been proven: what eventually ended the October 2022 price spike was the Governor’s directive to allow refineries to make an early transition from the state’s summer gasoline blend to the less stringent winter specification, thus increasing supply.

Relaxing the CARBOB requirement would probably have an adverse impact on air quality, although it is unclear exactly how bad; CARB has never taken it upon itself to investigate. A lot has changed since the 90s, when the introduction of CARBOB had an unambiguously positive impact on smog and health outcomes. A 2023 study found that CARBOB is probably still working to reduce ozone pollution, although the authors admit their results are confounded by changing California tailpipe standards over their study period; they also note their preferred model shows no statistically significant impact on ozone pollution. If the Governor is really serious about easing the supply problem, he will direct CARB to at least consider dropping the boutique fuel.

Time to embrace fuel abundance

This is where the rubber meets the road when it comes to California environmental policy. For a long time, the state has sought to gaslight the public into believing California can have it all—pristine air, rapid emissions reductions and affordable energy. The impending shortages and attendant high prices will definitively reveal this idea as a fiction.

While some elected officials appear poised to finally acknowledge that there are indeed tradeoffs between climate ambition and affordability, the Governor is not among them. Between his denial that the Valero exit is due to state policy and his cheap attacks on Michael Mische, the USC professor who is projecting $8 gas, he has thus far exhibited a disappointing unwillingness to allow that environmental policy has played even a small role in bringing about the coming crisis.

It is likely he will continue to publicly hold this line while quietly attempting to bring down gas prices by compromising on environmental goals—as we have seen with his letter begging the CEC to help the state’s remaining refineries stay in business. After the 2024 election, in which voters signaled their concern for consumer prices above all else, the political costs of high prices have become too stark to ignore. Indeed, it would not be surprising if this is what motivated the Governor, who has his eye on the White House, to finally start addressing the real causes of his state’s soaring gas prices. It’s just a shame it couldn’t have happened sooner.