Understanding California's Cap-and-Trade Regulations
Jul 27, 2011 QuickCounsel Download PDF
By Alex Hoover, Esq.
California is in the process of implementing the most aggressive cap-and-trade scheme in the United States. This effort is part of California’s plan under the California Global Warming Solutions Act (AB32) to bring statewide emissions down to 1990 levels by 2020. At its peak, California’s cap-and-trade program will cover roughly 80% of the California economy. To help companies understand the issues related to cap-and-trade, this QuickCounsel will address gases and entities covered by the program, the market operations of the program, and linkages with other carbon markets.
California’s cap-and-trade program establishes an annual emissions cap on companies covered by the program (see Covered Gases and Entities). Each entity is required to have an emissions allowance for every metric ton of CO2 emitted. Emission allowances can be allocated to a company by the government, bought at auction, traded amongst covered entities, or created through offset projects. Entities without enough allowances to cover their emissions face a fine. Each year, the overall cap is reduced to bring the economy closer to the target emission level.
The program is set to begin in the second half of 2012. At that time, the California Air Resources Board (CARB) will begin allocating and auctioning emission allowances. However, companies will not have any compliance obligations until 2013. The 2012 period will be a trial period to familiarize covered entities with the program and allow California to address any issues that arise. Once compliance obligations begin in 2013, California will require covered entities to submit allowances at the specified deadlines.
California’s cap-and-trade program is limited to those emitters and emissions with the most profound impacts on climate change.
The cap-and-trade program applies to only the most prevalent greenhouse gases (GHG’s):
CARB measures emissions by the metric ton of carbon dioxide equivalent (MtCO2e). This means that the other covered gases, like methane and nitrous oxide, will be measured by how many metric tons of carbon dioxide are necessary to reproduce the climate effects of one metric ton of the other covered gas.
The cap-and-trade regulations establish a tiered schedule for covered entities. Larger emitters, like power generators and heavy industry, will be covered in the beginning (2012-2014). Smaller emitters, like transportation fuel providers and commercial natural gas producers, will not be subject to regulation until the next compliance period (2015-2017).
The regulations further limit compliance obligations to entities that emit 25,000 MtCO2e during any of the three years prior to the compliance period. For instance, the regulations will cover a cement producer emitting more than 25,000 MtCO2e during any year between 2008 and 2010 for the 2013-2014 period. For reference, 25,000 MtCO2e is equivalent to the emissions generated by about 5,000 passenger vehicles or electricity for 3,000 homes. A covered entity may drop its compliance obligation for the next compliance period when GHG emissions drop below the threshold for an entire compliance period or all processes, units, and supply operations subject to reporting cease.
The cap-and-trade regulations also allow non-covered entities to voluntarily join and participate in the carbon market. The level of participation varies depending on the entity:
General counsel should be aware of the program’s gradual increase in the number and kinds of entities covered. Even though a company’s operations may avoid regulation in the near future, they may be covered as the regulations expand. Another issue to consider is the emissions threshold. For companies that fall just below the threshold, an increase in production or loss of efficiency could trigger increased regulation under cap-and-trade. An awareness of both issues will be critical as your company plans for the future in California.
An “allowance” is a tradable authorization, like a permit, to emit one metric ton of carbon dioxide equivalent. Entities receive allowances from the government through direct allocation or auction. Once distributed, the allowances may be exchanged on a secondary market to meet the needs of various covered entities.
In the beginning of the cap-and-trade program, CARB plans to freely allocate most emission allowances to specific covered entities in an effort to avoid steep price increases or shocks to the covered entities. The covered entities receiving allocated allowances are those entities in industries likely to flee California under cap-and-trade, like energy production and manufacturing. The number of freely allocated allowances a covered entity receives will depend on the entity’s production activity and efficiency compared with a sector-specific benchmark. An entity must make up any difference in the number of allocated allowances and the entity’s compliance obligation through auctions or the secondary carbon market.
As the cap-and-trade program progresses, CARB will rely more heavily on auctions to distribute allowances. CARB will hold quarterly auctions for low flee-risk industries quarterly starting in the second half of 2012. The auctions have price floors and caps to prevent the auction price from going too low or high. Each auction will have a price floor of $10 in 2012 with a 5% increase per year plus inflation. CARB may also release allowances from the Allowance Price Containment Reserve starting at $40 per allowance to avoid drastic allowance inflation. The cap-and-trade regulations also set a cap on the number of allowances a covered entity can purchase at 10% of the total allowances offered.
In addition to regular auctions, CARB will hold quarterly advanced auctions for a portion of the 2015-2020 allowances. Allowances purchased at advanced auctions are not valid for compliance purposes until the year of the allowance (e.g., 2015 allowance). The advanced auctions are designed to prepare entities for future compliance obligations and to give price signals for the 2015-2020 periods.
General counsel for covered entities should know whether they qualify for allocation or must go to auction for their allowances. That difference will affect the upfront costs of compliance, given that entities required to go to auction must pay an initial price for their allowances. This additional cost could affect a company’s financial planning.
California’s cap-and-trade regulations provide some flexibility in compliance by allowing covered entities to bank and trade their emission allowances. Banking allows entities to hold emission allowances until the entity needs them for future compliance obligations. An entity may only retire allowances by submitting them to fulfill a compliance obligation, voluntarily retiring the allowances, or retiring them through a linked cap-and-trade program. To prevent allowance hoarding, the regulations place holding limits on the number of allowances an entity can retain in their holding account.
Trading allows entities to buy and sell allowances on a secondary market to make up allowance deficits or profit from allowance surpluses. To combat market manipulation or fraud, the regulations set strict trading procedures, such as required recognition of a trade from all parties and the use of serial numbers for each allowance. The regulations also give CARB authority to reverse transactions, revoke a voluntary entity’s status, increase compliance obligations, or increase holding limits. The flexibility provided by banking and trading is intended to further relax the burdens placed on covered entities by compliance obligations.
Offset credits are compliance instruments that represent greenhouse gas reductions or removals of one metric ton of carbon dioxide equivalent.
General Offset Credits
An entity may offset its emissions by purchasing credits generated by specific projects that reduce emissions by sequestering or destroying GHGs. The regulations stipulate that only specific projects are eligible to generate offset credits:
Reductions from offset projects are further required to be “additional”. A reduction is “additional” where it is not required by law, regulation, or other legally binding mandate, would not otherwise occur in a business-as-usual scenario, commenced after Dec. 31, 2006, and is located in the United States, Mexico, or Canada. Once a project developer proves that the offsets originated from one of the qualifying project types and are additional, the regulations further place quantitative limits on the use of offsets and require ongoing verification, monitoring, and reporting of the emission reductions.
Early Action and Sector-Based Offset Credits
In addition to general offset credits, the cap-and-trade program will recognize Early Action and Sector-Based Offset Credits. The Early Action Offset Credit program rewards entities that voluntarily took action to reduce emissions prior to the enactment of cap-and-trade. The regulations limit qualifying early action credits to only those emission reductions occurring between Jan. 1, 2005 and Dec. 31, 2014.
Sector-Based Offsets are credits generated by projects in a jurisdiction targeting GHG emissions in a specific economic sector. The most notable sector-based program is the UN Reducing Emissions from Deforestation and Forest Degradation Program (REDD), which encourages to preservation of forests through market mechanisms. As of the writing of this QuickCounsel, California has not approved any sector-based programs for the generation of offsets.
For general counsel dealing with cap-and-trade, an awareness of offsets can be a cost-effective method of compliance. In many instances, generating offsets through projects may be cheaper than buying emission reduction technology or trading on the secondary market. General counsel should also be aware of the limits on offset use and the increased administrative burden offsets place on a company in the form of verification and monitoring costs.
California’s cap-and-trade regulations place strict compliance obligations on covered entities. To ensure that the obligations are respected, CARB retains powerful enforcement measures.
The cap-and-trade regulations create annual and triennial compliance obligations for each covered entity. For the annual obligation, an entity must submit allowances equal to 30% of the prior year’s reported GHG emissions. The triennial obligation requires each entity to submit allowances equal to total compliance obligation for the entire three-year compliance period, excluding the emission allowances already submitted under the annual obligation. The annual obligations are designed to ease the burden of the triennial obligation by forcing entities to meet some of the obligation during the compliance period instead of having to meet the entire three-year obligation in one year at the end of the compliance period.
CARB retains strong enforcement authority to ensure that the carbon market operates effectively. CARB may enjoin covered entities and set penalties for violations. Under the cap-and-trade regulations, a covered entity that misses the annual or triennial obligation deadline must submit emission allowances equal to four times the entity’s excess emissions. If the covered entity fails to submit the allowances for excess emission after 30 days, CARB may apply a $25,000 fine per missing allowance per 45 days. CARB may also suspend revoke, or restrict holding accounts for covered entities.
Given the stringent penalties for failed compliance, an awareness of the compliance obligations will be necessary for general counsel working with the cap-and-trade regulations. Avoiding the strict penalties will require a working knowledge of the various mechanisms that allow covered entities to bank and trade allowances and generate offset credits. Using those mechanisms and being aware of the annual and triennial obligations will allow general counsel to keep their company out of trouble.
California envisions its cap-and-trade program to be part of a larger domestic and international carbon market. The regulations provide for the future linkage of California’s cap-and-trade program with similar existing or proposed programs like the Western Climate Initiative and the EU Emissions Trading System. Linking programs would make allowances or offset credits in other jurisdictions valid under California’s program. As of now, California has not established any links with other programs, but the cap-and-trade regulations do contain provisions establishing the procedures for linkage and the treatment of those allowances.
The issue of linkage is important for general counsel in that as each connection is made with another carbon market, general counsel must be aware of the regulatory and market changes in other jurisdictions. For instance, a link between California’s carbon market and the European Union’s will affect the price of allowances and the flexibility in compliance by opening California to more compliance options.
California’s cap-and-trade program is slated to be an integral part of California’s emission reduction plans and, consequentially, a part of doing business in California. To that end, this QuickCounsel provides a basic understanding of cap-and-trade’s scope, market operations, and possible ways the program will expand. Companies doing business, directly or indirectly, in California need to have a fundamental understanding of cap-and-trade and know how they can address the regulations constructively.
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