California Air Resources Board Approves Regulations to Implement First Large-Scale, Market-Based Greenhouse Gas Emissions Cap and Trade Program in the United States
 
December 30, 2010
 
Paula C. Kirlin- San Francisco
Elizabeth Lake - San Francisco

Program Is a Model for Future National, Regional and State Cap and Trade Initiatives

On December 16, 2010, the California Air Resources Board (ARB) approved regulations¹ to implement a greenhouse gas (GHG) cap and trade program under the California Global Warming Solutions Act of 2006 (AB 32), Cal. Health & Safety Code §38500 et seq. California’s cap and trade system is the first of its kind in the United States, and is designed to achieve AB 32’s mandate to reduce California’s GHG emissions to 1990 levels by 2020. California’s groundbreaking program will serve as a model for similar initiatives that may emerge at federal, regional and state levels.

Here’s how it will work. The regulations establish a fixed limit on GHG emissions from sources responsible for approximately 85 percent of the state’s total GHG emissions, such as power plants, large industrial facilities and transportation fuel distributors. Companies will receive permits or “allowances” to cover a certain amount of GHG emissions. At first, ARB will distribute almost all allowances for free. From 2012 to 2020, the system will rely more heavily on auctioning, and the total number of available allowances will decrease, with the goal of forcing covered entities to reduce their GHG emissions. If a company exceeds its allowance allocation, it will need to purchase allowances at auction, trade allowances with other entities, and/or offset emissions by supporting verifiable, sustainable GHG-reducing projects. By 2020, the estimated 2.7 billion allowances on the market are projected to go for $15 to $60 for every metric ton of carbon dioxide equivalent (MTCO₂e) of GHG emitted.

This alert provides a broad overview of the regulations approved by ARB. All stakeholders will need to quickly become familiar with the program and monitor its continuing development in order to identify business risks, opportunities and compliance obligations that arise in the context of this new system. Although the comprehensive framework is now in place, several components of California’s cap and trade program are still being refined, including the allowance allocation system. In the coming months, ARB will address pending issues through public workshops and will propose further modified regulatory language for public review and comment. Entities that will be subject to California’s new cap and trade program may want to submit comments on these forthcoming regulatory proposals.

Key Components of California’s Cap and Trade Program

The following is a summary of key components of California’s new cap and trade program:

• Covered entities. Entities including industrial plants, electric utilities and fuel suppliers that meet or exceed specified GHG emissions thresholds are covered entities subject to the regulations.
• Compliance instruments. The regulations recognize two types of compliance instruments: allowances and offset credits. Covered entities’ GHG emissions generate compliance obligations, which covered entities can satisfy by turning in one compliance instrument for every metric ton of GHG emissions.
• Three-year compliance periods. The regulations provide for three three-year compliance periods: 2012-2014, 2015-2017 and 2018-2020. Covered entities must surrender a portion of compliance instruments annually, with the remainder due after the end of the three-year compliance period.
• Phase-in. During the first compliance period (January 1, 2012 to December 31, 2014), the regulations will apply to a select group of covered entities that includes large stationary sources and electricity suppliers. During the second compliance period (January 1, 2015 to December 31, 2017), the program will expand to cover fuel distributors to address transportation fuel and fossil fuel combustion emissions. All of these entities remain subject to cap and trade regulations during the third compliance period (January 1, 2018 to December 31, 2020).
• Market mechanisms. While allowances are directly allocated at the outset, the regulations also establish frameworks for compliance instrument trading and quarterly allowance auctions beginning on February 14, 2012. Covered entities that exceed their allowance allocation will need to cover their excess GHG emissions by purchasing compliance instruments through these market mechanisms.
• Linkages. California anticipates linking its cap and trade program with partners in other Western Climate Initiative (WCI) jurisdictions.

Each of these key components is discussed in greater detail below.

Who is subject to California’s new cap and trade regulations?

California’s new cap and trade regulations will be phased in over time to cover major sources of GHG emissions including refineries, power plants, industrial facilities, electricity suppliers and transportation fuel suppliers. Once a listed entity’s GHG emissions cross a certain threshold, it is considered a “covered entity” subject to the regulations.

As of January 1, 2012, the regulations will apply to large stationary sources in specified process or operations categories (e.g., heavy industrial processes, petroleum refining and stationary combustion) that emit 25,000 MTCO₂e or more per year, as well as to “first deliverers” of electricity (including both operators of electricity-generating facilities in California and electricity importers). In 2015 the program will expand to cover fuel suppliers with annual emissions equal to or greater than 25,000 MTCO₂e. In addition, the emissions threshold for all electricity importers will decrease to zero as of January 1, 2015.

California’s cap and trade program is not restricted to only those entities that automatically qualify as “covered entities.” The regulations allow voluntary participation by listed entities that do not exceed GHG emissions thresholds. These “opt-in entities” are subject to all reporting, verification and compliance obligations that apply to covered entities, and may be eligible to receive freely allocated allowances. The regulations also authorize voluntarily associated entities and other registered participants, which may include financial institutions, brokers and offset developers, to hold and trade compliance instruments.

What are the compliance obligations of covered entities?

Covered entities generate a “compliance obligation” for each metric ton of GHG emissions generated, as reflected in verified statements filed under ARB’s mandatory GHG reporting program.² Interestingly, the regulations provide that certain biomass emissions count toward applicable reporting thresholds, but do not count toward a covered entity’s compliance obligation. A company can satisfy its compliance obligation by surrendering to ARB compliance instruments in the form of tradable allowances and offset credits (discussed in greater detail below). Compliance obligations continue until either annual reports show annual emissions less than 25,000 MTCO₂e during one entire compliance period or the entity shuts down all processes.

All covered entities are required to register and create an account with ARB or a designated account administrator, and compliance instruments are transferred into these accounts. At the end of a compliance period, covered entities must surrender to ARB a sufficient amount of compliance instruments to meet their compliance obligations. The regulations establish both annual and triennial compliance obligations: annual compliance obligations equal 30 percent of reported GHG emissions from the previous year and triennial compliance obligations equal the total emissions from all three years of the compliance period.³ To discourage non-compliance, covered entities that fail to timely surrender compliance instruments are required to submit additional allowances.

How are allowances allocated?

Allowances are one of the most important features of California’s cap and trade system. The regulations contain an allowance budget that creates a limited number of allowances for ARB to issue in each year from 2012 to 2020.⁴ This allowance budget functions as the GHG emissions “cap.” Each allowance issued by ARB represents authorization to emit one metric ton of GHG emissions. Allowances may be surrendered by covered entities to comply with cap and trade regulations, traded, banked for future use, sold, or retired.

Allowance Budget

The 2012 allowance budget creates 165.8 million allowances and is based on the best estimate of actual 2012 emissions for sources covered at the beginning of the cap and trade program. The budget provides for a decreasing number of allowances each year (with an increase in the number of allowances in 2015 to account for expansion of the cap and trade program to cover fuel suppliers). Ultimately, the 2020 allowance budget is set to enable California to achieve AB 32’s goal of reducing GHG emissions to 1990 levels by 2020. Allowances in the budget may be directly allocated or placed in the reserve fund for auction (as explained below).

Direct Allocation

ARB has opted to “soft start” the cap and trade program and will at first distribute almost all allowances for free. In future years, California’s cap and trade program will rely more heavily on auctioning, as the percentage of the total allowance budget available for direct allocation decreases and the percentage designated for the reserve fund (discussed below) increases.

Under the regulations, ARB determines the number of allowances directly allocated to each covered entity. ARB will place directly allocated allowances into companies’ accounts on or before January 15 of each calendar year from 2012-2020.

Several essential aspects of the direct allocation system are still being finalized. The regulations identify two formulas for calculating direct allocations for industrial sources, both of which include an emissions efficiency benchmark that rewards facilities with greater energy efficiency.⁵ However, calculation methodologies for direct allocations to the electricity sector are not yet specified. ARB is also considering whether allowances should be allocated directly to natural gas utilities on behalf of their customers, and if so, what method should be used to calculate that allocation. During the first half of 2011, ARB will hold public workshops, solicit public comment and propose modified regulatory language to address these open items.

Allowance Auction and Pricing

In comparison with the still-evolving allocation program, regulation provisions governing allowance auction issues such as format, reserve price and purchase limits are more definitive. Each auction must have an auction reserve price and allowances may only be awarded if the bid meets the reserve price. For auctions conducted during 2012, the reserve price is set at $10 per MTCO₂e for vintage 2012 allowances and $11.58 per MTCO₂e for vintage 2015 allowances. In subsequent years, auction reserve prices will increase annually by 5 percent plus rate of inflation. Consistent with AB 32, auction proceeds obtained by an electrical distribution utility shall be used exclusively for the benefit of retail ratepayers (which could take the form of rebates, energy efficiency initiatives, or investments in renewable energy).

Finally, the regulations require establishment of an allowance reserve fund for a specified number of allowances from the budget discussed above. The reserve price for these allowances in 2012 will range from $40 to $50, and in subsequent years will increase by 5 percent plus rate of inflation. The percentage of the total allowance budget that must be deposited in the reserve fund will increase, from 1 percent of allowances from budget years 2012-2014 to 4 percent of allowances from budget years 2015-2017, and finally to 7 percent of allowances from budget years 2018-2020. The reserve fund and guaranteed prices are designed to guard against unforeseen shocks and price fluctuations.⁶

How can a covered entity use offsets to meet its compliance obligation?

Offsets are tradable compliance instruments that represent verified GHG emissions reductions in areas or sectors not covered by California’s cap and trade program. Each offset credit represents one metric ton of GHG emissions. Offset credits could be issued either by ARB or by an external program. Covered entities may use offset credits to satisfy up to 8 percent of their total compliance obligation.

Offset credits issued by ARB must meet criteria demonstrating that GHG emissions reductions are real, permanent, verifiable, enforceable and quantifiable. The offset project’s GHG emissions reductions must be in addition to what is already required by law, regulation, or legally binding mandate, or any GHG reduction or removal activities that would otherwise occur in a conservative business-as-usual scenario. In addition, ARB may only issue offset credits for projects that commence after December 31, 2006, and are based in the United States, Canada, or Mexico.

ARB will issue offset credits based on pre-approved compliance protocols. The regulations identify four approved compliance protocols for forestry, urban forestry, livestock (manure/methane management) and removal of existing stock of ozone-depleting substances. To ensure an adequate supply of high-quality offsets, ARB staff expect that additional protocols will be reviewed and brought to ARB for consideration starting in 2011. Approval of additional compliance protocols and updates or modifications to existing compliance protocols are subject to public notice and comment requirements.

With regard to offsets issued through other programs, the regulations provide a framework that would allow ARB to accept so-called “sector-based” offset credits from projects in developing countries. Currently, the regulations only authorize ARB to accept sector-based credits from “reducing emissions from deforestation and forest degradation” (REDD) plans. California is exploring other developing country-based offset credit opportunities in the forest and cement sectors, but further evaluation is needed before those credits could be incorporated into the state’s cap and trade program.

Will California link to other GHG emissions trading systems?

The regulations include a framework for linking California’s cap and trade program to anticipated future GHG emissions trading programs. Establishing a linkage would lead to reciprocal acceptance of compliance instruments issued by linked systems. During 2011, ARB will evaluate WCI partner jurisdiction cap and trade programs being developed in New Mexico, British Columbia, Quebec and Ontario, all of which are expected to be implemented by January 2012. Linkage would require ARB approval, and could only happen after public notice and opportunity for public comment.

Conclusion

While stakeholders now have a “big picture” understanding of California’s new cap and trade regulations, several important questions remain:

• How will compliance requirements be adjusted to sync with ARB mandatory GHG reporting cycles?
• How will direct allocation calculation methodologies for industrial entities be modified prior to the first distribution of allowances? How will the direct allocation methodology incorporate specific GHG emissions efficiency benchmarks?
• How will ARB handle direct allocation allowances for covered entities in the electricity and natural gas sectors?
• Will ARB modify the regulations to include an allowance set-aside to incentivize in-state production of voluntary renewable energy?
• What additional offset protocols will ARB consider to expand the scope of ARB-issued offset credits? Will ARB expand the scope of approved sector-based (developing country project) offset credits that covered entities can use to satisfy compliance obligations?
• What framework will ARB propose for periodic review of California’s cap and trade program?

ARB expects to resolve many of these issues during the first half of 2011. Stakeholders will want to closely monitor these developments, and affected entities should consider commenting on modified regulatory language proposed by ARB. We look forward to working with our clients to submit comments to regulatory proposals and to evaluate existing and likely future business plans in relation to California’s new cap and trade program. We are also available to assist clients throughout the country as other state and regional cap and trade initiatives emerge and evolve.

Holland & Knight lawyers are committed to staying at the forefront of climate change policy and law as it develops, and we provide this alert as part of a series of articles and alerts on sustainability and climate change issues. For further information, please see the following additional Holland & Knight alerts:

• California Entities Release New Reports on Climate Change and Sustainable Development (October 26, 2010)
• California’s Air Resources Board Adopts Aggressive Regional Greenhouse Gas Emissions Reduction Targets(October 12, 2010)
• DTSC Initiates Formal Rulemaking for Green Chemistry Products Regulation - The Final Rule in California: A Likely Model for Other Jurisdictions (September 30, 2010)
• California Air District Issues Prevention of Significant Deterioration Permit With Enforceable Greenhouse Gas Limits (February 24, 2010)
• White House Issues Sweeping Draft NEPA Guidance on Greenhouse Gas Analysis, Mitigation Monitoring and Categorical Exclusions (February 24, 2010)
• The Endangered Species Act and Climate Change (December 21, 2009)
• EPA Finds That Greenhouse Gases Endanger Public Health and Welfare (December 14, 2009)
• California’s Air Resources Board Provides First Preliminary Draft of Cap and Trade Regulation for Greenhouse Gases (December 4, 2009)
• California Continues Efforts to Link Greenhouse Gas Reductions to Land Use Decisions – But Offering Clear Advice Still a Challenge (November 6, 2009)
• California Air Resources Board, South Coast Air Quality Management District and San Diego County Release Recommendations for Setting Interim Significance Thresholds for Greenhouse Gases Under CEQA (November 19, 2008)
• California Court Rules Environmental Impact Reports Must Address Climate Change (August 22, 2008)
• Current Status of Climate Change Analysis Under CEQA (April 16, 2008)

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¹ The proposed regulations considered by ARB at its December 16, 2010 meeting are available online at www.arb.ca.gov/regact/2010/capandtrade10/capv1appa.pdf(last visited December 28, 2010). ARB’s regulations are the product of an extensive process that involved public engagement, solicitation of expert advice, and release of preliminary draft regulations (PDR) in November 2009 for public review and comment (for additional information about the PDR, see Holland & Knight’s December 4, 2009 alert, California Air Resources Board Provides First Preliminary Draft of Cap and Trade Regulation for Greenhouse Gases. The regulations apply to the following GHGs: carbon dioxide (CO₂); methane (CH₄); nitrous oxide (N₂0); hydrofluorocarbons (HFCs); perfluorocarbons (PFCs); sulfur hexafluoride (SF₆); and nitrogen trifluoride (NF₃).

² ARB also adopted amendments to the mandatory GHG reporting regulations on December 16, 2010. The proposed regulations considered by ARB, as well as related background information, are available online at www.arb.ca.gov/regact/2010/ghg2010/ghg2010.htm (last visited December 28, 2010).

³ The triennial compliance obligation can be adjusted to account for circumstances where an entity does not exceed the emissions threshold until the second or third year of a compliance period.

⁴ See § 95841, Table 6-1: California GHG Allowances Budget.

⁵ Calculation methodologies identified in the regulations are the product output-based allocation calculation methodology and the thermal energy-based benchmarking allocation calculation methodology. The regulations specify the allocation calculation methodology that must be used. See § 95891.

⁶ Felicity Barringer, Cap and Trade, the California Way, The New York Times, October 31, 2010.

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