California adopts landmark Cap-and-Trade

California adopts landmark Cap-and-Trade
Stoel Rives LLP
by Allison C. Smith

After a marathon 10-hour public hearing, the California Air Resources Board voted 9-to-1 to adopt the state’s landmark Cap-and-Trade Program. My colleague, Lee Smith, and I spent the day at the packed California EPA auditorium, monitoring the hearing. Over 150 people strode up to the podium to give testimony during the public comment period, spanning the gambit from staunch environmentalists, to climate change skeptics, environmental justice advocates, and many, many a representative of soon-to-be regulated industries and businesses. The chain of testimony was broken up six hours into the hearing by a feel-good guest appearance by Governor Schwarzenegger, who waxed eloquent on the mission of A.B. 32, California’s green jobs revolution, and the momentous step that the state’s Cap-and-Trade Program represented. Indeed, there were many thank yous from commenters to ARB staff and the Board for their hard work on crafting the extraordinarily complex Program and trying to make it more palatable for those affected. Regulated entities noted the outstanding efforts that staff had taken to work with them during the development process.

It was clear, however, that many are still not satisfied with the Program, whether as a whole or with the details of its implementation that will affect various sectors. Environmental justice advocates, such as representatives from the Center for Race, Poverty and the Environment, are largely not in favor of the Cap-and-Trade Program as proposed, dissatisfied with the lack of guarantees that the Program will not disproportionately impact low income communities or communities of color. Most people testifying made pleas to have one aspect or another of the Program changed in some manner.

Lucky for those industries hoping to get some kinks ironed out to make the regulation less painful for their business, staff’s job is not done yet. Many details on implementing the Program remain to be worked out. At the hearing, staff presented several modifications to the Cap-and-Trade regulation that was released in early November for public review, and Board members, based on testimony or questions they had, gave staff a laundry list of additional points to further study. The changes to the regulation and other “conforming modifications” will be released for a 15-day comment period. Staff will then continue to tweak the fine points that do not require further Board action, hopefully having all the details of the Program firmed up by July 2011. Regulated entities certainly canvassed for the implementing details to be finalized as soon as possible before the regulation goes into effect on January 1, 2012, in order to have some certainty as to their compliance obligations.

The first hour or two of public comment was dedicated to testimony on the forest projects offset protocol that will allow certain forest projects that sequester carbon to create offset credits which emitters can buy to meet a percentage of their compliance obligations. Several foresters and forest industry representatives testified, but the bulk of the comment was an emotional plea from environmentalists and residents of the Sierras to prevent clearcutting and forest monoculture under the proposed protocol.

How can a program to reduce greenhouse gas emissions involve clearcutting? The protocol requires adherence to California forest management practices, even for out of state projects. These forest management practices may be more stringent or protective of the environment than those of other states, but California practices allow for clearcutting on areas of 40 acres or less and for even-aged stand management. Under the forest projects protocol, such practices could be utilized in connection with an offset project, but staff and members of the working group that developed the protocol emphasized that the overall carbon storage of a forest stand in a project must be maintained or increased in order for it to qualify under the protocol and generate offsets. Even with an overall net storage of carbon, however, environmental groups stridently objected to even-aged stand management because older or more diverse forest stands may be replaced with stands having less biodiversity and such stands may be managed with herbicides.

With the considerable objections to this protocol and the Board’s aversion to appearing to be ‘for’ clearcutting, ARB considered modification of the protocol at the hearing. Board Member D’Adamo pressed for an exclusion of any future forest project that involved clearcutting, with several other Members agreeing. However, in the end, the Board approved the protocol as it was presented. Chairman Nichols noted that it may be beyond the scope of the Board’s job under A.B. 32 to dictate different forest practices from those developed by the state’s agencies charged with forest management. The environmental protections embedded in the protocol and the overall requirement to have a net zero carbon loss within any given project seemed to satisfy the majority of the Board in the end.

Continue reading for an explanation of some the major points of the Cap-and-Trade Program.

The Basics: the Emissions Cap and Covered Entities

• The Cap-and-Trade Program regulates sources that emit carbon dioxide, methane, nitrous oxide, hydrofluorocarbons, perfluorocarbons, sulfur hexaflouride, and nitrogen trifluoride. Only sources that emit more than 25,000 metric tons of carbon dioxide equivalents (“MT CO2e”) per year, termed “covered entities,” potentially have compliance obligations under the Cap-and-Trade Program.

• An entity’s emissions for purposes of compliance with the Cap-and-Trade Program are based its emissions reported under ARB’s Mandatory Reporting Program. Entities failing to report will still be assigned a place in the schedule by ARB.

• The Cap-and-Trade Program establishes an overall cap on GHG emissions that will decline over the period of the Program, leading to overall reductions by 2020 of approximately 18 to 27 million MT CO2e (“MMTCO2e”).
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• The initial emissions cap is set at 165.8 MMTCO2e, based on the total emissions of covered entities with obligations during the initial three-year period of the Program. This initial cap will decrease two percent each year to reach 159.7 MMTCO2e by the end of 2014. At the beginning of 2015, the cap will increase to 394.5 MMTCO2e to include emissions from fuel combustion, which are accounted for through the inclusion of distributors of transportation fuels, natural gas, and other fuels. From 2015, the cap will decline by three percent annually, to 334.2 MMTCO2e in 2020.

• Large industrial entities, including refineries, cement plants, chemical plants, etc., are included in the Program starting in 2012, if they emit more than 25,000 MT CO2e per year.

• The electricity sector is also included in the Program in 2012. While investor-owned and publicly-owned utilities will receive emissions allowances from ARB, electricity producers and importers are the entities within the electricity sector with compliance obligations. Through an auction by the utilities, producers and importers will obtain allowances to meet their compliance obligations. Compliance obligations are measured at the point of generation for electricity generated in state. For distributors of imported electricity, compliance obligations will be based on emissions from a particular facility where it is known; where the generator is unknown, a default emission factor will be used, based on the average emissions associated with the available electricity generation that could be sold on the spot market into California.

• Starting in 2015, natural gas suppliers will be included in the Program if their total deliveries in California, minus those amounts that are already accounted for through covered sources like electrical generators, exceed 25,000 MT CO2e . Transportation fuel suppliers will have to account for the total emissions of the fuel that they sell or distribute for consumption in California. Liquefied Petroleum Gas (LPG) producers, including fractioners and refiners and LPG importers, will have compliance obligations for emissions resulting from full combustion or oxidation of all fuels sold or distributed in California.
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• Certain electricity generators with GHG emissions are excluded from compliance obligations, even if their emissions put them over the 25,000 MT CO2e threshold. Combined heat and power facilities have a compliance obligation if their emissions exceed 25,000 MT CO2e. However, biomass energy facilities, including those using biomass fuel derived from landfills, wastewater treatment facilities, or at waste-to-energy facilities, are excluded from compliance obligations if the biomass fuel is reported and verified pursuant to the ARB Mandatory Reporting Regulation. If fossil fuels or unverified biomass-derived fuel supplement the use of verified biomass at a facility, the facility will be subject to compliance obligations for those supplemental fuels.

• Any entity that does not meet the 25,000 MT CO2e threshold can opt in during any compliance period and receive allowance allocations on the same terms as other participants in its sector, along with corresponding compliance obligations.
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• Any covered entity whose emissions exceed 25,000 MT CO2e during any year of a compliance period has a compliance obligation for that period and the next compliance period, unless a shift down of all sources of GHG emissions is made.
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Compliance
• The Program is divided into three-year compliance periods. The first compliance period is January 2012 to December 2014 and includes the electricity providers and large industrial sources described above. The second compliance period is January 2015 to December 2017 and includes fuel distributors for the first time. The third compliance period, with all covered entities, runs until 2020.

• Each covered entity must surrender compliance instruments equal to its actual emissions during a compliance period. Covered entities can meet compliance obligations with allowances and offsets. Each allowance allows the emission of one metric ton of CO2e each year.

• At the end of each year for the first two years of a compliance period, the complying entity will surrender compliance instruments equal to 30% of its emissions for the compliance period. At the end of the full three-year period the entity submits instruments equal to the balance of its compliance obligation which is the total emissions for the three-year period, less the amount covered during the first two payments.

• A failure to submit the adequate number of allowances (or offsets) when required will be considered excess emissions and the covered entity will then be required to surrender four allowances for each failure to submit a compliance instrument.

• An offset represents reduction or removal of GHG emissions from activities not covered by the Cap-and-Trade Program. These offsets are issued by ARB or programs linked to the Cap-and-Trade Program, e.g. projects developed under the offset protocols discussed below. Each offset also represents a metric ton of CO2e.

• The amount of external offsets allowed for compliance is limited to 8% of an entity’s total compliance obligation.

Allocation of Allowances and Auctioning

• The Cap-and-Trade Program provides for the free allocation of allowances during the first three years, with an increasingly greater percentage of allowances auctioned as the Program continues.

• Free allocations are being made to the industrial sector to ease the transition to manufacturing processes that produce less carbon emissions and to minimize the likelihood of “leakage” due to the shifting of production from California manufacturers to other states due to the inability of California facilities to pass the extra cost of compliance onto their customers. During the first compliance period, each industrial sector will receive free allocations equal to about 90% of that sector’s total emissions. In subsequent compliance periods, the total allocation will decrease, providing less transition assistance. Each industry has been evaluated for the likelihood of leakage, and those with a greater risk of leakage will continue to receive some free allocations even during later compliance periods.

• As noted above, the Program will allocate free allowances to utilities, which are required to use the proceeds from auctioning these allowances to generators for the benefit of their rate-payers. The Program assumes that independent generators will pass the cost of the allowances they must buy through to purchasers of their electricity.

• There will also be the advanced auctioning of 2% of ARB’s total allowance budget for use by covered entities in future compliance periods.

• The bulk of the auctioning of allowances will occur in the second and third compliance periods, as allowances will likely be auctioned for most types of fuels distributors, rather than freely allocated.

• ARB is working on a market tracking system to manage allowances and offsets, including tracking compliance instrument ownership and submittals and transactions of compliance instruments.

• California’s Program may eventually link to other cap-and-trade programs such as the Western Climate Initiative or the Regional Greenhouse Gas Initiative in the northeast.
Offset Protocols

• ARB approved four offset protocols on December 16, 2010: (1) the U.S. forest projects protocol, (2) the livestock manure digester products projects protocol, (3) the urban forests projects protocol and (4) the ozone depleting substances protocol.

• In addition to future projects developed under those protocols, certain existing projects will be able to generate offsets.

• ARB will consider additional offset protocols that will available to generate offsets. One of the first protocols that will be worked on is related to international programs to reduce emissions from deforestation and forest degradation in developing countries. California has entered into a memorandum of understanding with the states of Chiapas, Mexico and Acre, Brazil whereby preservation of forests in these states could generate offset credits available to covered sources in the Cap-and-Trade Program.

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