California's greenhouse gas cap-and-trade program in action with a new alliance, but facing renewed scrutiny

California’s Cap-and-Trade program is now in full swing, with four auctions planned per year, scheduled on the 12th business day of each quarter. The next auction is scheduled for May 16, 2013, just around the corner. Adding to this, on April 19, the California Air Resources Board (“CARB”) confirmed a date to officially link California’s cap-and-trade program with that of Quebec. As of January 14, 2014, California and Quebec will accept each other’s carbon allowances and approved offsets and share compliance tracking and market monitoring data. The program link will allow California’s manufacturers to capitalize on Quebec’s large hydropower capacity. Investors in California will be able to pursue additional opportunities in the expanded market. In addition, the link will afford both governments a way to refine their respective programs and test expansion potential to other jurisdictions.

While certain sectors did receive free allowances for the first compliance sector (in an attempt to quell the fear that businesses would flee California), other sectors did not, including the large investor-owned utilities who were then the largest and most prominent bidders in the auction. Using the same auction format as the Regional Greenhouse Gas Initiative (“RGGI”) of the Northeast and Mid-Atlantic States, California’s first auction on November 14, 2012, closed with a carbon price of $10.09/MtCO2e, just barely over the $10 floor. To set the context, as of November 2012, the first compliance period had not started, litigation threatened to stall or end California’s cap-and-trade program altogether, and uncertainty was high among industry. This uncertainty resulted in 97% of the bidders in the first auction being compliance entities, with no meaningful participation by traders to re-sell the allowances on the secondary market. Shortly thereafter, the first compliance period for large-scale manufacturers and electricity generators began on January 1, 2013, seemingly without any hiccups or real litigation. The second auction took place in February 2013 and was more successful, resulting in a healthy jump in the carbon price to $13.62 and more importantly, 25% more bidders, of which only 88% were compliance entities. Further, the second auction saw 40% of the future credits available for the second compliance period being purchased at a rate of $10.71/MtCO2e—a sign that industry is now fairly comfortable that California’s cap-and-trade program is here to stay.

Bids are in lots of 1,000 allowances, which “allow” the holder to emit greenhouse gases above their assigned cap. The auction’s carbon price is set by the lowest clearing bid. The quantity of allowances available for purchase is limited overall and by individual purchaser, and that limited quantity goes to bidders in order of the highest offer price until all of the allowances are auctioned. In the end, however, all purchasers pay the same price per lot of allowances—the lowest clearing bid, or the lowest price offered by a bidder that was still allotted allowances. Thus, since there are a set number of allowances available at the auction, the trick is to offer a high enough price to guarantee that the compliance entity receives enough allowances to be in compliance with its cap, but not to offer such a high price that the lowest clearing bid becomes too costly. Under AB 1532 and SB 1535, 25% of the proceeds from the auction will benefit disadvantaged communities and further the role of AB 32 to decrease greenhouse gas emissions to 1990 levels by 2020. Just this last week, on April 25, 2013, CARB held a Public Hearing on the draft Cap-and-Trade Auction Proceeds Investment Plan: Fiscal Years 2013–14 through 2015–16, outlining how CARB and the Department of Finance plans to allocate the funds, in accordance with this directive, which it will submit to the legislature for approval.

Also, gaining ground is the offsets market. Under the cap-and-trade regulations, CARB has developed a Compliance Offset Program that allows regulated industry to meet up to eight percent of its triennial compliance obligation through offsets. In order for an offset credit to count toward cap-and-trade compliance, it must be issued by CARB. There currently are four different compliance offset protocols (U.S. Forest Projects, Urban Forest Projects, Livestock Projects, and Ozone Depleting Substances Projects) that can be used to generate valid offset credits. Projects developed under these protocols must be listed with one of CARB’s approved offset project registries. The registries administer the offset program by listing, reporting on, and verifying projects, as well as issuing offset registry credits. Approved compliance offset projects still must work with a CARB-accredited verification body or offset verifier to ensure greenhouse gas reductions and removal enhancements meet regulatory approval. It is also possible for approved, early action offset programs to transition to CARB offset credits that can qualify toward cap-and-trade compliance. Even with four offset protocols approved thus far and a means to recognize early action offsets for cap-and-trade compliance, there is some question whether offset options are too limited to meet the market need for current and future compliance periods. Another issue centers on whether liability risks to buyers for offsets that are later determined to be invalid can and should be shifted to offset sellers to increase the use of offsets and reduce the overall costs of cap-and-trade compliance.[i]

Even as California’s program gains ground in the auction house, a recent lawsuit invites renewed scrutiny in the courthouse. On April 16, Pacific Legal Foundation (“PLF”) filed suit in the Sacramento Superior Court, challenging the cap-and-trade program under both the California Constitution and AB 32. PLF argues that the charge for emissions allowances under the cap-and-trade program constitutes an illegal tax, implemented in violation of the state’s two-thirds legislative vote requirement for any new tax.

[i] Todd Schatzki and Robert Stavins, Three Lingering Design Issues Affecting Market Performance in California’s GHG Cap-and-Trade Program (Analysis Group, Inc.: Jan. 29, 2013).