7. Cap-and-Trade Market Design and Flexible Compliance
7.1. Introduction
In this section, we outline some of the characteristics specific to the electricity sector that ARB should bear in mind as it considers market design and flexible compliance mechanisms for a multi-sector cap-and-trade system that may link to a regional and/or national program. We stress the importance of a liquid and transparent allowance trading system and sufficient flexible compliance options to help market participants meet their obligations while maintaining the environmental integrity of the emissions cap. We make our suggestions and recommendations based on the unique characteristics of the electricity sector as discussed below.
7.2. Unique Characteristics of the Electricity Sector
Parties point to a number of unique characteristics in the electricity sector that should be recognized in the design of a cap-and-trade market.
EPUC/CAC, SCPPA, and CUE argue that, in the electricity sector where the thing regulated is a commodity of necessity, it is particularly important to make a wide variety of flexible compliance tools available.
PG&E notes that, absent government approval, California's investor-owned utilities cannot choose to withdraw voluntarily from the electricity or natural gas business or move their business or facilities to another state or location. Likewise, PG&E points out that, because electricity utilities are relatively capital-intensive and subject to natural economies of scale for their transmission and distribution facilities, utility customers do not have the same choice to buy electricity or natural gas services from out-of-state suppliers or manufacturers as they have for other consumer products and services.
IEP cautions that electricity cannot be stored efficiently to any significant degree, and that most generators do not have 100% control over their operations in all hours.
SDG&E/SoCalGas suggest that GHG compliance obligations could cause price spikes in the electricity market due to inelastic demand for allowances by deliverers, which may be able to pass on the cost in the market price, as well as inelastic supply of allowances in the short term, since most emissions reductions will depend on investments that will take years to move from design to operation.
Several parties assert that the demand for allowances will be subject to annual variability due to the effects of weather on both the demand for electricity and the sources of energy. SMUD notes that over the past 18 years, while electricity sector emissions have remained relatively flat on average, annual variations in emissions of 15% and 2-year swings of 25% have occurred a number of times. Annual temperature variations lead to electricity demand variability, due in part to the increased demand associated with air conditioning on hot days. Weather also affects electricity supply, partially due to the relatively large role of hydroelectric generation in California's resource mix. Figure 7-1 illustrates the variation in California's hydropower generation during the period 1990-2005 and shows that the electricity sector's GHG emissions tend to be higher in years when hydroelectric output is low. Of particular concern is the potential for extended droughts to drive up the sector's demand for allowances as fossil-fired generation is substituted for carbon-free hydropower. Lengthy droughts are not uncommon in California. PG&E cites data from the Sacramento Valley Water-Year Index (Index), calculated by the California Department of Water Resources, which is closely correlated with the State's hydroelectricity supply. PG&E observes that "since recordkeeping began in 1906" the Index has been below normal for five periods lasting four years or more. In the worst sequence, the Index was at least 28% below normal for the first six years of a nine-year drought that began in 1929.
Figure 7-1
Correlation of Electricity Sector Emissions and
In-state Hydro Production
PacifiCorp notes that electricity may be used as a substitute fuel by other regulated sectors to reduce their own GHG emissions reduction obligations. PacifiCorp argues that switching from direct fossil fuel combustion in manufacturing and production processes, and fuel switching as a result of technology advancement (i.e., the plug-in hybrid electric vehicle technology), are very likely to be environmentally beneficial and cost-effective, but that the outcome would be to increase the electricity sector's overall compliance burden.
We agree that the electricity sector faces certain constraints due to its unique characteristics and that some of these factors increase the year-to-year variability of annual emissions, in addition to the effects of macroeconomic forces that influence all sectors. Of particular note are the requirement that retail providers provide electricity to customers on demand regardless of price; the fact that some retail providers hold long-term contracts for high-emitting power; the relatively long time-frame for planning, permitting, and construction of transmission and generation facilities needed to significantly change California's electricity supply mix; relatively inelastic demand; and annual variations in demand and in zero-emitting hydroelectric supplies. Because of these constraints, we believe that the electricity sector has a compelling need to be able to access low-cost emissions reductions commensurate with the size of the market and the extent of required reductions, and to manage their compliance options over time. Moreover, as ARB refines its market design and develops criteria for allowance allocation, it should take into account the potential for emissions to migrate across sectors as a result of fuel switching, vehicle electrification, and other shifts.
7.3. The Need for Flexible Compliance Options
Several parties submit that a narrow allowance market with few participants and difficult emissions targets likely would require more flexibility than would a broader market with less ambitious targets. Calpine and WPTF argue that greater participation in the market would increase the liquidity of the market and encourage emissions reductions in the least cost-intensive sectors. Similarly, SMUD maintains that additional flexibility is necessary in a market that requires steeper emissions reductions. SMUD contends that, if the electricity sector is required to reduce emissions only to 1990 levels, limited flexible compliance options could suffice. SMUD states that if, instead, the electricity sector is required to reduce its emissions to 30% below 1990 levels as indicated in the E3 Accelerated Policy Case, the electricity sector would need more flexible compliance options. Calpine argues that the rate at which the cap ratchets down over time also will influence the need for flexible compliance options.
PacifiCorp states that a cap-and-trade program with flexible compliance options would be, by necessity, more complicated to administer than one without flexible compliance options, but that this additional complexity would be a reasonable trade-off for avoiding unnecessary economic harm and ensuring equity.
GPI asserts that the appropriateness of many of the flexible compliance tools depends on the basic compliance system itself, as well as on the suite of other flexible compliance tools that are employed. For example, GPI submits that the need for banking and borrowing provisions is intricately related to the length of the compliance period that is adopted.
Some parties warn against the excessive use of flexible compliance options. NRDC/UCS maintain that trading in a cap-and-trade program is itself a flexible compliance option. Calpine asserts that flexible compliance options must be limited in order to ensure that new technologies are deployed and real emissions reductions are achieved within the covered sectors.
We agree that the need for flexible compliance options is tied directly to the size of the market, the emissions targets, and the trajectory of required reductions toward those targets. As discussed in Section 4.3.2.1, we favor equal annual reductions in the multi-sector emissions cap between 2012 and 2020.
7.4. Market Design
As discussed above, we believe that it is necessary to have a more complete picture of key market design elements in order to make specific decisions about the best approach to flexible compliance. The mix of flexible compliance mechanisms that is ultimately implemented should ensure a liquid and transparent allowance trading system, limit rate increases to consumers, and provide a reasonable range of compliance options for the electricity sector while also maintaining the environmental integrity of the emissions cap. While all aspects of the market design may potentially affect the electricity sector, we confine our recommendations to areas in which unique characteristics of the electricity sector raise concerns that we urge ARB to consider.
Several parties emphasize the need for a broad allowance trading market. WPTF states that the scope and design of the cap-and-trade system is the most effective tool for cost containment, on the basis that a broader market is likely to have a larger supply of low-cost options and lower compliance costs. PG&E and SCE argue that a broad market is likely to be more active, providing a sustained price signal to drive investment in low-carbon strategies. Similarly, IEP asserts that no amount of flexible compliance can make up for a poorly designed, narrow, and illiquid market. The Market Advisory Committee Report recommends that ARB should seek to expand the cap-and-trade program over time so that it covers as many sectors, sources, and gases as practicable.
In its Draft Scoping Plan, ARB supports the development of and linkage with a regional cap-and-trade market through the Western Climate Initiative. Multi-state trading opportunities would likely provide a broad and liquid market due the number of states and provinces participating, as well as the number of sectors and industries expected to participate, including the electricity sector, natural gas sector, refineries, cement, and transportation.
We agree with those parties that favor linkage with a broad trading market, and we strongly urge ARB not to pursue a California-only program, but rather to continue working with the Western Climate Initiative to help create and participate in a broad, liquid, multi-sector, regional cap-and-trade market that includes the electricity sector, major industrial sources, and the transportation sector. Such a broader program will provide greater market liquidity and price stability, as well as additional opportunities for low-cost GHG reductions. As some parties have noted, a broader program may also reduce the need for flexible compliance options relative to a program with narrower scope.
Parties are divided on whether to limit who can buy and sell allowances and offsets in the cap-and-trade system. Some parties assert that unlimited participation would increase market liquidity, increase efficiency within the cap-and-trade system, and decrease price volatility. These parties support broad participation by financial institutions, hedge funds, private citizens, and other non-obligated entities, in addition to entities with compliance obligations.
DRA submits that unlimited participation in cap-and-trade systems has not harmed other cap-and-trade programs. Morgan Stanley and other parties assert that there are operational advantages from having a broader range of participants. Morgan Stanley argues that intermediaries can offer many useful services in an open market, such as warehousing allowances and/or offsets, providing explicit and de facto financing, creating derivative instruments such as swaps and futures that provide flexibility and hedging opportunities, and making markets in the underlying instruments. Morgan Stanley also claims that, without speculators, forward prices could become distorted by the different risk tolerances of market participants. In addition, Morgan Stanley notes that commercial trading in allowances would be subject to applicable state and federal oversight.
PacifiCorp and CUE express concern that financial institutions and hedge funds could distort market operation by exerting market power to drive up prices. Several parties agree with IEP that the distribution of allowances, including auctions, should be limited to parties with compliance obligations. Dynergy and SCPPA argue that parties without compliance obligations should be prohibited from banking allowances, in order to discourage "hoarding."
DRA, Morgan Stanley, SCE, and WPTF argue that limiting participation in the emissions allowance market is impractical since it would be difficult to determine which parties have compliance obligations. This is because the definition of a deliverer potentially encompasses the entire array of entities-- including financial institutions and power marketers-- that regularly deliver energy into the California electricity markets.
DRA, PG&E, and Powerex argue that developing different rules for different classes of participants as a means to prevent market manipulation would create an overly complex market to administer and monitor, and could give participants an incentive to work around the rules.
We are convinced that a broad allowance market with a wide spectrum of participants would result in more liquidity and greater access to tools for managing risk. We also note the difficulties of developing and applying different sets of rules for market participants versus non-market participants, especially given the expansive definition of a deliverer. However, we are also troubled by the concerns raised about the risk of market manipulation and anti-competitive behavior. The very characteristics of the electricity sector discussed above that justify the need for ample provision of flexible compliance opportunities in this sector also argue for serious precautions - and careful oversight - to prevent market manipulation.
We encourage ARB to closely evaluate the benefits of providing full market access in light of the adequacy of safeguards under consideration to reduce the risk of market manipulation and anti-competitive behavior. Provided that ARB is satisfied that adequate safeguards are in place, we encourage ARB to allow unlimited participation in the cap-and-trade system. We encourage ARB to develop one set of rules for all classes of participants. We agree with DRA, PG&E, and Powerex that creating different rules for different parties could result in an overly complex market to administer and monitor, and could give participants an incentive to work around the rules.
Many parties support linking the California cap-and-trade system with other cap-and-trade markets to further encourage liquidity and potentially reduce compliance costs. PG&E argues that linkage would broaden trading opportunities, making the market more efficient. SDG&E/SoCalGas contend that trading with other systems could reduce compliance costs in California. The Market Advisory Committee Report recommends linkages with other mandatory cap-and-trade systems, commenting that program linkages can increase market liquidity and cost-effectiveness and improve the functioning of the cap-and-trade program without sacrificing environmental integrity. EPUC/CAC assert that linking with other programs is likely to discourage leakage and thus promote environmental integrity. They submit further that linking with trading systems in different regions will also help smooth the impact on allowance prices of localized variations in weather, rainfall, and economic activity.
Some parties advise caution when contemplating linkage with other trading systems. CUE argues that linkage would subject the California system to the market rules of the other systems, including some with which we might not agree. NRDC/UCS and GPI point out that use of allowances from other systems could transfer economic activity and co-benefits outside of the State. GPI also suggests that some limits on the use of allowances from other systems might make sense, especially at the beginning of the program when new rules are being tested and confidence in the verifiability of out-of-state allowances has not been established.
Many of the parties supporting linkage favor a bilateral approach, in which the allowances from one system would be fully fungible with the allowances from the other system. GPI states that bilateral linkages are preferable because each program could guarantee through a formal agreement that its own allowances would meet the minimum criteria established by the other program. Dynergy and Powerex submit that bilateral linkage can moderate price volatility if there are no limits on allowances obtained in other jurisdictions. The Market Advisory Committee Report states that the terms for linking with other programs will need to be negotiated individually with the specific jurisdiction(s) involved.
SCE, SDG&E/SoCalGas, and PacifiCorp argue for unilateral linkage, in which the allowances from other systems would be treated as offsets in California. SCE asserts that the offset approach would be the simplest and most straightforward manner for California to develop regulatory links with other regions. Morgan Stanley and IEP argue that California should use this approach if bilateral linkages are not possible.
Many parties support linking only with cap-and-trade systems that have equally stringent rules. NRDC/UCS argue that California should consider linkage only if the other system has a similarly tight cap, comparable verification and reporting requirements, and equivalent limits on offsets. DRA explains its view that, if penalties and other sanctions are not comparable between two linked systems, non-compliance is likely to be exported to the system with the lowest penalty level.
Some parties contend that allowance prices in linked systems are likely to converge. PG&E states that bilateral linkage might reduce or increase allowance prices in California, depending on the relative prices in California and the other system. However, PG&E states that unilateral linkage to another system might decrease, but would not increase, allowance prices in California.
We agree with the parties that state that linkage with other trading systems would add liquidity and efficiency to California's trading market. We also are convinced that bilateral linkage is the right approach to ensure that any allowances accepted by California entities from other systems are of comparable quality to California allowances. While we recognize the possibility that certain design features of other systems, such as price triggers or inadequate enforcement provisions, could affect environmental integrity adversely if linked with California's program, we believe that these issues can be worked out in advance through negotiations for bilateral linkage. We strongly support ARB's effort to link California's cap-and-trade system with the Western Climate Initiative. We recommend that ARB continue this effort and also pursue bilateral linkage with other local, regional, national, and international GHG cap-and-trade systems, as they emerge and are rigorously studied to establish that they have comparable stringency, monitoring, compliance, and enforcement provisions.
Borrowing would allow obligated entities to use allowances from their allotments in future compliance periods to meet current compliance obligations. Parties are divided on this issue.
Several parties argue that borrowing should be allowed. GPI asserts that borrowing would allow obligated entities to fall behind in their requirements, to a limited extent, in order to supply electricity needed during shortfalls, while ensuring that they do not fall so far behind that they can never make it up. SCPPA argues that borrowing would permit market participants to alter their "glide path" to emissions reductions through successive compliance periods. SCPPA contends that this is important because substantial lead times might be necessary to finance and install electricity infrastructure that may result in a sharp drop in emissions in later years.
DRA, NRDC/UCS, and CARE argue that borrowing should not be allowed. DRA asserts that borrowers might end up defaulting on their allowance debt, jeopardizing the program's ability to meet the overall reduction goals. The Market Advisory Committee Report recommends that borrowing should not be allowed.
NRDC/UCS, SDG&E/SoCalGas, and Calpine argue that borrowing, if allowed, should be limited. NRDC/UCS support limitations on the percentage of an entity's compliance obligation that could be borrowed, how often a single entity would be allowed to borrow over the life of the program, and how many compliance periods ahead an entity could borrow from. NRDC/UCS, SDG&E/SoCalGas, and Calpine argue that borrowed allowances should be paid back with interest, which SDG&E/SoCalGas assert would discourage entities from taking advantage of the time value of money and speculating on prices across compliance periods. SDG&E/SoCalGas state that borrowers should be subject to similar creditworthiness requirements as counterparties in energy trades.
Morgan Stanley, SDG&E/SoCalGas, and PacifiCorp suggest that borrowing possibly should be allowed only during the early years of the program. Morgan Stanley argues that emitters will not have had any significant opportunity for contingency planning at the outset of the program, and thus that an anomalous first compliance period could be problematic.
At this time, we do not recommend that ARB permit borrowing, because we are persuaded by the comments that borrowing could delay emission reductions and make it more difficult to achieve the program's emission reduction goals. Other flexible compliance measures discussed herein offer the potential to aid emitters in managing their compliance obligations with less risk to the program's environmental integrity.
Parties do not agree on the use of a price trigger or safety valve in the cap-and-trade program. A price trigger or safety valve would be engaged when allowance prices reach pre-determined levels, and additional allowances would be introduced into the market in order to guide prices downward. Several parties argue that such a mechanism could provide relief if the program proves to be excessively costly. SCE states that the program administrator should retain the option of offering additional allowances at a predetermined price in the event that the markets demonstrate economically burdensome price swings. SCPPA argues that a price trigger could be important to prevent a "market meltdown." Some parties, including PacifiCorp, suggest an approach in which additional allowances would be taken from the allotments to be distributed in future years, thereby maintaining the same level of emissions reductions over time.
Other parties argue that a price trigger or safety valve would threaten the effectiveness of the program. NRDC/UCS argue that such mechanisms would have the potential to break the emissions cap, undermining the purpose of the State's emissions reduction law. The Market Advisory Committee Report recommends against a safety valve, stating that total emissions within the program should not exceed the cap. Morgan Stanley asserts that safety valves would create uncertainty in the market, discouraging investments in new or existing emissions reduction technologies. Powerex and WPTF argue that including a safety valve or price trigger would make it more difficult for California to link with other trading systems that are not designed to have a similar mechanism. NRDC/UCS submit that a safety value is unnecessary because the Governor already can suspend any part of the program under the authority of AB 32 in the event of extraordinary circumstances.
PG&E asserts that a price trigger for allowing additional offsets into the trading system, such as that adopted by the Regional Greenhouse Gas Initiative might be ineffective because participants would not have adequate confidence or notice to actually make investments in potential offsets that they will be unable to sell into the market unless the price trigger is reached.
PG&E and FPLE argue for a "price collar" approach, in which a minimum price of allowances would be set along with a maximum price, giving investors in emissions reduction technologies and offset projects some degree of confidence that their product would have value in a future market. DRA opposes this approach, asserting that a minimum price for allowances would operate at the expense of ratepayers.
We are convinced that price triggers and safety valves could very likely distort or defeat the cap-and-trade market by creating uncertainty that investments in emissions reduction technologies would achieve returns commensurate with the level of reductions needed to meet the State's emissions reduction goals. Market certainty is important because the knowledge that allowance prices are likely to rise as the cap ratchets down over time is necessary to encourage long-term investments in emissions reductions that may not pay off in the short-term but that would be profitable in the long-term as a result of prices going up. We disagree with Powerex and other parties that a system-wide mechanism that borrows allowances from future periods, when allowances are likely to be in scarcer supply, would necessarily maintain the same level of emissions reductions over time. Such a mechanism would make allowances in these future periods even scarcer and could seriously jeopardize the State's ability to meet emissions limits during those periods. We find that this form of cost containment is not necessary, provided that the system contains other design elements such as multi-year compliance periods, unlimited banking, and a well-designed offset program. These design features would allow covered entities to manage their costs in a manner more likely to preserve the environmental integrity of the cap throughout the life of the program. Likewise, we disagree with those parties that argue for a price floor for allowances, because low prices are likely to indicate that the market is working to drive sufficient investment toward the required emissions reductions. We therefore recommend that ARB, in developing a cap-and-trade system, avoid creating any price triggers, ceilings, floors, or safety valves.
7.5. Flexible Compliance Options
The following options would introduce a useful degree of flexibility into the cap-and-trade market, while also satisfying other goals such as electricity system reliability and fostering reductions outside of the capped sectors. We encourage ARB to include these options in the cap-and-trade system.
Several parties argue that multi-year compliance periods (in which covered entities would have to surrender allowances at the end of the period) would facilitate compliance with emissions limitations. No parties argue against the adoption of multi-year compliance periods. SCE suggests that multi-year compliance periods would help reduce the volatility of supply and demand in the electricity sector due to dynamic changes in weather patterns. SCPPA asserts that longer compliance periods such as three years would help regulated entities smooth the impact of capital-intensive emissions reduction improvements that might result in a significant step decrease in the entity's emissions. The Market Advisory Committee Report recommends a compliance period of approximately three years.
Morgan Stanley suggests that it might make sense for the initial compliance period to be relatively long, with subsequent compliance periods of shorter duration. It argues that this would prevent an early anomalous event from causing a major disruption before emitters have had time to develop and implement contingency strategies to manage such situations. Over time, however, Morgan Stanley believes that emitters should expect that anomalous events will occasionally occur, and that it would be reasonable to expect emitters to have a contingency plan in place to manage such events.
Several parties suggest that staggered compliance periods could improve liquidity within the allowance market. SMUD argues that there would be value to having compliance periods that do not end at the same time, in order to avoid a rush for allowances at the end of each compliance period. SCE argues that electricity sector entities could be especially vulnerable to manipulation of allowances prices since the sector's compliance obligations would be well-known due to the regulated nature of the industry. SCE and PacifiCorp suggest that, to discourage market manipulation, individual regulated entities should have the option to end their own compliance periods early. WPTF and Calpine suggest a system of rolling compliance periods. In their proposal, entities subject to the cap would be required to surrender allowances annually to cover emissions in the previous year, but in exchange would be able to use a limited quantity of allowances from the next year.
Several parties agree with PG&E that compliance extensions could help regulated entities respond to unanticipated, extraordinary events. However, DRA, Morgan Stanley, and WPTF argue that extensions would be unnecessary, and could undermine the effectiveness of the program by discouraging investments in new technologies and emissions reductions.
We are convinced that multi-year compliance periods could provide compliance flexibility and reduce price volatility due to potential effects such as weather-driven variations in electricity supply and demand. It would be appropriate for ARB to adopt multi-year compliance periods during the early years of the program. However, we are also concerned that longer compliance periods could make it difficult to discern shortages or surpluses of allowances due to underlying characteristics of the market, and we agree with Morgan Stanley that emitters eventually should have plans in place to deal with anomalous events that may lead to price volatility. We encourage ARB to establish three-year compliance periods for the early years of the cap-and-trade program, and to consider the possibility of shorter compliance periods as the program matures. We believe that staggered or rolling compliance periods potentially could reduce price volatility further, but we do not have enough information to determine how these devices would work in practice. We therefore encourage ARB to give further evaluation and consideration to staggered or rolling compliance periods. Finally, we find that compliance extensions would discourage emissions reductions, and therefore encourage ARB not to grant extensions of compliance periods in the cap-and-trade system.
Many parties support a market feature that would allow parties to bank allowances and offsets for use in future compliance periods. Powerex argues that allowance banking would improve market liquidity, provide incentives for greater reductions during the early years of the program, and potentially allow covered entities to reduce their compliance costs. Powerex also suggests that banking could give covered entities that hold allowances due to early reductions a greater long-term commitment to the allowance trading system. SCPPA argues that banking would provide entities within the electricity sector with insurance against market illiquidity, including illiquidity that might be caused by market manipulation and abuse. DRA and EPUC/CAC comment that banking would help smooth out price variations in the market for allowances. EPUC/CAC argue that the allowance price volatility that was experienced by the European Union Emission Trading Scheme was due in large part to the lack of banking options between Phase I and II in that system. The Market Advisory Committe Report recommends that California issue allowances that do not expire and which may be banked for use in any subsequent compliance period.
No parties oppose allowance banking under all circumstances, but some argue for restrictions in order to discourage allowance "hoarding" and market manipulation. NRDC/UCS, GPI, and SMUD suggest that the number of allowances an entity is allowed to bank should be limited. NRDC/UCS, GPI, and TURN suggest limitations on the length of time that entities would be allowed to hold banked allowances. Dynergy and SCPPA argue that parties without compliance obligations should not be allowed to bank allowances.
Morgan Stanley argues against market restrictions intended to prevent "hoarding," contending that it almost always would be impossible to distinguish between a party holding allowances for "legitimate" purposes and one engaged in "hoarding." Morgan Stanley also asserts that banking large numbers of allowances for "hoarding" purposes likely would be prohibitively expensive.
We agree with those parties that suggest that allowance and offset banking likely would lead to greater market liquidity and compliance flexibility. Moreover, as discussed in Section 7.4.2, the deliverer definition renders efforts to differentiate between market participants and nonparticipants impractical. We also believe that banking would be an effective strategy to counter the uneven nature of the emissions in the electricity sector due to weather-driven variations in energy consumption and the supply of zero-emitting hydropower. However, we recognize the concerns about "hoarding" and market manipulation, and strongly encourage ARB to ensure that there are adequate safeguards to reduce these risks. With such safeguards, we suggest that ARB allow unlimited banking of allowances and offsets by all market participants.
Similarly, we recognize the point made by EPUC/CAC that restrictions on banking between phases of a program could increase market volatility, and therefore suggest that ARB consider recognizing allowances and offsets banked during the program from 2012 to 2020 in any post-2020 trading system as well.
Offsets are emission reductions or sequestration activities that are not otherwise required by regulation or created in common practice. They are a potentially valuable tool for covered entities to use to manage their compliance obligations and may help to limit rate increases to retail electricity customers. We recognize, however, that any cost saving realized by the use of offsets would prove a false economy if the underlying project did not actually produce the requisite emissions reduction. In the following discussion, we address the risks and benefits of allowing the use of offsets. We also identify several issues that we encourage ARB to consider in its evaluation of the potential establishment of a credible and reliable offset program.
Most parties support the use of offsets for compliance under certain circumstances. Morgan Stanley argues that the utilization of offsets that meet California's quality criteria would serve a useful cost containment function without impairing the environmental integrity of the program. The Climate Trust submits that offsets can stimulate GHG reductions in sectors that either are not covered by or are not appropriate for an emissions cap.
IEP points out that Section 38505(k)(2) requires that offsets must "result in the same greenhouse gas emission reduction, over the same time period as direct compliance with a greenhouse gas emission limit or emission reduction measure."
One party, CUE, argues that offsets should not be allowed. NRDC/UCS argue that an offset program should be approached with "an abundance of caution." CUE and NRDC/UCS assert that offsets would reduce incentives for investments in emissions reductions in sectors within the cap, and that ensuring that offsets actually achieve the reductions that they claim would be difficult and expensive. These parties also suggest that emissions in sectors outside the cap can be directly regulated or covered by another program.
Several parties argue that offsets should be allowed in unlimited quantities. Dynergy points out that there currently are no commercial technologies than can remove carbon dioxide from fossil fuel-fired electricity generators' exhaust gases. SCE asserts that limits on offsets would place a financial burden on covered entities that would reduce their ability to invest in technological changes needed to meet long-term emissions reduction goals. Other parties, including NRDC/UCS, argue that if offsets are allowed, they should be limited to a small percentage of each source's compliance obligation, in order to ensure that meaningful reductions occur within the capped sectors. DRA argues that quantity limits on offsets should be eased over time as California gains confidence in the integrity of offsets.
The Market Advisory Committee Report recommends that offsets should be allowed as part of the cap-and-trade program. The committee's members were divided on whether there should be a limit on the quantity of offsets that can be used for compliance purposes. Most, but not all, members of the committee believe that quantity limits are not the best way to promote GHG reductions by sources within the cap. In contrast, some other members believe that only with quantity limits on offsets will industry make the investments necessary to ensure that long-term GHG reduction goals are achieved.
We are convinced that sources within the electricity sector may have limited opportunities to make short-term GHG reductions at levels significantly larger than those associated with the programmatic energy efficiency and renewable energy measures recommended elsewhere in this decision. For these sources, the use of high-quality offsets could provide an alternative compliance option while also creating incentives for sources outside the cap to make GHG reductions that otherwise would not have occurred. However, we also note that the need for offsets for the electricity sector is directly related to the level of the overall cap, the quantity and method of allowance distributions within the electricity sector, the size and liquidity of the allowance market, and many other factors. If, for example, the cap-and-trade program does not require reductions in the electricity sector below what is expected from programmatic energy efficiency and renewable energy measures, there may be no need for a large pool of additional offset opportunities. On the other hand, in a significantly short or illiquid market, offsets may be one of the few compliance options available to covered entities, especially in the short run.
We therefore encourage ARB to allow covered entities to use offsets at levels that are appropriate given other program design parameters. Of course, the requirements of AB 32 must be met.49 As IEP argues, offsets should result in the same GHG emissions reductions over the same time period, and must be real, additional, verifiable, permanent, and enforceable, to ensure the integrity of the emissions reduction program. ARB's Draft Scoping Plan includes a provision to allow covered entities to use high-quality offsets for not more than 10% of their compliance obligation. We agree that, while we expect programmatic energy efficiency and renewable energy measures to be the primary driver for emission reductions in the electricity sector, a quantitative limit on the use of offsets may be desirable to ensure additional reductions from sources subject to the cap. We believe that the appropriate level of offsets should be determined relative to the scope and liquidity of the cap-and-trade market, as well as the emissions targets. Additional modeling work may be needed to determine an appropriate level of offsets for the cap-and-trade program.
Parties provided extensive comments on the merits of various proposals to restrict the use of offsets and to ensure that only high-quality offsets are used for compliance in California. These include whether there should be geographic limits on the sources of offsets, use of credits from the Clean Development Mechanism, discounting of offsets, requirements that offsets produce co-benefits, third party verification of reductions from offsets, and periodic external review of the offset program. For the most part, these issues are generic to an offset program without particular unique considerations for the electricity sector. We therefore take no position on the design of a prospective offset program at this time. We do, however, encourage ARB to avoid overly narrow limitations on the geographic sources of offsets.
Most parties argue that no geographic limits should be placed on offsets. PG&E asserts that limiting offsets based on location would increase the cost of the cap-and-trade program by not allowing entities to pursue possible low-cost emissions reduction opportunities. PG&E and SCE argue that offsets offer a way for California to exercise global leadership and engage uncapped regions in the challenge of reducing emissions. EPUC/CAC assert that geographic limits on offsets could impede California linkage with other programs. In support of geographic limits, NRDC/UCS and CARE argue that only projects within California would provide co-benefits to the State and would ensure that California's high standards for quality are met. However, DRA points out that projects outside of California may have different co-benefits that may advance other social or environmental goals.
Parties offer different perspectives on whether California should accept offsets from the Clean Development Mechanism. NRDC/UCS and GPI assert that the Clean Development Mechanism fails to guarantee that its offset projects provide real, truly additional, verifiable, permanent, and enforceable GHG reductions. However, the Climate Trust argues that, while not without its problems, the Clean Development Mechanism is evolving rapidly and is moving to address many of the concerns raised regarding the issue of business-as-usual projects earning offset credits.
We are convinced that geographic limits are not consistent with the underlying goals of the offset program to contain costs and encourage reductions beyond those that are covered by an emissions cap. We note that all offsets projects are likely to produce some co-benefits, and that projects located outside California could potentially reduce the "carbon footprint" of products imported into the State, and possibly provide out-of-state markets for clean technology products manufactured in California. We therefore encourage ARB to consider accepting high-quality offsets for compliance purposes without any geographic restrictions, provided that each offset from outside California meets the requirements of AB 32. We also support participation by the State of California, as feasible, in efforts to secure a post-2012 international climate agreement, and encourage ARB to consider accepting offsets from any offset program established pursuant to such an agreement for compliance with the California program, provided that ARB is satisfied that these credits meet high-quality standards and do not weaken the GHG emission reductions associated with the voluntary REC market.
7.6. Legal Issues Related to Market Design and Flexible Compliance
7.6.1. Statutory Issues Concerning Linkage and Offsets
7.6.1.1. The Requirement that ARB Monitor Compliance with, and Enforce, its Rules
CUE argues that linkage to carbon-trading systems outside California (or the acceptance of out-of-state offsets) would be illegal because Section 38580(a) requires ARB to "monitor compliance with and enforce any rule, regulation, order, emission limitation, emissions reduction measure, or market-based compliance mechanism adopted . . ." CUE further argues that ARB would not have the authority or ability to oversee and enforce trading occurring outside of California and therefore such trading cannot legally be included as part of the implementation of AB 32.
CUE, however, ignores the apparent purpose of Section 38580, which is to ensure that regulated entities comply with the regulations that are adopted. If, for example, ARB adopts a regulation that permits credits from certain specified trading systems with comparable stringency, monitoring, compliance, and enforcement provisions to be used in California, ARB should still be able to monitor and enforce its requirement contained in the regulation that the credits must be issued by the specified trading systems and not by some other carbon-trading system with which linkage has not been authorized. CUE does not explain why ARB would not be able to track the credit back to the originating trading system,50 nor why ARB would be unable to take enforcement action against a regulated entity that attempted to use a credit issued by a carbon-trading system with which linkage has not been authorized. Similarly, if ARB authorizes offsets from outside California, and requires that they conform with specified protocols and have been verified by authorized verifiers, ARB ought to be able to monitor and enforce compliance with such a regulation. Such monitoring and enforcement could be performed by reviewing the regulated entity's submission of verification reports showing (i) that the offsets come from a project that meets one of the authorized protocols and (ii) the amount of GHG emissions being offset. Nothing in Section 38580 requires that ARB itself be able to inspect the offset project to determine its compliance with the protocol or the amount of emissions being offset. In short, we agree with SDG&E/SoCalGas that nothing cited by CUE "even remotely suggests that the Legislature wanted to prohibit linkages to other systems, although it clearly could have so stated, if that was its intent." (SDG&E/SoCalGas Reply Comments at p. 15.)
Furthermore, CUE's argument ignores Section 38564, which states, in pertinent part:
[ARB] shall consult with other states, and the federal government, and other nations to . . . facilitate the development of integrated and cost-effective regional, national, and international greenhouse gas reduction programs.
This statutory encouragement for the development of integrated regional, national, and international GHG-reduction programs further supports our conclusion that AB 32 permits linkage to other GHG reduction programs and the use offsets from outside California.
7.6.1.2. The Definition of "Statewide Greenhouse Gas Emissions"
IEP notes that Section 38505(m) defines "statewide greenhouse gas emissions" as "the total annual emissions of greenhouse gases in the state, including all emissions of greenhouse gases from the generation of electricity delivered to and consumed in California . . . , whether the electricity is generated in state or imported." IEP submits that this definition could be interpreted to require a narrow focus on reducing GHG emissions "in the state" and thus could limit or prevent linkage or the use of out-of-state offsets.
IEP, however, concludes that it makes more sense to read the definition in Section 38505(m) as an effort to ensure that jurisdictional boundaries are respected, i.e., to ensure that AB 32 is not read as authorizing an encroachment into the jurisdiction of other states or the federal government. IEP also argues that it would be pointless for ARB to "consult with other states, and the federal government, and other nations to . . . facilitate the development of integrated and cost-effective regional, national, and international greenhouse gas reduction programs," as directed by Section 38564, if ARB were prohibited from participating in such regional, national, or international programs. Accordingly, IEP concludes that the definition of "statewide greenhouse gas emissions" should not be read to restrict ARB's ability to incorporate appropriate out-of-state carbon trading systems or offsets into its flexible compliance options.
No party supported the view that the definition of "statewide greenhouse gas emissions" prevents California from linking with other carbon trading systems or accepting out-of-state offsets. Section 38562(b)(1) directs ARB to design its regulations "to minimize costs." Out-of-state offsets should, and the use of other credits from linked systems may, help minimize the costs of GHG regulation to California. If, however, ARB concludes that it would be desirable to have legislation more explicitly authorizing out-of-state offsets and linkages, we would support ARB in seeking such additional legislation.
CEERT takes the position that an offset can only be accepted if it complies with the provisions of Sections 38562(b)51 and 38570(b).52
However, AB 32 does not require that each and every offset have the characteristics described in those sections. Section 38562(b) describes things that ARB should do in "adopting regulations" "to the extent feasible." It does not require each and every project carried out by private parties under those regulations to have the described effects.53 Similarly, Section 38570(b) only requires ARB, prior to the inclusion of any market-based compliance mechanism (such as offsets) in the regulations, "to the extent feasible" to (1) "consider" certain factors, including "localized impacts in communities that are already adversely impacted by air pollution," (2) "prevent any increase in the emissions of toxic air contaminants or criteria air pollutants," and (3) "[m]aximize additional environmental and economic benefits for California, as appropriate." (Emphasis added.) Furthermore, none of the parties commenting on the issue of offsets and co-benefits suggest that offsets would result in "any increase in the emissions of toxic air contaminants or criteria air pollutants" and we see no reason why the availability or use of offsets would produce that result.
NRDC/UCS apparently recognize that the factors set out in these two sections apply to ARB's regulations, and not to individual projects. Nevertheless, they express concern that "[i]t is not certain that offsets will achieve the . . . co-benefits for Californians as required by AB 32." (NRDC/UCS Comments at p. 26.) However, as pointed out above, these two sections of AB 32 require ARB to do certain things "to the extent feasible" and require ARB to balance a number of potentially conflicting goals, including minimizing costs (Section 38562(b)(1).) As we point out above, using offsets is one way to minimize costs. NRDC/UCS describe several hypothetical situations where they believe that allowing certain offsets would be a cause for concern.54 However, NRDC/UCS have not shown that the concerns they identify would apply to the offset program as a whole.
The Compact Clause of the U.S. Constitution provides that "[n]o State shall, without the Consent of Congress, . . . enter into any Agreement or Compact with another State . . . ."55 The Treaty Clause of the U.S. Constitution grants the President the power to make treaties with the advice and consent of the Senate and also provides that "[n]o State shall enter into any treaty, alliance, or confederation . . . ."56
While some parties suggest that linkage could raise issues under the Compact and Treaty Clauses, no party argues that linkage would violate either of those clauses, and a number of parties conclude that a violation of those clauses is unlikely. Indeed, no party cites, and we are not aware of, any case holding that an agreement between a state and other states or provinces violated either the Compact or Treaty Clauses.57
Nevertheless, case law (e.g., United States Steel Corp. v. Multistate Tax Commission, 434 U.S. 452 (1978)) does suggest that following certain principles in drafting linkage provisions will help avoid potential problems.58 This issue is discussed in Note: The Compact Clause and the Regional Greenhouse Gas Initiative, 120 Harv. L. Rev. 1958 (2007).
49 Section 38562(d) specifies that: "Any regulation adopted by the state board pursuant to this part or Part 5 (commencing with Section 38570) shall ensure all of the following: (1) The greenhouse gas emission reductions achieved are real, permanent, quantifiable, verifiable, and enforceable by the state board." Part 5, Section 38570 (a) states that: "The state board may include in the regulations adopted pursuant to Section 38562 the use of market-based compliance mechanisms to comply with the regulations."
50 Contrary to CUE's argument, Section 38580(a) does not require ARB to "oversee" every trading system that can be used to acquire credits for AB 32 compliance. It only requires ARB to monitor compliance with and enforce any market-based compliance mechanism that ARB adopts.
51 Section 38562(b) states, in part: "In adopting regulations pursuant to this section and Part 5 (commencing with Section 38570), to the extent feasible and in furtherance of achieving the statewide greenhouse gas emissions limit, the state board shall do all of the following:
"(1) Design the regulations . . . in a manner that is equitable, seeks to minimize costs and maximize the total benefits to California, . . . .
"(2) Ensure that activities undertaken to comply with the regulations do not disproportionately impact low-income communities.
. . .
"(4) Ensure that activities undertaken pursuant to the regulations complement, and do not interfere with, efforts to achieve and maintain federal and state ambient air quality standards and to reduce toxic air contaminant emissions.
. . .
"(6) Consider overall societal benefits, including reductions in other air pollutants, diversification of energy sources, and other benefits to the economy, environment, and public health.
"(7) Minimize the administrative burden of implementing and complying with these regulations.
"(8) Minimize leakage."
52 Section 38570(b) states: "(b) Prior to the inclusion of any market-based compliance mechanism in the regulations, to the extent feasible and in furtherance of achieving the statewide greenhouse gas emissions limit, the state board shall do all of the following:
"(1) Consider the potential for direct, indirect, and cumulative emission impacts from these mechanisms, including localized impacts in communities that are already adversely impacted by air pollution.
"(2) Design any market-based compliance mechanism to prevent any increase in the emissions of toxic air contaminants or criteria air pollutants.
"(3) Maximize additional environmental and economic benefits for California, as appropriate."
53 Indeed, one of the goals stated in Section 38562(b) that CEERT fails to cite is minimizing "the administrative burden of . . . complying with" the regulations. An offset program that required a showing from each offset project on each of the points described in Sections 38562(b) and 38570(b) would greatly increase the administrative burden of complying with the regulation.
54 NRDC/UCS argue that Section 38562(b)(8) means that the regulations should "prevent leakage of co-benefits outside of the state." (NRDC/UCS Comments, p. 28.) However, Section 38562(b)(8) refers to minimizing "leakage" and Section 38505(j) defines "leakage" as a "reduction in emissions of greenhouse gases within the state that is offset by an increase in emissions of greenhouse gases outside the state." The concern of NRDC/UCS, however, is not with an increase in GHGs outside of California, but rather with a reduction in GHGs outside California. (See NRDC/UCS Comments, p. 28.)
55 U.S. Const. art. I, § 10, cl. 3.
56 U.S. Const. art. II, § 2, cl. 2; id. art. I, § 10, cl. 1.
57 SDG&E/SoCalGas point out that no court has ever invalidated an interstate agreement for lack of consent under the Compact Clause, citing Note: The Compact Clause and the Regional Greenhouse Gas Initiative, 120 Harv. L. Rev. 1958, 1960 (2007).
58 DRA discusses some of the lessons that may be learned from this case in its Comments.
