After a full day of testimony and deliberation on December 16, 2010, the California Air Resources Board (ARB) adopted the state's Cap-and-Trade Program on a 9-to-1 vote. The Program is promulgated under the California Global Warming Solutions Act (A.B. 32) as a market-based compliance mechanism to help achieve reduction of the state's greenhouse gas (GHG) emissions to 1990 levels by 2020. The 10-hour public hearing on the proposed regulation included more than six hours of public testimony, crisscrossing the broad spectrum of stakeholders with an interest in the Program. The large scope of comments made it clear that there were numerous details that still need to be resolved, and that litigation may be pending. Indeed, even with the December 16 approval, there will be several modifications to the Cap-and-Trade regulation that was released in early November for public review, based on ARB staff-proposed changes presented at the hearing. These changes and other "conforming modifications" will be released for an abbreviated 15-day comment period. Staff will then continue to revise the fine points of the regulation that do not purportedly require further Board action, with a goal of having all the details of the Program confirmed by July 2011. ARB's approval also included four protocols for creating offset credits.

The Cap-and-Trade Program, which contains numerous convoluted provisions, consists of the major elements described below.

The Basics: The Emissions Cap and Covered Entities

  • The Cap-and-Trade Program regulates sources that emit the following GHGs: carbon dioxide, methane, nitrous oxide, hydrofluorocarbons, perfluorocarbons, sulfur hexaflouride, and nitrogen trifluoride. Only certain specified sources and industrial 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 on its reported emissions under ARB's Mandatory Reporting Program (MRP). 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 million to 27 million MT CO2e (MMTCO2e).
  • 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 2 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 sources, which are accounted for through the inclusion of distributors of transportation fuels, natural gas, and other fuels. From 2015, the cap will decline by 3 percent annually, to 334.2 MMTCO2e in 2020.
  • As noted, large industrial entities, including refineries, cement plants, and chemical plants, are included in the Program starting in 2012 if they emit more than 25,000 MT CO2e per year. Likewise CO2 suppliers are covered entities to the extent they supply more than 25,000 tons of CO2 per year. Electricity suppliers and generators are also covered entities during the initial phase of the Program.
  • 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. 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" (offsets or allowances) equal to its actual emissions during a compliance period. 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 percent 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 percent of an entity's total compliance obligation.

Covered Entities

  • The various categories of covered entities are treated differently under the regulations.
  • The electricity sector is included in the Program in 2012. ARB will account for emissions associated with both imported power and power generated in California. A first deliverer approach regulates the party first responsible for placing power onto the California grid, and it treats importers and in-state generators the same. Electricity deliverers are responsible for both specified and unspecified electricity delivered to the grid. These entities include electrical distribution utilities (those that sell to retail customers) and marketers (those that buy and sell in the wholesale electric market). Through an auction producers and importers can obtain allowances to meet their compliance obligations which 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 if that information is known; where the generator is unknown, a default emission factor will be applied 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 have obligations for their total deliveries in California, minus those amounts that are already accounted for through covered entities like electrical generators. 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.
  • 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 waste-to-energy facilities, are excluded from compliance obligations if the biomass fuel is reported and verified pursuant to the MRP. 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.
  • 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.

Allocation of Allowances and Auctioning

  • The Cap-and-Trade Program provides for the free allocation of allowances to certain categories of sources during the first three years, with an increasingly greater percentage of allowances auctioned as the Program continues. ARB has established a minimum price for allowances at auction of $10 per allowance.
  • Free allocations are being made to portions of 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 with compliance obligations will receive free allocations equal to about 90 percent 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.
  • Electrical distribution utilities provide electricity to residential and small commercial customers. These entitles include investor-owned utilities (IOU's) and publicly-owned utilities (POU's). Staff proposes to allocate allowances to electrical distribution utilities, as opposed to the generators, because electrical distribution utilities are best situated to utilize the value of allowances for ratepayer benefit.
  • To ensure that electricity ratepayers do not experience sudden increases in their electricity bills associated with the cap-and-trade regulation, staff proposes to allocate free allowances to electrical distribution utilities on behalf of ratepayers. The IOU's will be required to auction all of their allowances at auction. The electrical distribution utilities must use the value associated with these allowances for the benefit of retail ratepayers of each electrical distribution utility, consistent with the goals of A.B. 32. Allowance value could be used for rebates, customer bill relief, or to pay for GHG-reducing measures such as energy efficiency, renewable electricity generation, or other similar programs. An IOU would however have to purchase allowances at auction to meet compliance requirements for any generating facility it directly owns in California. Independent power producers that sell to IOU's have similar obligations. ARB assumed that independent generators would pass their costs of allowances through to purchasers of their power in the wholesale market. IOU's in turn will absorb the costs and pass it through in their rates.
  • POU's, because they in theory do not compete with independent power producers, may either auction their allowances or use them directly to meet compliance requirements for their own generated power. If they do auction their allowances they must use them to the benefit of their ratepayers in the same manner as IOU's.
  • The MRP requires rigorous verification to validate any emissions reported as biomass-derived fuel emissions that would not generate a compliance obligation. In the absence of certification of the fuel by an accredited certifier of renewable biomass-derived fuels, a verification body must verify a biomass-derived fuel that will not be subject to a compliance obligation pursuant to provisions in the MRP. If the verification body is unable to verify the biomass-derived fuel, it will be subject to a compliance obligation for emissions associated with its combustion.
  • To avoid potential double-counting of emissions reductions from biomass-derived fuels, any source of biomass-derived fuels that applies for offset credits under any ARB-approved offset protocol will be ineligible for exemption from a compliance obligation. This includes but is not limited to the California offset program or any other mandatory or voluntary offset program.
  • There will also be the advanced auctioning of 2 percent of ARB's total allowance budget for use by covered entities in future compliance periods. ARB will also create an allowance reserve that will offer allowances at a fixed price, even when allowance prices rise.
  • 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 that of the Western Climate Initiative.

Offset Protocols

  • ARB approved offset protocols for (1) U.S. forest projects, (2) livestock manure digester projects, (3) urban forests projects, and (4) ozone depleting substances destruction projects.
  • In addition to future projects developed under those protocols, certain existing projects may be eligible to generate offsets.
  • ARB considered modification of the U.S. forest projects protocol during Board discussion after closure of the public hearing on the Cap-and-Trade Program, but in the end, the Board approved the protocol as presented. The protocol requires adherence to California forest management practices, even for out-of-state forest projects. These forest management practices may be more stringent or protective of the environment than those of other states, but nevertheless include even-aged stand management and clearcutting of up to 40 acres at a time. Under the forest projects protocol, regardless of approved management practices utilized, in order for a project to generate offsets, the project must reduce or prevent GHG emissions to the atmosphere, by increasing or conserving forest carbon stocks .
  • ARB will consider additional offset protocols that will be available to generate offsets. One of the first protocols slated for further development 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 entities in the Cap-and-Trade Program.