In June, President Obama unveiled his Climate Action Plan (the Plan). As we reported in a previous Client Alert, President Obama emphasized three overarching goals: (1) reduce domestic carbon dioxide emissions by 17 percent between 2005 and 2020; (2) prepare the United States for the impacts of climate change; and (3) lead international efforts to combat climate change. While few specifics were offered, to achieve these goals, President Obama’s Climate Change Action Plan includes more than 30 new actions, such as efforts to reduce methane emissions from oil and gas development and the expanded use of renewables, and the President’s plan directs the U.S. Environmental Protection Agency (USEPA) to work quickly to complete carbon emission standards for new and existing power plants. This Reed Smith client alert will address the Climate Action Plan’s possible impact on the nascent California carbon market given (1) the likely increase in opportunities in renewable energy projects, and (2) the effect of federal efforts and regulation of existing power plants.

Likely No Impact of Plan Increase in Renewable Projects on AB 32 Cap and Trade

In his June 2013 Climate Action Plan, President Obama emphasized the recent success of renewable energy projects on public lands. The President lauded the Department of Interior (DOI) for meeting his previous goal to issue permits for 10 gigawatts (GW)1 of renewable energy projects on public lands by the end of 2012, and challenged the DOI to go even further, directing it to approve permitting for an additional 10 GW of renewable projects by 2020.2 Extrapolating from the percentage of renewable generating capacity that California federal lands provided toward the 2012 goal3, it is reasonable to assume that to accomplish the 2020 goal, California will need to provide at least 9.6 GW of generating capacity toward that 20 GW total. This large increase in renewable projects in California, and the corresponding decrease in CO2 emissions from electricity generation, may raise concerns of an over-allocated carbon market going forward. These concerns should be eased, however, because of the California Renewable Portfolio standards, already mandating a 33 percent renewable electricity supply in 20204. In calculating probable greenhouse gas reductions from ongoing measures, the California Air Resources Board (CARB) noted that the increase from 20 percent to 33 percent renewables would result in a reduction of 11.4 million tons of CO2 equivalent.5 The 2008 Scoping plan for AB 32 estimated that an additional 26.6 GW in renewable energy would be necessary to meet the 33 percent benchmark.6 Wind and solar are estimated to provide 18.7 GW of that capacity.7 It therefore seems likely that the 9.6 GW in solar and wind projects approved on federal land will go toward this overall goal of 33 percent renewables by 2020, the emission results of which have been accounted for by ARB. While this may result in a shift in the location of renewable energy projects inside California, it is unlikely to have any effect on the California carbon market.

Likely Impact on Cap and Trade from Plan to Regulate Carbon Emissions from Existing Power Plants

The linchpin of the Plan is the GHG controls on new and existing power plants. Forty percent of U.S. carbon dioxide emissions, and one-third of greenhouse gases overall, come from electric power plants, according to the federal Energy Information Administration.8 The Plan directs USEPA to propose carbon emission "standards, regulations, or guidelines" for emissions from existing, modified, and reconstructed power plants by June 1, 2014 under the Clean Air Act (CAA) section 111’s New Source Performance Standards (NSPS) program, and to finalize the standards by June 2015. Neither the Plan nor the President’s remarks included any details about how USEPA may try to reduce these emissions. Using section 111 to address existing power plants would be a new endeavor for the EPA. Also, Section 111 does not directly authorize EPA to establish standards of performance for existing sources. Rather, EPA is directed to "prescribe regulations which shall establish a procedure similar to that under [CAA § 110] under which each State shall submit to [EPA] a plan which . . . establishes standards of performance" for existing sources within the state.9 This is a subtle meta-level of potential complication: instead of giving USEPA direct authority to set national standards for existing power plants, Section 111 directs USEPA to establish regulations for states to issue performance standards for existing sources in that source category. These state plans must be submitted to EPA for approval, presumably much like a State Implementation Plan (SIP).10 After approval, it is likely each state will implement and enforce this standard under its SIP.

a. First, can cap and trade meet the federal NSPS for existing EGUs?

We can assume that plenty of discussion has been taking place leading up to this announcement between California and USEPA on whether and how the existing California cap-and-trade program would be an acceptable way for California to reach whatever standard the feds would eventually set.11 Can the cap-and-trade portion of AB 32 meet the federal NSPS for existing EGUs? The answer is, in theory, yes, although there are two main problems.

The first has to do with the scope of compliance entities under AB 32 compared with the scope of the NSPS for existing EGUs. Although California applauds Obama’s climate change efforts,12 the issue for California is that its cap-and-trade program covers more than just the power plants in California that USEPA’s NSPS standard would cover. To further complicate the issues, instead of EPA’s threshold of 25 MW capacity, AB 32’s cap-and-trade program covers plants that emit more than 25,000 tons – further entangling the scope of coverage issue. AB 32 also covers power imports and emissions from most industrial sectors and the transportation sector and AB 32’s cap-and-trade program is also linked to Quebec, which means some of California’s emission reductions might take place out of the United States altogether.

A second issue for California in getting its cap-and-trade program approved under any NSPS promulgated by USEPA, is that AB 32 accepts offset credits from a diverse and growing list of altogether different sectors across the country and, with linkage to Quebec, internationally.

All these scope questions will need to be analyzed to determine the effect on California’s NSPS-specific, regulated existing facilities. This separation exercise requires complicated modeling and technical analysis that will need to take place in California’s revised SIP to support California’s argument that it will reach the federal NSPS. Obama’s Plan establishes a date of June 30, 2016 for states to submit state plans to USEPA for the NSPS standards to existing power plants in their states – not much time for such a complicated analysis as California has before it. Plus, complicated modeling and analysis is often subject to challenge, by industry or NGOs. Assuming the state plan process is similar to SIPs, the State and local agencies must involve the public in the adoption process before state plan elements are submitted to EPA for federal approval or disapproval, and EPA must provide an opportunity for public comment before taking action on each state plan submittal. All of which does not bode well for timely approval of the California cap-and-trade system under the NSPS.

b. Second, will the federal NSPS for existing EGUs affect the carbon market?

If the California cap-and-trade system is approved under its SIP, the NSPS for existing EGUs may cause the California cap for the third triennial compliance period to be over allocated because supply will exceed demand for allowances and offsets.13 In a perfectly allocated market, supply equals demand. AB 32 requires CARB to identify the statewide level of greenhouse gas emissions in 1990 to serve as the emissions limit to be achieved by 2020.14 In December 2007, the Board approved the 2020 emission limit (the Cap) of 427 million metric tons of carbon dioxide equivalent (MMTCO2E) of greenhouse gases. CARB then made allowance supply decisions based on this Cap. If the existing EGU emission regulations developed under the Plan cause existing sources to significantly reduce their GHG emissions once effective, this could reduce actual emissions for the capped sector. In addition, USEPA’s NSPS for existing EGUs will lower emissions from imported power in California, which are also covered under the cap. Reducing ACTUAL emissions in a capped sector means each source, individually, demands fewer allowances for compliance, yet the supply of allowances (those that will be distributed at auction) remains constant because CARB based that supply on 2007 assumptions not taking the Plan reductions into account. Thus, unless CARB appropriately alters its supply assumptions once the federal NSPS for existing EGUS and other Plan aspects come into effect, supply could exceed demand.

And while we can expect CARB to possibly have the flexibility to address this allowance over-supply issue through reduction of auction allowances, there are aspects of supply in the California offset market that are somewhat beyond CARB's control that could force over allocation regardless of regulatory action. This is because while CARB has direct control over supply in the allowance market, it only has indirect control over supply in the offset market (via approval of protocols for offsets); direct control of offset supply is in the hands of the business community (those entities that chose to create offset projects). Offset projects are gearing to flood the market with offsets based on a demand calculated from historic emissions, also not taking into account the Plan measures. Offset demand in the California cap-and-trade market is expected to reach just over 200 million MMTCO2e by 2020.15 Although currently there is expected to be a shortfall in this market16 and CARB is working hard to approve more offset protocols to address this shortfall, this shortfall calculation does NOT take into account the effects of the federal NSPS or Obama’s Plan. This puts CARB in a bit of a regulatory Catch-22: If CARB approves new protocols17 without taking into account the effects of the federal NSPS or Obama’s Plan, this could further cause supply to exceed demand in the carbon market. But if the Plan never comes to fruition or is effective at a lesser level, then the offset market could be severely under allocated if CARB does not take action to approve new protocols now. This is a very difficult regulatory conundrum and if CARB gets it wrong, the market could suffer. Further, even if CARB appropriately solves the conundrum (strikes the right balance of "new protocols taking into account the Plan"), it has no control over the actual amount of offsets that come to market based on those protocols: if an offset project met protocol standards, CARB would have to issue the offsets even if they potentially flood the market.18

All of these factors taken together could have the hallmarks of an over-allocated market. Nonetheless, it is clear that this potential market issue of over allocation would only hit in the third triennial compliance period. And while over allocation is a problem for a healthy market, it spells compliance-cost relief for compliance entities, since it was in this third period that the largest compliance costs were expected to hit as the cap got more stringent.


Bottom line: market beware. From those of us who have followed carbon market both in the EU and elsewhere, there are dangers to an over allocated market. Some of them include decreased confidence in the market, collapse of market mechanisms to encourage offsets, trading malaise, and ineffective and inefficient greenhouse gas reductions. In these early days of cap-and-trade regulation in California (and globally), the industry is still learning about what and how policy decisions in various sectors affect carbon markets. And still learning to remember to consider what effect well-intentioned carbon policies aimed at one sector will have on carbon markets. It is worth remembering that some of the President's climate change policies in the Plan could have unintended consequences on the nascent California market.