On October 8, 2014, the California Air Resources Board (CARB) issued a preliminary determination invalidating more than 230,000 offset credits on grounds that an Arkansas-based chlorofluorocarbons (CFCs) incinerator was not in compliance with federal environmental laws at the time when CARB issued the offset credits to that facility. If CARB’s preliminary determination becomes final, those credits will be permanently invalid. Such a result highlights, among other things, the importance of well thought-out and effective risk allocation clauses in any contracts for California offset credits. In light of these developments, any current buyer or seller of California offset credits should do a comprehensive review of its exposure in this regard, because the risk of invalidation is now perhaps broader than before realized, and CARB may take similar action with other offsets. Further, any potential buyer or seller should carefully visit contract terms to assure that the proposed contract effectively transforms this regulatory risk into a matter of counterparty credit risk, and perhaps tweak other provisions to effectively deal with this new legal playing field.

The Clean Harbors Investigation CARB’s preliminary determination concerns the Clean Harbors Incineration Facility (Clean Harbors) in El Dorado, Arkansas, which destroys CFCs. The El Dorado incinerator accounts for 80 percent of the CFC destruction in the United States, with 230 tons destroyed in 2011 and 300 tons in 2012. CFCs from California reach Clean Harbors through arrangements with the San Francisco-based Eos Climate (Eos), which buys and collects CFC-containing materials and transports them to Clean Harbors. Eos’ arrangement with Clean Harbors generates offset credits under the state’s Cap-and-Trade Program as a result of the destruction of CFCs, which are ozone-depleting substances (ODS) that also contribute to climate change. California businesses then purchase these offset credits in order to achieve compliance with their greenhouse gas emissions limits under the Cap-and-Trade Program.

The Clean Harbors facility came under the scrutiny of the U.S. Environmental Protection Agency (EPA) beginning in 2009. EPA investigated whether Clean Harbors was in compliance with a permit under the federal Resource Conservation and Recovery Act (RCRA). Namely, EPA was concerned that Clean Harbors was selling a brine byproduct from its incineration process instead of destroying the substance, as required under RCRA.

On April 25, 2014, EPA and Clean Harbors agreed to a settlement and filed a Consent Agreement and Final Order alleging multiple counts of RCRA violations against the company, which the company denied. EPA asserted, among other things, that Clean Harbors violated RCRA by storing and treating saturator sludge in tanks and equipment in the brine processing unit in violation of its RCRA permit.

CARB also launched an investigation to determine whether Clean Harbors’ activities would invalidate any offset credits. On May 29, 2014, CARB blocked transfers of the potentially invalid compliance offset credits until its investigation could be completed, and until it could make a final determination on whether to invalidate any of the compliance offset credits.

CARB Preliminarily Determined that 231,154 Offset Credits Are Subject to Invalidation Based on its investigation, CARB preliminarily determined October 8, 2014, that Clean Harbors failed to comply with applicable environmental laws. Accordingly, CARB preliminarily invalided a total of 231,154 credits generated during the time period related to the violation. There were 4.3 million compliance offset credits subject to investigation, so CARB’s decision affects only a small portion of the offset credits generated by the Clean Harbors facility.

The posting of the preliminary determination begins a 10-day comment period that ends at 5 p.m. PT October 17, 2014. By November 17, CARB will make a final determination as to whether it will permanently invalidate those offset credits. Upon final determination, CARB will notify all holders of the invalidated offsets and return to the appropriate Compliance Instrument Tracking System Service (CITSS) accounts any offset credits it determines are not subject to invalidation.

Impact on Market, Compliance Deadline, Contractual Risk Allocation California places the risk of invalidation on the entity using the offsets for compliance purposes.1 This novel regulatory risk in California’s Cap-and-Trade system makes this compliance market different from most other established markets, and similar to the Renewable Identification Numbers (RINs) regulatory regime in that it relies on a “buyer beware” approach on whether any purchased credits are in fact valid.

Further, the Cap-and-Trade Regulation allows CARB to investigate and invalidate any compliance offset credits if the offset project failed to comply with any local, state, or federal environmental or health and safety regulations during the reporting period for which CARB issued the offset credits.2 The Clean Harbors invalidation followed a broad reading by CARB of its authority, which may be an indicator of future regulatory risk to the extent CARB interprets its invalidation authority more broadly than the market had expected.3

Moreover, CARB’s preliminary determination in Clean Harbors does not discuss its exercise of discretion to invalidate the offset credits. CARB may invalidate offset credits in the event of an environmental law violation, but it is not required to do so.4CARB’s preliminary determination provides no reasons for its exercise of discretion in this instance. Further explanation from CARB on the policy reasons behind its invalidation determination would be helpful for the offset markets to assess risk in offset contracts.

Risk assessment is particularly important at the moment in view of the imminent deadline on November 3, 2014, for annual compliance surrender—when entities must surrender compliance instruments to cover 30 percent of 2013 emissions. Clear guideposts from CARB on its invalidation determination would help investments in offset projects and increase market confidence.

How Can a Current or Potential Market Participant Address this Cluster of Regulatory Risk? First, any current buyer or seller of any California offset credits should do a comprehensive review of its exposure in this regard, because the risk of invalidation is now perhaps broader than before realized. Further, CARB may take similar actions with other offsets. This analysis is particularly important for compliance entities that do not want to be caught short with regard to a market position in view of the imminent November 2014 deadline. Additionally, litigation may ensue over invalidation risk provisions in offset purchase agreements, and wise parties should assess their risk of success (and failure) under every existing contract provision to properly assess both compliance and litigation risk.

Second, any potential buyer or seller should carefully review contract terms to assure that the proposed contract effectively transforms the Cap-and-Trade regulatory risk above into a matter of counterparty credit risk. By way of example, the parties may decide to shift risk of invalidation to sellers, which in turn requires strong counterparty credit and thorough due diligence.

Going forward, contractual risk allocation regarding offset invalidation may need to be adjusted in light of CARB’s actions. For example, settling with a government agency to avoid a finding of noncompliance may no longer be sufficient to avoid invalidation. This is especially problematic for a seller of credits that does not actually operate the offset project, and therefore has no role in ensuring compliance or settling with the government when an allegation of noncompliance is made. As a result, sellers may want to explore additional ways to shift ultimate liability to project operators. Sellers may also consider additional ways to ensure compliance through strengthened verification, including audits of project operators by independent organizations.