In accordance with California's landmark Global Warming Solutions Act of 2006 (also known as AB 32) and its goal of reducing greenhouse gas (GHG) emissions to 1990 levels by 2020, the California Air Resources Board (CARB) enacted a regulatory cap and trade program in October 2011, which took effect in January 2012. The program establishes a cap on overall GHG emissions and a market-based, pollution allowance trading program to meet the emissions cap. With compliance periods for the program rapidly approaching, businesses should be aware of cap and trade requirements and the legal developments surrounding the adoption and implementation of the program.

In general, the cap and trade program sets a limit (or cap) on the total amount of GHG emissions from certain regulated industries. Most industrial facilities with annual GHG emissions greater than or equal to 25,000 metric tons of carbon dioxide equivalent (CO2e) will be required to comply with the cap and trade program. Regulated entities must obtain an allowance (either through auction, for free from the State, or a combination of both) for each ton of GHG emissions they emit. Over time, the total amount of allowances (also referred to as permits or credits) available to all sources will be reduced, meaning overall emissions from those sources must also be reduced. For example, if an oil refinery emits 100,000 tons of CO2e but only has allowances for 75,000 tons, it must either buy credits for the additional 25,000 tons or lower its emissions by 25,000 tons. Under the same scenario, if the refinery were to reduce its emissions to 65,000 tons, it could bank or sell the unused 10,000 allowances to another regulated entity.

Under the program, covered facilities will have to register with CARB, report annual GHG emissions, and surrender allowances or offset credits (described in more detail below) equal to the amount of GHGs emitted by that facility. Entities covered by the cap and trade program must provide allowances and offset credits on an annual and triennial basis. In terms of annual reporting, industries must provide allowances every year amounting to 30 percent of the previous year’s total emissions. The triennial compliance period requires companies to provide allowances and any offsets to cover the remainder of emissions in that three-year compliance period. By the end of the three-year compliance period, the entity must have submitted allowances and offsets for the total amount of GHGs emitted during the past three years. If a regulated entity does not timely meet its annual or triennial compliance obligations, the entity must submit allowances representing four times its excess emissions (i.e., the difference between the GHGs emitted and the allowances timely surrendered) within a specified period from the next auction or reserve sale, whichever is later. 17 California Code of Regulations § 95857.

The first phase of compliance, starting January 1, 2013, will apply to 350 electricity generators, importers of electricity, and heavy industrial energy users in California. This will affect nearly 600 facilities, including electricity generating facilities, refineries, and cement, paper, and glass facilities. The 2013 cap is 162.8 million tons of CO2e, which is the estimated level of emissions for all facilities covered by the program in the first phase of the program. That cap will decrease by 2 percent each year until the second phase of the program takes effect in 2015. In 2015, the program will expand to include distributors of gas, propane, and transportation fuels not covered in the first phase of the program. When these entities are added, the 2015 cap will increase to 394.5 million metric tons of CO2e. Each year after 2015, the cap will be reduced by 3 percent annually, ultimately resulting in the cap set at the reduced emissions goal of 334 million metric tons of CO2e in 2020.

The carbon trade, or carbon market, portion of the program allows entities to acquire allowances and offset credits through market mechanisms. Allowances for each industrial sector will be set at approximately 90 percent of average emissions. To ensure a gradual transition into the program, some covered entities will receive free allowances for the first phase of the program. In later years, companies will have to purchase all allowances they require for operating their facilities. Quarterly auctions and reserve sales will allow entities to acquire allowances directly from CARB. The first auction is scheduled for November 14, 2012. It is estimated that the state may eventually reap billions per year as a result of these auctions, depending on the demand for the allowances. “Cap-and-trade gets a test drive,” Contra Costa Times, August 30, 2012.

In addition to purchasing allowances, regulated entities may purchase offset credits that will allow them to submit fewer allowances than tons of GHGs they emit. An offset is a tradable compliance instrument issued by CARB that represents a GHG reduction or GHG removal enhancement of one metric ton of CO2e. While only 8 percent of an individual facility’s total emissions may be satisfied with offsets, up to 85 percent of all GHG reductions required by the program could theoretically be met through offsets. “Offsets Could Make Up 85% of California’s Cap and Trade,” New York Times, August 8, 2011. In order to qualify as an offset credit, the offset project must be real, additional, quantifiable, permanent, verifiable, and enforceable. “Additional” is defined as GHG reductions or removals “that exceed any greenhouse gas reduction or removals otherwise required by law, regulation or legally binding mandate, and that exceed any greenhouse gas reductions or removals that would otherwise occur in a conservative business-as-usual scenario.” 17 California Code of Regulations § 95802(a)(3). Further, the offset credits will only be issued to offset projects using approved Compliance Offset Protocols. Currently, there are four approved Compliance Offset Protocols that may be used to develop offset projects under the Cap-and-Trade Program: urban forestry, forestry, livestock digesters, and destruction of ozone depleting substances.

As anticipated, the cap and trade program has faced legal challenges since its adoption last year. In Association of Irritated Residents v. California Air Resources Board, 206 Cal.App.4th 1487 (2012), the petitioners challenged the scoping plan adopted by CARB to achieve the goals of AB 32, including a challenge to the cap and trade program. Although the appeal focused broadly on whether the scoping plan complied with AB 32, petitioners did allege that CARB failed to consider the feasibility of alternative measures to the cap and trade program. Employing the deferential arbitrary and capricious standard, the First District Court of Appeal dismissed this claim, reasoning that CARB had in fact evaluated other measures and had satisfactorily explained its reasons for rejecting them.

In Citizens Climate Lobby and Our Children’s Earth Foundation v. California Air Resources Board, San Francisco Superior Court Case No. CGC-12-519554, petitioners seek to repeal the offset credit program, alleging that the offset provisions exceed CARB’s authority and are in conflict with AB 32. Specifically, petitioners contend that the offset program impermissibly allows non-additional reductions to qualify as offsets and includes regulatory definitions that are subjective and vague. CARB will likely vigorously defend this action as it has previously opined that the offset program is a critical component of the cap and trade program, one that is necessary in order to keep compliance costs low. The case is set for a trial court hearing on November 6, 2012.

In short, businesses should be proactive in assessing whether their operations are subject to the cap and trade program and enacting protocols to ensure that they comply with mandatory reporting of GHG emissions and other obligations. Industries are further advised to keep up to date on the evolving regulatory and judicial developments surrounding the cap and trade program and associated compliance obligations. For instance, regulated entities may wish to attend and comment on the proposed auction process at the CARB hearing scheduled for September 20, 2012 in Sacramento. While recent legal challenges demonstrate that the cap and trade has not been accepted with open arms, the public policy embraced by the program and the deferential standard of review employed by the courts suggests that the program stands a good chance of surviving legal attacks.

Kara DiBiasio is a Summer Associate with Sedgwick LLP.