The Obama Administration has signaled its intent to take a leadership role in facilitating an agreed outcome from the upcoming international climate change meetings to take place in Paris in 2015. The release on June 2, 2014, of the U.S. Environmental Protection Agency’s (EPA or the Agency) highly anticipated proposed rule addressing carbon dioxide emissions from existing power plants (Proposed Rule) is a key pillar of the President’s Climate Change Action Plan. The Climate Change Action Plan is being unveiled in stages leading up to the 2015 Paris meeting known as Conference of the Parties or “COP”, where the international community is supposed to agree on a new “protocol, another legal instrument or an agreed outcome with legal force under the Convention applicable to all Parties” to take effect in 2020. The Proposed Rule was issued under Section 111(d) of the Clean Air Act utilizing EPA’s existing authority without the need to obtain Congressional approval.

While the Proposed Rule is legally completely independent from any international diplomatic efforts on climate change, it is most certainly informed by the broader international dynamic at play. Any comprehensive legislative approach has been ruled out, so the Administration is marshalling all of the tools available to it in crafting an overall climate plan that can show to the international community the U.S. is serious about reducing greenhouse gases. This showing is an essential component of any agreed outcome in Paris. Without the U.S. being able to demonstrate leadership, there is little chance that China and the rest of the developing world will step up to announce their own commitments. So far, the President’s plan seems to be working. In the aftermath of this current Proposed Rule, China has already signaled that it is considering an absolute cap on greenhouse gas emissions. This is at least an early signal that the Proposed Rule along with the other actions forming the President’s Climate Change Action Plan are being viewed abroad as serious commitments and efforts to manage the climate challenge.

In the U.S., the Proposed Rule is likely going to be the subject of significant debate and challenge. It covers a large number of sources, requiring states to address carbon dioxide emissions from the more than 1,000 existing fossil-fuel fired power plants around the country. It also is aggressive, both in timing for implementation and in the level of reductions being sought under existing legal authority. States would be required to develop initial plans within one to three years after finalization of the Proposed Rule and, by 2030, the Proposed Rule would cut carbon dioxide emissions from the power sector by 30 percent from 2005 levels.

This client alert provides an overview of some of the key features of the Proposed Rule, as well as a foreshadowing of the inevitable legal challenges and timeline to come. For greater detail on the Proposed Rule and potential implications for your business, please contact a member of Baker & McKenzie’s North American Environmental Markets team.

"Building Blocks" as BSER

Section 111(d) of the Clean Air Act requires states to implement “standards of performance” for existing sources that would otherwise be regulated by a new source performance standard if they were new sources. Section 111 defines “standards of performance” as the level of emission reductions achievable by applying the “best system of emission reduction…adequately demonstrated” (BSER). In the Proposed Rule, EPA spends considerable effort (and pages) justifying how it defines BSER. EPA broke this phrase into three components, starting with “system of emission reduction”. EPA concludes that because the affected sources under the Proposed Rule (i.e., fossil fuel EGUs that were in operation or had commenced construction as of January 8, 2014) are part of a “highly interconnected, integrated” electricity system, carbon dioxide emission reductions from such units can be based on measures undertaken throughout the entire electricity system, and not merely at the affected sources themselves. EPA then considered what types of carbon dioxide emission reduction measures are “adequately demonstrated” and also would represent the “best” system of emission reductions. Taken together, EPA identified four “building blocks” for achieving BSER:

  1. Inside the fence heat rate improvements at the affected sources;
  2. Prioritizing dispatch of existing (and new) natural gas combined cycle (NGCC) generation over coal-fired generation;
  3. Accounting for increasing renewable generation and nuclear generation that is under construction or will have extended life; and
  4. Increased utilization of end-use energy efficiency.

In building blocks 2-4, EPA is proposing BSER include reductions outside of the power plants’ boundaries (i.e., “beyond the fence line”) because it determined that “greater carbon dioxide emissions can be achieved at lower cost.” EPA is seeking comment on these options and its determination of BSER for CO2 emissions from power plants in general. As described further below, this determination is critical to the rule because it defines the scope of activities that EPA has used to calculate the state emission goals. In the absence of the broad view of “system of emission reductions” which includes the entire electricity system, EPA would be limited to a focus on reductions that can be achieved “within the fence line” of each affected source. This approach would result in a far less ambitious overall reduction target -- one that would not bode well for the forthcoming international negotiations.

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State "Goals"

The Proposed Rule includes a primary and alternative goal for each state. The primary goal, in turn, includes an interim goal, which is the average of the yearly goals from 2020 to 2029, with the final goal in 2030 being the 2029 goal. The alternative goal accelerates the compliance period but reduces the level of reductions, with the alternative interim goal being the average of the yearly goals from 2020 to 2024 and the alternative final goal in 2025 being the 2024 goal. The goals for each state are emission-rate based, expressed as lbs of carbon dioxide per MWh. As stated, the sum of the individual state emission-rate based goals would achieve a 30% reduction in carbon dioxide emissions from 2005 levels by 2030. Interestingly, EPA’s choice in presenting the overall reductions to be achieved by affected sources under the Proposed Rule is consistent with how it has stated its existing pledge for economy wide emission reductions under the Copenhagen Accords -- 17% reductions from 2005 levels by 2020.

Rather than beginning from a specific, required percentage reduction against a baseline year, EPA calculated the state goals by determining the extent of “adequately demonstrated” reductions in each state. Specifically, the Agency first compiled the total annual quantities of carbon dioxide emissions, as well as net electricity generation and capacity data for 2012 from all affected power plants. Then, EPA applied the “building blocks” described above to incrementally reduce carbon dioxide emissions:

  • For building block 1, EPA reduced the emissions from coal fired EGUs across each state by 6%, which reflects EPA’s assessment of the average opportunity to reduce carbon dioxide emissions through heat rate improvements.
  • For building block 2, EPA adjusted the state’s emissions to reflect a potential increase in utilization of natural gas combined cycle power up to a 70% capacity factor.
  • For building block 3, EPA estimated renewable energy generation (based on average renewable portfolio standards for regions) for each year of the program and included new nuclear generation under construction and assumptions on extending the life of certain nuclear generation set for retirement.

For building block 4, EPA calculated the reduction in MWh due to implementation of demand-side energy efficiency programs resulting in annual incremental reductions in the state’s electricity usage of 1.5 percent each year.

The result of these calculations is a state-specific emission reduction goal. For example, for Illinois the 2012 emission rate from affected sources is 2,189 lbs of CO2/MWh and the interim goal (average of 2020 through 2029) is 1,366 lbs of CO2/MWh and the final goal is 1,271 lbs of CO2/MWh, on an average basis across the state.

Each state has the flexibility to determine how to meet its goal. Limits set by the state to meet the state-specific goals can either apply directly to the power plant or be met through reductions in power plant emissions through implementation of energy efficiency or renewable energy measures in the state. Interestingly, EPA suggests in the Proposed Rule that states may place the responsibility for meeting the state goals not only on the affected sources regulated under the Proposed Rule, but also on non-affected sources throughout the “electricity system” (e.g., renewable energy providers). Each state can choose to include measures that EPA determines constitute BSER or may choose additional measures, as long as such measures achieve the emission reduction necessary to meet that state’s goal set by EPA.

The term “goal” is somewhat of a misnomer. The EPA determines the goal, and once each state’s goal is issued in the final rule, they are binding and will not be changed by EPA (absent a litigated outcome).

Role of markets and offsets

Throughout the Proposed Rule, EPA emphasizes the flexibility of the states to decide how to reduce emissions to meet the state goals. The Agency is also clearly proposing to authorize the use of market-based mechanisms in the Proposed Rule and devotes significant discussion to the role of the Regional GHG Initiative (RGGI) and California’s cap-and-trade program in reducing carbon dioxide emissions of the power sector. In addition, EPA Administrator Gina McCarthy has noted that interstate trading programs are likely to provide the most cost-effective reductions under the state plans required by the Proposed Rule.

While the state-specific goals are rate-based, the Proposed Rule notes that states can translate the rate-based goal to a mass-based goal. A mass-based goal, which would provide an amount in absolute tons (or a “cap”), would be more amenable to the implementation of a cap-and-trade program to meet the state target. The devil is always in the details, however, and the Proposed Rule is lacking in the details on how states can effectively convert their rate-based standards to mass-based standards. The details of this conversion for states will be key in determining the degree to which more states choose to adopt mass-based cap-and-trade policies into their respective plans.  The rate-to-mass based conversion questions are only highlighted further when considering multi-state approaches. EPA is publicly supportive of the development of multi-state plans, but as of yet has not provided sufficient details for states to make informed decisions on how to design such plans. These details will undoubtedly be fleshed out as states begin their own plan development preparations in consultation with EPA.

With respect to non-sector greenhouse gas (GHG) offsets (e.g., sustainable forestry), the Proposed Rule acknowledges that all existing cap-and-trade programs (i.e., RGGI and California’s program) recognize offsets for compliance purposes within such programs. The Agency states that offsets may continue be used in a state’s cap-and-trade program, but, when determining compliance with the state’s 111(d) goal through the state plan, emissions from GHG offsets must not be counted toward meeting that 111(d) state goal. The practical impact of this approach would be that states would either have to “make up” any reductions from out-of-sector offsets recognized in the cap-and-trade program through other policies (e.g., renewable energy or energy efficiency programs), or require a more stringent cap-and-trade target and allow out-of-sector offsets to be used only in the headroom above the EPA-required goal. Thus, the Proposed Rule allows states the flexibility to use GHG offsets to encourage emission reductions in non-power sectors but does not allow these offsets to be used to meet the federal requirements for power plant reductions.

Overall, the ability for states to use markets to meet the state goals is positive for those states with cap-and-trade programs like California and the RGGI states. It may also provide an incentive for one or more states that currently do not have a cap-and-trade program to consider adopting such a program for itself or perhaps joining the existing programs, such as RGGI or the California program. Given the complexity of the Proposed Rule and the substantial details imbedded within each state’s calculated emissions reduction goal, states will be evaluating a number of options over the coming months and years as this rule moves forward.

Timing for finalization of the proposed rule

In a June 2013 memorandum, President Obama directed EPA to finalize the Proposed Rule by June 2015. Under the terms of the Proposed Rule, states would be required to submit their plans for approval by June 30, 2016. If a state needs additional time, it must submit an initial plan by the June 30, 2016 deadline and include commitments that will ensure the state will submit a complete plan by June 30, 2017. If the state develops a plan that includes a multi-state approach, the state will have until June 30, 2018 to submit a final plan. If a state does not submit an appropriate plan, EPA can directly implement a federal plan in the state to obtain the necessary reductions.

The Clean Air Act compels EPA to finalize its new source performance standards (NSPS) for fossil-fuel fired electric generating units before finalizing the Proposed Rule. President Obama’s June 2013 memorandum did not establish a deadline for finalization of the NSPS, but EPA will clearly need to finalize the new source rule by June 2015 in order to meet the President’s directive for existing plants. In addition, the existing and anticipated legal challenges to both the proposed NSPS and this Proposed Rule could affect the ultimate timing and implementation of these rules. We think EPA is likely to proceed in the normal course with finalization of both rules in accordance with the timing outlined above. We also think it is unlikely that the courts will stay the effectiveness of each of the rules pending the judicial outcomes.

Context for legal challenges

As noted above, the Proposed Rule under 111(d) of the CAA can only apply to existing sources that would otherwise be subject to regulation under 111(b) for new sources. Thus, the fate of the proposed NSPS for greenhouse gas emissions from new fossil fuel fired EGUs under 111(b) is critical to any final action on the Proposed Rule. The primary legal challenge to the proposed NSPS is that EPA exceeded its statutory authority by requiring any new coal-fired power plant to employ partial carbon capture and storage (CCS) technology. The basis for this challenge is the argument that CCS technology is not “adequately demonstrated” as required for emission standards under section 111 of the CAA. This argument is bolstered in part by a provision in the Energy Policy Act of 2005, which foreshadowed this debate, and states “that no technology… solely by reason of the use of the technology… by 1 or more facilities receiving assistance under this Act, shall be considered to be … adequately demonstrated for purposes of section 111 of the Clean Air Act.”  42 U.S.C. §15962. EPA’s analysis of whether CCS technology is “adequately demonstrated” included both projects that have received federal funding under the Energy Policy Act of 2005 and ones that did not. EPA argues that its determination is not based “solely” on those projects receiving federal funding.

This current legal challenge brought by the state of Nebraska in the U.S. District Court for the State of Nebraska is at the early motion stage, with EPA filing a motion to dismiss as the proposed NSPS does not amount to appealable final agency action. In the alternative, EPA requests the case be transferred to the U.S. District Court for the District of Columbia, which has exclusive jurisdiction over Clean Air Act matters. It remains to be seen whether EPA’s proposed NSPS will survive this legal challenge without the need for changes. The timing for final resolution of this underlying challenge to the NSPS also remains unknown, as any decision on the merits by either the Nebraska or D.C. Circuit Court will likely be appealed.

Once the Proposed Rule goes final, it inevitably also will be litigated by a number of affected parties. EPA’s broad view of the “system for emission reductions” is likely to be challenged. Beyond that, the means by which EPA has set each state’s emissions goal may be challenged as it is a highly complex and detailed assessment involving a number of assumptions and data points. Undoubtedly, certain affected sources in certain states will feel as though they are being unfairly treated relative to other affected sources in other states. The success of any challenge is murky, as EPA enjoys considerable deference from the courts on interpreting the CAA. In this case, that may favor EPA even more, as Section 111(d) has been used only sparingly over the past several decades, so litigants will have little precedent upon which to rely. EPA has been successful in recent court cases challenging a variety of regulations, including the Mercury and Air Toxics Standards and the Cross-State Air Pollution Rule. Courts have recently reaffirmed the deference afforded the Agency’s interpretation of the law and to their expertise in the area. While these non-climate, non-Section 111(d) cases are not directly on point, they may be used to support deference to EPA’s interpretation of Section 111(d).

In the meantime, the various states will likely take a range of approaches in responding to the Proposed Rule and eventual final rule. We think states are likely to fall into one of three camps:  (1) actively supportive of EPA’s Proposed Rule; (2) actively hostile to EPA’s Proposed Rule; and (3) neither proactive nor recalcitrant, but seeking the most cost effective and easily implementable plan to meet their requirements. As a result, a majority of the states will likely proceed with developing and submitting their state plans in the midst of the legal challenges and ultimate uncertainly. It is likely that several states will fight EPA’s proposed rule from the outset. Those states may have a federal plan imposed on them, unless they are ultimately successful in the courts.

Next steps

The Proposed Rule was released on June 2, 2014 and has not yet been published in the Federal Register. EPA is accepting public comment on the proposed BSER, the proposed methodology for calculating state goals and state-specific data used in the calculations. The Proposed Rule is open for public comment for 120 days after publication in the Federal Register, which is a longer than usual timeframe in consideration of the importance of the rule.

As this regulatory process unfolds over the coming months and years, the U.S. will work hard to show it has taken meaningful steps to significantly reduce greenhouse gases from its domestic industry so that it can lead the negotiations for a new agreed outcome in 2015 at the Paris COP. This is a legacy issue not only for President Obama but also Secretary of State John Kerry, who has been one of the country’s most committed and long-standing advocates for tackling the climate change issue. In light of these dynamics, and a lack of Congressional support, stay tuned for more regulations coming from EPA, including a key decision by EPA on whether to regulate methane emissions in the oil and gas sector.