MEMORANDUM. June 6, 2012

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1 MEMORANDUM June 6, 2012 To: WSPP Participants From: Arnie Podgorsky Patrick Morand Re: California Cap and Trade: Potential WSPP Impacts This memorandum summarizes aspects of the cap and trade program ( Program ) administered by the California Air Resources Board ( CARB ) to reduce greenhouse gas ( GHG ) emissions in California. The purpose of the memorandum is to help evaluate and respond to impacts the Program may have on WSPP transactions, and also to set out the broader regulatory context for that evaluation. To enhance understanding of the Program, the memorandum also summarizes some of the comments market participants submitted to CARB after a CARB workshop conducted on May 4, The regulations and interpretations of regulations are constantly evolving. In that respect this paper may be a work in progress. We welcome all comments and corrections. I. The Cap and Trade Program A. Overview of the Program and Timing of Implementation The Program is one element of the California Global Warming Solutions Act of 2006 (Assembly Bill 32; Stats. 2006, Ch. 488) ( AB 32 ). The goal of the Program is to reduce GHG emissions to 1990 levels by 2020, and ultimately achieve an 80% reduction from 1990 levels by The Program targets major emissions sources that are responsible for some 85% of California s GHG emissions ( Covered Entities ). 2 Initially, the Covered Entities include those 1 2 California is working with British Columbia, Ontario, Quebec and Manitoba through an organization formed by these jurisdictions, the Western Climate Initiative ( WCI ), to develop harmonized cap and trade programs. See California Environmental Protection Agency, Air Resources Board, Cap-and-Trade Program, Background, available at: ( Background webpage ). See California Environmental Protection Agency, Air Resources Board, Overview of ARB Emissions Trading Program, available at: trade_overview.pdf ( Overview webpage ).

2 large industrial facilities and electricity generation resources that emit annually more than 25,000 metric tons of carbon dioxide equivalent ( MTCO 2 e ). See Cal. Code Regs. tit. 17, Electricity generation includes imports from outside of California. Id. In 2015, the definition of Covered Entities will expand to include distributors of transportation fuel, natural gas and other fuels. Id. Other entities may participate in the Program as Opt-in Covered Entities. These are industrials that otherwise qualify as Covered Entities except that they emit less than 25,000 MTCO 2 e. Id (a). Also, Voluntary Associated Entities include entities that do not meet the requirements of Covered Entities or Opt-in Covered Entities that, subject to registration and reporting requirements, intend to hold and trade allowances and offset credits (described below). Id The participation of these additional entities is expected to add liquidity to the Program s market. The Program went into effect on January 1, 2012; Covered Entities compliance obligations begin January 1, See Background webpage. Registration for the initial phase of the Program concluded on January 31, 2012; approximately 440 entities registered. 3 The first two years of the Program ( ) are the first compliance period, the next three years ( ) are the second compliance period, and the next three years ( ) are the third compliance period. See Cal. Code Regs. tit. 17, The Covered Entities are already subject to complementary GHG reporting requirements under AB 32 referred to as the Mandatory Reporting Requirements ( MRR ). See id et seq. Pursuant to the MRR, industrial facility operators are required to complete their emissions data reports for the previous year by April 10, and electric power entities by June 1. Id (e). The Covered Entities must contract with third-party entities to verify their emissions data reports. Id (f). These verification entities must submit their reports to CARB no later than September 1. Id. The MRR became effective on January 1, 2012; Covered Entities must report their emissions data for 2011 onward. Id (h). The amount of GHG emissions a Covered Entity reports pursuant to the MRR is the referent for that Covered Entity s compliance obligation in the Program. Id B. Mechanics of the Program 1. CARB sets an annual cap on the number of allowances issued An allowance is a limited tradable authorization to emit up to one MTCO 2 e. See Cal. Code Regs. tit. 17, 95802(8). CARB will issue allowances every year, assigning each allowance a unique serial number indicating the year in which it was issued. Id (a). In 3 See California Air Resources Board, Cap-and-Trade Workshop: Regulation for Linking California s and Quebec s Cap-and-Trade Programs at 4 (Feb. 3, 2012) available at: 2

3 addition to allowances, CARB will issue offset credits; one offset credit also is equal to one MTCO 2 e. Id (b). Collectively, allowances and offset credits are referred to as compliance instruments. See id (c). Because entities may only meet up to 8% of their compliance obligations through offset credits, this memorandum focuses primarily on allowances. See id The Program s regulations define the cap as the total number of [allowances] that [CARB] issues over a given period of time. Cal. Code Regs. tit. 17, 95802(42). More specifically, the cap is a budget of allowances for each year. See id The cap declines each year: the cap for 2013 is set approximately 2% below the forecasted emissions level for 2012, and will decline approximately 2% for See Overview webpage. The overall cap will increase in 2015 when Covered Entities will expand to include distributors of transportation fuel, natural gas and other fuels, but will decline approximately 3% annually for 2015 to Id. Thus, the total budget of allowances across all sectors for 2013 is million allowances, and million allowances for 2014; million allowances for 2015, million allowances for 2016, etc. See Cal. Code Regs. tit. 17, The Program s regulations also provide specific budgets for the industrial and electric utility sectors. Id (d)&(e). For example, the 2013 budget of allowances for the electric utility sector is 95.8 million allowances. Id (d) & Table 9-2. These allowances are then budgeted to each electric utility based on specified percentage allocation factors. Id (a) & Table 9-2. As would be expected, the larger utilities have greater percentage allocation factors (e.g., Southern California Edison s is over 34%) than the smaller utilities (typically, publicly owned utilities) which often have percentage allocation factors of 1% or less. 2. CARB establishes accounts for administration of the Program When a Covered Entity registers to participate in the Program, CARB will create a holding account, limited use holding account, and compliance account for the Covered Entity. Id (a)(1). 4 The Covered Entity will hold the allowances directly allocated to it from CARB in the limited use holding account. Id (a)(3). The Covered Entity will transfer the allowances required to meet its compliance obligation into the compliance account. Id (a)(4). Otherwise, the Covered Entity will hold its allowances in its holding account. CARB also will establish and maintain an Allocation Holding Account, Auction Holding Account, Allowance Price Reserve Containment Account, and Retirement Account. The Allocation Holding Account is the account into which CARB will register the serial numbers of allowances when they are issued. Id (b)(1). Each of the other accounts will be addressed in the following sections regarding the allocation, auction, and retirement of allowances. 4 CARB will create an exchange clearing holding account for Voluntary Associated Entities and not a compliance account because they do not have a compliance obligation. See id (a)(5). 3

4 3. CARB allocates, auctions, and sells allowances CARB will directly allocate allowances to electric utility and industrial Covered Entities. Id (d)&(e). To be eligible for these direct allocations, the Covered Entities must comply with the requirements of the MRR, including obtaining verified statements for the prior year. Id For electric utility Covered Entities, CARB will place allowances in their limited use holding accounts (publicly owned utilities may choose to have the allowances placed in their limited use holding accounts or the compliance accounts of designated electrical generating facilities). Id (b). CARB will designate for sale at auction all remaining allowances not otherwise allocated to the electric utility and industrial Covered Entities or certain other accounts. Id (f). CARB will place all allowances designated for sale at auction in its Auction Holding Account. See id (b)(2). The Program s regulations provide for two separate auctions each quarter: the auction of allowances from the current and previous budget years; and the auction of allowances from future budget years. Id (c). In 2012, electric utility Covered Entities that receive a direct allocation of allowances from CARB must offer one sixth of those allowances for sale in the November 12, 2012 auction. Id (c)(1). 5 In each year thereafter, electric utility Covered Entities that receive direct allocations of allowances from CARB must offer all of those allowances for sale in the auctions of allowances from current and previous budget years. Id (c)(2). The electric utility Covered Entities must transfer the allocated allowances from their limited use holding accounts to CARB s Auction Holding Account. Id (a)(3)&(b)(2). Any such allowances not sold at auction will be returned to the respective source accounts. Id (b)(5)(A). The auction proceeds and allowance value obtained by an electric utility Covered Entity must be used exclusively for the benefit of ratepayers. Id (d)(3). In addition, CARB will sell allowances from its Allowance Price Reserve Containment Account (the Reserve ). Id (a). Only Covered Entities will be eligible to purchase allowances from the Reserve. Id (c). CARB will conduct the Reserve sales six weeks after each quarterly allowance auction. Id. CARB will divide the Reserve allowances into three tiers by price, and will conduct sales from each tier in succession, beginning with the lowest to the highest priced tier, until all allowances are sold. Id (d) and (f). The proceeds from the Reserve sales will be deposited in the Air Pollution Control Fund. Id (g). 5 The Program s regulations provide for two auctions in 2012, id (a), but at this time CARB s website indicates that only the November 2012 auction will be held. See California Environmental Protection Agency, Air Resources Board, Auction Information, available at: 4

5 4. Covered Entities must meet compliance obligations As noted above, each Covered Entity will have a compliance obligation equal to the amount of GHG emissions that it reports pursuant to the MRR, id , and that compliance obligation will begin in the first compliance period (i.e., on January 1, 2013). Id (a). Covered Entities must meet their compliance obligations on an annual, id , and triennial basis. Id By November 1 of the calendar year following the year for which the compliance obligation is calculated, the Covered Entity must transfer from its holding account to its compliance account (i.e., surrender) a sufficient number of allowances to meet the annual or triennial compliance obligation. Id (c)&(d). In a typical compliance period, following each of the first two years, the Covered Entity must surrender allowances equal to 30% of its emissions, id , and following the final year it must surrender allowances equal to the remainder of its emissions. Id (f). For example, if a Covered Entity has a compliance obligation of 100 MTCO 2 e in each of the three years of the compliance period, then it would be required to surrender allowances equal to 30 MTCO 2 e following the first two years of the compliance period and surrender allowances equal to 240 MTCO 2 e following the final year of the compliance period. If a Covered Entity fails to meet its annual or triennial compliance obligation, it will be subject to a compliance obligation for untimely surrender, or excess emissions. Id (a). The quantity of excess emissions is the difference between the compliance obligation and the allowances timely surrendered by the Covered Entity, with the compliance obligation for untimely surrender being four times the quantity of excess emissions. Id (b). Allowances must comprise at least 75% of the compliance obligation for untimely surrender, while offset credits may comprise no more than 25%. Id. When CARB determines that a Covered Entity has met its compliance obligation, it will retire the allowances surrendered by the Covered Entity by moving them into CARB s Retirement Account. Id (g); see also id (253). Once an allowance is registered in CARB s Retirement Account, it cannot be removed. Id (253). 5. CARB will track and oversee the market CARB, through the WCI, is developing the Compliance Instrument Tracking System Service ( CITSS ) which will be a multi-jurisdictional tracking system to support implementation of state and provincial trading programs (i.e., analogous to WREGIS but for cap and trade). See California Environmental Protection Agency, Air Resources Board, Compliance Instrument Tracking System Service, available at: system/markettrackingsystem.htm. The Program will have an independent market monitor to review auction procedures, monitor allowance holding and transfer activity, and prepare reports on market trends. See California Environmental Protection Agency, Air Resources Board, Cap and Trade: Market Oversight and Enforcement, available at: 5

6 oversight.pdf. CARB is coordinating with the United States Commodity Futures Trading Commission (CFTC) with respect to any potential market manipulation or fraudulent practices. Id. II. Issues Identified by Market Participants The following summarizes certain issues identified by Program market participants in comments submitted in response to a workshop held by CARB on May 4, A. Electricity Imports The market participants identified several related issues regarding electricity imports into California. The Program s regulations define an electricity importer as the entity identified on the NERC E-tag as the purchasing-selling entity ( PSE ) on the last segment of the E-tag s physical path for electricity delivered from a balancing authority area outside California to a balancing authority area inside California; or, as the facility operator or scheduling coordinator when the electricity does not cross balancing authority areas when entering California. See Cal. Code Regs. tit. 17, 95802(87). The issues involve whether the seller or the buyer should bear the compliance obligation for electricity sales into California and how the drafting of the E-tag may affect the outcome. 1. First Deliverer or Importer of Electricity Several market participants asked CARB to create a hierarchy for determining responsibility for imported electricity; specifically, that CARB should look first to the PSE listed on the E-tag, then to the scheduling coordinator, and last to the facility operator. As one market participant explained, In most cases the owner of the power will be the scheduling coordinator; however, when a broker is involved and ownership of the power does not transfer, the obligated entity will be the generator. Market participants cautioned, however, that there is inconsistency in how E-tags are written and, unless CARB adopts standard protocols, CARB s use of E-tags as the primary means for determining the compliance obligation could result in complications. Several market participants expressed concerns that electricity sales into the California ISO from outside the state potentially raise jurisdictional issues because both the PSE and the point of delivery would be located outside of California. According to one market participant, the California ISO requires a scheduling convention for E-tags that lists the scheduling coordinator selling to the California ISO as the PSE (as opposed to a bilateral transaction where the buyer is listed on the E-tag as the PSE). If the sale to the California ISO is made at a point outside of the state (e.g., at Palo Verde), the transaction would place a compliance obligation on an out-of-state entity (the seller/pse), arguably causing CARB to exceed its jurisdiction. Other market participants reasoned that such sales to the California ISO are in fact sales into California and therefore within CARB s jurisdiction. Additionally, one market participant argued that the California ISO s E-tag convention is necessary in order to keep the playing field level. That is, if the out-of-state seller was not designated as the PSE, and therefore did not have 6

7 the compliance obligation, the price on its sales into the California ISO would not reflect the carbon premium that in-state sellers would need to bear. 2. Specified vs. Unspecified Sources Electricity imports must be designated as coming from either a specified source or an unspecified source. A specified source is defined in the Program s regulations as a facility or unit which is permitted to be claimed as the source of electricity delivered and for which [t]he reporting entity must have either full or partial ownership in the facility/unit or a written power contract as defined in [the MRR regulations] to procure electricity generated by that facility/unit. Id (264). The MRR regulations define a written power contract as a written document, including associated verbal or electronic records if included as part of the written power contract, arranging for the procurement of electricity and explain that written power contracts may be, but are not limited to, power purchase agreements, enabling agreements, and tariff provisions, without regard to duration. Id (301). The Program s regulations define an unspecified source as electricity generation that cannot be matched to a specific electricity generating facility or electricity generating unit or matched to an asset-controlling supplier recognized by [CARB]. Id (278). The MRR regulations, however, define an unspecified source as electricity procured and delivered without limitation at the time of transaction to a specific facility s or unit s generation. Id (399). Both sets of regulations explain that unspecified sources contribute to the bulk system power pool and typically are dispatchable, marginal resources that do not serve baseload. Besides the obvious issue of having two different definitions for unspecified source, the definition of unspecified source from the MRR regulations creates an ambiguity: it is not clear whether the transaction occurs when the electricity is procured or when it is delivered. The seller may change the type of generation resource between the time the electricity is procured and when it is delivered (e.g., from coal to wind, or vice versa). A change in generation resources potentially could result in a resource shuffling violation as discussed below. B. Resource Shuffling The market participants identified two related issues regarding resource shuffling: the definition of resource shuffling lacks clarity, creating ambiguity as to exactly what conduct will be resource shuffling. The ambiguity will tend to cause utility personnel to refrain from signing the attestation required by the Program. The Program defines resource shuffling as any plan, scheme, or artifice to receive credit based on emissions reductions that have not occurred, involving the delivery of electricity to the California grid. Id (251). CARB identified some practices that it considers to be resource shuffling: cherry picking (choosing a low emitting resource to import); facility swapping (an asset-controlling supplier choosing to sell its low emitting generation to California, replacing it with a high emitting resource from its portfolio); and laundering 7

8 (hiding the identity of a high emitting resource so that it becomes an unspecified resource). 6 CARB explained that its resource shuffling provisions are necessary to address the problem of leakage, i.e., the reduction of in-state emissions with a parallel increase in emissions out of state. Id. at The Program s regulations state that resource shuffling is prohibited and require personnel of first deliverers of electricity into California to submit attestations that they have not engaged in resource shuffling. See Cal. Code Regs. tit. 17, 95852(b)(2). The primary concern of the market participants is that legitimate scheduling decisions could be construed by CARB as resource shuffling. For example, as one market participant explained, Electricity import transactions will be based on economic dispatch considerations, including electricity demand in California, the available supply on a least-cost basis to serve that demand, and available transmission capacity for imports into California. The result of these considerations could be that a lower emitting resource is dispatched into California, and that such a decision should not be construed as a plan, scheme, or artifice. Commenting market participants asked CARB to provide a more detailed definition of resource shuffling or, in the absence of such a definition, to provide case-by-case guidance in the form of no-action letters or other similar guidance. C. Qualified Export Adjustment The Program presently includes a Qualified Export ( QE ) adjustment which provides that [a]n adjustment to the compliance obligation... may be made for exported and imported electricity during the same hour by the same PSE and that such emissions claimed by a first deliverer must not exceed the product of (1) the lower of either the quantity of exports or imports (MWh) for the hour; multiplied by (2) the lowest emission factor of any portion of the qualified exports or corresponding imports for the hour. Id (b)(5). One market participant described it as a mechanism designed to recognize that power wheeled through California and power that enters California as part of a simultaneous exchange does not have in-state GHG emissions consequences that should be subject to the cap and trade regulations. Another explained that AB 32 directs CARB to account for GHG emissions from all electricity consumed in the state, but not electricity exported and consumed outside of California. CARB asked the market participants whether it should retain the provision. Most market participants were in favor of retaining it in its original form or with some modifications. Although, one market participant suggested removing because it creates substantial reporting burdens with little net benefits. 6 See California Air Resources Board, Cap-and-Trade Program Electricity Workshop at 24 (May 4, 2012) available at: may4electricityppt.pdf. 8

9 D. RPS Adjustment The Program provides for a Renewable Portfolio Standard ( RPS ) adjustment to the compliance obligation for imported electricity so long as the electricity importer has ownership or contractual rights to the eligible renewable energy resource; the associated RECs are retired during the same year in which the RPS adjustment is claimed; and the quantity of emissions included in the RPS adjustment is calculated as the product of the default emissions factor for unspecified sources and the reported electricity generated (MWh). Id (b)(4). One market participant described the RPS adjustment as a way first deliverers can avoid a compliance obligation for electricity imported under firming and shaping agreements into a California balancing authority area. Because the Program requires the first deliverers to retire the RECs associated with these transactions in the same annual compliance period that the renewable generation actually occurred, the requirement is contrary to the RPS regulations which allow retirement of RECs within 3 years from when the energy was generated. Market participants asked CARB to harmonize these provisions. III. WSPP Considerations WSPP may consider revisions to the WSPP Agreement to address certain aspects of the regulatory framework. At this time, it could be sensible to address electricity imports and resource shuffling; other contractual fixes may arise as the regulations evolve). Specifically, WSPP may consider the including the following additional provisions for applicable Service Schedule C and B transactions (possibly A as well): a check-the-box provision in the Confirmation for Parties to indicate whether the electricity is from a specified source or an unspecified source a damages provision in the event a Party fails to deliver a specified source a representation and warranty provision regarding resource shuffling possibly a damages or indemnity provision regarding resource shuffling By adding a check-the-box provision to the Confirmation, Parties will have the option to indicate that the power is from a specified source and to specify that source. In addition to the check-box, WSPP may wish to include language for Service Schedule A or C transactions to confirm that the default source is an unspecified source. Because failure to provide a specified source may cause the non-breaching Party to incur a greater compliance obligation and cost, in addition to any replacement cost for power not delivered, WSPP may consider including a Program-specific damages provision or, perhaps more likely, providing a mechanism for the parties to specify any additional damages arrangements they may agree upon, including, reimbursement for penalty-type losses. As noted above, the Program s regulations require personnel of first deliverers of electricity into California to submit attestations that they have not engaged in resource shuffling. 9

10 WSPP may consider an option by which the seller would provide a representation and warranty that it has not engaged in resource shuffling, or provide a seller indemnity to the buyer against losses due to resource shuffling Straw language will be provided before the meeting. IV. Other Programs Other cap and trade programs exist or in various stages of planning. These include the following: Regional Greenhouse Gas Initiative ( RGGI ), a mandatory program among Connecticut, Delaware, Maryland, Maine, Massachusetts, New Hampshire, New York, Rhode Island and Vermont, places a cap on GHG emissions from power plants and requires them to possess a tradable allowance for each ton of GHG they emit Midwest Greenhouse Gas Reduction Accord ( MGGRA ), begun by the Midwest Governors Association but never implemented, it was a commitment by the governors of Illinois, Iowa, Kansas, Michigan, Minnesota, and Wisconsin, and the premier of Manitoba to reduce GHG emissions through a regional cap and trade program the Florida legislature passed a statewide cap and trade program, but it does not appear to us to have been implemented /// 10