Summary of California s Proposed Cap-and-Trade Regulations

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1 Summary of California s Proposed Cap-and-Trade Regulations On October 28, 2010, the California Air Resources Board (ARB) released its proposed regulations for greenhouse gas cap-and-trade program. The cap-and-trade is central to ARB s plan to reduce greenhouse gas emission to 1990 levels by 2020, as required by the Global Warming Solutions Act of 2006 (AB 32). ARB expects to implement the cap-and-trade program starting in 2012 by covering electric generators, large industrial sources, and imported electricity. In 2015, the proposed program would expand to cover emissions from the combustion of fuels by residential, commercial, small industrial, and transportation sources. When fully implemented, the program is expected to cover approximately 85 percent of the state s greenhouse gas emissions. ARB intends to link its cap-and-trade with similar programs developed by other members of the Western Climate Initiative as they take effect. ARB is accepting comments on the proposed regulations until December 16, 2010, which is the date of the scheduled hearing for the board to consider adopting the proposal. Additional information is available here. Coverage and Caps The proposed regulations will create a cap-and-trade program which takes effect on January 1, When fully implemented in 2015, the program would cover an estimated 85 percent of the state s GHG emissions. Allowance Budgets: Section of the proposed regulations establishes the annual allowance budgets for 2012 through 2020 as detailed in the table below. Compliance Period First Second Third Budget Year Annual Allowance Budget (Millions of Tons) The 2012 budget was set a level of projected emissions from covered entities at the start of the program. In 2015, the cap expands to account for the projected emissions of additional source categories. The emission reduction trajectory is intended to guarantee that California meets the AB 32 goal of reducing statewide emissions to 1990 levels by Since these budgets were established to include emissions from imported electricity, California will have to reevaluate and possibly alter the budget each time that it links with another WCI member. M.J. Bradley & Associates LLC 1 November 3, 2010

2 Large Industrial Electricity Covered Gases: In accordance with Section 95810, the cap-and-trade program would cover the following gases: carbon dioxide (CO 2 ), nitrous oxide (N 2 O), methane (CH 4 ), sulfur hexafluoride (SF 6 ), hydrofluorocarbons (HFCs), perfluorocarbons (PFCs), and nitrogen trifluoride (NF 3 ). Covered Entities: Section of the proposed regulations describes the emission sources covered under the program. The covered entities are as follows: Emission Source In-State Generation Covered Entity Generators located in California Initial Compliance Year 2012 Imports (specified sources) Combustion and Process Emissions Industrial-based CO 2 Marketers/retail providers that hold title to imported electricity 2012 Specific industrial sectors Producers or importers of industrial-based CO Commercial/ Residential/ Small Industrial Combustion Liquefied Petroleum Gas (LPG) Combustion Transportation Fuels Natural gas local distribution companies or owners of interstate 2015 pipelines that deliver gas directly to end users Producers or importers of LPGs derived from either petroleum or 2015 natural gas liquids Suppliers of gasoline and distillate fuel oil 2015 Opt-in Entities Under Section 95813, any source that meets the definition of a covered sector but does not exceed the coverage threshold described below can elect to be covered under the cap-and-trade program. Opt-in entities are subject to the same requirements as other covered entities and may be eligible to receive allowance allocation, if they meet all applicable requirements. An entity may opt out of the program after the end of a compliance period. Opt-in entities do not increase the state s overall annual allowance budget. 1 Operators of facilities in the state that conduct one or more of the following processes or operations: cement production; cogeneration; glass production; hydrogen production; iron and steel production; lime manufacturing; nitric acid production; oil and natural gas systems; petroleum refining; pulp and paper manufacturing; selfgeneration of electricity; or other stationary combustion. M.J. Bradley & Associates LLC 2 November 3, 2010

3 Coverage Threshold: Any source included in the table above that emits 25,000 MTCO 2 e per year or more is covered under the program. From 2012 to 2014, electricity importers that deliver electricity from specified sources outside California are covered if the emissions associated with the delivered electricity are 25,000 MTCO 2 e or greater. If the imported electricity is generated from unspecified sources, the importer is covered automatically. Starting in 2015, this zero threshold also applies to all imported electricity. For fuel suppliers (natural gas, transportation fuels, and LPG), delivering products which would emit 25,000 MTCO 2 e per year when combusted results in a compliance obligation. Exempt Emissions Section lists the following emission types that are exempt from coverage under the cap-andtrade program and do not count towards a compliance obligation: Combustion emissions from biomass-derived fuels (except biogas from digesters), from the following sources: Solid waste materials; Waste pallets, crates, manufacturing and construction wood wastes, tree trimmings, mill residues, and range land maintenance residues; All agricultural crops or waste; or Wood and wood wastes that adhere to certain sustainability guidelines. Biodiesel. Fuel ethanol. Municipal solid waste. Biomethane from the following sources: All animal and other organic wastes; or Landfill gas and wastewater. Fugitive and process emissions from: CO 2 and CH 4 from geothermal CO 2 emissions from hydrogen fuel cells; Asphalt blowing operations, equipment leaks, storage, and loading operations at petroleum refineries; and Certain other emissions from petroleum and natural gas systems. These emissions may still be subject to reporting requirements. Beginning and End of Compliance Obligations: Any source that belongs to a sector covered during the first compliance period that meets the emissions threshold in any year from 2008 to 2010 has a compliance obligation starting in 2012 (Section 95812(b)). Any source that that belongs to a covered sector starting in the second compliance period that meets the coverage threshold in any year between 2011 and 2014 has a compliance obligation starting in 2015 (Section 95812(d)). If an entity first triggers the coverage threshold during a compliance period, it has a compliance obligation starting the year it surpasses the threshold. However, if the entity first meets the coverage threshold in the third year of a compliance period, that entity does not have to surrender allowances at the end of that compliance period. Instead, the entity s first-year compliance obligation is added to its obligation for the following compliance period. Once an entity triggers the emissions threshold, it continues to have a compliance obligation until emissions fall below the threshold for an entire compliance period or the entity shuts down all processes, units, or operations that are subject to emissions reporting (Section 95812(e)). M.J. Bradley & Associates LLC 3 November 3, 2010

4 Noncompliance Penalty: Under Section 9587 of the proposed regulations, any covered entity that fails to surrender sufficient allowances to cover its emissions by the applicable compliance deadline must surrender four compliance instruments for every ton of excess emissions. Allowance Allocations Subarticle 8 describes the disposition of allowances under the proposed cap-and-trade program. This section includes provisions for allocating allowances to: Electrical distribution utilities; Industrial facilities; The Allowance Price Containment Reserve; and The state s Air Pollution Control Fund. In addition, the proposal includes placeholders for allocating allowances to natural gas distribution utilities and for a voluntary renewable energy set-aside. Electric Sector: The proposed regulations include an allocation of allowances to electrical distribution utilities for the benefit of their ratepayers. However, the proposed regulations do not include the methodology for distributing allowances among utilities. Quantity Section 95870(c)(1) allocates 89 million allowances to electrical distribution utilities in This allocation declines annually according to by a predetermined cap adjustment factor. The allocation to electric distribution utilities amounts to approximately 54 percent of the state s annual budget from 2012 to 2014, and approximately 22 percent of the annual budget from 2015 to In total, electric utilities would receive approximately 28 percent of the state s total allowance budget from 2012 through The table below details the proposed allocations to electric utilities for budget years 2012 through Budget Year Cap Adjustment Allocation to Percent of Factor Electric Utilities Total Budget ,000,000 54% ,309,000 54% ,707,000 54% ,016,000 21% ,325,000 22% ,723,000 22% ,032,000 22% ,341,000 22% ,739,000 23% Total N/A 741,192,000 28% Methodology The proposed regulations contain a placeholder for how allowances will be distributed among electric utilities (Section 95892(a)). M.J. Bradley & Associates LLC 4 November 3, 2010

5 Monetization Requirement Sections 95892(b) and (c) requires investor-owned utilities (IOUs) to offer all current vintage allowances that they are allocated for sale at auction. Any unsold allowances from previous years must also be auctioned. Publicly owned utilities may elect to transfer some or all of the allowances they receive directly into a compliance account for meeting a compliance obligation Use of Auction Proceeds Utilities receive the proceeds from the sale of these allowances and must use the revenues solely to benefit retail ratepayers as described in Section 95892(d). In particular, the use of allowance auction proceeds must adhere to the following principles: IOUs must treat customers of electric service providers and community choice aggregators equally to their own customers; Any rebates must be awarded based on a fixed portion of customers bills or be an otherwise fixed amount; and Any rebates must not be based exclusively on the quantity of electricity delivered to ratepayers any time after In addition, IOUs must abide by any restrictions put in place by the California Public Utilities Commission. Publicly-owned utilities must adhere to the requirements restrictions surrounding rebates and any others imposed by their governing boards. Natural Gas Sector: The proposed regulations include placeholders for allocating allowances directly to natural gas distribution utilities for ratepayer protection. Since natural gas distribution utilities are not covered under the program until 2015, these sections may remain incomplete even after the initial regulations are finalized. Industrial Covered Entities Under Section 95870(d), industrial facilities are eligible to receive direct allowance allocations for transitional assistance and to help avoid emissions leakage. CARB is proposing to use benchmarking approach for allocating allowances to industrial facilities. Depending on the sector, allowances will be allocated according to either a product-based benchmarking or a thermal energy-based benchmarking approach. For certain industries, CARB will establish an emission performance standard per unit of output and award allowances based on a facility s average production over the previous three years. In industries where this approach is not practical, allowances will be distributed based on a facility s average historical steam and fuel consumption. A facility receives a predetermined fractional number of allowances per MMBtu of steam and fuel input. Direct allocations to industrial covered facilities decline over time based on the cap adjustment factor discussed above and an industry assistance factor which is dependent on CARB s assessment of the industry s vulnerability to emissions leakage. The total quantity of allowances allocated to industrial facilities cannot exceed the remainder of California s annual allowance budget after taking into account the other allocations and set-asides. If the CARB calculates that the sum of all industrial allocations would exceed this amount, the available allowances will be prorated among the eligible sources. Air Pollution Control Fund: All allowances that are not allocated for the purposes described above or set aside for the Allowance Price Containment Reserve will be auctioned directly by CARB. The CARB staff s Initial Statement of Reasons for the proposed regulations suggest the following uses for these proceeds: M.J. Bradley & Associates LLC 5 November 3, 2010

6 A per capita consumer rebate program; A community benefit fund; and A low carbon investment fund. In addition, Section 95870(b) of proposed regulation allocates 2 percent of the allowance budget from years 2015 through 2020 for an Advance Auction. The proceeds from the Advance Auction are also transferred to the Air Pollution Control Fund. Allowance Auction CARB or a designated third-party will administer quarterly allowances auctions in accordance with Section The first such auction is scheduled for February 14, One fourth of all allowances made available for sale in a given year will be offered at each quarterly auction. Allowances Auctioned: The proposed regulations do not establish a precise quantity of allowances that will be offered for auction. However, the regulations specify that current vintage auctions will consist of at least the following: All allowances allocated directly to IOUs (95892(c)); and Any excess allowances that are not expressly allocated for other purposes (Section 95870(f)). In addition, allowances from the budget years three years in advance for the current vintage will be made available at each quarterly auction (e.g allowances will be offered in 2012). Two percent of each future year budget from 2015 to 2020 will be offered at these advance auctions. Auction Format: Allowance auctions will follow a single-round, sealed bid format (Section 95911(a)). Auction Reserve Price: All auctions will employ an auction reserve price, below which allowances will not be awarded. In 2012, the allowance reserve price will be $10 per metric ton for vintage 2012 allowances and $11.58 per metric ton for 2015 allowances (Section 95911(b)). The auction reserve price for both current and future vintage allowances will increase by 5 percent plus the rate inflation each year. Auction Purchase Limit: In accordance with Section 95911(c) of the proposed regulations, no covered entity or opt-in entity, except IOUs, can purchase more than 10 percent of the allowances made available for sale at a given auction. IOUs are not subject to any purchase limit. All other entities that participate in auctions may not purchase more than 4 percent of the total allowances offered. If an otherwise winning bid would violate the purchase limit for any entity, this bid will be automatically rejected. In addition, if any bid would cause an entity to exceed the holding limit, it will also be rejected. Alternative Compliance Mechanisms and Flexibility The proposed regulations include a number of provisions intended to increase the compliance flexibility, including: a limited 3-year compliance period; banking of allowances; offset credits, and an Allowance Price Containment Reserve. Compliance Period: Section establishes three compliance periods of three years each: , , and A covered entity must settle its three year compliance obligation after each compliance period. However, a covered entity must also surrender allowances to cover at least 30 percent of its M.J. Bradley & Associates LLC 6 November 3, 2010

7 emissions on an annual basis (Section 95855). An entity is exempted from the annual compliance obligation if it first becomes a covered entity in the third and final year of a compliance period. In this case, the annual compliance obligation is added on to the entity s total obligation for the following compliance period. Trading, Banking, and Borrowing: Subarticle 11 allows for trading and banking of allowances. However, the proposed regulations would establish general prohibitions on trading, information requirements for each trade, and a holding limit to prevent entities from manipulating the market. Trading Each transaction of compliance instruments must be approved by the entity that administers the trading platform, potentially ARB. Trading is unlimited unless the administrator determines that a trade would result in some form of market manipulation or violate the holding limit described below. Banking California GHG allowances do not expire and can be held across compliance period. No entity can bank allowances in excess of the holding limit described below. Holding Limit Section 95920(b) establishes a maximum quantity of allowances that any entity of group of associated entities may hold. The proposed regulations provide a formula for calculating the holding limit based on the state s annual allowance budget. The holding limit starts at about 3.6 percent of the annual allowance budget during the first compliance period and falls to about 3 percent of the budgets during the second and third compliance periods. Allowances that are transferred to an entity s compliance account during the calendar year are exempt from the holding limit up to the quantity of allowances that would cover the entity s total emissions for that year. Borrowing The proposed regulations do not allow for borrowing of allowances from future compliance periods to cover a compliance obligation from an earlier compliance period. Offsets: Quantitative Limits Section establishes a quantitative limit of offset credits of 8 percent of an entity s triennial or annual compliance obligation. Sector-based offset credits, described below, may only be used for 25 percent of this limit (2 percent a compliance obligation) in the first and second compliance periods. Starting in the third compliance period, sector-based offset credits can be used for up to 50 percent of the quantitative offset limit (4 percent of a compliance obligation). Protocol Approval Under Section 95972, an offset protocol must achieve the following to be approved by CARB: Accurately determine the quantity of emission reduced by an offset project; Establish appropriate data collection and monitoring procedures for the offset project type; Establish a project baseline that reflects conservative estimates of business-as-usual performance or practices for the offset project type; Account for leakage; Account for uncertainty with regards to the quantity of emission reductions achieved; M.J. Bradley & Associates LLC 7 November 3, 2010

8 Ensure that GHG emission reductions are permanent; and Abide by the crediting period lengths described below. Section requires CARB to hold a public comment period before approving an offset protocol. As part of the cap-and-trade rule package, CARB is proposing to adopt protocols developed by the Climate Action Reserve for the following four types of offset projects: Ozone depleting substance; Livestock projects; Urban forest projects; and U.S. forest projects. Crediting Periods Protocols approved by CARB must have crediting periods of at least 7 years and no greater than 10 years for non-sequestration projects. For sequestration projects, crediting periods must be at least 10 years and no greater than 30 years (95972(b)). Section 95975(i) allows for up to two extensions of the offset crediting period equal to the original crediting period for non-sequestration projects. The crediting period for sequestration projects can be renewed without limit. Sector-Based Offset Credits Sections through of the proposed regulations establish requirements for sector-based offset crediting programs that may be approved by CARB. The proposed regulations only allow for offsets generated from Reducing Emissions from Deforestation and Forest Degradation (REDD) plans, but there are placeholders for other sector-based credits. Allowance Price Containment Reserve: Under the proposed regulations, CARB would establish an Allowance Price Containment Reserve from which covered entities can purchase allowances in the case of high allowance prices or market shortages. Reserve Quantity Section 95870(a) establishes the Allowance Price Containment Reserve, which is initially filled with approximately million allowances. Allowances for the Reserve are drawn from each compliance years as follows: 1 percent from budget years ; 4 percent from budget years ; and 7 percent from budget years In total, the Reserve consists of approximately 4.6 percent of the state s total allowance budget from 2012 to In addition, any allowances offered by the state that are not sold at quarterly auctions are added to the Reserve, along with any allowances surrendered as a penalty for noncompliance. Eligible Participants Section 95913(c)(1) limits the purchase of allowances from the Allowance Price Containment Reserve to covered entities that have no allowances or other compliance instruments in their holding accounts. Opt-in entities may also purchase allowances from the Reserve. Reserve Sale Prices Under the proposed regulations (Section 95913(d)), CARB would divide the allowances in the Reserve into three equal tiers. Allowances in each tier will be offered at a different, fixed price. In 2012, the M.J. Bradley & Associates LLC 8 November 3, 2010

9 price of allowances in each tier will be $40, $45, and $50, respectively. Each year thereafter, the fixed price of each tier will increase by 5 percent plus the rate of inflation. Timing of Sales Allowances will be made available for purchase from the Reserve three weeks following each quarterly allowance auction (Section 95913(c)(3)). Eligible entities that wish to purchase allowances from the Reserve must submit bids to CARB at least two weeks before the scheduled sale for the quantity sought from each tier. Linking to External Programs Subarticle 12 of the proposed regulations allows for CARB to link the state s cap-and-trade program with external greenhouse gas emissions trading systems (GHG ETS). Linking with an external GHG ETS would require a case-by-case analysis to ensure that the external system is at least as stringent as the California program. Under Section 95941, CARB must hold issue a public notice and allow for public comments before approving an external GHG ETS under Subarticle 12. Compliance Instruments from Linked Program Section describes how compliance instruments issued by linked programs are treated under the California cap-and-trade. Allowances from linked programs are fungible with California allowances. Offset credits issued by linked programs are subject to the same quantitative usage limit as offsets issued by CARB. M.J. Bradley & Associates LLC 9 November 3, 2010