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  California carbon market faces challenges

Risk.net ‎- 22 hours ago

 

California’s first auction for carbon allowances on November 14 was hailed as a success by state officials. But the fledgling market must survive a barrage of legal challenges before it can truly take off. Alexander Osipovich reports

The past few years have been gloomy for US emissions traders and environmentalists concerned about climate change. But on November 14, they finally had something to celebrate. On that day, California held the inaugural auction of its new cap-and-trade programme, kicking off what promises to develop into the world’s second-largest carbon market after the European Union Emissions Trading System (EU ETS).

California says it has absorbed the lessons of other cap-and-trade programmes and designed its market to be robust and effective in reducing greenhouse gas emissions. That has stoked cautious optimism among advocates of carbon trading, who were disappointed when federal cap-and-trade legislation stalled in the US Senate in 2010.

“Everybody’s watching what happens in California, not only in the US and Canada, but also around the world, to see how it plays out,” says Fabio Nehme, Houston-based head of environmental products at EDF Trading North America. “If it’s successful, it could have a broad impact beyond the US and Canada. It will export momentum to similar cap-and-trade initiatives in other parts of the world.”

In a free market, leakage is tough to address when you’re sort of an island and standing on your own

But first, California’s experiment will need to survive existing and potential legal challenges. State officials hailed the debut auction as a success, pointing out that it went smoothly and drew interest from dozens of market participants. However, market participants say the result of the auction was marred by a last-minute lawsuit that caused buyers to hesitate, pushing the price of California Carbon Allowances (CCAs) down to rock-bottom levels.

The auction was the first in a series of planned quarterly sales by the Sacramento-based California Air Resources Board (Carb), which oversees the cap-and-trade programme. The central goal is to reduce California’s greenhouse gas emissions to 1990 levels by 2020. To accomplish that, Carb has established an emissions cap for the state’s largest polluters and will gradually lower it over three compliance periods, which cover 2013–14, 2015–17 and 2018–20. Companies may comply with the rules by either reducing emissions or purchasing CCAs. These represent one tonne of carbon dioxide equivalents and must be surrendered annually beginning in November 2014.

Results of the first auction, which Carb released on November 19, surprised some market participants. Despite the fact that the auction for 2013 CCAs was more than three times oversubscribed, indicating healthy demand, they cleared at a price of $10.09, just nine cents above a $10 floor price established by Carb. Traders in the forward market had expected the price to be closer to $12, according to carbon market analysis firm Thomson Reuters Point Carbon. One reason for that dislocation, say analysts and market participants, was a lawsuit filed just one day before the auction by the California Chamber of Commerce, a Sacramento-based business lobby. The November 13 lawsuit challenges Carb’s right to auction CCAs and characterises the programme as an unlawful tax.

“[It] may have caused some parties to pause, if they thought that the whole programme could be deemed unlawful,” says Steven Kelly, director of policy at the Sacramento-based Independent Energy Producers Association (IEPA), a trade group representing independent energy producers and power marketers. If the programme is struck down by a court ruling several months from now, companies might find they have spent millions of dollars on CCAs that are now worthless, he notes. “It’s not really clear that they would get their money back,” says Kelly.

Pay as you pollute

The crux of the lawsuit is Carb’s plan for polluters to buy a portion of the CCAs they require, rather than giving 100% of the allowances away for free. During the first compliance period, large industrial firms such as oil refineries will receive free allowances representing an average of 90% of their emissions, but they are required to buy the rest, either at auction or in the secondary market. Moreover, Carb says that in future compliance periods it will reduce the proportion of allowances given away for free. Since Carb has also imposed a $10 floor price for each CCA, companies may find themselves shelling out significant amounts of money for the allowances they need, which has led to some grumbling the auctions are really a money-raising scheme for the cash-strapped state government in Sacramento. Indeed, the November 13 lawsuit notes that the state governor’s 2012–13 budget “assumes that $500 million from [Carb’s] auction can be used to offset general fund costs”.

The Chamber’s lawsuit reflects worries by energy companies that California’s cap-and-trade programme will saddle them with stiff compliance costs. “We believe the goals of the programme can be met without an auction process,” says Chris Chandler, manager of a Los Angeles refinery owned by US downstream firm Phillips 66. “In an economy that has over 10% unemployment, you have to ask, can California manufacturing afford to pay what will eventually be billions of dollars to the state just to stay in business?”

Carb denies that its aims are to raise money for the state, insisting that its auctions have been designed to make CCAs a scarce commodity with genuine value. Some emissions traders agree. “While Carb is taking some well-advised measures to allocate carbon allowances for free when necessary, their decision to sell a significant portion of them and make sure they have a dollar value from the get-go will help ensure their programme is real and has more bite,” says Jonathan Burnston, manager for environmental markets at Karbone, a New York-based brokerage firm.

Though the lawsuit attracted a great deal of attention, it has a “low probability of success”, says Kevin Poloncarz, a San Francisco-based partner in the environmental and energy practice of law firm Paul Hastings. According to Poloncarz, California’s cap-and-trade programme faces a much more serious threat: a potential lawsuit arguing that Carb is violating the US constitution, which grants the federal government the power to regulate interstate commerce and limits the ability of states to regulate economic activity outside of their borders.

The key issue in such a lawsuit would be Carb’s efforts to stop leakage, the phenomenon in which cap-and-trade programmes can cause emissions to shift to different jurisdictions.

But even those sympathetic to the goals of Carb’s programme see that as a difficult challenge for the agency to tackle.

“In a free market, leakage is tough to address when you’re sort of an island and standing on your own,” says Gary Hart, Alabama-based senior market analyst at brokerage Icap Energy. “It’s kind of hard to put up walls at the border.”

California imports much of its electricity from other US states, with the level of imported electricity standing at about 30% in 2011, according to state government statistics. Consequently, Carb crafted the cap-and-trade programme to account for the emissions of out-of-state generators in an attempt to ensure it doesn’t lead to greater emissions from power plants elsewhere. That led to a complex set of rules applying to “first deliverers of electricity” – companies in California that receive power from sources outside the state. Under those rules, first deliverers must account for the greenhouse gas emissions of power sources located outside California and comply with the cap-and-trade scheme accordingly. They are also prohibited from resource shuffling – or making changes that reduce the emissions reportable to Carb, but do not actually lower the total level of emissions they produce. This could involve modifying power purchase agreements so that electricity from a wind farm is routed into California, for example, while electricity from a coal-fired power plant is redirected into Nevada instead.

Boundary dispute

These rules have come under fire from energy firms based outside of California, with lawyers warning they could be challenged on the grounds that Carb is reaching beyond its jurisdiction. While there are persistent rumours that such a legal challenge is in the works, no lawsuits had been filed at the time Energy Risk went to press. Nonetheless, if a legal challenge succeeded on those grounds, it would be a serious blow to California’s efforts – with Poloncarz at Paul Hastings suggesting it would require a major rewrite of the current regulations.

Carb says it is ready to fight back if such a lawsuit emerges. “We have been very careful in how we’ve structured this programme and we really think that it will stand up to any legal challenge,” says a Sacramento-based spokesman at Carb.

If California’s programme survives, carbon traders are hopeful it will create a robust market that can serve as a model for other cap-and-trade schemes. “Carb has been thoughtful and careful in designing this programme, taking into account the lessons learned from cap-and-trade programmes developed elsewhere in order to avoid similar difficulties,” says Nehme of EDF Trading North America.

One aspect of California’s programme that has won praise from traders is its framework for emissions reporting, which was designed to avoid the problems that initially plagued the EU ETS. Launched in 2005, the European scheme saw prices for allowances crash more than 50% in April 2006 after the release of the first EU-verified emissions data, which showed regulators had hugely over-allocated allowances when launching the ETS. In contrast, California issued guidelines for reporting emissions in 2008 and has been collecting annual emissions data from firms ever since, boosting confidence in the structure of the market.

“We have a pretty accurate inventory that gives us a good idea, facility-by-facility [and] sector-by-sector, of what we’re dealing with,” says the Carb spokesman. “We learned from the EU, because when they launched they didn’t have a lot of the verification in place.”

Another way in which California has learned the lessons of other cap-and-trade programmes is in its handling of carbon offsets – or projects designed to mitigate emissions. The world’s leading carbon offset market, the United Nations’ Clean Development Mechanism (CDM), has been criticised for providing offsets to schemes that do not actually reduce overall emissions, as well as its bureaucratic process for approving new projects. To avoid similar problems, Carb has agreed to partner with offset registries, such as the Los Angeles-based Climate Action Reserve, which are expected to be far more efficient than the CDM. Carb has also imposed rules requiring third-party verification of offset projects to ensure they are achieving genuine emissions reductions.

Despite this, Carb’s approach to offsets has been criticised by industry groups. Under the rules, companies can only satisfy 8% of their compliance mandates through the use of California Carbon Offsets (CCOs), while the rest must be satisfied through CCAs. In addition, Carb has only approved four protocols for offset projects to date, leading to concern there could be a shortfall of CCO supply. Since offsets help to hold down the price of allowances, this has led energy companies to worry that an offset shortage could add to already significant compliance costs.

“We are big supporters of offsets,” says Catherine Reheis-Boyd, president of the Western States Petroleum Association, a Sacramento-based trade group. “They are a very good way to minimise costs in complying and we believe that the 8% cap should be escalated dramatically and more protocols should be issued as soon as possible.”

California’s push to create a cap-and-trade programme was initially part of an even grander experiment to create a regional carbon market. That was the idea behind the Western Climate Initiative (WCI), a consortium of US states and Canadian provinces created in 2007. But the WCI did not live up to these expectations. The six other US states in the body eventually left, amid a difficult political environment for supporters of cap-and-trade programmes. That left California as the lone US member, together with British Columbia, Manitoba, Ontario and Quebec. Currently, California and Quebec are looking to harmonise their rules in an attempt to link their markets – something Carb expects to happen in 2013.

Whether more linkages take place, and whether California can help inspire carbon markets elsewhere in the world, depends on whether the programme survives its initial challenges. In the meantime, Kelly at IEPA says the spectre of legal action will inevitably create uncertainty for market participants. “It creates problems, obviously, for electric generators and industrial guys trying to figure out what to do,” he says. “So hopefully we can get these litigation issues resolved… as quickly as possible, and can move on from there

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