10 Questions about California's Cap and Trade Program

Last month, the California Air Resources Board unanimously approved California’s first-of-its-kind cap and trade program to cut greenhouse gas (GHG) pollution across the economy.  As the world’s twelfth-largest emitter of GHGs, California’s leadership in taking action to curtail its carbon footprint promises to have impacts beyond our borders.  The program is a critical component of the state’s larger plan to reduce GHG pollution and transition to a clean energy economy under the Global Warming Solutions Act of 2006 (AB 32). Here are some answers to some frequently asked questions about the nuts and bolts of California’s cap and trade regulation:

Q1: How does the program work?

A: California’s cap and trade regulation puts a cap (or a hard limit) on the aggregate GHG pollution emitted from large sources across the economy.  Regulators create “allowances” equal to the total number of emissions under the cap, and require large sources of pollution to surrender one allowance for every unit of GHG pollution they emit (measured in metric tonnes of carbon dioxide equivalent). All told, this ensures the total level of GHG pollution emitted by polluters cannot exceed the number of allowances available under the cap. The cap starts at expected business-as-usual emissions levels in 2012, and declines 2-3% per year through 2020. Fewer and fewer allowances are available each year, requiring polluters to reduce their emissions or pay increasingly high allowance prices.  The cap level is set in 2020 to ensure California complies with AB 32’s emission reduction target of returning to 1990 GHG emission levels.

Q2: How does the cap and trade regulation fit in to California’s broader climate and clean energy strategy developed under the AB 32 Scoping Plan?

A: The cap and trade program caps emissions from the industrial, utility, and transportation fuels sectors – which account for roughly 85% of the state’s GHG pollution.  However, since other regulations included under the AB 32 Scoping Plan (such as the clean cars standard and the renewable portfolio standard) will achieve reductions from the same sectors, the cap and trade regulation is projected to account  for less than 20% of the total emissions reductions under the Scoping Plan.  Should the other Scoping Plan measures that cover capped sectors underperform, however, the cap provides a backstop to ensure California will comply with AB 32.

Q3: What sources are included in California’s cap and trade regulation?

A:  The program contains three compliance periods:  (1)2013-2014; (2) 2015-2017; and (3) 2018-2020.

In the first compliance period (2013-2014), scope includes:

• All electricity generated and imported into California. The first deliverer of electricity into the state is the capped entity (the one that will have to purchase and surrender allowances).
• Large industrial facilities emitting more than 25,000 tonnes of GHG pollution/year. Examples include oil refineries and cement manufacturers.

In the second compliance period (2015-2017), scope expands to:

• Distributors of transportation fuels (including gasoline and diesel), natural gas, and other fuels. The regulated entity will be the fuel provider that distributes the fuel upstream (not the gas station).

In total, the program is expected to include roughly 350 large businesses, representing about 600 facilities.  Individuals and small businesses will not be regulated.

Q4: How does ARB know how much GHG pollution each source is emitting?

A: ARB adopted mandatory emission reporting rules and has been collecting verified emissions data since 2008. This data allows ARB to track annual emissions by source and trends over time.  Unlike the EU’s early experience with their cap and trade program, verified data will also enable ARB to set an appropriate cap level.  ARB will continue to collect this data every year to ensure entities meet their compliance obligations and maintain a steady downward trajectory of the cap.

Q5: How do regulated entities acquire emissions allowances?

A: There are two ways to get an allowance initially: buy it or get it for free.  After that, entities can purchase and sell allowances amongst themselves.

Over the course of the program, ARB will sell most of the allowances in an auction.

• About 10% of future permits will be available in an advance auction starting in 2012 (the lavender area in the chart below, labeled ‘Forward Auctioning”).
• About 10% (the exact amount is not yet determined) of the industrial sector’s allowances will be auctioned (the gray, blue, peach and maroon areas at the bottom of the chart below, labeled “Leakage Prevention”).

ARB will also give out some allowances for free in order to mitigate price impacts, provide sufficient transition time, and maintain a level playing field for entities that compete with out of state emitters.

• Allowances for each industrial sector covered under the cap are set at about 90% of average emissions, based on a benchmark that rewards efficient facilities.
• Publicly-owned utilities (such as the Los Angeles Department of Water and Power, the Sacramento Municipal Utilities District, and Burbank Water and Power) will receive allowances for free, with a mandate that they use the value of the allowances to help them transition to clean energy and mitigate risks for their customers.

Hybrid (The fuchsia area in the graph below, labeled “Allocated to Electrical Utilities on Behalf of Customers”)

• The investor-owned utilities (PG&E, Southern California Edison, and San Diego Gas & Electric) will receive allowances for free with the requirement that they sell those allowances in a “consignment auction” and use the revenue on behalf of their customers.  Their use of revenue will be regulated by the California Public Utilities Commission.

Source: California Environmental Protection Agency

Q6: What are offsets and what role do they play in the program?

A:  Offsets are pollution reductions that occur outside of capped sectors, but that can be used to meet compliance obligations under the cap and trade program.

In order to ensure that offsets are “real, permanent, verifiable, enforceable, and quantifiable” (ie: that they are actually reducing pollution), ARB has limited the quantity and adopted strict standards governing the quality of offsets that may be used for compliance with the cap and trade regulation.

An entity may meet no more than 8% of its compliance obligation with offsets.  If, for example, a refinery emits 100 tonnes of pollution, it can surrender 92 allowances and 8 offsets to ARB.

To date, ARB has approved only four offsets project types. Each offset must comply with detailed accounting and reporting requirements (know as an “offset protocol”) and all offsets must be verified by a third party. Further, offset credits can only be generated by projects located in the US – no international offsets can be used in the California program at this time.

The four eligible protocols are:

• Livestock (i.e. manure digesters)
• Destruction of ozone depleting substances (i.e. refrigeratants).
• U.S. forests (i.e. afforestation, forest conservation, and improved forest management)
• Urban forests

Q7: How often do capped entities have to surrender allowances?

A: Starting in 2014, entities must annually surrender allowances equal to 30% of their verified emissions from the year before (they have to verify and report their emissions every year – see above). Every three years, each entity must surrender allowances or offsets equal to all of the pollution it has emitted in the past 3 years. For example, if the refinery above emitted 100 tonnes of pollution every year for three years, it would need to annually surrender at least 30 allowances to cover its emissions in years 1 and 2, and then 240 allowances in year 3 to make up the deficit.

Q8: How can we be sure market prices won’t get out of control?

A: The purpose of the cap and trade regulation is to cap overall emissions but allow flexibility for businesses to find the most cost-effective ways to reduce pollution, thus keeping costs down 

In addition, ARB has designed the program to include many cost containment options for regulated entities:

• They can bank allowances for use in future years.
• They have three-year compliance periods that allow them a longer planning horizon to make investments.
• They can use offsets (which may be cheaper than allowances) for 8% of their compliance obligations (see question about offsets above).

Finally, ARB has set aside 4% of the total allowances in a strategic reserve to be released in the event prices rise above predetermined triggers (starting at $40 per tonne in 2013). If this happens, ARB will release these allowances into the market to increase supply and drive prices down.

On the flip side, ARB has built in a price floor (starting at $10/ton in 2013) to ensure the cap provides a stable market signal to move towards lower carbon alternatives. 

Q9: How can we be sure this market won’t turn into another Enron-type boondoggle?

A: ARB has taken several steps to guard against the risk of market manipulation, including requiring every market participant to register and submit to California’s jurisdiction (ARB retains broad authority to revoke registration status for any foul play), limiting how many allowances any entity can hold. ARB is also developing an Emissions Tracking System to keep track of every transaction and who is holding allowances, so they can detect and head off any attempts at market manipulation.

Q10: What if something else goes wrong that we haven’t thought of yet?

A: ARB is using 2012 as a ramp up year to stress test market monitoring operations, auction platforms, and other aspects of the program.  After the program launches in 2013, ARB will continue to monitor and provide updates to the Board on how the program is performing, and is developing an Adaptive Management Plan to respond more quickly if problems arise. Should anything go awry, ARB retains broad authority to make any necessary changes.