Western States Issue Design Recommendations for Regional GHG Trading System

Members of the Western Climate Initiative (“WCI”) recently took additional steps towards establishing a regional greenhouse gas (“GHG”) trading system in the western United States. Earlier this month, WCI subcommittees issued design recommendations for key elements of a Western regional GHG cap-and-trade program. The design recommendations cover the scope of coverage and points of regulation, allocation of emission allowances, and the use of offsets. The WCI intends to take additional public comment on the subcommittee recommendations in the spring and early summer and then present a final design for a regional cap-and-trade program to lawmakers in August 2008. Once it is operational, the WCI program will be the second regional GHG trading program operating in North America.

What is the WCI?

The WCI is a collaboration of seven western states and two Canadian provinces which are collaborating to develop regional strategies to reduce GHG emissions. In August 2007, the WCI took its first major action by adopting a regional emission reduction target to reduce GHG emissions, in the aggregate, across all nine member states and provinces, by 15 percent below 2005 levels by 2020. For more information see States Move Forward With Implementation of Greenhouse Gas Reduction Initiatives. The goal announced by WCI is economy-wide, meaning it calls for overall reductions in all sectors of the economy. It covers all GHGs, including carbon dioxide, methane, nitrous oxide, hydrofluorocarbons, perfluorocarbons and sulfur hexafluoride.

One of the goals of the WCI is to develop a regional market-based mechanism, such as an emissions cap-and-trade program, to accomplish GHG reductions throughout the region. To achieve that goal, the WCI established working subcommittees responsible for developing design recommendations. The design recommendations are considered “starting points” for narrowing and focusing the WCI’s efforts in developing a final program design by August 2008.

This article summarizes the design recommendations from the WCI for key elements of a Western GHG cap-and-trade system, including the scope of coverage, the allocation of allowances, and the use of offsets.

Recommended Cap-and-Trade-System’s Scope of Coverage

The “scope” of a cap-and-trade system refers to the number and type of emission sources that the program covers, the GHGs that fall under the cap, and the points of regulation where the cap would be enforced. The recommendations from the scope subcommittee contain an extensive analysis of the appropriate scope for the WCI program.[1] They note that a broad scope, which covers many emission sources, increases emission reduction opportunities, promotes market liquidity, and ensures that there are enough players in the marketplace. But a narrow scope also has advantages. While it covers fewer (generally large) emitters, it also simplifies the program, reduces concerns about “leakage” outside the system, and keeps overall administrative, monitoring, and transaction costs relatively low.

The WCI subcommittee evaluated seven different design options that it considered feasible for the program.[2] After analyzing the different options against its design criteria, the subcommittee recommended that the program begin with a narrow scope that would cover the electricity sector, large fossil fuel stationary combustion sources, large industrial process emissions, and emissions from the production and processing of fossil fuels.[3] Large stationary sources and industrial process emissions would be regulated at the point of combustion. Fossil fuel and production and processing emissions would be regulated at the facility level, such as the oil and gas field, gas processing plant, or coal mine.[4] The appropriate point of regulation for the electricity sector was analyzed in a separate WCI subcommittee report entitled Draft Electricity Point of Regulation Recommendations for Public Review and Comment.[5]

The WCI estimates that a “base” program that includes the sources identified above would cover less than 50% of the GHG emissions in the region.[6] In order to increase coverage of the program and the likelihood that the regional emissions reduction target will be achieved, the WCI recommends conducting further economic analysis to determine the appropriateness of including transportation fuels and residential and commercial fuel combustion in the program. Inclusion of these sectors, which represent about 44% of the region’s GHG emissions, would increase the program’s overall coverage to more than 80% of the region’s emissions.[7]

The WCI report also recommended that thresholds be established to define the minimum size or emission level of an entity that would be regulated under the cap-and-trade program. The Report did not however, identify or recommend a specific threshold level but rather noted that further assessment of this issue is needed.[8]

Recommendations on Allocation of Allowances

An allowance is essentially an authorization or permit to emit a specified amount of pollution. One of the most challenging tasks for regulators developing a cap-and-trade program is determining the appropriate number of allowances to apportion. If too many allowances are allocated, regulated facilities will be able to obtain and sell credits without making any particular efforts towards improved energy efficiency. On the other hand, if too few allowances are allocated, the cost of compliance could become very high for regulated entities. In addition to how many allowances to allocate, regulators must also determine how to distribute allowances among companies required to participate in the regulatory program. The options typically include distributing allowances for free or auctioning them off. How allowances are distributed directly affects the compliance costs for meeting the emissions reduction targets. Complicating the process for the WCI is the fact that there are multiple jurisdictions participating in the program and finding agreement over how to distribute allowances could prove difficult.

The WCI Allocations Subcommittee was tasked with, among other things, providing recommendations for determining how many allowances to allocate and the method for distributing budgeted emissions allowances.[9] Some of the major recommendations from the Allocations Subcommittee include:

Allowance Budgets

Each participating member (state or province) of the WCI will have an allowance budget and the regional cap will be equal to the sum of all the members’ allowance budgets.[10] Allowance budgets will be determined at the outset of the program for every year through 2020, with changes to the budgets occurring only when errors are discovered, or new sectors are added to the cap.[11]

Allowance budgets for members will be established using a yet-to-be-determined methodology. The WCI notes however that the methodology will set the budgets at levels needed to achieve the economy-wide reduction goals. The WCI recognizes that the data set available for calculating allowance budgets is not perfect, and that future adjustments to allowances budgets may be necessary if the mandatory GHG reporting that is being implemented in all member states reveals data errors.[12]

Distribution/Issuance of Allowances

Under the WCI proposal, members would distribute allowances (as opposed to the WCI itself).[13] The WCI recommends that a minimum percentage of the allowances be auctioned off by member states through a coordinated regional auction. A precise percentage was not recommended; however the WCI did suggest a range of between 25% and 75%.[14] The WCI recommends that the percentage of allowances to be auctioned should increase over time, and eventually reach 100%.

Beyond the minimum auction amount, members would initially have discretion as to how and to whom they issue their allowances. For example, members could decide to auction all of their allowances (as opposed to just the minimum auction amount), distribute the remainder for free, or retire them so that they cannot be used.[15] In order to avoid market instability, the WCI recommends that each member’s allowance distribution plans be made public at the beginning of each compliance period. This is intended to create greater certainty regarding the volume of allowances that will be available to the regulated community during each compliance period.

The WCI stated a concern that distribution methods may vary widely among member states and that this may create economic advantages/disadvantages among competing industries across the region. For example, if Washington chooses to auction all of its allowances and Oregon chooses to distribute allowances for free, Oregon companies would potentially have a competitive advantage over their Washington neighbors. The WCI acknowledges that there may be situations that require that “allocations to a particular sector … be treated uniformly by all Partners … to address competition among entities within the WCI region.” To prevent this scenario, the WCI recommends that over time, members seek to standardize how allowances are distributed. In the interim however, the WCI is prepared to conduct case-by-case sector-specific analyses to determine whether standard allocation approaches are necessary to prevent economic disparities.[16]

Early Action Credits

Early actions are emission reduction measures that occur before the commencement of a formal regulatory program. The WCI recommends that members be allowed to give credit for early actions; however, the credits would be subtracted from the members’ allowance budget. [17]

Banking and Borrowing

The WCI recommends against allowing regulated entities to borrow allowances from future compliance periods. However, they do recommend that entities be allowed to bank an unrestricted number of allowances for use in future compliance periods.[18]

Compliance Period

The WCI recommends a compliance period of three years. This is consistent with the compliance period used by RGGI.[19]

Recommendations on Offsets

Another significant issue in developing a GHG emissions trading system is whether and to what extent to allow offsets. An offset is a credit for emission reductions that are achieved by an entity in a sector that the regulatory program does not cover. The WCI Offset Subcommittee has recommended that offsets be included as an element of the cap-and-trade program.[20] According to the committee, the offset program could help to reduce overall compliance costs and encourage innovation and GHG reduction from sectors and sources not covered by the cap.[21]

The WCI recommends utilizing both a standardized and an ad-hoc approach to approving offset projects. The standardized approach involves developing, prior to the launch of the trading program, a list of pre-approved offset project types and protocols that must be followed in order to receive credit.[22] The ad-hoc approach would involve creating a review process for projects that have not been pre-approved as eligible offset projects. The WCI recommends that projects located anywhere in the United States, Canada or Mexico could be approved by the WCI so long as they meet appropriate standards for validation, verification and enforcement.[23]

The WCI also recommends that offsets and allowances from other GHG trading systems, such as the RGGI program, that meet appropriate environmental integrity standards be allowed to be used for compliance purposes.

Finally, the WCI recommends that a limit be placed on the amount of offsets that can be used by a regulated entity for compliance purposes. They did not, however, provide a specific recommendation on this point.[24]

Conclusion

The WCI is well on its way to designing a GHG cap-and-trade program covering large portions of the western United States and western Canada. Implementation of the trading system is likely going to have significant economic impacts, not only on industries that are highly dependent on the combustion of fossil fuels, but eventually on all users of fossil fuel generated energy and transportation fuels. As the WCI completes the design of the regional trading program, what remains to be seen is whether the region will proceed on its own or whether the federal government will intervene and adopt a nationwide GHG trading program. Either way, things are getting interesting.

For more information on emissions trading, contact any member of Marten Law Group’s Climate Change/Sustainability Practice Group.