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California Cap and Trade Update: Low-Carbon Fuel Standard Enjoined. What Next?

January 25, 2012

On December 29, 2011, the U.S. District Court for the Eastern District of California (Judge O’Neill) issued two rulings that struck down California’s low carbon fuel program and enjoined its further enforcement. At least some commentators believe California’s recently-adopted cap-and-trade rules under AB32 could be similarly enjoined if the same types of challenges are brought. Following is a summary of the decisions and an explanation of how the rulings in Rocky Mountain Farmers Union, et al. v Goldstene, et al. CV-F-09-2234 could be applied to the AB32 cap-and-trade program.[1]

Background

One of several programs under the Global Warming Solutions Act (AB32) implemented by the California Air Resources Board (CARB) was a low carbon fuels program intended to reduce the “carbon intensity” of motor fuels. The program establishes low carbon fuel standards (LCFS) under which regulated entities must achieve an average of a 10% reduction in the “carbon intensity” of covered motor fuels by 2020. Carbon intensity (CI) is a calculated number for specific categories of motor fuels and motor fuel substitutes (such as biofuels) that takes into account the life-cycle greenhouse gas emissions (GHGs), including indirect emissions associated with production and transportation.

Summary of Decisions

Judge O’Neill’s decisions found that the LCFS program violates the interstate commerce clause of the United States constitution. The commerce clause is interpreted to bar states from imposing restrictions on commerce that adversely affect the ability of out-of-state persons to conduct business within another state. The judge’s analysis is important in assessing the potential implications for other AB32 programs, such as cap-and-trade.

The two tests applied to state regulation under the commerce clause are the strict scrutiny test and the balancing test. If a state law facially discriminates against out-of-state businesses, the strict scrutiny analysis assesses whether the law is necessary to achieve a valid state objective and is the least restrictive method of doing so. The balancing test applies if the state law is not facially discriminatory, but has an adverse effect on interstate commerce. Under a balancing test, the court would determine whether the burden imposed on interstate commerce is “outweighed” by the interests sought to be achieved by the state.

Judge O’Neill concluded that the LCFS program is facially discriminatory against out-of-state fuel substitutes because the scoring methodology for carbon intensity assigns a higher CI to Midwestern biofuels than it does to locally-produced fuels because of the distances involved in delivery and the heavier use of coal in Midwestern electricity production. The court found that the factors used to calculate CI are not related to in-state activities or fuel composition, but are related to behaviors outside of California. Judge O’Neill likened such regulation to an attempt to regulate activity (e.g., emissions of GHGs) in other states. The judge effectively found that the discriminatory effect of the program was the relevant factor, regardless of whether the regulatory methodology was superficially neutral.

After finding that the LCFS program facially discriminates against out-of-state biofuels, Judge O’Neill applied the strict scrutiny analysis. He found that the program was adopted to serve a legitimate state interest (reducing GHG emissions to combat global warming), but concluded that the state had not borne its burden of showing that the LCFS program was the least discriminatory program that would have served the purpose. He suggested, for example, that a tax or a fuel standard or efficiency standards could have been imposed to reduce GHG emissions from motor fuels.

Effects on Cap-and-Trade

In October 2011, CARB approved a cap-and-trade program under AB32 for the regulation of GHGs in California. That program imposes a GHG emissions cap, and allocates the right to emit via allowances and other compliance instruments. The allowances are allocated to some regulated entities for free, but are allocated by blind auction, to the highest bidder, for significant portions of the California economy. Beginning in 2013, the program will impose compliance obligations on electricity generators and importers, and in 2015 on fossil fuels. The cap-and-trade program is subject to some of the same objections under the commerce clause as the LCFS program – namely, that it unlawfully discriminates against out-of-state power producers.

In order to understand the similarity of the LCFS rules and the cap-and-trade program, it helps to understand the concept of “leakage.” Under a cap-and-trade program, “leakage” refers to the migration of emission-generating activities from a regulated jurisdiction to an unregulated jurisdiction. The theory is that higher regulatory costs on in-state suppliers of goods and services will naturally lead to a competitive advantage for out-of-state suppliers. Leakage would occur as emission-generating activities in California migrate to other states, perhaps resulting in lower emissions within California but potentially raising emissions in other states.

The cap-and-trade program incorporates anti-leakage elements. With respect to electricity, the cap-and-trade program imposes requirements on emissions of fossil fuel-based generation in California, requiring an allowance to be submitted for each ton of regulated GHG emissions in California. In order to avoid leakage of emissions to other states, California has imposed an allowance requirement on imported electricity representing the emissions of GHGs imputed to such electricity.

CARB presents the compliance obligations upon imported electricity as a way to ensure the program’s integrity. It is in fact a different type of regulation. Within the state, allowances are required for combustion of fuels that release GHGs. With respect to imported electricity, importers are subject to allowance surrender requirements even though they do not emit GHGs. This means that in-state entities and out-of-state entities are treated differently, setting up arguments that the cap-and-trade program is facially discriminatory.

The cap-and-trade program is similar to the LCFS program in at least two other ways that raise commerce clause concerns. First, the effect of the program adversely affects out-of-state generators more severely than in-state generators, because all coal-fired generation and much of the gas-fired generation on which Californians depend are located in other states. Secondly, the imposition of allowance requirements on importers of electricity is an indirect attempt to regulate emissions from facilities in other states.

The only way a facially discriminatory regulation can survive is to demonstrate that it is the least restrictive means of achieving a legitimate environmental objective. The problem is that there are always other approaches available that affect in-state and out-of-state businesses in a non-discriminatory way (e.g., a tax imposed on users), and there are other approaches that would only affect in-state resources (e.g., a GHG compliance requirement on in-state combustion with no attempt at penalizing imports). As a result, it is very difficult for a program designed to prevent leakage to survive strict scrutiny.

On the other hand, the proposed allowance requirements under California’s cap-and-trade program for petroleum products and natural gas may not violate the commerce clause. The allowance requirements for fuels come into force in 2015, and apply to suppliers of fuels within the state. The allowance surrender requirements would be based on the emissions of GHGs from the assumed use of such fuels, regardless of source. This type of regulation does not appear to discriminate against out-of-state businesses, and does not seem intended to regulate out-of-state behavior.

Although such a regulation does not appear to be facially discriminatory, there remain significant challenges to the California program under a balancing test. Under the cap-and-trade rules applicable to fuels, the balancing test would require an assessment of the degree of burden on interstate commerce. The effects of cap-and-trade on the costs of energy in California, and the related impact on interstate commerce and the California economy, are not yet known. Given CARB’s intent to send a “price signal” to reduce fossil fuel use, such effects could be significant.

On the other end of the balancing test, the benefit of the program is unclear with respect to a global issue like climate change. One state, even a large one, cannot materially affect globally concentrations of carbon dioxide and other GHGs. Even CARB has not asserted that the program will result in real environmental benefits within California or elsewhere. As a result, a court may find that the potentially significant economic impacts outweigh the limited benefits of cap-and-trade.

CARB has appealed Judge O’Neill’s decisions to the Ninth Circuit Court of Appeals. There will be many twists and turns to this story, and we will continue to follow it.

For more information on California’s cap-and-trade program, please contact any member of Marten Law’s Climate Change practice group.

[1] The decisions also addressed a consolidated case, National Petrochemical & Refiners Association, et al. v. Goldstene, et al., CV-F-10-163, which raises the same issues.

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