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California Offset Program Upheld

February 11, 2013

Introduction

California’s carbon offset program was upheld on January 25, 2013 when Superior Court Judge Ernest Goldsmith rejected an effort by environmental groups in Citizens Climate Lobby and Our Children’s Earth Foundation v. California Air Resources Board, Case No. CGC-12-519554 (Citizens Climate Lobby) to invalidate the California Air Resources Board’s (“CARB”) offset rule. Two public interest groups had challenged the rule on grounds that it failed to meet the so-called “additionality” requirement, which ensures that offsets will provide “additional” carbon reduction benefits over and above “business-as-usual.” Offsets are a key element of the state’s controversial cap-and-trade climate change regulation. The decision gives encouragement to offset producers and buyers, although CARB continues to face litigation and it will be some time until all the challenges are heard.

California’s Global Warming Solution Act of 2006, more commonly known as AB 32, requires CARB to develop a comprehensive plan to reduce GHG emissions in the state to 1990 levels by the year 2020.[1] The program establishes a declining limit on approximately 85% of the state’s total GHG emissions[2] in order to reach that goal. Entities subject to the cap (“covered sources”) must surrender “compliance instruments” to CARB that are equal to their GHG emissions.[3] The system provides for two types of compliance instruments: allowances and offsets. Allowances are issued by CARB and represent the right to emit one ton of carbon.[4] Allowances may be acquired either by allocation (from CARB), auction, or purchase on the secondary market. The first auction of allowances occurred November 14, 2012, as we previously discussed in Marten Law News here. The auction process has been challenged by the California Chamber of Commerce in California Chamber of Commerce v. California Air Resources Board,Cal. Super. Ct., No. 34-2012-80001313. (The complaint is available here.)

Offsets are tradable reductions of carbon produced by projects which are not subject to the cap-and-trade. The theory behind offsets is that they reduce the overall cost to the economy by creating a mechanism where projects which are not required to reduce, but which can do so cheaply, are incentivized to reduce emissions so they can sell these reductions to the market.[5] Covered emitters can then purchase these offsets at a lower price than they could by acquiring allowances at auction or by doing the reduction themselves. For example, it may be cheaper to reduce a ton of carbon emissions by growing trees that “sequester” carbon than to install expensive carbon pollution control equipment. The Obama Administration famously tried – and failed – to establish a cap-and-trade system during the President’s first term, and that system would have established a role for carbon offsets.[6] The Administration has apparently abandoned the idea, but California – which by itself is the world’s sixth biggest economy – has not.

Under the CARB rules in California, offsets may be used to satisfy up to eight percent (8%) of a covered source’s emissions.[7] Offsets are only awarded for projects carried out pursuant to one of four protocols adopted by CARB: U.S. Forestry Projects, Urban Forest Projects, Livestock Projects and Ozone Depleting Substances Projects.[8]

The crux of the issue is that in order to maintain the integrity of the system and ensure that overall emissions are in fact reduced, each offset must be “additional.” This means that the reduction would not have occurred without the financial incentive provided by the sale of the offset. It is this “additionality” requirement that was the subject of the Citizens Climate Lobby and Our Children’s Earth Foundation case.

Additionality

CARB adopted a standards-based approach to determining additionality. The standards-based approach creates additionality thresholds for particular categories of projects rather than determining it individually for each project. Under the standards-based approach, if a project developer can show that a project has met or exceeded the relevant standard, the project is deemed to satisfy the criterion of additionality. For example, under the U.S. forest protocol performance standards, if a piece of land had less than 10% tree canopy cover for 10 years, then a project which increases trees on that land and meets the performance requirements set forth in the protocol will be considered to be additional.[9] This is in contrast to having to prove all aspects of additionality for the individual project.

By way of comparison, the Clean Development Mechanism of the Kyoto Protocol uses a project-by-project approach. Under this method, additionality is determined by looking at each project’s unique location and circumstances. While in theory this approach is the most rigorous and precise way to determine additionality, it increases the expense of implementation. A standards-based approach reduces transaction and administrative costs and lends transparency to the verification process. On the flip side, standardization can lead to systemic inaccuracy if the standard is not appropriately calibrated. The use of a standards-based approach to determining additionality was the subject of the Citizens Climate Lobby case.

The Case

Two environmental groups, Citizens Climate Lobby and Our Children’s Earth Foundation, filed suit against the State of California last year.[10] This Newsletter discussed the case when it was filed, here. The plaintiffs argued that the standards-based approach adopted by CARB was inherently subjective and unreliable.[11] Their line of attack was two-fold.

First, the environmental groups advanced the argument that CARB’s use of a standards-based approach to determining additionality was beyond the power the California legislature had conferred upon the agency. The court rejected this argument, noting that the legislature granted CARB broad discretion to promulgate any type of GHG reduction measure, as well as the authority to determine whether a market-based carbon trading system would best achieve the goal of reducing GHG emissions.[12] In fact, Judge Goldsmith noted that plaintiffs acknowledged that CARB has the authority to use a standards-based approach; plaintiffs merely took issue with how CARB had devised its system.[13]

Second, the plaintiffs argued that the protocols implementing the offset program were arbitrary and capricious. This argument also failed. Plaintiffs maintained that the use of performance standards is so fundamentally subjective and uncertain that it would create a high likelihood of producing large numbers of qualified projects for which emissions reductions or removals cannot be considered truly additional.[14] The superior court reasoned that it is not its place to reweigh the evidence before it.[15] The four protocols involve complex statistical analysis and scientific studies, and the court deferred to CARB’s expertise and experience.[16] Judge Goldsmith further concluded that plaintiffs had “failed to demonstrate that the legislature foreclosed the use of standardized additionality mechanisms or demonstrate that [CARB] acted arbitrarily or capriciously in promulgating additionality standards.”[17] Significantly, the court also supported CARB’s rejection of the project-by-project approach.

Why It Matters

2013 marks the first year that covered sources must surrender compliance instruments to CARB.[18] However, during the ramp up to 2013, market participants have been trading offsets for years in voluntary and pre-compliance markets. These participants include project developers, covered sources, other emitters seeking to voluntarily offset their emissions and/or ramp up internal processes, and investors seeking to take advantages of lower pricing in pre-compliance markets. Many contracts are for future delivery of offsets. These represent significant financial investments, the value of which largely depends on the ability of CARB to implement cap-and-trade.

While CARB has been working through implementation of the cap-and-trade regulation, issuance and oversight of offsets has been performed by private parties. These include the Climate Action Reserve (the “Reserve”), which offers protocols similar to those adopted by CARB. Offsets issued by the Reserve are called Climate Reserve Tonnes or CRTs. The Reserve also maintains an offset registry which tracks ownership and retirement of CRTs.[19]

On December 14, 2012, CARB announced that certain CRTs generated under four Reserve protocols which are analogous to the CARB protocols will be convertible to CARB offset credits and accepted as AB 32 compliant offsets, referred to as ARBOCs.[20] This announcement had been widely expected by market participants, who had been investing in CRTs based on their convertibility.

CRTs are typically sold through over-the-counter transactions between buyers and sellers. These transactions are often in the form of short- or long-term forward contracts. The price paid varies depending on the term of the contract, whether all or a portion of the contract price is prepaid and the allocation of various risks between the parties. Industry standards with respect to pricing and allocation of regulatory, project, and counterparty risks are treated as proprietary information which is closely guarded.[21] As a result, parties who intend to participate in offset trading under California’s cap-and-trade need to have a solid understanding of the potential risks which might lower the value of their investment, as well as the likelihood that such risks will transpire.

Challenges to AB 32, and its component cap-and-trade and offset program, create uncertainty in the market. The Citizens Climate Lobby decision falls in line with earlier court decisions affirming AB 32 and cap-and-trade, signaling again the state’s commitment to moving ahead with its ambitious carbon reduction program. However, until remaining challenges are resolved, such as the California Chamber of Commerce litigation, the specter of regulatory uncertainty will continue to impact the pricing signal for carbon, and how these risks are allocated will continue to inject extra complexity into the negotiation of offset sales contracts.

Other Considerations

In addition to the regulatory risks discussed above, market participants continue to grapple with other near- and mid-term uncertainties. As of the date of this writing, CARB has not yet implemented the infrastructure necessary to issue or convert ARBOCs.[22] Project developers and purchasers remain in a no man’s land, generating and trading CRTs and relying on being able to convert them to ARBOCs when CARB systems are complete. This introduces the risk that at least some CRTs may not be convertible, or that the timeframe for conversion may be too long. Buyers and sellers have been structuring contracts to deal with this risk in a variety of ways. These structures range from forward contracts for ARBOCs if and when they are produced, to purchase contracts for CRTs with various conversion options. As would be expected, pricing and payment differ depending on how each deal is structured.

Other risks include the possibility that offsets can be invalidated for up to eight years from the date of issuance.[23] If an offset is invalidated, buyers that had surrendered the offset for compliance must replace the invalidated offset to remain in compliance.[24] This puts buyers in a position where they remain exposed to increases in the price of carbon, which could be substantial, through the entire invalidation period. Buyers are mitigating this risk in a variety of ways. Some project developers offer offsets which have been double-verified, which reduces the time period for invalidation to three years. Purchasers can also look to lower risk projects (such as destruction of Ozone Depleting Substances) as a source for offsets. In all cases, sufficient due diligence should be performed on the offsets prior to acquisition. Finally, buyers may also be successful in negotiating indemnification from the seller if offsets are invalidated, although given the long time periods in question this raises the question of counterparty credit risk.

Conclusion

The purpose of the offset program is to provide a mechanism for encouraging least-cost reductions of carbon, thereby containing costs and increasing the overall efficiency of reducing GHG emissions under AB 32. The court’s decision in Citizens Climate Lobby adds some certainty, but the system continues to face both legal, political and implementation challenges.Pricing and trading conventions will evolve rapidly as momentum continues to grow in this nascent market.

For more information, please contact any member of the firm’s Climate Change practice group.

[1] Assembly Bill 32: Global Warming Solutions Act, California Air Resources Board.

[2] T. O’Conner, AB 32 & Cap and trade: “Nuts and bolts,” Environmental Defense Fund (Sept. 20, 2012)

[3] Regulatory Guidance Document, California Air Resources Board (Dec. 21, 2012).

[4] Id.

[5] See, e.g., R. Frank, Carbon Offsets: A Small Price to Pay for Efficiency, New York Times (May 30, 2009).

[6] See, e.g., J. Carey, Obama’s Cap-and-Trade Plan, Bloomberg Businessweek (Mar. 4, 2009).

[7] Compliance Offset Program, California Air Resources Board (Feb. 1, 2013).

[8] Id.

[9] Compliance Offset Protocol U.S. Forest Projects, California Air Resources Board (Oct. 20, 2011).

[10] See K. Haroff, Public Interest Groups First to Challenge California Cap-and-Trade Rules, Marten Law Environmental News (Apr. 16, 2012).

[11] Id.

[12] Id.

[13] Id.

[14] Id.

[15] Id.

[16] Id.

[17] Id.

[18] Supra note 3.

[19] CRT Marketplace, Climate Action Reserve.

[20] CRT Carbon Credits, Your Vercarbon Guide; Climate Action Reserve Approved to Register Offset Projects for California’s Cap-and-Trade Program, BusinessWire (Dec. 14, 2012).

[21] See Program Manual, Climate Action Reserve (Mar. 16, 2010).

[22] See Air Resources Board sets stage for carbon offset projects (Dec. 14, 2012) (announcing CARB’s formal approval of the Climate Action Reserve, but not identifying any infrastructure to guide issuance or conversion of ARBOCs).

[23] Introduction to the Climate Action Reserve and California Offsets, Climate Action Reserve.

[24] D. Morris & H. Fell, Cap-and-Trade in California: An Introduction to Offset Buyer Liability, Resources for the Future: Commentary Series (July 27, 2012).

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