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At least 1 flower blooms: CARB releases cap-and-trade draft regulation

Last Friday, the California Air Resources Board (CARB) released its draft cap-and-trade regulation for public review and comment. I haven’t had a chance to go through the entire proposal in detail yet but a few issues are immediately striking about CARBs draft rule. The rule represents a significant concession to business interests in the state that are very concerned about the costs of an emissions trading program. Is that a bad thing? Probably not in this case, largely because the toughness of the Preliminary Draft Regulation (PDR), released earlier this year, left plenty of space for CARB to make concessions to industry. The draft rule appears in its major structural components, to be one of the most thoughtfully designed cap-and-trade programs proposed to date. Mary Nichols and her staff at CARB deserve to be congratulated both for their political and their policy acumen.

Here are some of the key features of the draft rule and the differences, if any, from the earlier PDR:

(1) The cap: The final objective of the program, to return California statewide emissions of 6 greenhouse gases to 1990 levels in 2020 remains unchanged. However, the CARB wisely adjusted the schedule of interim caps that will begin in 2020 to reflect the fall in statewide emissions due to the recession. This should prevent the early carbon market from being over allocated (net long supply of allowances relative to BAU emissions) in the early years of the program. Over allocation was the cause of a notorious market crash in Phase I of the EU ETS and has caused the RGGI market to fall below RGGI Inc.’s auction reserve price.

(2) Allowance allocation: The biggest concession to industry in the draft rule has to do with the way that permits to emit GHGs will be distributed to polluters. The PDR proposed widespread auction of the vast majority of allowances with quite limited free allocation. The draft rule takes an about face on this issue and proposes free allocation for almost all major emitters. This will make the program far less costly for emitters and may even create net profits for some facilities (if compliance costs are less than the value of allowance grants). In addition, the CARB plans to use its free allocation scheme to create incentives within industries to reduce emissions. It will accomplish this by calculating a firms allowance grant based on the average carbon intensity of an industry – if a firm is below this level it will get fewer allowances than it needs, if above, it will get more than it needs. This will create some incentive to reduce emissions intensity. It’s important to emphasize that, as Rob Stavins of Harvard’s Belfer Center has pointed out, how allowances are distributed (auction or free allocation) doesn’t impact the overall environmental outcome of the program, which is set by the cap. So there is no environmental harm in free-allocation. This argument is to some extent called into question if the money raised by allowances auctions would have been used to fund additional emissions reducing activities. Given California’s budget woes, this “double dividend” was unlikely to be collected and this no doubt entered into CARB’s calculations.

(3) Offsets: The draft rule allows up to 8% of Climate Action Reserve issued offsets (known as CERTs) to be used in lieu of allowances. This is nearly twice the number in the PDR and a major concession to industry concerns regarding program costs. It makes it very important that the CAR offsets be of extremely high quality. At the same time, this quantitative limit has to be put in perspective – it’s the same number as used currently in the EU ETS and far far less than would have been the case during the early years of a federal program had Waxman-Markey been enacted into law.

(4) Strategic Reserve: New in the draft rule is the “Allowance Price Containment Reserve” (ACPR), analogous to the Strategic Reserve concept first championed by Brian Mignone of Brookings and others and eventually incorporated into the Waxman-Markey legislation. The ACPR works by withdrawing a percentage of the allowances in each year from the market. If at the time of any allowance auction, the market price for allowances exceeds $40 (increasing by 5% + CPI after 2012), then the reserve can be accessed, with more allowances being sold out of the reserve as prices go even higher. The basic idea is to provide a means to contain unexpected price volatility should it occur. The allowances deposited into the reserve are to be precisely equal to the number of extra offsets allowed – about 4% of the cap. In effect, this provides an insurance program for the offsets system. In the event that up to half of the offsets allowed into the system turn out to be problematic, and so long as prices remain at the low levels predicted by most economists who have studied the CARB proposals, then CARB will have allowances in reserve to cover the bad offsets. This proposal is really clever in that it gives industry all of the assurances that it has been clamoring for while still providing NGOs with assurances about environmental credibility. This has to be the smartest and most innovative part of the draft rule. Kudos to CARB for dreaming this deal up.

(5) Banking/Borrowing: The draft rule allows unlimited banking of allowances from earlier 3-year compliance periods into later compliance periods. No borrowing from future periods is permitted. This is unchanged from the PDR.

(6) Compliance Periods: The draft rule continues to envision a 3-year compliance period during which firms could bank and borrow freely. This will help firms to smooth compliance costs over a multi-year time frame. I and others (notably Severin Bornstein of Cal) objected strongly to this for two reasons. First, because we believe that firms should treat allowances just like any other input in the compliance process and should account for them accordingly (ideally at least on a quarterly basis). Second, because of the fear that firms would go bankrupt during the 3-year period and then default on their obligations. Long standing precedent holds that environmental liabilities are given low priority relative to other claims in a bankruptcy proceeding. The CARB struck a balance between the original proposal and responding to these concerns. They require firms to surrender 30% of their allowances each calendar year with the balance due at the end of the 3-year compliance period.

All in all, a program design that compares VERY WELL to the federal proposals after the sausage got made and even to the

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