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Refining California’s Cap and Trade Program: Plan Accordingly

By Jerry Bloom (left) and Andrew Mayer (right), Winston & Strawn LLP

On July 25, 2017, California Governor Jerry Brown signed Assembly Bill (AB) 398 into law, extending the state’s signature climate change program – the Cap and Trade Program (the program) – through 2030. AB 398 represents a key milestone for the program and will have several important effects on entities regulated under the program.

Perhaps most importantly, AB 398 resolves significant uncertainty about the future of the Cap and Trade Program. Prior legislation only provided explicit authorization for the program through 2020, and it was unclear whether the California Air Resources Board (CARB) had authority to continue regulating greenhouse gas (GHG) emissions beyond that date. Further, the fact that AB 398 was passed by a supermajority vote in the state legislature put to rest legal questions about whether the program’s auctions of GHG allowances constitute an unlawful “tax.” By providing clarity on the program’s legitimacy and continuance, AB 398 will allow covered entities to develop long-term compliance plans, and may bolster the market for compliance instruments.

AB 398 also requires CARB to make some important changes to the structure of the Cap and Trade Program. The new law requires CARB to modify its regulations by January 1, 2021, to set a price ceiling on auctioned allowances. Specifically, CARB is instructed to (1) utilize any allowances remaining in CARB’s Allowance Price Containment Reserve (APCR) as of December 31, 2020, exclusively for sale at the price ceiling; and (2) issue new allowances at the price ceiling if APCR allowances are exhausted. This new feature of the program effectively sets a firm cap on the price for compliance instruments. CARB has discretion to set the level of the price ceiling, though in doing so it must take into consideration several factors, including “the need to avoid adverse impacts on resident households, businesses, and the state’s economy.” Once set, the price ceiling will provide regulated entities in California some certainty as to the maximum cost of program compliance.  

Another important feature of AB 398 is that it requires CARB to continue to allocate free allowances at the same levels applicable to the 2015-2017 compliance period, through the compliance period commencing in 2021. This means that regulated entities that are currently receiving free allowances under the existing Program regulation can plan on receiving the same allocation through the next two compliance periods. However, we note that the duration of the compliance period commencing in 2021 is unknown, and it is likely that CARB will begin to ratchet down the allocation of free allowances in order to meet the state’s aggressive GHG reduction targets. Businesses will need to plan accordingly.

In an effort to obtain votes of state legislators aligned with environmental justice advocates who have historically opposed the use of GHG offsets, AB 398 also reduces the amount of offsets that may be used for program compliance after 2020. This is significant because offsets, which are developed and marketed by private offset project developers, tend to be less expensive than the GHG allowances sold by CARB. Currently, the program allows covered entities to use offsets to cover up to 8% of their compliance obligations. AB 398 reduces that percentage to only 4% from 2021 through 2025, and 6% from 2026 through 2030.  

Additionally, beginning in 2021, AB 398 requires that half of the offsets used by covered entities must be generated by projects that provide “direct environmental benefits” to the state – a rule that could significantly constrain the supply of offsets. That said, CARB has the discretion to construe this language broadly. For example, CARB could determine that offset projects have a “direct environmental benefit” to California if they improve the health of watersheds that provide water used by Californians, including the Colorado River watershed. Such an expansive regulatory interpretation could increase the scope of offset projects that would be eligible for program compliance, potentially increasing the supply of offsets in the 2021-2030 period.

AB 398 also seeks to address concerns over the potential for windfalls accruing to market participants through gaming of the program by instructing CARB to “[e]stablish allowance banking rules that discourage speculation, avoid financial windfalls, and consider the impact on complying entities and volatility in the market.” While it is unclear at this time what these new allowance banking rules will ultimately look like, covered entities can expect CARB to propose regulatory changes that will further limit the trading and banking of compliance instruments, and could restrict the range of available compliance strategies.  

Generally, while AB 398 makes several important changes to the program, it leaves CARB with broad discretion to implement these changes through regulation. The precise regulatory effect of AB 398 will therefore ultimately be determined by CARB through the rulemaking process. Stakeholders can and should engage with CARB to help determine the end result of AB 398, both through informal engagement with CARB, and through the formal rulemaking process.  

AB 398 has lifted clouds of uncertainty that were casting a shadow on the future of California’s Cap and Trade Program. Through changes and the extension of the Program through 2030, the legislature has ensured that California will continue its leadership position in addressing climate change. Nationally, implementation of cap and trade programs continues to gain momentum and, as has occurred to date, other states can be expected to follow suit with California and leverage off the lessons and program refinements.

Jerry Bloom is Senior Counsel in the Los Angeles office of Winston & Strawn LLP. He can be reached at jbloom@winston.com.

Andrew Mayer is an associate in Winston & Strawn’s San Francisco office. He can be reached at amayer@winston.com.

 

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