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Cap-and-trade is strongly advocated as an ultimate solution to reducing U.S. carbon emissions.  California led the country by passing the Global Warming Solution Act (AB32), which creates an instate carbon cap-and-trade program.  AB32 enforcement begins next year by capping Power and Industrial sectors’ carbon emissions.  To sustain operations each facility must reduce carbon emissions or purchase carbon allowances at auction.  The first carbon allowance auction began November 14, 2012.  We all await anxiously to witness the results of this new cap-and-trade program in the near future. 

Brief U.S. and California Carbon Regulation History – The U.S. Senate unanimously rejected the 1997 UN Kyoto Protocol that requires signatory (Annex 1) Developed countries to substantially reduce their future greenhouse gas (GHG) emissions.  In 2005 the Kyoto Protocol entered into force, which generally obligates Annex 1 signatory countries to reduce their carbon emissions below 1990 levels this year.

In 2007 the state of Massachusetts won a Supreme Court case against the EPA for not controlling U.S. carbon emissions under the Clean Air Act (CAA).  This Court decision was made despite carbon dioxide (CO2) not being specifically listed as a CAA pollutant.  The Court required the EPA to make an impact determination of CO2 on the U.S.  In 2009 the EPA determined that CO2 was a harmful pollutant and should be controlled to protect public health and the environment.  The EPA has yet to develop specifics on controlling future U.S. carbon emissions.

The House of Representatives passed the 2009 American Clean Energy and Security Act (H.R. 2454).  H.R. 2454 would have reduced U.S. carbon emissions by 17% in 2020 and 83% in 2050 (2005 basis), and would have also created the first U.S. carbon emission cap and trade program.  For a variety of reasons (pending 2010 election?) the Senate did not address H.R. 2454.

California has a history of leading the U.S. in many environmental areas (Re. State Laws).  In addition to the 2005 AB32, California Global Warming Solution Act, the state has passed numerous GHG related regulations.  These include the 2002 AB1493, Pavley that reduces future new instate vehicle GHG’s, the Renewables Portfolio Standards, a Renewable Electricity Standard, the Low Carbon Fuel Standard, etc.

California Global Warming Solutions Act (AB32) Summary – AB32 requires the State to reduce total GHG or carbon equivalent emissions (CO2-e) to 1990 levels (427 million-metric tons (M-MT)) by 2020.  Covered GHG’s are essentially the same as the Kyoto Protocol.  The AB32 Phase 1 (2012-2015) covered or affected California business sectors are initially the Electric Power and Industrial sectors (Re. List of Covered Entities).  AB32 Phase 2 (2015-2020) covers nearly all business sectors, including Distributors of transportation fuels and natural gas, and most other significant GHG emission sources.  Phase 2 covers about 85% of all significant (>25,000 MT/yr. CO2-e) instate GHG emission sources.

All covered businesses are required to report their total annual carbon (CO2-e) emissions.  Those facilities with carbon emissions >25,000 MT/yr. are subject to AB32 reduction caps.  The California Air Resources Board (CARB) then issues or allocates a limited number of ‘free’ carbon allowances to each covered entity based on prior year emissions and future year emission caps or carbon reduction targets.  Free allowances begin at about 90% of prior year’s actual carbon emissions and are reduced in future years.  Companies are then responsible to either reduce their carbon emissions by modifying their operations or purchasing needed carbon allowances at quarterly auctions in order to meet maximum allowed CO2-e annual emission targets.  Companies that fail to obtain sufficient allowances or offsets equivalent to their actual carbon emissions will be severely penalized. 

The carbon emission or allowance trading program provides for covered companies to purchased needed allowances for next year and future years’ compliance.  The program sets a minimum price of $10/MT and a maximum price of $40/MT initially on auctioned allowances.  Future allowance costs are increased each year by 5% plus inflation.  On November 14, 2012 CARB held their first auction for carbon allowances.  This auction put up 23.1 MMT (2013 vintage) and 5.6 MMT (2015 vintage) allowances for covered entities to bid on.  Average 2013 allowances sold for $13/MT and 2015 allowances sold for $11/MT.  These auction carbon allowance costs are relatively cheap compared to reduction options such as ‘carbon capture and sequestering’, with estimated costs of about $50/MT.

California Cap-and-Trade Program Interim Performance – In theory the carbon (CO2-e) allowances or offsets purchased at quarterly auctions are supposed to be equivalent to reductions in actual carbon emissions elsewhere within the state or other U.S. offsets.  Unfortunately most California auctioned carbon allowances are not based on actual or currently tangible reduction of carbon emissions.  Total annual carbon allowances for a given year are based on prior year actual total covered entity reported emissions minus AB32 annual reduction targets.  The net total balance of carbon allowances is then split between ‘free’ and ‘auctioned’ allowances.  For example, if a manufacturer receives 90% of its required historic carbon allowances for free and must purchase another 10% of allowances at auction (assuming no change of operations or CO2-e emissions), no reduction in total facility CO2-e emissions is actually accomplished.  The covered facility has just basically paid the State a form of a carbon tax in order to continue with current production and associated CO2-e emission operations. 

Despite auctioning carbon allowances that appear to not represent actual reductions in emissions, the State claims that the sale of these allowances is not a tax since the revenues generated at auction will be invested in energy projects that will help reduce total California CO2-e emissions elsewhere within the state.  While this legal argument probably passes the ‘Sinclair Paint Company’ test (Re. Use of Cap-and-Trade Auction Revenues), the probability of the State investing auction revenues and generating actual CO2-e emission reductions equivalent to the absolute number of allowances sold at auction is very questionable. 

Governor Brown has preliminarily budgeted that the State should receive about $1 Billion from the cap-and-trade carbon allowance auction sales.  He tentatively plans to commit about $500 million of the total allowances to pay for the cap-and-trade program administration costs. The net directional reduction in actual state CO2-e emissions for this administrative activity is difficult to rationalize and estimate.  Next, the Governor plans to invest most the balance of allowance auction revenues into different existing GHG reduction and clean energy programs.  Once again, determining the actual carbon emission reductions of just replacing existing general state funds with auction revenues (deficit reduction) in supporting existing programs is debatable and uncertain.

California Cap-and-Trade Program Overall Performance – At the end of each year the estimated carbon reductions that can be reasonably credited to the AB32 cap-and-trade program will depend on the data used.  Based on the uncertainty of allocated and auctioned carbon allowances vs. actual CO2-e reductions, overall program performance should not be determined from California carbon allowance data.  Actual CO2-e reductions should be based primarily on ‘mandatory greenhouse gas reporting’ data.  Based on the latest data reported by CARB, total gross GHG emissions have declined from 479 MMT in 2005 to 453 MMT in 2009.  These data show that California has already reduced its total gross CO2-e emissions to within 26 MMT of the AB32 1990 target.  Since the AB32 cap-and-trade program was originally designed to reduce CO2-e emissions by 80 MMT 2012-2020, achieving the 427 MMT target should be much less challenging. 

Achieving the AB32 1990 carbon emission basis target should not be over sold as a landmark accomplishment or major success since achieving a 26 MMT reduction in carbon emissions only represents less than 0.5% of total U.S. carbon emissions.  The majority of California 2012-2020 carbon emission reductions appear to be due to the economic decline in California following the U.S. 2007-09 economic recession and not the AB32 cap-and-trade program.

Is California’s Cap-and-Trade Program the Solution to Reducing U.S. Carbon Emissions? – The answer depends on how much the redirecting of allowance auction revenues to non-CO2-e reduction activities depreciates the value of issued or auctioned carbon allowances.  The current cap-and-trade program appears to be largely a carbon tax that generates significant revenues for activities other than directly reducing carbon emissions.  Besides diverting $500+ million of allowance auction revenues to cover cap-and-trade administrative costs and existing GHG reduction programs, Governor Brown has plans to divert additional allowance revenues to other non-GHG reduction programs.  The Governor recently signed a new bill that directs 25% of all auctioned allowances be diverted towards ‘economically disadvantaged communities’ for improvements other than carbon emission related.  After diverting over half of the total cap-and-trade allowance revenues to administrative costs, existing GHG related programs and disadvantaged communities, means that the California auctioned allowances will likely be worth less than half of their face value (i.e. actual carbon MT reductions vs. number of allowances sold).  Future auctioned allowance CO2-e reduction values will depend on how much of the revenues are diverted to non-GHG reduction programs and the effectiveness (actual CO2-e emission reductions) of the GHG reduction programs that receive the auction revenues.

Due to the performance of the current California cap-and-trade program and the questionable carbon reduction value of the allowances issued by the State, the California CO2-e emission allowances are not likely to qualify for other carbon credit international markets.  This of course could change if California were to change the allocation of allowance revenues to only effective GHG reduction programs and offset projects; the original intent of the AB32 approved by Governor Schwarzenegger in 2005.  With Governor Brown’s apparent priority of seeking additional revenues for general state deficit reduction, correcting the current deficiencies with the AB32 cap-and-trade program does not appear promising.  More broadly expanding California’s carbon cap-and-trade nationwide will likely be much less effective than most advocates generally believe.

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