California Cap-and-Trade Program Overcomes Ballot Measure Challenge; Proposed Rules Released

November 5, 2010

This week’s sweeping victory by the Republican Party to regain control of the U.S. House of Representative has wide ranging impacts on the future direction and timing of climate change policy in the United States. Most prominently, a comprehensive, market-based legislative approach to greenhouse gas (GHG) emission reductions is off the table indefinitely at the federal level.

At the state level, however, Tuesday’s election had at least one different result. California decided to move forward with its market-based program first established by its Global Warming Solutions Act (AB 32) in 2006. California voters defeated Proposition 23, a ballot measure that would have suspended implementation of AB 32 until California’s unemployment rate dropped to 5.5% or less for 4 consecutive quarters (currently unemployment in the state is approximately 12%).[1]

The defeat of Proposition 23 comes on the heels of the much-anticipated release by the California Air Resources Board (CARB) of its proposed GHG cap-and-trade program (“Proposed Rules”). The proposal, released October 28, builds upon the basic conceptual framework released by CARB a year before. The Proposed Rules are open for public comment for a 45-day period closing December 15, 2010. More information can be found on CARB’s website.

I. California Cap-and-Trade Program Overview

The Proposed Rules would set a cap on GHG emissions that will act as the total program budget. Freely tradable emission allowances will be issued to all major covered (i.e. regulated) entities[2] in amounts equal to their portion of the overall cap, which will be calculated based on GHG reporting amounts. The cap will steadily decline over time to reach 1990 emission levels by 2020. The cap will be enforced by requiring covered entities to turn in one allowance or equivalent offset credit for every metric ton of carbon dioxide equivalent (MTCO2e) it emits during each 3-year compliance period. The price of the allowances will be determined by the market.[3]

Beginning in 2012, the Proposed Rules would cover electric generation, including out-of-state imports, and large industrial sources/processes with annual emissions above 25,000 MTCO2e, equaling a cap of 165.8 million MTCO2e. In 2015, the program would automatically expand to include fuel distributors (e.g. transportation fuels, natural gas and propane combustion). The expanded cap is proposed to be 394.5 MTCO2e.

CARB will issue a total of approximately 2.7 billion allowances through 2020. Covered entities will not be the only entities able to buy, sell and hold allowances. Entities under the 25,000 MTCO2e threshold can “opt-in” to the program (called “Opt-In Covered Entities”), and any interested non-covered entities can participate as well (called “Voluntarily Associated Entities”).

The Proposed Rules include a number of cost containment mechanisms, including the aforementioned 3-year compliance period, unlimited allowance and offset banking, the offset regime itself, an Allowance Price Containment Reserve (i.e. soft cap price ceiling), and finally potential linkage with other trading systems (most notably the Western Climate Initiative).

a. Covered Entities Explained

CARB is proposing to implement a “first deliverer” approach for the electric sector to account for emission associated with both power generated in-state (called specified power) and power imported from out-of-state (called unspecified power).[4] For imports, the covered entity will be the first entity to place power onto the California bulk transmission grid. Electric deliverers include distribution utilities selling at retail and energy marketers brokering at wholesale. For the industrial sector, the covered entity will be the facility operator. The covered entity for industrial gas users would be the supplier. For the transportation fuels, the covered entity would be the fuel suppliers, and would be regulated based on the quantities of fuel consumed by their customers. For natural gas, CARB will regulate the owner of the fuel when it is distributed. Here is a breakdown of the regulated sectors:[5]

Sources of
Points of Regulation Year Entering the
In-State Electricity
Those who generate electricity in-state and deliver it to the California electricity grid 2012
Imported Electricity First deliverers of electricity to the California electricity grid 2012
Industrial –
Combustion and
Process Emissions
The Source for large stationary combustion and process emission sources 2012
Carbon Dioxide
Those who supply carbon dioxide 2012
Industrial Combustion
Where fuel is distributed, including natural gas local distribution companies (LDCs) and natural gas transmission pipelines 2015
Liquefied Petroleum
Gas Combustion
Those who import or produce liquefied petroleum gas, including fractioners or refiners 2015
Transportation Fuel Combustion Enterers and position holders of transportation fuels, and producers of biomass-derived fuels 2015

b. Annual Compliance Obligation

During the first two years (2012, 2013), a regulated entity will have to surrender allowances of qualifying offsets equal to 30% if its verified emissions for that year. After that, the 3-year compliance periods commence. Regulated entities will have to surrender its total verified emissions. CARB intends the ramp-up two years to allow them time to resolve all emission reporting and verification issues with entities.

c. Allocation

The overall allocation scheme proposed will be (1) creation of the Allowance Price Containment Reserve,[6] (2) free allocation of allowances to the industrial sector for “transition” assistance[7] and leakage prevention, (3) free allocation to electric distribution utilities for the benefit of ratepayers,[8] and (4) phased-in auctioning of the remaining allowances.[9]

d. Market Oversight

California allowances will not expire, thereby allowing covered entities the ability to bank the assets indefinitely for later use. Borrowing future year allowances, however, will not be permitted. CARB proposed rules to require trading activity disclosure, prevent market manipulation (e.g. establishing a holding limit), and prohibit fraud.

e. Linkage with Other Carbon Programs

CARB’s Proposed Rules leave open the possibility of linking the California program with a future WCI regime or other WCI partner entities. If officially linked through CARB Board approval, CARB would accept and recognize allowances and offsets issued by other approved programs to meet California compliance requirements. Covered entities would be able to use allowances and offsets from a linked program if they were less expensive than making reductions or buying California carbon assets.

f. Offsets Regime

CARB is initially being conservative as to what offset types qualify and how many offsets a covered entity can use toward compliance. CARB proposes a maximum 232 million offset credits may be used over the life of the program, which roughly equates to an 8% limit for individual entity’s compliance obligation.

Offsets issued by CARB must be quantified and approved according to Board-approved methodologies and protocols. While additional protocols may be developed, the Proposed Rules include four initial offset protocols from the Climate Action Reserve, including:

  • U.S. Forest Projects;[10]
  • Livestock Manure (Digester) Projects;
  • Urban Forest Projects; and
  • U.S. Ozone-Depleting Substances Projects.

To receive and be issued offset credits, CARB will require that projects meet standards established under the protocols as well as additionality and verifiability, be located in North America, and comply with all applicable laws and regulations at the state and federal levels.

In addition to the initial offset project types, the Proposed Rules also leaves open the future potential to allow sector-based offsets to be eligible for use and certification. Each sector-based crediting mechanism would need to be approved by CARB. The Proposed Rules state that the likely first type of sector-based program will be Reducing Emissions from Deforestation and Forest Degradation (REDD). CARB states that any REDD program will need to meet certain minimum criteria.

For further information on the CARB’s Proposed Rules please contact the authors.


1. Another California ballot initiative that may have collateral impact on AB 32, Proposition 26, passed. The measure will change how California defines taxes and regulatory fees by requiring legislative approval of any taxes and fees going-forward post-2010 by a two-thirds majority. There are arguments that this change could inhibit the state’s ability to regulate carbon emissions by restricting the ability to assess fees on covered entities. The chairwoman of the California Air Resources Board (ARB), however, has stated that Proposition 26 will not affect AB 32 implementation because it was passed in 2006. Litigation over the applicability of these new rules to AB 32 is likely.

2. Covered sources include refineries, power plants, industrial facilities and transportation fuels.

3. There will be a reserve price of $10/ton in 2012 for any auctioned allowances, however. Allowances will be sold in 1,000 unit bundles.

4. Electric sector compliance obligations are based on emissions from plants exceeding the 25,000 ton threshold and that generate electricity if the source is “known”. If the source is unknown, compliance is based on megawatt-hours and a default emission factor based on the reported mix of imported electricity within the Western Electricity Coordinating Council (WECC) region.

5. CARB clarified the following for other sectors of emissions. Combined heat and power facilities will be regulated if they exceed the 25,000 ton threshold. Combustion emissions from specified (i.e. known) biomass-derived fuels are not regulated, unless supplemental fuel exceeds the threshold. Landfills and wastewater treatment facilities are excluded unless it combusts fuels or uncertified biomass-derived fuels above the threshold will have a compliance obligation. Waste-to-energy facilities would have an obligation for any biomass fuel is not verified through the State reporting system requirements.

6. The Proposed Rule includes a reserve pool of allowances to manage price volatility. Covered entities (but not voluntary participants) will have the option to buy from the reserve pool at fixed prices. Sales from the auction would take place a few weeks after each quarterly auction. The proposed fixed prices that would increase over time are $40/ton, $45/ton and $50/ton.

7. Transition assistance includes calculation of energy-intensive trade-exposed (EITE) entity’s emission intensity per unit of output.

8. Allowances allocation methodologies for electric and natural gas distribution utilities are still under CARB consideration. Allowances freely allocated to IOUs would be placed in the IOU’s Limited Use Holding Account and required to be put up for quarterly auction. CARB argues that by requiring the IOUs to auction their allowances maintains the “competitiveness of the deregulated California electricity market”. An additional placeholder is established for voluntary renewable energy allowance set-asides. CARB intends to develop and review accounting rules and process for retiring allowances from the set-aside.

9. The auction revenues could be used for a per capita consumer rebate program, a community benefit fund, and a low carbon investment fund.

10. For this protocol, CARB proposed to establish a Forest Buffer Account to account for permanence issues attendant to forestry projects.