California’s cap-and-trade program took effect in 2012. The rules, set by the California Air Resources Board (ARB), apply to electric power plants, industrial plants and fuel distributors that emit 25,000 tons of “carbon dioxide equivalent” per year. Once the total cap on emissions is determined, it is split into allowances, which determine an entity’s compliance obligations. A compliance obligation is equivalent to the quantity of allowances or offset credits a facility is required to surrender to the ARB by a specified deadline. Between 2015 and 2020, the cap declines 3% annually. The cap is set to decline at a faster rate between 2021 and 2030, incentivizing entities to become more efficient. Beginning in 2018 the California, Quebec and Ontario cap-and-trade programs linked together, creating a single marketplace for auctioning and trading emission allowances and offsets.

Emission allowances are distributed through free allocations or quarterly, sealed bid auctions. Electric utilities, industrial facilities and natural gas facilities were initially given free allocation of allowances but those free allocations decline over time. ARB also allocates free allowances to certain energy-intensive trade-exposed industries based on how much of their product (not GHG emissions) they produce in California. Investor-owned utilities must sell free allowances and redistribute funds to its rate-paying customers. In 2012, the price minimum was set at $10 per allowance and the price maximum at $40, each increasing 5% annually over inflation in each ensuing compliance period. In 2021, a hard price ceiling will be determined and an unlimited supply of allowances will be available at that price.

At auction, bidders must place orders for the number of emissions allowances they seek to purchase in terms of “lots.” Lots represent 1,000 allowances. Bidders must also submit the “vintage” year they are bidding for, which corresponds to the compliance phase for which the allowances will be used. Auctions are conducted by filling bids from highest to lowest until either all allowances are sold or the reserve price is reached. This price becomes the auction settlement price paid by all successful bidders. The settlement price is defined as the higher of the next highest bid above the floor price or the last highest bid that clears.

When receiving allowances, an entity may bank or hold onto those allowances for future use with no expiration date. However, the program creates holding limits based on an entity’s annual allowance budget. Holding limits restrict the maximum number of allowances banked at a given time.

Offset credit program

California also offers an offset credit program, which can be used in conjunction with the cap-and-trade program. Offset credits are tradable compliance instruments, representing verified greenhouse gas (GHG) emission reductions or removal enhancements. They are issued to offset projects made in sectors and through sources not covered by the cap-and-trade program. Offsets are sold through these private, non-regulated entities through bilateral purchase agreements to regulated entities through the ARB rules and offset protocols.

The ARB has adopted six Compliance Offset Protocols (“protocols”) to date: U.S. Forest Projects, Urban Forest Projects, Ozone Depleting Substances Projects, Livestock Projects, Mine Methane Capture Projects and Rice Cultivation Projects. The holding limit that applies to the number of allowances a regulated entity may bank for future use does not apply to offset credits, but those entities regulated under the cap-and-trade program may only use offset credits to fulfill up to 8% of their GHG emissions compliance obligation for a respective compliance period. This 8% cap applies through 2020. Between 2021 and 2025, regulated entities are only allowed to meet 4% of their emissions compliance obligation with offset credits. Beginning in 2021, at least half the offsets used for compliance must come from projects that directly benefit California. Between 2026 and 2030, the cap increases to 6% of total compliance obligation.

Once regulatory requirements are satisfied and the project successfully completes verification, registry offset credits may be issued to the offset project by an Offset Project Registry. A registry offset credit is a credit issued by an Offset Project Registry for a GHG reduction or removal enhancement. These credits signal where a project exists in the compliance process and are not compliance instruments under the cap-and-trade program. Once the offset project has been issued registry offset credits, the Offset Project Operator may request the issuance of ARB offset credits. These credits act as the tradeable compliance instruments that can be used in the wider cap-and-trade program. Upon successful review, issued registry offset credits can be cancelled on the Offset Project Registry and re-issued as ARB offset credits, useable under the cap-and-trade program.