A cap-and-trade system for controlling greenhouse gases that the California Air Resources Board adopted on December 16 is expected to affect all GHG-emitting power plants in the state as well as companies that import power from other states for sale in California.

As this article went to press, the board—called “CARB”—had not yet published the final adopted resolution. Also, CARB staff will be developing important details of the cap-and-trade program over the next several months. Nevertheless, the broad outlines of the program are already clear enough to be able to comment on the effect on electricity generators.

The cap-and-trade system is one of the key tools CARB will use to meet strict greenhouse gas emission reduction targets that California set for itself in Assembly Bill 32. Under AB 32, California must reduce its GHG emissions to 1990 levels by 2020 and begin work toward a longer-term goal of reducing GHG emissions by 80% by 2050.

CARB expects more than 25% of the 2020 emissions reductions to come from the cap-and-trade system.

CARB expects additional emissions reductions (16% of expected 2020 emissions reductions) from a recently-adopted “renewable electricity standard” that requires both investor-owned and municipal utilities to supply 33% of their loads from renewable resources by 2020.

CARB will also rely on a massive expansion of end-use energy efficiency, GHG emissions standards for light-duty vehicles, a low-carbon standard for transportation fuels and a number of other programs to reduce GHG emissions to the levels required by AB 32.

Program Overview and Scope

The cap-and-trade program creates “allowances” for emitting greenhouse gas emissions, with the overall number of allowances being reduced each year. Each allowance represents the equivalent of a metric ton of CO2 emissions.

“Covered entities” that are subject to the program must have allowances equal to the difference between their GHG emissions and any allowed offsets.

As the cap on the overall supply of allowances declines, the cost of allowances should increase, making emitting greenhouse gases more expensive. This, in theory, will provide covered entities with an economic incentive to improve operating efficiency or otherwise reduce emissions.

As presently structured, starting in 2012 so-called “first deliverers” of electricity (such as generators located in California or entities that sell imported electricity in-state) and certain large industrial facilities will be covered entities unless they receive exemptions from the cap-and-trade program. In 2015, the cap-and-trade system will expand to cover distributors of transportation fuels, natural gas, and other fuels. When the new covered entities join the program in 2015, the overall cap on GHG emissions will increase to accommodate the expanded program scope.

Entities that emit less than the equivalent of 25,000 metric tons of CO2 per year are exempted from the cap-and-trade program. Exempted entities, such as low GHG-emitting renewable generators, may participate on a voluntary basis.

Mechanics

CARB will distribute allowances for free to certain covered entities.

Covered entities that do not receive from CARB enough free allowances to cover their emissions must purchase allowances from other entities. CARB will hold annual auctions at which covered entities can purchase allowances.

To reduce the cost of purchasing allowances, covered entities may use offsets to reduce the quantity of allowances needed for compliance by up to 8%. CARB defines offsets as the reduction or removal of GHG emissions not covered in the cap-and-trade program. CARB will closely scrutinize any offsets used by covered entities to ensure that the offsets are legitimate.

The cap-and-trade program is not expected currently to provide any free allowances to electric generators. However, CARB has instructed its staff to continue to consider whether it should provide free allowances to certain generators that are unable to pass the cost of allowances to their offtakers. CARB expects that these details will be worked out by July 2011.

It is expected that electricity costs will increase as generators pass along their allowance costs to their offtakers or as the utilities purchase greater levels of renewable resources under the renewable energy standard.

The cap-and-trade program will provide no-cost allowances to the state’s investor-owned and municipal utilities. The investor-owned utilities must sell their free allowances in the annual CARB auctions and use the proceeds from these sales for specific actions to help mitigate costs of the GHG program to their customers. If the investor-owned utilities’ own power plants need allowances to comply with the requirements of the cap-and-trade program, the utilities must purchase these allowances in the CARB auction; they cannot use their free allowances for program compliance. Municipal utilities have the option either to sell their allowances in the CARB auction or to use them to cover the allowance requirements for their own power plants.

Costs and Cost Control

It is hard to predict how much allowances will cost. The California Public Utilities Commission has proposed using three different allowance price forecasts in its current long-term procurement proceeding, with allowance prices in 2020 ranging from $32.44 to $54.06 per ton (see Table 1).

Table 1: GHG Allowance Prices Assumed by the CPUC (in nominal dollars per metric ton)

Year

Low Carbon
Price Estimate

Base Carbon Price
Estimate

High Carbon
Price Estimate

2011

0

0

0

2012

10.00

10.44

13.05

2013

13.37

17.83

22.29

2014

15.81

21.08

26.35

2015

18.26

24.35

30.44

2016

20.93

27.91

34.89

2017

23.62

31.49

39.36

2018

26.53

35.37

44.21

2019

29.47

39.29

49.11

2020

32.44

43.52

54.06

While CARB cannot directly control allowance prices in its auctions, it does have ways to try to influence the price, if needed.

To ensure that allowance costs are not so low that they provide little incentive for covered entities to reduce their GHG emissions, the cap-and-trade program has a floor price for allowances sold at auction. This floor price starts at $10 per metric ton of CO2 and increases each year at inflation, as measured by the Consumer Price Index, plus five percentage points.

To prevent costs from rising too high, CARB will hold a certain number of allowances in reserve (123.5 million allowances out of 2.7 billion allowances issued through 2020). CARB will use these allowances to increase market supply if allowance prices spike at auction. Some stakeholders are worried that the proposed reserve will not provide adequate protection against high prices.

CARB also established other rules to give covered entities an opportunity to control the cost of compliance. Covered entities can buy their allowances up to three years at a time rather than annually, and they may bank allowances in excess of their compliance obligation in the event that lower-cost allowances become available. They may also use offsets in place of allowances to meet up to 8% of their compliance obligations. Since offsets are expected to cost less than allowances, this could reduce overall compliance costs for some entities.

Interaction with Regional Program

The CARB cap-and-trade program is the first mandatory cap-and-trade program in the western United States, but it has not been developed in a vacuum.

California has been an active participant in the Western Climate Initiative or “WCI,” a cooperative effort to reduce GHG emissions on a regional basis. California’s rule development schedule is being coordinated with the WCI timeline for development of a regional cap-and-trade program.

In order to enable trading across jurisdictions, WCI has proposed a number of program elements that CARB has included in its cap-and-trade program, such as allowance banking, limited offsets, three-year compliance periods and auction floor prices. These linkages will allow California entities to trade allowances freely with entities covered by cap-and-trade programs in other WCI partner jurisdictions. It is currently expected that California entities will have trading partners in four WCI partner jurisdictions in 2012: New Mexico, British Columbia, Ontario and Quebec. CARB is working with five other states and one other Canadian province that are planning cap-and-trade programs that will not be operational until after 2012.