California Offset Market Slow to Ramp Up

26 February 2015 | There is some truth to the insider joke that the cap-and-trade aspect of California’s climate policy gets 90% of the attention but provides 20% of the benefit.

Aside from setting up cap and trade, California’s Global Warming Solutions Act (AB 32) also required a third of California’s energy come from renewable sources by 2020 and mandates steep increases in vehicle efficiency. However, the market-based aspect of the program seems to dominate headlines, though speakers at a side event at this week’s Climate Leadership Conference in Washington, D.C. believe the attention may be warranted.

“Command-and-control programs will contribute about 80% and cap and trade will play the backstop and make up an estimated 20% [of emissions reductions], said Brad Neff, a senior energy policy manager at PG&E, the utility that provides most Californians with their electricity.

“But of course, if the economy grows faster than expected or if these programs don’t perform as expected, the cap-and-trade market, that price on carbon, will have to absorb more of those reductions.

As of 2015, California’s climate cap more than doubled in size as distributors of transportation fuels and natural gas were folded under compliance, joining the power and industrial sectors.

Economic Growth and Emissions Growth Divorce

Launching a state-wide climate change policy on the tail of a staggering economic recession was perhaps a risky move or, as a recent assessment of California’s carbon market puts it, a “grand experiment. But two years into the implementation of carbon pricing in the state, the numbers show that the “decoupling of economic and emissions growth has been tentatively successful. While Gross Domestic Product in California grew 2% and the state added almost half a million jobs in 2013, the emissions of capped sectors dropped 3.8%.

The sale of allowances the transferrable permits to pollute that constitute the “tradingaspect of cap and trade has also raised significant funds for the state, with $902 million budgeted for re-investment through mid-2015, according to the Environmental Defense Fund’s (EDF) benchmarking report. The money will be spent on carbon-lowering investments such as high-speed rail, weatherization, solar installation, wetland restorations, and urban forests.

California law requires that 25% of the money going into the state’s Greenhouse Gas Reduction Fund be spent on reducing pollution in disadvantaged communities that are disproportionately affected by bad air quality.

“Pollution is problem number one, two, and three in Californian communities, said Tim O’Connor, Director of the California Climate Initiative at EDF.“We lead the nation with the top five most polluted cities, mostly in the Central Valley and Los Angeles.

Offsetting’s Full Potential?

In addition to creating a pool of money for re-investment, cap and trade also serves as a cost-containment mechanism for compliance entities and one they have taken full advantage of so far. Allowances have sold out at every quarterly auction to date, staying on average 15 cents above the floor price, which in 2014 was $11.34 per tonne.

The results from this month’s auction the second joint auction for California with its trading partner Quebec show that all 73.6 million allowances available sold at $12.2 per allowance, above the $12.1 reserve price. The vast majority of allowances 93.5% were purchased by compliance entities. Additionally, all 10.4 million 2018 vintage allowances available sold at the $12.1 reserve price.

However, another aspect of the cap-and-trade program carbon offsets have so far been underutilized. Under AB 32, compliance entities may purchase offsets to meet up to 8% of their emissions reduction requirement.

With about 145 million tonnes falling under the cap in the first compliance period (2013-2014), companies could have theoretically purchased 11.6 million tonnes of offsets to comply with regulation.But only 1.7 million offsets were turned in last November, when companies had to “true-up” their emissions for 2013, Neff said.

California’s Air Resources Board (ARB) has issued 17.9 million compliance-grade offsets to date, with the first forestry issuances occurring in the second half of 2013. The state has adopted five offset protocols that focus on sectors not capped by regulation forestry, urban forestry, livestock methane, destruction of ozone depleting substances and mine methane that otherwise leak into the atmosphere.

“[Offsets] also allow you to reduce more emissions more quickly,” said Gary Gero, President of the Climate Action Reserve, which establishes standards for and issues carbon offsets. “They specifically and importantly allow you to get emissions reductions outside of the regulated sectors.”

Though there were not enough compliance offsets available to allow companies to utilize the 8% maximum in the first compliance period, demand not supply was the limiting factor.

The Limiting Factors

Since compliance entities won’t have to balance their 2014 emissions books until November of this year, it’s possible that additional offsets will be surrendered then, Gero said.

“But there are a couple of other things at play here,” he said. “One is that California cap and trade is probably like most cap-and-trade systems anywhere, which is it’s probably over-allocated in the early years, quite honestly. And when you’re over-allocated there just isn’t that demand pressure for offsets. I think that will grow over time as the cap tightens.”

Offsetting may also be limited by compliance entities, learning curves, with most companies focusing on getting a handle on the allowance auctions before delving into offsetting, O’Connor added.

“On the offset side, there is still a little bit of mystery about it,” he said.“It’s only really the very well-trained, well-versed, and probably well-consulted companies that have the capacity to really go out there and procure offsets.”

Investor-owned utilities such as PG&E also face additional rules around their offset purchases, requiring that the seller take on the risk of offset invalidation. The California ARB may invalidate an offset up to eight years after it is issued if they uncover problems such as double counting or environmental non-compliance. They exercised that authority last November when they invalidated 88,955 offsets produced by an Arkansas facility destroying ozone-depleting substances. The offsets themselves were soundly verified, but the facility was out of compliance with its operating permit at the time.

Though the invalidation represented less than 1% of the total offsets on the market, market activity decreased substantially during ARB’s five-month investigation of the Arkansas facility, according to the EDF report.

Despite the challenges, many emitters do see offsetting as a less expensive way to meet compliance obligations, so “there’s an economic reason why they’re going to try to work through those transactional costs,” Gero said.

With the addition of fuel distribution sectors in the second compliance period, the emissions cap jumped to 394.5 million tonnes in 2015, creating a theoretical demand for 31.5 million offsets ifcompliance entities were to offset the full 8% of their emissions allowed in 2015.

PG&E is one company that plans to take advantage of the offsetting provision, which Neff sees as a way to simultaneously reduce emissions at lower cost and invest in landscapes that serve as carbon sinks.

“PG&E has issued a couple of offset RFOs and we are very interested in spurring the offset market for its general benefits, although there are some struggles and it’s a bit burdensome right now, Neff said. “Unfortunately, not all companies with compliance obligations feel that same urge.