California To Put Buyers On
The Hook For Forest Offsets

Gloria Gonzalez

The California Air Resources Board (ARB) is scheduled to sign off on a proposal to shift the invalidation risk away from forest owners to the buyers of offset credits from approved forestry projects next month. The regulators are aiming for consistency, but at least one major emitter is concerned that making buyers responsible for the risk will make it more difficult to purchase forestry offsets.

9 September 2013 | The California Air Resources Board (ARB) will have a lot on its plate at its October board meeting, including the anticipated addition of a coal mine methane protocol for use in the state’s cap-and-trade program. One proposal that has flown under the radar would shift the risk of invalidation for forestry offsets away from forest owners to regulated emitters that submit the credits for compliance.

The so-called buyers’ liability provisions featured in the cap-and-trade regulations allow the regulators to invalidate credits that are found to be faulty or fraudulent and require regulated entities to surrender replacement offsets for compliance. Currently, forest owners are responsible for the invalidation risk, but the buyers bear the risk for the other project types eligible for the California program. In amending its regulations, the ARB is aiming for consistency in its rules governing the invalidation risk, a spokesman said.

The buyers’ liability provisions have been the bane of existence for market players since the ARB insisted on including them in the trading system, despite significant pushback from industry players who argued that no compliance program has ever featured such provisions and that they would only serve to stifle offset transactions. That prediction proved true in 2012, as the provisions were cited by market participants as one of the key reasons that pre-compliance activity in the North American market remained flat despite the scheduled January 2013 launch of the program, according to Ecosystem Marketplace’s 2013 State of the Voluntary Carbon Markets report.

General support exists for the ARB’s efforts to ensure uniformity of the invalidation rules across all project types, according to stakeholders.

“By bringing consistency to the program and having it at the buyer level, it will probably actually lead to more project development,” says Gary Gero, president of the Climate Action Reserve (CAR). “I think probably on an overall basis it’s a good thing for the forest carbon sector because forest owners will be willing to have projects move forward if they’re not going to be the ones who have to replace invalidated credits.”

“It makes sense for the ARB to bring the invalidation rules in line for these projects because the invalidation rules are actually a good idea,” says Julian Richardson, CEO of Parhelion Underwriting Ltd, an insurer offering policies to cover the invalidation risk for California-bound offsets. “The ARB had the benefit of learning from Kyoto and the (European Union Emissions Trading Scheme). It’s that learning that has led them to write the invalidation rules and it’s one of the ways they ensure robust and rigorous environmental integrity in the offset system.”

The larger compliance entities generally have robust risk management staffs and strategies and should be able to manage what is essentially just another element of risk with relative ease, Gero says. “I think for the large buyers this is not a sea change,” he says.

Chevron Pushes Back

At least one major emitter has expressed concerns about the proposed shift. In comments submitted to the ARB in early August, oil major Chevron states that the ARB’s proposal to shift the invalidation risk for forestry projects raises a number of serious issues.

“ARB’s existing rule places responsibility with forestry owners because forests are a unique type of offset,” says Lloyd Avram, Chevron’s manager of state government affairs. “The forest owner has control over the forest and can manage it in accordance with the requirements or choose not to do so.”

Chevron declined a request for a follow-up interview.

“We are concerned that by changing the invalidation risk to the covered entity that uses the offset, ARB is adding unworkable burden and risk to forestry offset buyers which will ultimately discourage use of this important resource to reduce greenhouse gases (GHG) under ARB’s cap-and-trade program,” he says in the comments.

The proposal would result in a significant change in risk transfer for existing transactions that were negotiated and priced based on the current regulations, according to Avram. At a minimum, the ARB should not enforce the amended provision retroactively, he says.

“Applying the change to previously negotiated or listed projects would introduce further uncertainty to the nascent offset market, a particularly vulnerable time for any market,” he says. “Changing rules after a market has begun punishes early market participants that have already made investments and undertaken significant risk to create a market that furthers the program’s objectives – contrary to AB 32’s directive to encourage early action to reduce GHG emissions.”

AB 32 is the common name of California’s Global Warming Solutions Act, the legislation that set the target of reducing the state’s GHG emissions to 1990 levels by 2020 and paved the way for the trading program.

Reforestation, improved forest management, avoided conversion and urban forestry projects are currently eligible for California’s cap-and-trade program. The ARB is also expected to develop regulations to allow reduced emissions from deforestation and forest degradation projects into the program although the timeframe is still unsettled.

The ARB has given plenty of notice that it is preparing to make the invalidation change for forestry projects, but while the goal of consistency is a noble one, changing the rules after the fact does create uncertainty for project developers, according to another market participant.

“I think it’s problematic that they are changing it midstream, but I don’t necessarily see it as problematic on the face of it,” the participant says. “If people had been developing their projects with that in mind, it wouldn’t be as much of a negative impact as them thinking it was going to be a different way and then having it change after they’ve already started project development.”

Insurance to the Rescue

The shift may be problematic for medium-size entities that are seeking to reduce their risk as much as possible by purchasing golden California Carbon Offsets – which require the seller to replace invalidated offsets with allowances or replacement offsets – or insurance to address the invalidation risk, Gero says.

“That makes them think a little bit harder about forest carbon, but they’re already thinking hard about the risks associated with the other project types because that risk is already on them,” he says.

Parhelion, a specialty insurer focusing on the climate finance sector, is ready to step in to insure forest carbon projects against the invalidation risk if the ARB implements the change, Richardson says. Earlier this year, the insurer began offering a policy to insure against invalidation of livestock and ozone-depleting substances (ODS) offsets that are transitioned from credits originally issued by CAR to California’s compliance program.

The company initially decided not to offer the coverage to forestry projects because the structure of the invalidation risk as it currently applies to forestry would not have triggered demand for the product from developers or buyers as it would for the other project types.
“Therefore, we didn’t feel it was a priority sector for us,” he says.

However, the insurer is already fielding inquiries from forest carbon project developers and buyers about its intentions to expand coverage of the invalidation risk if the ARB goes through with the change, Richardson says.

Although it is unclear what the final rules will say, Parhelion does not anticipate major differences in the policies it would write for forestry projects compared to the ones it is working on for livestock and ODS projects. The insurer has yet to finalize policies for those two eligible offset project types, but Richardson hopes the first policy will be issued by the end of the year.

Permanence Comes First

Forest owners are already facing a number of uncertainties about their forest projects, not the least of which is that they are on the hook for maintaining that forest carbon for 100 years, Gero says.

“I think that by removing the invalidation risk from the forest owner, that’s one less thing that forest owners and project developers have to worry about,” Gero says. “Of course, it’s one more thing that a buyer of credits does have to worry about.”

Shifting the invalidation risk to the buyer is “probably the right thing to do,” but landowners interested in participating in California’s program are far more concerned about the impact of the permanence requirements on their ability to manage their lands than they are about the invalidation risk, says Chandler Van Voorhis, Managing Partner, project developer C2I.

“(The invalidation risk is) an issue that comes way down the line as a landowner is looking at it,” he says. “It’s not a big hurdle.”

The permanence requirements for forestry projects are particularly complicated considering that the cap-and-trade program is only scheduled to run through 2020 at this point, stakeholders say.

“The issue of 100 years has always been a challenge,” Van Voorhis says.

For the sake of forest owners, a signal should be sent as early as possible about the future of the program beyond the scheduled 2020 conclusion, Gero says.

“Forest owners don’t go into these projects lightly and they need to have a great deal of certainty that the projects are going to generate credits,” he says. “I think having that kind of signal will foster even more forest owners to come in.”