Podcast - Cap-and-Trade Programs: A Primer for 2023

Andy Kriha: Hello and welcome to the second in our four-part series on the year ahead in carbon markets. I'm Andy Kriha, I'm an associate at Holland & Knight in our Washington, D.C., office, and I'm joined today by Alex Holton, a partner in our Washington, D.C., office. Our first podcast was about the renewable fuels standard, and today we will be talking about state and regional cap-and-trade programs. Our agenda includes the launch of the new Washington State cap-and-invest program, which came into effect on January 1 of this year, the proposed cap-and-trade program in New York, the status of Pennsylvania and Virginia's participation in the Regional Greenhouse Gas Initiative, or RGGI, and the status of California's cap-and-trade program following the release of California's five-year scoping plan in December of last year. So, let's begin with Washington State. As I mentioned, Washington State's cap-and-invest program took effect on January 1. This is going to operate very similar to California's existing cap-and-trade program and most cap-and-trade programs in existence, in that it will set a certain number of allowances that represent one ton of emissions, and those will be mostly distributed through auctions. The first allowance auction is February 28 of this year. The application deadline for that has already passed, so anybody interested in participating that has not already applied can get in on the second auction, tentatively scheduled for May 31 of this year, with a May 1 application deadline. Participants register through the CIS System, which is the same as California and other Western Climate Initiative states, although the programs are not yet linked.

Alex Holtan: Andy, on that, I think we've had a number of clients apply to participate in that first auction in Washington, and they've found the application process and timeline very reasonable so far, and the staff at Ecology have been great to work with, and they managed to get up and running with their CIS accounts in Washington in a matter of weeks to maybe two months. You compare that with California, I know we'll touch on California later, which has had a lot more interest given the size of the market historically. Their current applications are taking months, if not close to a year, for voluntary participants for people who would enter the market just to trade.

Washington's Cap-and-Invest Program: An Overview

Andy Kriha: So, quick overview of the program. It's extraordinarily similar to the California program, and the reason for that is that there is an intent to link with California and Quebec at some point in the future, although that has not happened yet. They want to get their feet under them first and understand how this program is going to work before joining the larger market. The program aims to reduce emissions to 45 percent below 1990 levels by 2030, and 95 percent below 1990 levels by 2050. So, that means there is going to be much more aggressive reductions in the first seven years of the program, and then it'll level off a little bit, still reducing each year, but not by the same amount. It covers approximately 75 percent of all emissions sources in the state, including most businesses that generate over 25,000 metric tons of carbon dioxide equivalent per year. One note is that landfills were exempted by separate legislation that was passed after the bill. They now participate in their own landfill-specific methane program. In addition, natural gas and electric utilities, and some designated trade exposed entities, are provided free allowances to minimize the impact to consumers on prices. Beyond those that are given out for free, all of their allowances are auctioned at the quarterly auctions that we've already discussed. There is a price containment mechanism that sets a floor and a ceiling at auction prices each year. Each year those prices rise 5 percent above inflation, and then allowances can be traded among both obligated and non-obligated entities. Carbon offsets also represent a portion of the program as an alternative to allowances. Carbon offsets are produced under approved protocols and can be used to cover a small percentage of obligations, which we will describe further below. But before we dig into offsets, which really represent the biggest difference between the Washington and California programs, Alex, is there anything else that we need to consider when it comes to trading?

Alex Holtan: As you described, Andy, the two programs in California and Washington are quite similar. In terms of trading carbon in the U.S., the California program has been the gold standard. So, I think a lot of the lessons learned in California can be applied to Washington, but there are a few things to consider. First, given the size of the program, the holding limit in Washington — so essentially the amount of allowances a particular entity can hold — is considerably lower in terms of absolute dollar value than California. So, for people who are setting up trading funds in California, those funds could typically reach $2 to $300 million. In Washington, the funds will be in the $50-ish million range, so, just something to consider. I think a lot of people like the value proposition of Washington with the more aggressive emissions cut plan. And we actually saw the first futures contract trade based on the Washington program at a price of $35 a metric ton. And if you compare that with current California prices, that's a slight premium. So, I think there's definitely trader interest in the market. It'll be interesting to see whether that holds over the medium term.

So, for people who are setting up trading funds in California, those funds could typically reach $2 to $300 million. In Washington, the funds will be in the $50-ish million range, so, just something to consider.

California vs. Washington: A Deep Dive into Program Differences

Andy Kriha: Great. So, now I'm going to dive into differences between the California and Washington program. In terms of the actual regulations, this is primarily going to occur in the way offsets are used, but first, one note. Washington's program, as I said earlier, goes through 2050. California, under existing regulation, only goes through 2030. There are some political reasons that we're not going to dig into on this podcast as to whether or not we think California's program will be extended beyond 2030. I think there are certainly some real risks that it will not, although there are certainly incentives that it will as well.

Alex Holtan: Andy, for those that are new to carbon, the carbon world altogether, you mentioned the big difference in the Washington and California program being offsets and not necessarily the allowances. It might be helpful to give a quick synopsis on the difference between the two types of attributes.

Andy Kriha: Right, absolutely. Thanks for that. So, allowances, as I mentioned earlier, this is a right to emit one metric ton of carbon dioxide equivalent. This is generated by the state and sold to allow companies that are already emitting to continue emitting. A carbon offset is where a project somewhere else — and we'll get into it a little bit but generally going to be in the state — voluntarily reduces emissions or creates some sort of emissions reduction that wasn't required by law or by a contract or some other program. So this could be, for example, entering into a contract to preserve a forest that otherwise would have been cut down, or installation of renewable energy sources in areas that previously had fossil fuel emitters, and then selling that reduction, quantifying that reduction and selling it to somebody else to claim the reduction as their own. There is a lot of controversy around carbon offsets. We're going to dive really deep into that in our fourth episode on voluntary markets, but I think that's what you probably need to know for now. And because of the controversy around offsets, they're fairly limited in how they're allowed to be used in the programs. So, California right now allows 4 percent of any company's application to be met through the use of offsets as opposed to allowances. California seems to be somewhat confident that more higher-quality offsets will be available in the future, so they actually upped that to 6 percent of the obligation from 2026 through 2030. Washington, on the other hand, has a decreasing level of offset used throughout the life of its program. Currently, 8 percent of an obligation may be met through offsets. That is 5 percent through any offset project and 3 percent through projects that are in federally recognized tribal lands. And the reason for that is to help meet Washington State's environmental justice goals from 2027 through 2030. That reduces to 6 percent of the obligation that can be met through offsets, 2 percent of which must be on tribal lands, only 4 percent of which can come from not tribal lands. And then from 2031 through the end of the program in 2050, that obligation reduces to 4 percent and no tribal requirement for that. As long as Washington State is not linked to any other programs, all offset projects must have a direct environmental benefit within the state of Washington. If Washington links with other programs, which we believe it will, then until 2030, 50 percent of any projects must have a direct benefit in the state. That's the same as California's requirement. And after 2030, 75 percent of projects must have a direct environmental benefit in the state. These offsets must be generated under approved project protocols for different types of projects. California already had six types approved, and Washington adopted four of those. So, Washington adopted the Livestock Projects Protocol, the Ozone Depleting Substances Protocol, the U.S. Forest Projects Protocol and Urban Forest Projects Protocol. Washington did not adopt the Mine Methane Capture Protocol and the Rice Cultivation Protocol that are allowed under the California program. So, with that, Alex, is there anything else you would like to add on Washington before we move on?

California seems to be somewhat confident that more higher-quality offsets will be available in the future, so they actually upped that to 6 percent of the obligation from 2026 through 2030. Washington, on the other hand, has a decreasing level of offset used throughout the life of its program. 

Alex Holtan: No, I think we've covered it. So, why don't we move on to New York? I guess my question to start New York is, are we going to see a California east with a form of cap-and-trade program any time soon in New York?

New York Cap-and-Trade Program

Andy Kriha: So, I think the answer to that is yes. New York is required by law, by a law called the Climate Leadership and Community Protection Act of 2019, to promulgate rules that will help it meet its emissions reductions goals, and those rules must be promulgated by the end of this year. There's not a set timeline on when they come into effect. Presumably, once the rules are finalized, there will be some sort of waiting period before the program actually starts. That law was kind of vague. All it said was that there must be an emissions reduction of 40 percent below 1990 levels by 2030 and 85 percent below 1990 levels by 2050, and then left it up to executive organizations to figure out how to get there. And part of the law was to create what's known as the Climate Action Council, which was tasked with creating a scoping plan by January 1, 2023, and then tasked the Department of Environmental Conservation, or DEC, with promulgating the legally binding regulations to achieve the reductions by January 1 of 2024. The only rule that the law really gave was that any mechanism could be used, but the rules had to substantially follow the recommendations of the Climate Action Council. So, the Climate Action Council released its scoping plan on December 19 of last year, and it recommended an economy-wide cap-and-invest program. Because it did so, DEC is now legally bound to create such a program, otherwise it would not be substantially similar to the recommendations of the Climate Action Council. The scoping plan, however, did not go into specifics about how the program should be implemented. All it really says is that it should include innovative mechanisms to address environmental justice concerns. One example that they gave was a mechanism to preclude sources located in or near disadvantaged communities from purchasing allowances that are sold to them by sources outside disadvantaged communities. They also noted that offsets should have little to no role in the program and that mechanisms should be put in place to accommodate continued participation in RGGI, which we're going to talk about in just a minute, such as an exemption for entities that are covered by the RGGI program, or using some of the funds raised by the New York cap-and-invest program to subsidize RGGI participation. So, I think the answer here to your initial question then, Alex, is yes, we will see something akin to California east. It's not really clear exactly what the mechanisms are going to be yet, but because of the Climate Action Council's recommendations, it's likely going to go a step further than California — and potentially even a step further than Washington — in minimizing the use of offsets, if at all, and then promoting environmental justice concerns. So, we'll see those rules by the end of the year. In fact, they need to be finalized by the end of the year, so we'll ideally see those rules sometime midyear and then this program will get kicked off at some point after that.

So, I think the answer here to your initial question then, Alex, is yes, we will see something akin to California east. It's not really clear exactly what the mechanisms are going to be yet, but because of the Climate Action Council's recommendations, it's likely going to go a step further than California — and potentially even a step further than Washington — in minimizing the use of offsets, if at all, and then promoting environmental justice concerns. 

Alex Holtan: Well, you've just outlined the required timeline for implementation, or at least rule publication, but we all know that those things can slip. If you had to guess, when do you see New York starting with their cap-and-invest program?

Andy Kriha: If I had to guess, I would say that it would probably become effective around January 1 of 2025, would be my best guess. If there's additional slippage beyond what I expect, you know, potentially mid-2025 as well. Obviously, if that happens, if the rule is not finalized by the end of this year, really by January 1 of next year, there will be lawsuits almost for sure that try to force that process along, and given New York's political environment as a relatively liberal state, I would expect them to not want the negative publicity around those types of lawsuits and to really act to get this moving as fast as they can.

Alex Holtan: All right. Well, let's move to RGGI, I guess the granddaddy of all emissions trading programs here in the U.S., and I know that there have been a series of updates and happenings in both Pennsylvania and Virginia that you wanted to share.

Talking Regional Greenhouse Gas Initiative (RGGI)

Andy Kriha: Right. So, just a quick overview, RGGI is the Regional Greenhouse Gas Initiative. This is a regional cap-and-trade program that covers just the electric generation sector in several northeastern states. It has grown to include more states over the years. There have been departures before. The state of New Jersey left at one point and then came back several years later. Under the program, each state contributes its own allowances and administers the program under its own regulations. However, the regulations across the states are nearly identical, and allowances from the various states are considered fungible. So, an allowance contributed to the program by Virginia can be retired for compliance by somebody in New York. So like you said, there's two current controversies around two states, one that is trying to join Pennsylvania and one that is trying to leave Virginia. So, we're going to go ahead and start with Pennsylvania. Pennsylvania's push to join RGGI occurred through purely executive action. The Democratic governor of the state, Tom Wolf, whose term just ended, directed his Department of Environmental Protection to join the RGGI program. This was purportedly done under statutory authority from Pennsylvania's Air Pollution Control Act, which gives the Department of Environmental Protection authority to set maximum quantities of air contaminants and to collect any fees that are necessary to implement its programs. There are currently three separate lawsuits that are challenging various procedural and substantive aspects of the program, with no set timeframe for a decision. Ultimately, we believe that the procedure was fine, and that this is going to be determined on the substantive issue of whether the amounts that would have to be paid by companies to purchase allowances would represent a fee which the Department of Environmental Protection is allowed to collect, or a tax which the Department of Environmental Protection is not allowed to collect. There's reasonable arguments on both sides of this issue. I think if I had to take a stance based on the reading that I've done, my personal view is that it probably does look more like an allowable fee. But really, this is going to come down to the views of individual state judges, and in Pennsylvania, we don't have experience with state judges in Pennsylvania. So, it's very difficult for us to prognosticate on whether or not Pennsylvania is going to be allowed to join. Despite there not being a formal timeline, we would expect a decision from the lower court probably in the first half of this year. Two of the three cases had their oral arguments in the fall. One case has yet to have its oral arguments. After those happen, there will probably be a decision relatively quickly. But regardless of the outcome, there's going to be an appeal to the state Supreme Court. And so, it's entirely possible that there's not resolution of these lawsuits this year. However, that said, all of the administrative procedures required to implement the rules are in place. So, as soon as there is favorable resolution from the highest court, if there's favorable resolution, Pennsylvania will be able to join RGGI in fairly short order and most likely, depending on the timing, be able to participate in the next available auction after a favorable ruling. So, if that does come down this year, it is entirely possible that we see Pennsylvania join the program already, potentially third quarter or fourth quarter of this year. So, on to Virginia. Virginia joined RGGI following a 2020 law that expressly authorized the Department of Environmental Quality to implement a regulation to join. At the direction of Governor Glenn Youngkin, the Air Pollution Control Board recently voted to repeal the state's RGGI regulation, launching an administrative repeal process that is expected to be complete in time for the state to exit RGGI by the end of this year. There is a complicated administrative process that Virginia goes through, so there has already been one public comment period on this rule. By the time this podcast is posted, a second public comment period will have opened on January 30, and will remain open through the end of March. That said, many people believe that the exit from the program is illegal and must be completed via a legislative process as opposed to executive action. The move cannot be challenged in court, however, until the repeal rule is finalized. I will note briefly here, that Republicans in the legislature of Virginia did attempt to pass a law to repeal it to avoid these likely court challenges. And just two days ago, as of this recording, that bill died in committee. So, they are now moving full steam ahead on the administrative action, and there will be court challenges. The legal argument centers on two back-to-back sentences and the authorizing legislation. The first says that the Department of Environmental Quality is authorized to establish, implement and manage an auction program to sell allowances into a market-based trading program consistent with RGGI. So, where the law there just uses the word "authorized to establish," the Republican administration has argued that is not a mandate to join the program, but just an allowance to join the program. And so, the executive branch is able to come and go at will. The next sentence, however, states the Department of Environmental Quality shall seek to sell 100 percent of all allowances issued each year through an allowance auction, unless the department finds that doing so will have a negative impact on the value of allowances and result in a net loss of consumer benefit. So, supporters of RGGI in the state have argued that the requirement that the department shall seek to sell allowances does in fact create a mandate for the state to join RGGI, and thus only legislative action can repeal it. This is a very interesting argument that has come about due to what in hindsight was clearly poor drafting by the legislature that passed this law.  Like with Pennsylvania, this is a close call due to the ambiguity of the statute that's ultimately going to come down to the views of independent state judges, so we don't hold a view at this time as to whether or not Virginia will be allowed to leave the program. However, barring intervention of the courts, Virginia is expected to exit at the end of this year. It's hard to prognosticate whether or not a court would enjoin an exit pending the outcome of any sort of lawsuit. Again, it kind of comes down to the same views of independent state judges. So, definitely something to watch. As we go forward, it is likely that states would continue to recognize any allowances that were issued by Virginia after Virginia exits, until those allowances are all retired. That's what they did when New Jersey first left and certainly provides a lot more certainty to the program. So, to the extent anybody is worried about that, I don't believe that's going to be an issue. Anything to add on RGGI, Alex?

So, as soon as there is favorable resolution from the highest court, if there's favorable resolution, Pennsylvania will be able to join RGGI in fairly short order and most likely, depending on the timing, be able to participate in the next available auction after a favorable ruling. So, if that does come down this year, it is entirely possible that we see Pennsylvania join the program already, potentially third quarter or fourth quarter of this year. 

Alex Holtan: No, so why don't we move to California. We've received questions from a number of clients about the political future of the California cap-and-trade program. Will it survive in its current state? Will it be significantly changed or amended at some point, or will it, under a number of theories, end up lapsing at some point in the not so distant future? I understand there have been a few developments that may provide us a bit of direction, but maybe more on that front is still to come.

The Future of California's Cap-and-Trade Program

Andy Kriha: Yeah, I think that's right. So, first of all, there's a debate that's happened in California as to whether or not the California Air Resources Board, or CARB, is allowed to extend the program beyond 2030 on its own without additional legislation, or whether additional legislation is required. There are two separate provisions in California law that could potentially apply and, when read individually, are somewhat contradictory. When read together, we've taken the view in the past that legislative action is required to extend the program beyond 2030, and that CARB is likely not able to do it itself. So, that then raises political questions as to whether or not it actually will be extended. There has been a lot of criticism from the Left of the program in recent years on various aspects of the program that could ultimately result in some legislators deciding that it's not doing its job and isn't worth extending. Definitely going to be more to come. One of the big reasons for that is that after the last extension, there were a lot of allowances banked and the allowance bank is now very high, which allows allowances that were generated in the past to be used in the future instead of direct reductions in the future. So, that's gotten a lot of criticism. California recently took the stance that excess allowance bank is going to be exhausted in the fairly near future, so they don't see it as big of an issue, but definitely a lot to come. The biggest thing right now is that in December of 2022, California finalized its five-year scoping plan to assess progress toward the state's emissions reduction goals and identify actions needed to fill any gaps. Finding was that there is significant acceleration of reductions that are going to be needed to meet the state's 2030 goals and indicated, though, however, that only minor changes are likely for the cap-and-trade program. It does seem at this point that the state is instead looking toward more radical shifts in its low-carbon fuel standard, toward its new electric vehicle rules and other potential interventions in the future to make up the gap in reductions that it's projecting for 2030. However, CARB is going to evaluate any weaknesses in the cap-and-trade program. They stated that they will identify recommended changes for presentation to the legislature by the end of this year. Any actual changes that come out of that will be at some point in the future, probably later next year. However, in order to develop the recommendations, it's likely they will hold a public workshop, receive public feedback, so look for that potentially in the second half of this year. In the meantime, CARB is going full steam ahead with public workshops on LCFS program, and we're going to discuss that in detail in the next episode of our series. But potentially very large changes there, especially around the use of renewable natural gas. Anything else on California, Alex?

There has been a lot of criticism from the Left of the program in recent years on various aspects of the program that could ultimately result in some legislators deciding that it's not doing its job and isn't worth extending. Definitely going to be more to come. 

Alex Holtan: No. So, while in our last few minutes here to wrap things up, I mean, we've been talking exclusively about the states and the various different cap-and-trade greenhouse gas reduction programs across the country. But we also frequently get questions as to what's happening on the federal level and, specifically, whether we'll ever see a federal cap-and-trade program that will sit on top of, or perhaps replace, the various state-level programs. So, I have my thoughts on that, but Andy, why don't you share with the group on what you think the prospects for a federal cap-and-trade program might be.

Federal Cap-and-Trade Program Prospects

Andy Kriha: Well, I would say in my view, at this point, the federal cap-and-trade program is probably unlikely. You know, we did see one proposed back in 2009 that failed for various reasons. At the federal level, I think the driver toward any sort of carbon action at the federal level is probably going to be international trade agreements. We know that Europe has set carbon pricing standards and that those are going to apply to all imports, including those that come from the U.S., and that for the U.S. to obtain favorable treatment, it's probably going to need its own carbon pricing mechanism. Some sort of a border adjustment would definitely be in play. And in order to have a successful border adjustment, there would also need to be an internal domestic carbon price in order to not violate WTO rules and make that all work. That's probably, if it happens, going to be a carbon tax as opposed to a cap-and-trade, in my view. I don't see any near-term movement on that, though. Definitely welcome to your thoughts.

At the federal level, I think the driver toward any sort of carbon action at the federal level is probably going to be international trade agreements. We know that Europe has set carbon pricing standards and that those are going to apply to all imports, including those that come from the U.S., and that for the U.S. to obtain favorable treatment, it's probably going to need its own carbon pricing mechanism.

Alex Holtan: Yeah, I agree with you nearly 100 percent. You know, with the death of Waxman-Markey back in, I think it was 2009, we really haven't seen a federal cap-and-trade program come to the floor since then. There are myriad of different reasons for that, and a whole host of political challenges associated with the federal cap-and-trade program, and I think any form of federal action on this type of program is going to be in response to Europe's sea ban. The carbon border adjustment mechanism, which is the import tax that Andy was talking about, you know, just one variation on how that might get done in the U.S. Carbon tax, we're setting a federal price on carbon would be, setting the price of carbon would be required. A tax would be the easiest way to do that, but also comes with a lot of political hair. So, one idea that had been floated internally within the administration within the last year was trying to perhaps quantify the cost of compliance with the various different federal environmental regulations to try to come up with a cost of carbon that way, and to use that as the basis of any sort of border adjustment we could put in place here in the U.S. So, more to come on that, but we'll see what happens. 

Andy Kriha: Great. Well, thank you for joining us for this episode, and we look forward to having you come back for episode three, which is going to cover State Low-Carbon Fuel Standards.