Podcast: A Deep Dive into State Low Carbon Fuel Standards

Susan Lafferty: Hello and welcome to our third podcast in the series on the year ahead in carbon markets. This is Susan Lafferty, I'm a partner at Holland & Knight. I'm joined by Andy Kriha, who's an associate here at the firm with me. Today, we're going to talk about state LCFS programs, Low Carbon Fuel Standard. What we've previously talked about is the federal Renewable Fuel Standard, or RFS, and state cap-and-trade programs, and we are going to have right now a fourth in this series on voluntary markets, so stay tuned for that in a couple of weeks. This episode was actually supposed to film a couple weeks ago, but California held a key workshop at the end of February on the 22 to discuss proposed changes to its LCFS. California is, of course, the premier leader in the Low Carbon Fuel Standard arena, having had a program in place for over a decade, and as we're going to discuss further on this podcast, Oregon and Washington state have followed suit and adopted their own Low Carbon Fuel Standard programs. And the proliferation of the programs continue to be discussed in other states, but right now, there is not any true legs that we're seeing in terms of something that is eminent in another state. So, I'm going to turn it over to Andy to talk more about what CARB is doing, and especially what they did on February 22. Andy?

An Update: California Air Resources Board's (CARB) Low Carbon Fuel Standard Program

Andy Kriha: Great. Thanks, Susan. So, big news coming out of CARB. We say big news, it wasn't completely out of the blue. Last November, CARB actually held a workshop in which it introduced several concepts for potential changes to the LCFS. This included more aggressive carbon intensity and reduction targets for the program overall and various additions and changes to the program. As part of that workshop, CARB modeled three possible scenarios that mixed and matched various proposals that were under consideration, including the biomethane provisions that we'll talk about in a minute, which really we think are the most controversial and largest changes. There was a comment period that ran until mid-December after that workshop. There were positive and negative comments on various aspects of the proposal, but there was significant backlash to the biomethane proposals, which is what makes it somewhat surprising that those popped back up in this most recent workshop. So, we mentioned that the most recent workshop occurred on February 22 of this year, and at that time, in addition to holding the workshop, CARB released partially completed draft regulatory language for the changes that they discussed at the workshop. There is a comment period that is open through March 15, which is the day this podcast is going to be released. But don't worry, if you did not comment, there will be more opportunity. The rule will be officially proposed sometime this summer. There will be at least 45 days to comment on that before there's a board hearing in late summer or early fall to finalize the rule. And right now, they're targeting implementation of any changes for early next year. So, we are going to talk about a handful of the changes. But first, we really want to do a deep dive on these two big biomethane provisions, which have really dominated the discussion up to this point. The first one of those is that CARB proposed a deliverability requirement to begin in 2028. So what that means is right now projects anywhere in North America are able to participate and generate credits by using book and claim accounting to match biomethane that is injected into commercial pipeline systems anywhere in North America with transportation use within California. The new rule would require a demonstration of a pipeline pathway all the way from the injection point to the state of California. And more importantly, evidence that every segment of the pipeline path flows in the direction of California 50 percent of the time on an annual basis. It's not clear yet exactly how California is going to define or measure this 50 percent requirement, but it does at this point seem difficult that the vast majority of projects in the country would be able to comply, particularly any of those east of the Rockies. CARB stated in response to a question that was asked during that February 22 workshop that there will be grandfathering for pathways that were approved prior to 2028. However, this grandfathering is not currently in the draft language, so it is important for projects to comment and engage with CARB to ensure that this intent is actually reflected in the language that's finalized. Additionally, assuming grandfathering happens, it's not clear yet if a temporary pathway, a provisional pathway or a final pathway would be needed to obtain grandfathering status. And obviously, those are significantly different points in time that could alter by a couple of years, the projects that can actually get in. The second biomethane proposal is that no new pathways will be approved after 2030 that use avoided methane as part of the CI's scorings. This would result in a complete phaseout of avoided methane credits by 2040. It's not in the draft language yet, but CARB is seeking comment on possible options that, for pathways that expire from 2031 through 2035, to be able to get a single five-year extension of their pathways with avoided methane crediting. CARB has emphasized that this is not a ban on biomethane projects, that instead it simply means that any projects, whether they're biomethane or not, will no longer get credit for avoided methane emissions towards their CI score and instead will only get credit for other emissions reductions — although it's kind of difficult to see in many instances how this does not practically function as a ban on biomethane projects. So with that, Susan, I want to throw it over to you for your reaction and what this all means.

There were positive and negative comments on various aspects of the proposal, but there was significant backlash to the biomethane proposals, which is what makes it somewhat surprising that those popped back up in this most recent workshop. 

Susan Lafferty: Great. Well, as you know, it's all crystal clear, or not so much. So, with the deliverability demonstration requirement, we immediately consulted our FERC partner to get his views on this, you know, again, preliminary language regarding the fact that there's a 50 percent requirement that every segment of the pipeline path flows in the direction of California on an annual basis. You know, assuming this proposed standard means that the gas flows towards California at least six months out of 12 in a given year, there are still a number of pipes, for example, El Paso Transwestern, that do flow from Texas to California. For pipes that are east of the Rockies, or the Mississippi River, the question then will become how flows on those pipes would be treated, you know, for purposes of satisfying the 50 percent standard. Pipes, according to our FERC colleague, are increasingly bidirectional in flow, and this is largely due to shale gas from the Marcellus and shale production areas. So, in addition to, you know, one directional flow, unidirectional flow pipelines that flow west to east or southeast-north, are supposed to always provide backhaul service, which then would allow flow in the opposite direction. So, you know, the bottom line will be exactly how CARB is going to define what constitutes flowing gas towards California 50 percent of a given year, and what kind of flexibility they might incorporate in that in terms of whether there's actual flow or feasible flow. How you demonstrate that is going to be a real question. It could be that the demonstration requirements are just too onerous to comply with, especially year to year. So, I think this is a real EPA in terms of how CARB further explains and defines what it means here. As Andy also said, this question of grandfathering was one that was responded to positively by CARB staff when asked. The concern is that right now the very limited draft language on this provision doesn't indicate what grandfathering will occur and be allowed. So as Andy said, we just think that this is a place where if you've got a currently or imminently impacted project, this is very much worth submitting comments to CARB and probably trying to go and talk to them, you know, on the phone, on Zoom, live, just to reiterate the position that this could really hurt, you know, existing projects and really be a disincentive for future projects. You know, again, as Andy said, CARB went to some effort to say they're not trying to disincentivize biomethane from coming into the state, and they claim that they will incentivize biomethane and other transportation programs. But you know the question, what will projects move forward without knowing what those programs are? I think that's really hard to say right now. Projects might move more sideways in terms of they might still look very much at California, but try to build some wiggle room into any agreements that would allow them to pivot to other programs either in the state or outside of the state, if and when necessary. So that could be you know, you still have a 10-year offtake still going to California, but maybe in two years you agree that you're going to both look at the economic feasibility of the existing project or you specifically say if CARB adopts any sort of requirements in this area, we will deal with that in a manner. And, you know, frankly, CARB might achieve what they appear to be wanting to achieve, which is getting projects to look at other non-transportation fuel outlets. It may not just be in the state of California, but nonetheless, this makes sense for projects to perhaps be a little bit broader in what they're looking at and considering in terms of longer-term payback for projects. Unlike EPA, CARB does tend to meet its deadlines. So we do expect much more clarity by the summer when CARB releases what it proposes to be final language and when they have a hearing. And so there is a time frame by which I think companies can largely expect to know more about what they're going to be dealing with in the state. Andy, do you want to give any further reactions on your end?

You know, again, as Andy said, CARB went to some effort to say they're not trying to disincentivize biomethane from coming into the state, and they claim that they will incentivize biomethane and other transportation programs. But you know the question, what will projects move forward without knowing what those programs are? I think that's really hard to say right now.

Andy Kriha: Yeah. So, one thing I just want to point out here is that, you know, while this does seem like a jolt to the system and is a pretty large departure from how this program has operated in the past, it really does fit in pretty well with some of the broader trends that we've been seeing in carbon markets and that we expect with carbon markets more generally going forward. You know, one thing to note is that policymakers at all levels, but in particular state policymakers in blue states, view natural gas as a bridge fuel that is not necessarily part of their vision for long-term net zero future. And so they want to, you know, craft these policies in a way that discourages overbuilding of natural gas infrastructure because they don't want that infrastructure building to lock in natural gas by creating incentives to keep natural gas around so that companies can recoup their investments. And they don't want the assets to become stranded either if they are successful and driving natural gas out of the energy system. And so this type of movement really fits that view and fits kind of what we expect from blue states. In addition, something that we're going to talk about extensively in our next episode on voluntary markets is the difference between, you know, credits for avoided emissions and credits for emissions that are actually captured and removed directly from the air. And there is a long-term movement away from avoided emissions because really it's impossible to truly get to net zero, you know, at an economy-wide basis, so long as avoided credits are still being used. And so 2040 for this phaseout seems about right if you're looking at a 2050 net zero goal. This really does fit what we've seen. Now, what's interesting about this particular policy decision is that it's impacting biomethane as opposed to natural gas more generally, which is going to be a really difficult substance for policymakers to work with going forward. Because the fact of the matter is, landfills are going to exist forever. Dairies, you know, there's some consumer preference shifts away from dairy products. There are some alternatives coming onto the market. But also, I don't think I'm going out on a limb to say that dairies are still going to be around for at least several more decades, and these are going to produce methane and we need to do something with it. So, while this does fit the broader natural gas narrative that we kind of expected, you know, there is still some question about whether or not this is the right choice, even from that point of view as it comes to biomethane. So, certainly something to keep thinking about and something to keep watching for. So, we did promise that we would touch on the other changes coming in California. The biggest thing, I think, is that there is now a more aggressive CI reduction target and, even more importantly, an automatic adjustment mechanism that would make the CI reduction target become even more aggressive automatically if California gets ahead of schedule. In addition, there's a proposal to make intrastate aviation obligated parties that are not obligated fuel under the program. There are incentives to build medium and heavy duty zero electric vehicle refueling infrastructure, incentives for hydrogen production and then an entire suite of streamlining provisions to try to make this whole process easier on both regulated parties and CARB itself. So with that, anything else before we move on to Washington?

But also, I don't think I'm going out on a limb to say that dairies are still going to be around for at least several more decades, and these are going to produce methane and we need to do something with it.

LCFS Program Happenings in Washington

Susan Lafferty: No, I think we can head north to Washington. So, Washington is following in California and then Oregon's footsteps. They have adopted a clean fuels program that became effective the beginning of 2023, January 1. And it's generally very similar to the California LCFS. California did the hard legislative work and put together this program again, as I said, quite some time ago. And so it's definitely the model that Oregon and Washington have adopted. And we would expect if other states go the LCFS route or Clean Fuels Program route, as they might call it, that, that California would continue to be the primary model for that. It's a much more appealing format than the federal RFS, if you are looking to have a fuel neutral program that obtains greenhouse gas reductions or carbon reductions. One of the big differences that we'll note for biomethane, the Washington Clean Fuels program, is that if book and claim accounting is used, then the reporting party is required to retire either a renewable thermal certificate or a renewable energy certificate, a REC, that represents all of the environmental attributes of the fuel. California right now is only requiring a party to show that it owns the relevant environmental attribute at the time of retirement. This is a slight deviation from that requirement. The only exceptions in the Washington program are for the federal RFS and RIN program, and the Washington state cap-and-trade program. So therefore, even though the emissions are the only attribute that matter for the program, no other environmental attributes can be separated and monetized. And this has been a big issue in the more recent renewable fuel standard proposed rule, where EPA is proposing, of course, to have renewable electricity, eRINs, and EPA did touch on RECs in its preamble and made some statements that, in typical EPA fashion, really didn't clarify anything. Some are reading it to endorse the use of the continued viability, if you will, of RECs along with RINs. We read it more circumspect and think that EPA was just saying that they weren't outright trying to usurp any state program in this area, but we think that having the two could be problematic. And again, it's quite interesting when you look at California's program and now how Washington is implementing this program, that it's going to actually require the retirement of either the REC or the thermal certificate. And, you know, again, it's likely not, may not be that big of a deal right now for participants in the state, but it could become a bigger issue if markets develop for other environmental attributes, or if in the future, as Andy was discussing earlier, if Washington follows California again and stops crediting for avoided methane. Washington currently does not place-specific conditions on receiving avoided methane credit for biomethane from manure, although avoided methane is accounted for in the CI calculation. So, just like California, only parties in the fuel supply chain can participate in the Washington program, and there is no ability for other entities such as investment funds to participate in the Clean Fuel Standard. So, that is different, again, from the federal RFS program where an entity can register and then acquire and trade RINs. You can't do that in the California program. You can't do that in the Washington program. You have to be an actual regulated party to participate. So, one of the things that regulators are always worried about with these programs are bad actors. And Oregon, as I mentioned, and you likely know, already has a clean fuels program in place, and it has experienced its first fraud case. So, Andy, you want to give a description about the shenanigans going on in that state?

And this has been a big issue in the more recent renewable fuel standard proposed rule, where EPA is proposing, of course, to have renewable electricity, eRINs, and EPA did touch on RECs in its preamble and made some statements that, in typical EPA fashion, really didn't clarify anything.

Oregon's First Fraud Case Related to the Clean Fuels Program

Andy Kriha: Absolutely. Like Susan said, this is Oregon's first big case of fraud, and it's not clear yet exactly how they're going to end up responding to this in terms of any long-term fixes to the program. So, this is a pretty small time operation. It was two men, Merlin Thompson and his nephew, James. Merlin owned his own repair company where, along with James, he repaired electric vehicle chargers. The company was pretty young. it was founded in 2021, shortly after Merlin had declared a personal bankruptcy and after the failure of Merlin's previous computer repair business. And so, after a few months of operation, it was this repair business in December of 2021, Merlin applied to participate in the Clean Fuels Program as a provider of EV charging. He did actually order three EV chargers, but because of supply chain backlogs, they did not arrive at his physical location until April of 2022 and were never actually installed. Despite the fact that they were never installed or used to charge any EVs, the men submitted their first quarter compliance report in June 2022 and generated credits equivalent to what could have been produced had those chargers been operating for the entire quarter. They sold those credits for about $1.8 million to an unsuspecting obligated party in the program. In August of 2022, before the second quarter report was submitted, a whistleblower who was a disgruntled employee alerted Oregon to the issue. So, in addition to taking an enforcement action, Oregon has stated that the long-term fix here is to require third party verification, and it should be noted that this third party verification requirement actually was effective at the time of this fraud. The third party verification requirement became effective for the first quarter of 2022, but was applicable at that time to the 2021 compliance year because it only applies annually. So, Merlin Thompson and his nephew James would have had to comply with the third party verification requirement, but not until the first quarter of 2023. Oregon has also said that it had not yet reviewed the first quarter report before the whistleblower came forward, but is confident that it would have caught this fraud had it had the opportunity to review the report first. Obviously, we don't know if that's true or not. So, you know, Susan, I know you've told me that in the early days of the Renewable Fuel Standard, there were a lot of pretty similar schemes going on with small-time players not actually producing the fuel for the credits they were generating. Can you tell us a little bit about how EPA reacted to that and what that might mean for Oregon, or lessons that Oregon could take away?

Oregon has also said that it had not yet reviewed the first quarter report before the whistleblower came forward, but is confident that it would have caught this fraud had it had the opportunity to review the report first. Obviously, we don't know if that's true or not.

The Environmental Protection Agency's (EPA) Reaction to Oregon

Susan Lafferty: Yeah, absolutely. Yeah, that's exactly right. These programs definitely offer an opportunity for bad actors. I think that the reliance, what we're going to see is the continued reliance on third party verifiers, QAP auditors in the RFS program, engineers, test auditors are going to continue to play a bigger and bigger role because doing the kind of checks that are necessary at a regulatory level to verify compliance are just going to be too much for any one government body, you know, whether it's at a state level or a federal level, to do on their own. So, I do think that having a partnership with the third party is going to continue for sure. In the states versus federal it's interesting because, at least the way California is set up, there are more people working at CARB focusing on the fuels programs, including compliance, — and therefore including enforcement — than there are for the EPA program, the RFS, which is obviously a federal program. So, Oregon's situation with Merlin aside, it may be a little bit less likely that there's going to be state fraud if Oregon and, as we discuss, Washington state now, man their regulatory agencies and these programs in particular in a manner that's more similar to California's. California really takes pride of having boots on the ground and really knowing the companies that are producing, and importing, and blending, and trading fuel in their state. So, this might be a little bit of a wakeup call to Oregon that maybe they need to hire a few more FTEs. From a commercial standpoint, when this happened initially in the RFS program, we had clients coming to us who had acquired what turned out to be invalid RINs and sometimes retired them, sometimes traded them, some of them still had in their system, and their documentation was incredibly lacking. And this really led to the standardization of RIN agreements, largely using the LEAP forms or some variation of the LEAP. And so, I would expect, again, the same thing in Oregon, and if you're participating in Oregon, that you or any of the states, frankly, that you expect to have a very robust commercial documentation for the credits that you are acquiring. That is essential to protecting your stake in the credits that you are receiving. The market standard has typically been that if you buy what later turns out to be invalid credits, that your counterparty will acquire and pass along to you or cover your cost to acquire valid credits in replacement. And so then the question, of course, is always knowing where you are in the chain. If you're buying from the generator of the credit and something happens to them, then you might be the first one, the one left holding the bag. So, it's just another sort of lessons learned in terms of understanding where you are in the chain. Therefore, what kind of criteria might you have for whom you will buy from and what kind of verification you want to see that they are actually, you know, in this case, they're actually operating EV chargers and validly generating the credits, and then making sure that your commercial documentation is really up to snuff and really covers exactly what would happen if something like this occurs. I'll end on a warning that regulatory agencies, and certainly this is what EPA did, tend to write their statutes and their regulations very broad, such that often anyone that touches that in credit could be held responsible. These are strict liability programs. So, even the trading of a credit that you don't realize is problematic, could be problematic for your company. So, that is where, you know, one of the many reasons why you need to take compliance and again, verification, reasonable verification that your counterparties also take compliance seriously so that you can avoid being in a situation where you're not only dealing with invalid credits that you either, you know, you somehow need to replace, but potentially also penalties from the regulatory body. So, on that dire note, Andy, you want to bring us home with something a little bit more positive?

So, I do think that having a partnership with the third party is going to continue for sure. In the states versus federal it's interesting because, at least the way California is set up, there are more people working at CARB focusing on the fuels programs, including compliance, — and therefore including enforcement — than there are for the EPA program, the RFS, which is obviously a federal program.

Concluding Thoughts

Andy Kriha: Yeah, absolutely. So, thanks for joining us today. Just wanted to note our next episode coming up in two weeks and the last episode of this four-part series, Alex Holtan and I will be discussing the year ahead in voluntary carbon markets. We'll be talking about the FTC green guide rule. We'll be talking about the SEC disclosure rule. And we'll be getting into some of these nitty gritty technical issues that impact the construction of a whole new market from the ground up, which is what's happening in the Wild West of voluntary markets right now. So thank you again and hope you'll join us in two weeks.