California‘s cap-and-trade program was adopted in October 2011 in order to give effect to the California Global Warming Solutions Act of 2006 (AB 32) which requires the greenhouse gas (GHG) emissions in California be reduced to 1990 levels by 2020. The relevant provisions took effect on January 1, 2012. The first compliance period under the program begins on January 1, 2013.
California cap-and-trade has relatively “soft” start as the first deadline for surrendering allowances as a discharge of annual compliance obligation is November 1st, 2014, and by this date facilities must surrender allowances worth only 30% of its emissions (from 2013).
The full settlement (“true up”) for the first compliance period (consisting of years 2013 and 2014) is delayed till November 1st, 2015.
So, it appears that covered entities are allowed sufficient time to elaborate on their carbon market strategies, exploit opportunities as well as to manage inherent risks.
Under the California program covered entities are generally required:
- register with California Air Resources Board,
- report and verify GHG emissions annually,
- comply with recordkeeping and market rules, as well as with other program specifities.
Of central importance is that entities are required surrender compliance instruments to match covered emissions at the end of each compliance period, and in the event that a regulated entity is out of compliance with its cap-and-trade obligations, it is required to make-up for non-compliance, by surrendering three allowances or offsets for every one missed, in addition to replacing the original number of allowances missed.
Compliance obligation calculated from reported and verified emissions in brief may be outlined as follows:
- three compliance periods: 2013–2014, 2015–2017, and 2018–2020,
- annual surrender: Nov 1, 2014, 2016, 2017, 2019, and 2020 – surrender instruments equal to 30% of the previous year’s emissions with a compliance obligation (based on the reported data)
- triennial surrender: Nov 1, 2015, 2018, and 2021 – surrender instruments equal to its compliance period obligation minus what has previously been surrendered (based on verified data).
The program initially covers industrial facilities, electricity generators, electricity importers and suppliers of carbon dioxide. With the start of the second compliance period in 2015, the program will also include suppliers of natural gas, RBOB, distillate fuel oil and liquefied petroleum gas. Only entities that need to balance annual emissions above a threshold of 25 kt CO2 are included automatically. Entities with emissions below this threshold may apply to be included via opt-in provisions.
California Cap-and-Trade Specificity
Experiences gained by market participants for instance in EU ETS are helpful in the California scheme to the limited extent only. The differences between the two schemes are significant and market mechanisms designed in the California program cause the demand and supply interplay in different manner.
Market mechanisms applied in the California cap-and-trade, unknown under EU ETS rules (for short overview look here: The Cost Containment Mechanisms in the California Cap-and-Trade Program – why absent in the EUETS?) are, among others, specific design for CO2 permits auctions (auction floor price including - see below) and the Allowance Price Containment Reserve.
Allowances from the Allowance Price Containment Reserve are divided into three equal-sized tiers. This device collects a portion of allowances from auction each year and release them if certain predetermined trigger prices are reached (for particulars see Allowance Price Containment Reserve – the mechanism for managing the risks of the California carbon market or the risk in itself?).
The problem for companies’ affiliations – in the EU ETS somewhat neglected – is perceived and emphasised in many specific regulatory designs for the California cap-and-trade (see Beneficial holdings disclosure requirements for emissions agents under the California cap-and-trade and Major overhaul of the California cap-and-trade - linkage with the Quebec scheme and the KYC-checks substitution for the beneficial holding disclosure provisions.
As regards the said matter also the enforcement of the surrender obligation seems in the California scheme considerably improved.
Design for Auctions
Auctions under California programme have a floor price starting at $10 for 2013 allowances (indexed annually by 5% plus the rate of inflation, which is calculated by the Consumer Price Index). Significant distinctions between European and Californian auction model allow for certain comparisons (see Californian v European model for emission allowances auctions – which of them is better suited to the market), however, it should be noted that practical experiences with fully-fledged carbon auctioning in both schemes are currently not impressive (under EU ETS auctioning as a default way of distributing allowances starts in 2013, in the second trading period 2008 – 2012 there were auctioned relatively small amounts of allowances only, and when it comes to first California cap and trade auction, it took place on November 14, 2012 only).
Entities that are required to consign allowances to the auction and covered industrial entities eligible for free allocation of allowances must have an account in the Compliance Instrument Tracking System Service (CITSS) to consign or receive allowances. CITSS represents a market tracking system that supports the implementation of California’s Cap-and-Trade Program and provides accounts for market participants to hold and retire compliance instruments and to participate in transactions of compliance instruments with other account holders.
The CITSS, being a some sort of an EU ETS emission allowances registry, is also the record of ownership of compliance instruments; records information related to accounts; enables and records compliance instrument transfers; facilitates compliance verification; and supports market oversight through the collection of relevant information.
Establishing accounts in the CITSS is a multi-step process that, according to the ARB, can take several weeks to complete. To establish accounts, each entity must complete the following steps:
- two representatives must complete the user registration online data entry in the CITSS,
- both representatives must complete and submit required hard copy documentation required for user registration,
- both representatives must receive user registration approval from the California Registrar,
- the entity must complete account application data entry in the CITSS to establish an entity account,
- the entity must complete and submit account application forms and hard copy documentation,
- receive approval of the account application from the California Registrar.
All entities with direct corporate associations to other entities that have or will establish accounts in the CITSS must complete a Consolidated Entity Account form. The form must be submitted with the account application documentation. The elaboration on some details can be found in Consolidated account as a means of managing compliance instruments and compliance obligations for entities with a direct corporate relationship under California cap-and-trade.
Use of Offsets as Compliance Instruments
Each covered entity is limited to satisfying up to 8% of its total compliance obligation, per compliance period, with offset credits. There is, however, no limit on the percentage of offsets that may be used to satisfy the annual 30% surrender requirement.
For comparison, the limit on the use of international units under the Australian scheme is 50%, but it relates to the flexible charge years i.e. as from 1 July 2015, and in earlier years (so-called fixed charge years) the use of international units under the Australian program is forbidden.
Sector-based offsets, in addition to counting towards the usage limit for total offsets, face in the California cap-and-trade additional limitations. They are limited to 2% of a firm’s total compliance obligation in the first compliance period and 4% of a firm’s total compliance obligation in the second and third compliance periods.
There are currently four offset protocols: for ozone depleting substance (ODS), livestock, urban forests, and US forest projects. Under these protocols, no offsets are allowed outside of the US, Canada, and Mexico. Non-sequestration projects are eligible for credits for a period of between 7 and 10 years. Sequestration projects are entitled to longer crediting periods between 10 and 30 years.
Given the specificity of the California offsets they need tailor-made risk estimations (How much discount apply on account of invalidation risk of California offsets?).
California Program and EU ETS
Given the diverse structures of the US and EU administrative, legal, energy and financial markets frameworks, the differences in the scheme designs seem to be inevitable.
But the differences in designs unnecessarily must lead to the opinion that the linkage of both schemes would be impossible. On the contrary, the said schemes need not to be identical, in order to be linked.
Notwithstanding the issue of linking, whether it materialises or not, Californian cap-and-trade can be perceived as a new investment opportunity. The first step in order to examine these opportunities is to be well acquainted with formal requirements for investing in Californian emission allowances.
Indications for some other systemically significant nuances can be found in 'Discrepancies in views on the finality of transfers in emission trading among EU ETS and California cap-and-trade regulators'.