Federal Cap and Trade System and RPS Standards on the Horizon

On June 5, 2010, the South Asian Bar Association hosted the 2010 NAPABA Western Regional Conference in San Francisco.  One panel, entitled “Green 2 Green: Carbon Credits, Renewable Energy Certificates and the New Markets Driving the Clean Energy Economy,” addressed the failure of existing markets to price carbon and other greenhouse gas (GHG) emissions and discussed the potential for market-based mechanisms to solve the problem.  This panel was particularly timely because of recent congressional discussion with respect to the EPA potentially regulating GHG.  Recently, the Senate failed to pass a resolution (47-53) blocking this regulatory authority under the Clean Air Act (for more information see this article).  The options are to have Congress or the EPA set the rules for emissions reduction.

The panel included representatives from the California Public Utilities Commission, Pacific Gas & Electric Company, and from a law firm.  In addition to discussing market-based mechanisms to promote renewable and clean energy, the panelists also informed the audience about GHG caps generally, carbon credits, renewable portfolio standards, and renewable energy certificates.

So why do we need market-based mechanisms?

The U.S. has traditionally relied heavily on fossil-fuel powered generating facilities.  These facilities provide cheap electricity for consumers, but at the expense of the environment.  Without a price for carbon emissions, there is no incentive to construct renewable energy facilities or to develop more clean energy sources.  The resulting consequences on our climate and economy are dire.  Many people believe that now is the time for federal and state governments to act and to develop the regulatory and market frameworks necessary to address this problem.

From a policy perspective, greater integration of renewable energy sources will:

  • increase the reliability of our power supply
  • protect public health and the environment
  • promote energy independence
  • promote economic efficiency
  • promote national security
  • promote the stability of electricity prices
  • promote the sustainability of economic development
  • create domestic jobs

Most interestingly, the panel discussed two key market-based mechanisms to promote renewable and clean energy: a cap and trade system and RPS goals.

What are the benefits of market-based mechanisms?

The discussion started with questions about the advantages of a cap and trade system and RPS goals over tax-based approaches and straight government mandates.  In particular, the issue is whether the public can trust new market-based mechanisms given the recent economic downturn.  The benefits of a cap and trade system are:

  • certainty as to the amount of reductions that occur,
  • flexibility for businesses to be innovative, and
  • flexibility for businesses to find the most cost-effective way to meet emissions limits, since policymakers do not always know what the lowest cost will be.

While the benefit of a carbon tax is price certainty, it is extremely difficult to determine what tax levels really reduce carbon emissions and encourage the construction of modern renewable energy facilities.  Generally, a carbon tax disincentivises the continued production of energy from traditional-fuel powered plants, but excessive taxes could also cripple economic development by unduly raising the cost of electricity and disproportionately impacting coal states.

Tax incentives, in contrast, are a great supplement to the new market-based mechanisms being developed.  Such incentives include accelerated depreciation, RECs, cash grants for renewable energy leases, production tax credits, and investment tax credits.  Policymakers need to focus on integrating a flexible cap and trade framework within a scheme of tax incentives that will ultimately result in low-cost solutions.

How does a cap and trade (carbon trading) system work?

Carbon trading is a market-based mechanism that reduces GHG emissions by allowing parties to trade emissions under a cap and trade system, or trade credits that pay for or offset GHG reductions.

For a carbon trading market to thrive, many argue that an emissions cap must be set by a governing body such as a regulatory or private agency.  The market-based framework then allows trading activity to take place.  The following are important elements:

  • The emissions cap should be decreased gradually to achieve real greenhouse gas reductions.
  • The market-based framework can function as an auction, a trading system, or a regulated market for participants to buy, sell or trade emissions allowances.
  • Proceeds can then be used to research and develop other energy efficiency and renewable energy (e.g., wind, solar, geothermal, biomass, etc.) solutions which helps companies meet their compliance obligations and spurs more investment opportunities.

What are RPS standards and how does it relate to carbon trading?

A renewable portfolio standard (RPS) generally refers to a regulation that encourages electric supply companies (such as PG&E) to produce a specific percentage of their electricity from renewable energy sources.  In California, for example, the RPS requirement is 20% by 2010.  Governor Schwartzeneggar also signed an executive order in 2008 mandating 33% by 2020.

When a certified renewable generator produces renewable electricity, it earns a certificate (REC) that can be sold along with the produced electricity to the supply company.  The supply company demonstrates its compliance with the RPS requirement with these RECs.  RPS compliance relies on the market and therefore allows more price competition based on factors such as renewable energy source type and project size.  This in turn results in more energy efficiency projects that produce renewable energy at the lowest cost–making it more competitive with cheaper, traditional fossil-fuel sources.

RPS requirements encourage the development of more renewable energy projects.  RECs can be traded or sold on the market and as companies reduce their GHG emissions, emissions allowances can also be made available on the market for trading.

Important Carbon Trading Frameworks and Legislation

Regional exchanges –important regional exchanges include:

Regional Greenhouse Gas Initiative (RGGI) – the RGGI is the first mandatory, market-based effort to reduce green house gas emissions in the United States.  The 10 participating states in the Northeastern and Mid-Atlantic states include Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire, New Jersey, New York, Rhode Island, and Vermont.  Emissions allowances are sold through auctions and the target goal is to reduce CO2 emissions from the power sector 10% by 2018.

California – The California Air Resources Board, pursuant to AB 32, intends to develop a cap and trade system by 2012 for California.  AB 32 requires the reduction of GHG emissions to 1990 levels by the year 2020 and is similar to the Kyoto Protocol approach and standards.

Chicago Climate Exchange (CCX) – The CCX is a U.S.-based reduction and trading system.  Its participants include various major corporations including Ford, DuPont, and Motorola, as well as several universities including UC San Diego, Tufts University, Michigan State University, and University of Minnesota.  The CCX also supports renewable energy projects generated by offsets across North America and Brazil.  The Financial Industry Regulatory Authority (FINRA) acts as the independent, third party verification for the Chicago Climate Exchange even though the exchange is not regulated.  FINRA’s role is to verify and review emissions reports and offset projects, as well as monitor its trading activity.

Western Climate Initiative (WCI) – The WCI started in the western region of the United States and has spread across the United States and Canada.  Its U.S. partners include California, Montana, New Mexico, Oregon, Utah, and Washington, while its Canadian partners include British Columbia, Manitoba, Ontario, and Quebec.  Its observers include Alaska, Colorado, Idaho, Kansas, Nevada, and Wyoming, as well as various Mexican states.  The Initiative’s cap and trade proposal would help reduce carbon emissions from major sources of carbon emitters and also alleviate economic impacts on those regulated sources.  The program would begin in 2012.

Congressional Action

Currently, the federal government is actively working on energy issues, including the development of a cap and trade system.  The following summary is provided here to a comparison of the following legislation.

  • The Clean Energy Jobs and American Power Act (S. 1733 or CEJAPA or Power Act) was passed by the Senate Environment and Public Works Committee on November 5, 2009. This bill would create a federal GHG cap and trade system. The cap and trade program would be administered by the EPA and carbon market oversight would be delegated to the Commodity Futures Exchange Commission (CFTC) alone.
  • The American Clean Energy and Security Act of 2009 (HR 2454 or ACES) passed the House on June 26, 2009 by a vote of 219 to 212. ACES combines standards and incentives to promote clean energy and energy efficiency technologies with a firm cap on GHG emissions.  The cap and trade program would be administered by the EPA and deletes carbon market oversight to the Federal Energy Regulatory Commission and the CFTC.
  • The American Clean Energy Leadership Act (S. 1462 or ACELA) passed the Senate Energy and Natural Resources Committee on June 17, 2009 by a vote of 15 to 8. ACELA is an energy bill that incorporates many policies similar to those in ACES; the Senate is constructing a climate component to add to the bill, but currently ACELA does not include provisions to cap and trade greenhouse gas emissions. It does, however create federal RPS stnadards.

Cap and trade is not new.  What are some lessons learned?

As mentioned above, cap and trade is not new and the federal government is currently developing a cap and trade system, as evidenced in the Power Act.  The California Air Resources Board, pursuant to AB 32, intends to develop a cap and trade system by 2012 for California.  With all this legislative momentum, what are some of the lessons learned from the existing regional cap and trade frameworks mentioned above?

One panelist discussed the RGGI.  Unfortunately, the GHG prices are low because not all states connected to the grid participate in the program.  Power is therefore available outside of the RGGI framework and available at below-premium prices.  California needs to keep in mind that it can regulate prices within the state, but cannot regulate out-of-state power plants and the prices that are set.

Another panelist focused on the Clean Development Mechanisms of the Kyoto Protocol.  This mechanism encourages developed nations to invest in emissions reductions in developing nations.  But, as in any market-based system, one problem is gaming.  It is important that when the federal government develops a cap and trade system, it creates an infrastructure that guards against that possibility (e.g., ensure that third-party verification and certification processes are in place to ensure that reductions are legitimate).  Any cap and trade system must have built-in processes that preserve the integrity of the transactions that occur and the value of the underlying assets.

What does the future hold for the carbon trading market?

For the most part, the panelists seemed optimistic about a federal cap and trade system.  Regulatory uncertainty freezes markets and investments.  Once the government puts the appropriate regulatory framework in place, businesses are likely to have the confidence to make more investments, create more jobs, and spur the green economy.  While the federal government has unsuccessfully attempted to implement a cap and trade system in the past, this administration seems more receptive to passing comprehensive energy and climate legislation.

What will this mean for the carbon markets and as a result, the alternative investment industry?  If passed, the Power Act in its current form will allow entities to meet their emissions targets by submitting tradable emissions allowances.  It will grant the CFTC authority to regulate the GHG trading markets and amend the Commodity Exchange Act to regulate the trading of GHG instruments (including emission allowances, offset credits, and derivatives) in a manner similar to how agricultural commodities are regulated.  In particular, all trading of GHG instruments must take place on an exchange or be cleared through a carbon clearing organization.  Participation in the trading of allowances will be limited to CFTC-regulated carbon market participants and registered compliance entities.  Participants of derivative trading is not limited.  The Power Act would also prohibit short sales and sets position limits to prevent excessive speculation.  It is yet to be determined whether these provisions will restrict access to the market or adversely affect market liquidity.

The success of carbon trading in the investment management industry will depend greatly on the regulations put in place for the carbon markets.  It will be interesting to watch how the federal government and the CFTC work to create the framework for carbon and emissions trading.


Other related hedge fund law articles:

Cole-Frieman & Mallon LLP is able to provide the following legal services to both domestic and offshore hedge funds:

  • Offer investment advice to funds interested in the purchase of carbon offsets
  • Provide legal advice to clients in regards to carbon market regulations
  • Assist hedge funds with the creation of investment projects that generate carbon credits and offsets
  • Advise on marketing strategies for those clients interested in selling their carbon offsets or promoting their renewable energy projects
  • Provide networking opportunities with other lawyers engaged in the carbon market field
  • Advise clients on the policies and risks involved with credit trading

For more information, please call Bart Mallon Esq. at 415-868-5345.

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