London, 22 January 2010

California's cap and trade proposals to cut greenhouse gas emissions provided much of the template for a national system. How the state forges ahead, or whether it postpones the programme, will indicate if a national system is eventually possible.

As the prospect of Congress enacting a nationwide scheme recedes, attention will switch back to developments at state and regional level.

The Regional Greenhouse Gas Initiative (RGGI), covering states in the north-east, began emissions trading in 2009. But emissions prices have been hit by the slack economy and, at $2 per tonne, are nowhere near high enough to have much impact.

More interest centres on the pioneering trading system due to be launched in California as early as 2011-12, at the centre of a looser grouping of states across the western United States and much of Canada, the Western Climate Initiative (WCI). State-level actions could create a sufficiently high "carbon price" and give investors in new power plants and other emissions sources enough certainty to produce effective reductions even if the federal government fails to act.

Regional schemes would not be as efficient as a single nationwide market, though in practice the efficiency loss should be small, provided they cover enough states. The real problem is how to prevent regulatory arbitrage, loss of competitiveness and carbon leakage between different systems undermining the political will to sustain them. As in so much else, California is likely to be the bellweather.

GLOBAL WARMING SOLUTIONS ACT

California's Global Warming Solutions Act of 2006 (AB 32) requires the state to reduce its greenhouse gas emissions back to 1990 levels by 2020. The 2020 target of 427 million tonnes of carbon dioxide equivalent (MMtCO2e) will require a cuts of around 11 percent from 2008 and almost 30 percent (169 million tonnes) from the projected 2020 level under business as usual.

The California Air Resources Board (CARB) has developed a "Scoping Plan" detailing how the state will achieve the required cuts. The plan uses a mix of direct regulations or mandatory reduction programmes to cut emissions in specific areas, as well as proposals for an over-arching cap and trade programme designed to create financial incentives to reduce emissions.

CARB sees the two systems as complements rather than substitutes: "By itself, a cap-and-trade program alone will not deliver the most efficient mitigation outcome for the state. There is a strong economic and public policy basis for other policies that can accompany an emissions trading system".

Specific regulations are intended to achieve about 140 million tonnes of reductions compared with the baseline by 2020. Cap and trade will reinforce those efforts, as well as forcing a further 34 million tonnes of additional reductions (see CARB-SCOPE grahic below).

STATE-LEVEL CAP AND TRADE

CARB issued a Preliminary Draft Regulation (PDR) in November 2009 for public comment. The Board's Economic and Allocation Advisory Committee (EAAC) is due to make recommendations later this month about how to allocate emission allowances to different industries. Final regulations will be published in September and are due to be adopted in October. Initial allowance auctions will be held in the closing months of 2011 and the cap and trade programme will go live in 2012.

Phase I (2012-2014) would cover electricity generation and imports, as well as emissions from large industrial sources emitting 25,000 tonnes or more (around 600 stationary sources in total). Phase II (starting in 2015) would expand cap and trade to cover smaller industrial sources, residential and commercial combustion of natural gas and propane, and transportation fuels.

AB 32 makes emissions reductions mandatory by 2020. CARB is given discretion about whether or not to use a trading programme ("the state board may include ... the use of market-based compliance mechanisms") but the legislation contains a strong indication market mechanisms should be used where possible, and detailed rule-making for a scheme is already very advanced.

Even if Congress declines to enact a national cap and trade programme, California's state programme will probably go ahead. While CARB has discretion over how to achieve reductions, it has no discretion over the total amount that will be required. Changing the targeted reduction would require fresh legislation.

The law permits the state governor to delay implementation for up to a year "in the event of extraordinary circumstances, catastrophic events, or threat of significant economic harm". At least one candidate to replace Governor Arnold Schwarzenegger has promised to use the provision to delay cap and trade for a year to study its impact. In theory the provision could be invoked sequentially to put off the programme indefinitely, but that would be open to a court challenge.

WESTERN CLIMATE INITIATIVE

California hopes to link its programme to a wider regional cap and trade system being developed by the Western Climate Initiative (WCI). The initiative is a "collaboration" between 13 U.S. states (seven partners and six observers); six Canadian provinces (four partners, two observers) and six Mexican states (all observers) to identify and implement policies to tackle climate change at regional level. The goal is to reduce emissions 15 percent below 2005 levels by 2020, which is broadly in line with California's own target.

Since the state is effectively leading the system, the basic outlines of the scheme closely track California's. In theory the first phase will start in 2012, with a second beginning in 2015.

REGIONAL LINKAGES CRUCIAL

Linking California's system with other cap and trade programmes is crucial to delivering significant emissions reductions at low cost. Coordination with neighbouring states would reduce the risk of "leakage" (a reduction in emissions within the state offset by an increase elsewhere) either as electricity consumption shifts in favour of imports or business activity shifts across the state line.

More importantly, California's electricity sector is not selfcontained. The state is linked to neighbouring areas through the Western Interconnection (WECC) and much of the power consumed in the state is imported. It is likely the state's imports will grow significantly in coming years.

California's own electricity generation is fairly "green". It contains little coal-fired generation and includes mostly low-carbon natural gas, nuclear and hydro units. For cost reasons, generators already use ("dispatch") plants in emissions order (nuclear and hydro first, then gas, only then coal). Cap and trade will not impact on emissions by changing the dispatch order or new investment mix unless permit prices soar to $100 per tonne.

But much of the state's imported electricity is generated in dirtier coal-fired units. In theory, the state's own programme would still capture these emissions because importers would have to acquire California permits based on the carbon emissions of the generated power. In practice, a regional system is the only way to prevent "contract shuffling" -- where out-of-state power producers claim the power they export to California is from "green" sources while reserving dirtier power from local use.

The WCI programme would cover most of the generation in WECC. Natural gas would begin to edge out coal-fired production at permit prices as low as $50 per tonne and there would be a significant shift at $60, according to the California Energy Commission.

Ends --

By John Kemp, Reuters columnist. The views expressed are his own.

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