Market Design Of Allowances, Offsets, And Renewable Energy Credits In The U.S. Carbon Markets

Companies are confronted with many business decisions as they consider actions to reduce their greenhouse gas emissions, whether as a result of potential future regulation by federal or state governments or on a voluntary basis for environmental benefits, cost-savings, marketing, or other reasons. Understanding the existing and potential future landscape for the "carbon markets" is crucial in the current economic climate and can enable companies to identify (1) new markets and other business opportunities; (2) additional sources of financing, cost savings, and improved operations; (3) options for greenmarketing and other public relations efforts; (4) ways to mitigate costs of compliance or meeting emissions reductions goals; and (5) other potential benefits and risks.

Allowances and offsets are the "currency" underpinning existing and future potential carbon markets. The trading of allowances and offsets in the global carbon market reached $136 billion in 2009, representing transactions for 8.2 billion metric tons, according to Point Carbon. Allowances and offsets are the units by which greenhouse gas reductions are measured, and their functionality and value depend on the market design of the emissions reduction program or the voluntary markets that create them, as the case may be. Their emerging intersection with the markets for renewable energy credits is also becoming a key component of the U.S. carbon markets.

Allowances

Allowances are marketable instruments issued by an emissions reduction program that entitle the holder to emit a defined quantity of greenhouse gas during a specified compliance period. Collectively, all allowances for a specified compliance period equal the aggregate emissions cap established under an emissions reduction program. These allowances are distributed either by auction or allocation (or a combination of both), and at the end of a specified compliance period, the entities that are covered under the emissions reduction program are required to submit allowances that are equivalent to their actual emissions during the specified compliance period.

Emissions reduction programs that utilize an emissions cap along with marketable allowances are known as "cap and trade" programs. The trading of allowances enables covered entities to formulate their strategy for compliance under the emissions reduction program based on the costs of reducing their emissions. Covered entities that face lower costs in reducing their emissions will implement technological or operational changes to their business to reduce emissions and thereby purchase fewer allowances or sell any surplus allowances. Other covered entities would presumably purchase allowances to the extent that it would be more economic than implementing reductions to their own emissions. In either case, cap and trade would provide covered entities the flexibility to determine their approach to compliance in a manner that lowers the overall economic costs of the emissions reduction program and promotes technological innovation.

Existing and Proposed Programs. At present there are two active cap and trade programs in the United States. The Regional Greenhouse Gas Initiative ("RGGI") is a mandatory program covering Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire, New Jersey, New York, Rhode Island, and Vermont that caps carbon dioxide emissions from specified fossil fuel-fired electric power plants. The Chicago Climate Exchange ("CCX") is a voluntary program under which companies legally bind themselves by contract to reduce their emissions of six different types of greenhouse gases.

There are also currently three proposals for climate change legislation pending in Congress. The House of Representatives has passed H.R. 2454, the American Clean Energy and Security Act of 2009 ("Waxman-Markey"), sponsored by Representatives Henry Waxman and Edward Markey, and the Senate Environmental and Public Works Committee has voted out S.1733, the Clean Energy Jobs and American Power Act ("Kerry-Boxer"), sponsored by Senators John Kerry and Barbara Boxer. A third bill, the Carbon Limits and Energy for America's Renewal Act ("CLEAR"), sponsored by Senators Cantwell and Collins, was proposed in the Senate at the end of 2009.

In addition, there are a number of regional emissions reduction programs that are in the process of forming. The Western Climate Initiative released a design document in September 2008 laying out the basic structure of a cap and trade program that is scheduled to commence in January 2012. It is intended to cover Arizona, California, Montana, New Mexico, Oregon, Utah, Washington, British Columbia, Manitoba, Ontario, and Quebec, with another six U.S. states, one Canadian province, and six Mexican states designated as observers. As part of Assembly Bill 32, California is developing a cap and trade program for California that would link with the Western Climate Initiative. The Midwestern Greenhouse Gas Reduction Accord released a draft model rule in October 2009 for a cap and trade program that is scheduled to commence in January 2012. It is intended to cover Illinois, Iowa, Kansas, Michigan, Minnesota, Wisconsin, and Manitoba, with another three U.S. states and one Canadian province designated as observers.

Architecture of Allowances. To provide context for the utilization of allowances, it is necessary to understand the policy decisions behind the architecture of the emissions reduction programs that create the allowances. The following is a summary of the key questions and options to consider in evaluating each of the existing and proposed cap and trade programs, including:

What emissions are covered? What entities are required to comply? What is the baseline for measuring emissions reductions and the amount and timing of reductions? How are allowances distributed? Are they auctioned or allocated or a combination of both? Are banking and borrowing permitted? Are there cost containment provisions? Covered Emissions. Certain emissions reduction programs are tailored to cover only carbon dioxide (CO2), while others cover a wider range of emissions such as methane (CH4), nitrous oxide (NOx), sulfur hexafluoride (SF6), hydrofluorocarbon (HFC), perfluorocarbons, and nitrogen trifluoride (NF3). Allowances are measured in carbon dioxide equivalents (CDE or CO2e) and describe the amount of global warming a given type and amount of greenhouse gas may cause, using the functionally equivalent amount or concentration of carbon dioxide (CO2) as the reference. For example, under an emissions reduction program, methane (CH4) can have a CDE of 21, meaning that a given quantity of methane in the atmosphere is deemed 21 times as potent as the same quantity of carbon dioxide (CO2) in contributing to climate change.

Covered Entities. Emissions reduction programs must establish which entities will be "covered" and thus submit allowances equal to their actual emissions. Reflecting the challenges of regulating emissions in a comprehensive and cost-effective manner, programs may target regulation at (1) direct sources of emissions such as electric utilities and manufacturers of cement, steel, textile, fertilizer, and other industries that rely on fossil fuels (i.e., "downstream" regulation), and/or (2) fossil fuel suppliers such as fuel refineries, natural gas distributors, and importers as a means of covering both direct sources and more diffuse greenhouse gas emissions emanating from vehicles and other small or mobile sources that are difficult to regulate directly (i.e., "upstream"...