California Offsets: Unfortunate Choices, and the Struggle to Define “Direct Environmental Benefits in the State”

by | Jun 6, 2018

Introduction

The California Air Resources Board (ARB) is in the midst of a comprehensive review of its Cap and Trade program. Although updates occur frequently, this year the agency is undertaking an important overhaul required by the passage of Assembly Bill No. 398 (AB-398) in July 2017. AB398 signaled the California legislature’s approval of the Cap and Trade program put in place by ARB and extended the program through 2030. While AB398 supported the Cap and Trade program, it also required that ARB make a number of significant changes to the program, to elements such as price ceilings, reserve auctions, banking rules, and many other aspects of the program—including the offset program. This post focuses specifically on the changes that the legislature asked for regarding the offset program.

 

Background

Offsets Explained

Offsets are a very small component of the Cap and Trade program in California, but they are perhaps the most targeted and misunderstood aspect of the program.  In general terms, offsets are credits that are granted for activities that reduce or sequester CO2, methane, and other global warming gases.  Think of an offset as a certificate demonstrating that 1 metric ton of carbon dioxide was either sequestered or did not get released, because of some effort or activity that prevented it.  Throughout the world, many regulatory programs that seek to limit climate change have offsets as a component of their program.  Offset projects can also be undertaken voluntarily, and many conscientious individuals, businesses, and government bodies support those projects through the voluntary purchase of the resulting credits.

California Cap-and-Trade Program Offsets

In the California program, an “offset” is a short way of saying a California Compliance Offset (CCO).  In technical terms, an offset in this context represents one metric ton of CO2-equivalent (CO2e) emission reductions that has been verified by a third-party verification body, approved by both a registry and the ARB, and issued by the ARB as a CCO.  This CCO can then be used as a compliance instrument to address an emitter’s obligations in the Cap and Trade program.

The “Cap” and “Trade” in Cap and Trade 

The California Cap and Trade program requires that the total emissions from all entities subject to the program decline each year in order to hit a predetermined annual emissions target, which is referred to as the “Cap”. This Cap is the hard ceiling under which emissions must fall each year.  The “Trade” component comes from the fact that each emitter can choose how they comply with this Cap; 

• They can reduce their internal emissions;
• They can purchase allowances from the state at auctions; 
• They can purchase allowances from other parties; 
• They can purchase CCOs; 
• Or they can purchase any combination thereof. 
 
This is where the “trade” part comes in. Flexibility is important because it allows emission reductions to be achieved by whoever is best able to achieve them and at the lowest cost. Because greenhouse gases do not impact health on a localized basis, it is not important where the emissions occur, only that the total emissions released each year meet the declining “Cap”.

It is imperative to allow for cost-effective emission reductions rather than implementing a command-and-control stance, which forces reductions everywhere without regard to cost. Utility bills and gasoline prices would be impacted heavily by such a policy, and utility and gasoline price increases are felt the hardest by the lowest-income citizens in California. Implementing an inflexible command and control policy would directly target the most disadvantaged households with a regressive tax.

An emitter can surrender a CCO for up to 8% of its compliance obligations (emissions). This helps the emitter save costs since through its purchase of the CCO, it is financing cost-effective projects that reduce emissions outside of its “fence line” or normal business operations.

How California’s New Rules Affect the Cap-and-Trade Program

AB-398 directs the ARB to reduce the number of CCOs that an emitter can use to meet its annual obligations, beginning in 2021. At that time, an emitter will only be able to submit CCOs to cover a maximum of 4% of its compliance obligation, as opposed to the original 8% (this number increases from 4% to 6% beginning in 2026). This change will result in a cost increase. The bill also directs the ARB to only accept CCOs to cover 2% of an emitter’s compliance obligation, if those CCOs do not have “Direct Environmental Benefits in the State.”

Defining Direct Environmental Benefits in the State: Why it Matters and Why the Discussion Is So Misplaced and Potentially Harmful

There are three significant concerns with the design of ARB-398:

  1. Reducing the overall limit from 8% to 4% is based on a misunderstanding of what offsets are and what purpose they serve.
  2. Dividing CCOs into buckets (i.e., those that benefit the state and those that do not) and implementing what amounts to a protectionist 50% California-advantaged requirement (half of the 4% total limit) not only flies in the face of an offset program’s purpose but also misunderstands the science of climate change as a global challenge.
  3. Defining “Direct Environmental Benefits in the State” can only lead to confusion and potential chaos. Science suggests that all emission reductions have a global impact. Thus, by definition, all reductions positively impact California residents. Yet, some environmental lobbyists are suggesting that the California Legislature intended something else, but what?

Reducing the overall offset usage limit from 8% to 4% will limit the cost savings achieved by emitters, with the added costs undoubtedly passed through to California-based consumers. This reduction was likely implemented to address issues raised by environmental justice advocates, though it misses the mark.

Environmental justice groups have a legitimate and serious concern: that local air and water quality issues exist in California and that those issues hit disadvantaged communities hardest. Low-income neighborhoods frequently bear the brunt of point-source emissions; of that, there is little debate. The question, however, is whether a program with the goal of reducing global greenhouse gas emissions is the venue for this debate. California already has an extensive list of programs to address local air and water quality issues. Those programs are better equipped to address this major concern.

What Offset Projects Are Designed to Do

It may sound like heresy from an offset project developer, but the most important aspect of an offset project is not the exact number of metric tons of emissions it has reduced; it is how the project impacts the future.

The most important aspect of an offset project is its ability to simultaneously engage external parties, provide pricing signals, drive innovation, and bring technologies and practices to scale.

My greatest desire is that I will not have a job developing offset projects in the future. If I do my job well, offset projects will become common practice, and offset credits will no longer be warranted. Offsets provide a bridge to innovative technologies, new regulations, and new practices; they are not an end in themselves.

What the California Legislature has done is to severely limit the ability of offset project developers to conduct research, act as California’s climate ambassadors, and communicate the value of reducing emissions to external stakeholders. The big picture has been lost in this battle.

How the Bill Misunderstands Climate Change

The AB-398 requirement that half of the offsets surrendered by an emitter have “Direct Environmental Benefits in the State” places the ARB in an unenviable position of having to 1) interpret what that even means and 2) figure out how to operationalize it in the context of program regulation.

Clearly, the policy was intended to provide economic or additional environmental benefits to residents of California. Putting aside the possibility that this protectionism may be unconstitutional, the policy misunderstands both the purpose and benefits of offset projects (described above) as well as climate-change science. All offset projects anywhere in the world directly benefit California. From New Zealand to France to the United States, we are all in this battle together. It matters not to the planet where the emission reductions occur.

 

Although I might wish to rail against this aspect of AB-398, I applauded the bill’s passage. What remains is the implementation of this legislation by the ARB, and it is here that much can be done. The CA Legislature has left it to the ARB to interpret “Direct Environmental Benefits in the State.” The ideal solution would be the most flexible possible definition that will recognize the science yet meet the legislative intent if it is challenged in court.

A couple of possible approaches have been proposed — 1) a positive list of geographies/activities/pollutants that qualify or 2) a path for each developer to petition individually for a project to qualify for acceptance based on some yet-to-be established criteria. Each is an exercise in contortionism, bending reality in an attempt to meet some perceived legislative agenda.

I would urge the ARB to abandon these potential approaches and instead fight for the science, adopting the position that an emission reduction anywhere has a direct, positive environmental impact on California residents. For too long, Climate Change, and programs to address it have fallen under attack and have bowed to political whims that are either grossly uninformed or obviously self-interested. Assaults on science-based solutions—no matter from which side of the political spectrum they emanate—should not be part of the Climate Change solution in California. California is viewed as a world leader on environmental issues, and the world is most certainly watching the design of this program, hoping California can ultimately develop a cost-effective program that can be replicated in other jurisdictions.

About the Author

Derek Six serves as Chief Business Officer at ClimeCo, where he leads the company’s cross-cutting business functions, as well as the firm’s ODS management program and private equity fund. He holds an MBA in investment management and portfolio analysis from Pennsylvania State University’s Smeal College of Business.