An inside look at California's cap-and-trade program

California is gearing up to set in motion cap-and-trade, its market-based program for curbing greenhouse gas emissions, with the state’s first auction for carbon allowances next month.

The program was created by the state’s Global Warming Solutions Act of 2006, which aims to reduce emissions in the state to its levels in the 1990s by 2020. The way it works: Businesses, utilities, refineries and manufacturers in California that spew more than 25,000 metric tons of carbon dioxide per year are required to obtain allowances to emit greenhouse gases. The program will cover around 350 to 400 businesses, according to officials at the California Air Resources Board, the agency managing the program. Even those headquartered out of state are required to participate if they operate facilities in California.

Each year, the "cap," or the overall amount of emissions the state allows, will shrink,  as will the number of allowances for sale. That means emitters will need to shrink their greenhouse gas levels or buy allowances.

The Air Resources Board distributes sizeable portions of these allowances for free to many businesses. Some utilities, for example, receive all their allowances at no cost. Businesses that have to purchase a portion of their allowances must buy them either at an auction held by the Air Resources Board on Nov. 14, or in the marketplace from other companies. Businesses can also meet the cap by purchasing a limited amount of “offset” credits from projects that reduce greenhouse gas emissions offsite -- for instance, from companies that specialize in disposal of ozone-depleting refrigerants, agency officials said. The offset credits need to be approved by the Air Resources Board.

GreenBiz’s Ambika Kandasamy talked to Dave Clegern, a spokesman at the California Air Resources Board, on what companies need to know about how the new carbon market will be implemented. This interview has been edited for length and clarity.

GreenBiz: Is cap-and-trade a mandatory program?

Dave Clegern: Any business that is generating more than 25,000 metric tons of carbon dioxide a year is covered by cap-and-trade. They’re in. Companies that generate less can opt in to the program, and some of them have. Companies generally opt in when their business plans indicate they can receive free allowances by following the cap-and-trade regulations -- monitoring and reporting emissions. The advantage to them is that they do their calculations, and determine that they will receive enough allowances under the program that they can sell some.

GB: When does the emissions cap go into effect, and who is under the cap in the first year of launching the program?

DC: The first compliance period begins Jan. 1, 2013. The cap is 162.8 million metric tons of carbon dioxide. They [the participants] are primarily refineries, utilities, cement manufacturers, glassmakers and some of the larger food processing facilities. That’s the lion’s share of them.

GB: The California Air Resources Board is holding an auction on Nov. 14 to bid on allowances. Which businesses are participating in the auction? What’s the auction platform, and process?

DC: We don’t know finally at this point. We’ll have an idea after everybody’s registered for the auction platform. We’re still registering participants until Oct. 15. The auction platform is being run by Markit North America. It interfaces with our financial services provider, which is Deutsche Bank. The auction itself is closed. It’s a blind auction -- the people who are bidding can’t see each other’s bids.

There’s a floor price [for each allowance]. It’s technically called a reserve price. That’s $10 an allowance.

GB: How many allowances could a single business purchase? Is there a limit on this?

There are limits at the Air Resources Board auctions. Covered companies can purchase no more than 15 percent of what’s available, and third parties no more than 4 percent. We have no involvement in the secondary market, other than that all trades or sales must be registered with us. 

GB: How are allowances allocated to businesses?

DC: They’re based on the products that businesses in the different sectors produce. There’s basically a benchmark process, and if you’re significantly below the benchmark, you will end up with a surplus of allowances. And if you are at or above the benchmark, you will likely have to go out and get some from somebody else or buy them at auction. The benchmark differs by sector and is essentially an average of the carbon intensity for the finished products produced in each sector.

But for the first two years, all of the industrial entities get 90 percent free, so they only have to account for 10 percent of their emissions in terms of actually buying something or reducing emissions. If they reduce their emissions, they don’t have to buy anything.

GB: Which businesses get free allowances?

DC: The utilities get all of their allowances free for the duration of the program, but the utilities operate under a different set of rules in that they -- the investor-owned utilities and some of the public ones -- are required to sell all of their free allowances at auction and then put [the proceeds] into a process that will return some value to their customers. It could be in terms of controlling rates. It could be using more renewable fuel. The Public Utilities Commission is working out the details on that, because they manage rates.

GB: And which ones get up to 90 percent free?

DC: Those would be the industrial ones. Refineries. Phillips 66, Chevron, all of those folks. There are a number of cement plants.

Photo of oil refinery provided by David Sprott via Shutterstock

Next page: Leakage risks, costs of program

GB: One of the concerns of this program is that companies might move out of the state to avoid participating in it -- the concept of “leakage” -- what can be done to prevent it?

DC: Well, it is an issue, and what is done to prevent it at this point is that a certain percentage of the free allowances that companies get are based on preventing leakage. If we run into a particular sector or a facility that is in some way unique and has a problem in meeting what we need them to accomplish is that we will work with them.

A good example of that is the cement industry. One of the more common kinds [of cement] is called hydraulic cement, which is the kind of cement that will stay hard underwater. In the process, what’s called clinker [a substance necessary to producing hydraulic cement] is made.

The problem with clinker is that there is no alternate technology for making it. And at this point, there is no way to make hydraulic cement without manufacturing it, but it is extremely greenhouse gas intensive. So we sat down with the cement people and talked that through, and what we arrived at was that, because their process emissions is not something that they can really do anything about except go out of business, we gave them a modification to their allowance budget that will take that into consideration.

GB: What modifications are given to businesses like cement companies that have difficulty lowering their emissions?

We work with individual facilities and entire sectors to make compliance manageable. In some cases, that has involved additional [free] allowances. In others, it has involved allowing them to enter the program later, as is being done with the combined heat and power facilities. 

GB: How can businesses that are not participating in the auction in November buy their allowances?

DC: In 2013, there will be four auctions, and in 2014, there will be four auctions. There’s also whatever’s out on the secondary market, which we really have no involvement with, other than that we track the allowances that are handed off from party to party. There should be adequate allowances around. The primary advantage of getting into it early is that there’s a very good chance that the price will be lower.

GB: Is California’s cap-and-trade program modeled after other cap-and-trade programs in the world?

DC: To some extent California’s program is modeled after the regional greenhouse gas initiative in the Northeast, and the European Union’s emissions trading system. But the Air Resources Board has adapted those plans and made changes to suit the market we’ll be dealing with. 

GB: What are the costs associated with California’s cap-and-trade program?

The projected costs for the various contracts associated with cap-and-trade program are (24-month contract): 

Auction operator -- Markit, North America: $750,000

Financial services administrator for auctions -- Deutsche Bank: $500,000

Market analytics -- Market monitor: $400,000

Market training for state staff -- Cutting Edge Capital: $200,000

Development of tracking system, international linkage administration, contract management and other services -- Western Climate Initiative, Inc.: $3.7M