California’s carbon offset program was upheld on Jan. 25, when San Francisco Superior Court Judge Ernest Goldsmith rejected an effort by environmental groups in Citizens Climate Lobby and Our Children’s Earth Foundation v. California Air Resources Board, CGC-12-519554, to invalidate the California Air Resources Board’s offset rule. Two public interest groups had challenged the rule on grounds that it failed to meet the so-called "additionality" requirement, which ensures that offsets will provide "additional" carbon reduction benefits over and above "business as usual." Offsets are a key element of the state’s controversial cap-and-trade climate change regulation.

Under the CARB rules in California, offsets may be used to satisfy up to 8 percent of a covered source’s emissions. Offsets are only awarded for projects carried out pursuant to one of four protocols adopted by CARB: U.S. forestry projects, urban forest projects, livestock projects and ozone depleting substances projects.

The crux of the issue is that in order to maintain the integrity of the system and ensure that overall emissions are in fact reduced, each offset must be "additional." This means that the reduction would not have occurred without the financial incentive provided by the sale of the offset.

Additionality

CARB adopted a standards-based approach to determining additionality. The standards-based approach creates additionality thresholds for particular categories of projects rather than determining it individually for each project. Under the standards-based approach, if a project developer can show that a project has met or exceeded the relevant standard, the project is deemed to satisfy the criterion of additionality. For example, under the U.S. forest protocol performance standards, if a piece of land had less than 10 percent tree canopy cover for 10 years, then a project which increases trees on that land and meets the performance requirements set forth in the protocol will be considered to be additional.

By way of comparison, the Clean Development Mechanism of the Kyoto Protocol uses a project-by-project approach. Under this method, additionality is determined by looking at each project’s unique location and circumstances. While in theory this approach is the most rigorous and precise way to determine additionality, it increases the expense of implementation. A standards-based approach reduces transaction and administrative costs and lends transparency to the verification process. On the flip side, standardization can lead to systemic inaccuracy if the standard is not appropriately calibrated. The use of a standards-based approach to determining additionality was the subject of Citizens Climate Lobby.

The case

Two environmental groups, Citizens Climate Lobby and Our Children’s Earth Foundation, filed suit against the state of California last year. The plaintiffs argued that the standards-based approach adopted by CARB was inherently subjective and unreliable. Their line of attack was twofold.

First, the environmental groups advanced the argument that CARB’s use of a standards-based approach to determining additionality was beyond the power the California Legislature had conferred upon the agency. The court rejected this argument, noting the Legislature granted CARB broad discretion to promulgate any type of GHG reduction measure, as well as the authority to determine whether a market-based carbon trading system would best achieve the goal of reducing GHG emissions. Judge Goldsmith noted that plaintiffs acknowledged CARB has the authority to use a standards-based approach; plaintiffs merely took issue with how CARB had devised its system.

Second, the plaintiffs unsuccessfully argued that the protocols implementing the offset program were arbitrary and capricious. Plaintiffs maintained that the use of performance standards is so fundamentally subjective and uncertain that it would create a high likelihood of producing large numbers of qualified projects for which emissions reductions or removals cannot be considered truly additional. The superior court reasoned that it is not its place to reweigh the evidence before it. The four protocols involve complex statistical analysis and scientific studies, and the court deferred to CARB’s expertise and experience.

Why it matters

2013 marks the first year that covered sources must surrender compliance instruments to CARB. However, during the ramp-up to 2013, market participants have been trading offsets for years in voluntary and pre-compliance markets. These participants include project developers, covered sources, other emitters seeking to voluntarily offset their emissions and/or ramp up internal processes, and investors seeking to take advantages of lower pricing in pre-compliance markets. Many contracts are for future delivery of offsets. These represent significant financial investments, the value of which largely depends on the ability of CARB to implement cap and trade.

While CARB has been working through implementation of the cap-and-trade regulation, issuance and oversight of offsets has been performed by private parties. These include the Climate Action Reserve, which offers protocols similar to those adopted by CARB. Offsets issued by the reserve are called Climate Reserve Tonnes or CRTs. The reserve also maintains an offset registry which tracks ownership and retirement of CRTs.

On Dec. 14, 2012, CARB announced that certain CRTs generated under four reserve protocols which are analogous to the CARB protocols will be convertible to CARB offset credits and accepted as AB 32 compliant offsets, referred to as ARBOCs. This announcement had been widely expected by market participants, who had been investing in CRTs based on their convertibility.

CRTs are typically sold through over-the-counter transactions between buyers and sellers. These transactions are often in the form of short- or long-term forward contracts. The price paid varies depending on the term of the contract, whether all or a portion of the contract price is prepaid and the allocation of various risks between the parties. Industry standards with respect to pricing and allocation of regulatory, project and counterparty risks are treated as proprietary information which is closely guarded. As a result, parties who intend to participate in offset trading under California’s cap-and-trade need to have a solid understanding of the potential risks which might lower the value of their investment, as well as the likelihood that such risks will transpire.

Challenges to AB 32, and its component cap-and-trade and offset program, create uncertainty in the market. Citizens Climate Lobby falls in line with earlier court decisions affirming AB 32 and cap and trade, signaling again the state’s commitment to moving ahead with its ambitious carbon reduction program. However, until remaining challenges are resolved, such as a lawsuit brought by the California Chamber of Commerce last November to challenge the allowance auction process, the specter of regulatory uncertainty will continue to impact the pricing signal for carbon, and how these risks are allocated will continue to inject extra complexity into the negotiation of offset sales contracts.

Other considerations

In addition to the regulatory risks discussed above, markets continue to face other near- and mid-term uncertainties. As of the date of this writing, CARB has not yet implemented the infrastructure necessary to issue or convert ARBOCs. Project developers and purchasers remain in a "no man’s land," generating and trading CRTs and relying on being able to convert them to ARBOCs when CARB systems are complete. This introduces the risk that at least some CRTs may not be convertible, or that the time frame for conversion may be too long. Buyers and sellers have been structuring contracts to deal with this risk in a variety of ways. These structures range from forward contracts for ARBOCs if and when they are produced, to purchase contracts for CRTs with various conversion options. As would be expected, pricing and payment differ depending on how each deal is structured.

Other risks include the possibility that offsets can be invalidated for up to eight years from the date of issuance. If an offset is invalidated, buyers that had surrendered the offset for compliance must replace the invalidated offset to remain in compliance. This puts buyers in a position where they remain exposed to increases in the price of carbon, which could be substantial, through the entire invalidation period. Buyers are mitigating this risk in a variety of ways. Some project developers offer offsets which have been double-verified, which reduces the time period for invalidation to three years. Purchasers can also look to lower-risk projects (such as destruction of ozone depleting substances) as a source for offsets. In all cases, sufficient due diligence should be performed on the offsets prior to acquisition. Finally, buyers may also be successful in negotiating indemnification from the seller if offsets are invalidated, although given the long time periods in question this raises the question of counterparty credit risk.

Conclusion

The purpose of the offset program is to provide a mechanism for encouraging least-cost reductions of carbon, thereby containing costs and increasing the overall efficiency of reducing GHG emissions under AB 32. The court’s decision in Citizens Climate Lobby adds some certainty, but the system continues to face both legal, political and implementation challenges. Pricing and trading conventions will evolve rapidly as momentum continues to grow in this nascent market.

Erika Anderson is of counsel and Daniel Kolta is an associate in Marten Law’s San Francisco. Anderson represents clients in complex transactional matters relating to cleantech, energy and sustainability. Kolta’s practice focuses on environmental law and litigation, energy, and clean technology.

In Practice articles inform readers on developments in substantive law, practice issues or law firm management. Contact Vitaly Gashpar with submissions or questions at vgashpar@alm.com.