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Washington State’s Cap-And-Invest Carbon Trading Program: Does It Correct California’s Design Flaws?

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Blog Posts Johns Hopkins School of Advanced International Studies

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Last spring Washington State passed a comprehensive Cap-and-Invest program as part of the Climate Commitment Act (CCA), the second state in the United States to have an economy-wide program for CO2 cap-and-trade program, which they named “Cap-and-Invest”. This followed a fierce political battle where progressive environmental activists were pitted against one another, for and against emissions trading, voting out a cap-and-trade program twice in previous votes. A newly elected Democratic majority in the state senate and its environmentalist governor, Jay Inslee, who favored an emissions trading program, finally succeeded in passing a new bill in April of 2021, effective in 2023. The details of the bill are now being worked out in committee, but the legislation guiding the structure of the bill is in place. In designing the program, legislators used a laundry list of California’s mistakes to guide the environmental committee in creating a program that was stringent, flexible, effective, and ultimately environmentally just, hoping to avoid some of the pitfalls of the California program. The opprobrium leveled against California’s CCTP (California Cap and Trade Program) program, supervised by the CARB (California Air Resources Board), was so fierce, that it derailed Biden’s choice for EPA (Environmental Protection Agency), Mary Nichols who headed CARB.   

California’s Cap And Trade Program, Blasted By Environmental Justice Groups        

California’s Cap and Trade Program (CCTP) has been blasted by environmental justice groups for its ineffectiveness in reducing emissions from the state’s worst carbon emitters. The use of out-of-state offsets, usually forestry, and the liberal disbursement of free allowances, allowed the state’s worst energy industry emitters to increase CO2 emissions, along with co-pollutants such as fine particulate matter.  Whatever emission reductions the oil industry showed because of offsets or allowances, Independent data showed that through the duration of the first program, California’s oil and gas industry actually increased CO2 emissions by 3.5%. Stationary emitters, such as the refineries of the two largest refiners in the state, increased emissions, and created local hot spots of carbon dioxide as well as co-occurring fine particulate matter, with many deleterious health effects in the disadvantaged communities where these plants were aggregated. As a result, the program, which was started in 2013, came under heavy criticism from many sectors: environmental, justice groups, and the medical community. Will Washington State be able to correct California’s CCTP design flaws to achieve greater effectiveness, stringency, flexibility, and greater equity? 

Washington State’s Program Design: Modeling, But Correcting California Design Flaws          

Washington State modeled its Cap-and-Invest system on California in scope and structure. It has been part of the Western Climate Initiative, a working group formed in 2011 to devise a regional strategy for reducing emissions. Many of Washington’s design features align with California because of this influence and the possibility of later linkage.  It also establishes an economy-wide program, covering 75-80% of the economy, but has a smaller energy industry presence, with no oil or gas production, mainly hydropower-generated electricity supply, only one oil refinery, and less than 25% of the CO2 emissions with 100 covered entities. The smaller size and less energy industry influence did not make the politics much more manageable, however, with two previous attempts to institute a system rejected by voters, the State used the woes of California to guide them.

Sen. Reuven Carlyle, Chair of the Senate Environment, Energy and Technology Committee, had a list of requirements using California as a guide as well as information from the stinging reports from ProPublica on emission increases in the oil and gas sector and the California Offset program.

Program Scope

The scope of the Washington Cap-and-Invest includes about 100 entities versus 500 in California and allocation via quarterly auction. In California, industrial facilities were previously subject to a declining percentage of free allocations based on a formula ranking level of exposure to leakage or risk of competition. AB 398 (Assembly Bill 398) eliminated this to provide free allocation to all industrial facilities, effective in 2021. Electrical and natural gas facilities and natural gas suppliers receive free allowances, which they must use for compliance or auction for the benefit of ratepayers. Washington has a tighter plan on the allocation of free allowances. Energy-Intensive-Trade-Exposed (EITE) entities would receive 90% of their allowances for free, declining yearly by 5% until 2026 to 75%. In 2024, the Department of Ecology, the Washington regulator, will create rules for 2026 onward. Some electric utilities will receive allowances, but unused allowances must be consigned for sale for ratepayer benefit.  The same rule applies to Natural Gas Utilities, which will receive free allowances for the whole of the program.  In contrast, Gov. Brown of California allocated free allowances to refineries to garner necessary political support for the program. There is no ranking in terms of trade exposure as in the previous AB 32. On both systems, allowances can be banked and do not expire.  California’s banked allowances are huge: total allowances now “banked” by covered entities are 226 MT CO2 as of the last 2018 update, with current updated 2021 numbers being issued shortly. California now limits allowances but has a loophole that exempts covered entities.

Washington’s ambition level is more significant than California, not in terms of the amount of carbon to be mitigated but in the rate of reducing the cap. The current level of decrease in California is 5% lower yearly until the 2030 expiration of the program. The rate of cap decrease in Washington is 7% until 2030, then 2.5% until the program expiration in 2050.

Market Stability Mechanisms

Market Stability Mechanisms in California and Washington are price-based, unlike the EU ETS set by the number of allowances banked.  Both California and Washington have an auction minimum price; California’s price level is 17.50, where the traded price is now. Washington is in the Rulemaking and Comment phase and will be determining these price levels over the next several months. California has recently revised its Price Cap above the market. A certain number of allowances are put into an Allowance Price Containment Reserve (APCR).  There are two price tiers below a hard price cap. Additional allowances will be released at the first tier of $41.40, and at the second tier of $53.20, the second tranche of allowances will be released from the ACPR. The hard price cap is placed at $65, which trade cannot exceed.  These mechanisms have never been used in California, where prices have remained depressed. The Washington Cap-and-Invest Plan is similar, now being worked out now in the Rulemaking and Comments process. These caps and floors transform these trading instruments into hybrid, tax-like collar structures. These structures must be aligned if the two exchanges link up their trading systems.

Penalties for non-compliance are similar but more clearly delineated in the Washington program, which requires four allowances for every required allowance not submitted; after 60 days, a fine of $10,000 per day is levied. The 4-allowance penalty is the same for California, and a financial penalty may be levied but is not specified. Washington has instituted a new pollution monitoring system with an accompanying online map, highlighting daily pollutant levels at different locations, including “disadvantaged communities”. It has the power to require greater compliance from entities in these communities and levy penalties for infractions.  

Offsets:  The Fly In The Ointment 

The real differentiation with California comes with the treatment of Offsets, the allocation of revenues, the proactive relationship with the community, the increased requirements for covered entities in “overburdened” communities, increased monitoring, and the creation of an Environmental Justice Council, appointed by the Governor to review all design decisions connected with CCA and Cap-and-Invest. 

Offsets in California contributed to both the allowance oversupply problem and the resulting continued pollution in disadvantaged neighborhoods, damaging them and the political viability of the program. In addition to their questionable climate mitigation value, the Offsets exist outside the State’s total emissions cap. Under AB 32 (Assembly Bill 32), covered entities were allowed to meet 8% of their obligations by Offsets, so they essentially expanded the state’s Allowance Budget allocations to potentially 108% of the emissions budget. These were largely forestry and could be anywhere in the United States; critics complained that California was polluting at home and providing benefits elsewhere. In AB 392 (Assembly Bill 392), California has since adjusted its use of Offsets to 4% of a covered entity’s obligation, and half must be providing direct benefits to the State. However, in 5 years, this level will increase to 6%.`Washington has recognized the design of Cap-and-Trade systems to reward collective goals and not the local quality of life. These programs are politically enabled, and California provided a valuable object lesson on how not to handle the communities affected by pollution.  

Addressing this Offsets issue was critical for Washington for the integrity of the exchange. In contrast to California, allowable Offsets in Washington are within the State emission’s budget. In the first compliance period of 2023-2026, the total number of offsets is limited to 5% of a covered party’s obligations, with 50% of the offset to provide direct benefits to Washington State. An additional 3% is allowed if the offsets are projects on tribal lands. The formula decreases for the next compliance period, 2027-2039, to 4% of the covered entity’s requirements, with an additional 2% allowed for projects on tribal lands. These are critical distinctions to the California bill.

The allocation of revenues is different in both States. The allocation addresses the environmental justice issues and local issues with transportation, which comprises 45% of the State’s carbon emissions. From 2023 to 2037, low-carbon transportation initiatives, mostly transit, will receive $5.2 billion; the Air Quality and Health Disparities Improvement account will receive $20 million every two years. The remaining funds will be split two ways: 75% will be directed to the Climate Investment Account for climate mitigation and adaptation projects, as well as $20 million for relocation costs to tribal communities threatened by rising sea levels. The remaining 25% will go to the National Climate Solutions Account for natural resources management and resilience. All the investments made with CCA revenue are broken down as follows: 35-40% must be targeted to overburdened communities, affected disproportionately by pollution, and an additional 10 percent to tribal nation projects. All funding must be reviewed and approved by an Environmental Justice Council advising Washington agencies on the implementation of the CCA and advising agencies on incorporating environmental justice in agency activities. it will oversee program design, potential linkage to California, and monitor pollution levels in “overburdened” communities. California has a plan which allocates the major portion of the revenue to the Greenhouse Gas Reduction fund; a minimum of 35% must go to “overburdened communities,” and revenues from the Utility-owned allowances are auctioned for the benefits of the ratepayers. However, Washington is more focused on environmental justice issues.

The Big Picture: Potentially Linking To Other Carbon Trading Exchanges

Regarding potential linkages to other exchanges, Washington State could potentially link to California which is linked to the Quebec, Montreal system but there are several requirements and challenges. It is a kind of dream of environmentalists and commodity traders to see carbon exchanges linked to provide fungible, commoditized prices for carbon. This would theoretically expand the opportunities for a larger pool and more efficient pricing due to the different structures and the fact that there are so many exceptions and rules tailored for different constituencies that you can never quite standardize the instruments. Regarding linking California, this is a possibility but with several caveats. Washington insists that this decision must serve the interests of Washington State locally which points directly to their concerns with environmental justice as well as the massive oversupply of instruments which would affect the stringency of Washington State’s program and just export California’s problems.  Operationally, all the auction reserve floors would have to align, as well as the Cap prices and reserve tiers. 

Conclusion

 Washington has the opportunity for a fresh start, benefiting from a period of political unity to craft a better, more locally acceptable version of California’s ambitious economy-wide Cap-and-Trade program. Like the EU ETS before it, California suffers from a surfeit of allowances, the result of years of concessions to powerful energy industry trade groups. The literature makes clear that this is a problem endemic to trading systems: maintaining a trading system that accurately prices carbon’s externalities to support decarbonization and technological innovations requires a sharing of the cost by industry, which has shown an unwillingness to do. Washington State has identified points in the California trading system model which affect stringency – Offsets, banking, rapid allowance reduction rates, penalties – optimizing them for greatest efficiency, recognizing and addressing equity issues, and passing has done the most they could with them. They recognized and addressed the issues of equity. They managed to pass a bill authorizing the system for another 29 years, whereas California will have to go through this political fight again in 9 years. Washington’s bill addresses the issues of environmental justice by shaping policies such as Offsets to benefit the State and “overburdened communities” including tribal lands. Washington will have to monitor closely the system to assure that it too does not eventually over-allocate. And it appears that this model for a trading system that operates along other complementary carbon mitigation programs will likely not have a high carbon price, as is the situation with California. Washington is working its way through the Rulemaking and Opinion phase but appears to have refined the model for greater effectiveness, stringency, flexibility, equity, and potential regional, though not global, linkage. 

***

Patricia A. Hemsworth is Master of Arts in Sustainable Energy candidate at the Johns Hopkins School of Advanced International Studies. She specializes in energy derivative markets and holds the position of Senior Vice President at Paragon Global Markets.

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