emissions trading programs are evolving

Emissions reduction and trading programs in the United States have experienced significant growth and evolution in recent years.

In addition to the federal sulfur dioxide (SO2) and state-implemented nitrogen oxide (NOx) programs initiated under the Clean Air Act in the 1990s, the Chicago Climate Exchange (CCX) created a voluntary greenhouse gas (GHG) reduction and credit trading platform that opened for trading in 2003. The CCX then created the Chicago Climate Futures Exchange in 2004, the first exchange to facilitate the trading of SO2 emissions allowance futures. The emergence of GHG trading programs, such as CCX, has been followed by a wave of regional and state-initiated carbon allowance trading programs, most notably the Regional Greenhouse Gas Initiative, a cooperative effort among the Northeastern and Mid-Atlantic states.

Markets for additional emissions products, including, but not limited to, mercury, are also materializing beyond the state level. Although the EPA has published proposed rules for mercury trading, the actual implementation of a trading program is uncertain due to ongoing public criticism, but all signs indicate that the EPA intends to continue pursuing the plan.

federal and state emissions trading programs

U.S. emissions trading began with the 1990 Clean Air Act’s creation of EPA programs for the reduction of acid rain and ground level ozone, including a program for the nationwide reduction of SO2 emissions. The EPA later promulgated regulations requiring states to implement programs for the reduction of NOx emissions. These EPA-administered emissions reduction programs established a new, flexible, market-based cap-and-trade approach to reducing pollution.

State programs are largely modeled on the EPA’s trading programs and are typically administered similarly to the EPA’s SO2 program. The most common state programs involve a credit known as an Emission Reduction Credit (ERC) that, notably, differs from state to state.

California, for example, is divided into 35 regional Air Pollution Districts. Some of California’s ERC programs allow for trading between Air Pollution Districts, but there are limits on the interchangeability of ERCs from one Air Pollution District to another. The use of ERCs from outside one’s own Air Pollution District often requires approval by the local or California Air Resources Board, particularly if the EPA has classified the particular Air Pollution Districts into different air quality levels for different pollutants.

Programs for the reduction and trading of GHG emissions allowances, in particular carbon dioxide (CO2), are relatively new to the United States. The CCX, the first major attempt to establish a voluntary, market-based program for carbon trading and reduction, was developed by 28 large companies, including Ford, DuPont and BP America, and is based upon voluntary reductions of GHGs, specifically CO2, as well as the generation of offset credits (e.g., planting trees). Continuous electronic trading of GHG emissions allowances and offsets on the CCX began on Dec. 12, 2003, but due to its voluntary nature, the market has not advanced as quickly as had been hoped.

the RGGI draft model rule

The latest development in GHG emissions allowance trading programs is the Regional Greenhouse Gas Initiative (RGGI), a multi-state, regional initiative among several Northeastern and Mid-Atlantic states. As opposed to the CCX, RGGI is a mandatory, market-based, flexible cap-and-trade program to reduce CO2 emissions from power plants in the Northeastern U.S. In the future, RGGI may be extended to include other sources of greenhouse gas emissions as well.

On Dec. 20, 2005, the governors of Connecticut, Delaware, Maine, New Hampshire, New Jersey, New York and Vermont signed a Memorandum of Understanding to move forward with the implementation of RGGI. In April, Maryland passed legislation requiring the state to be a full participant in RGGI by June 30, 2007, but several other states, including Rhode Island, Massachusetts, Pennsylvania, and the District of Columbia, remain observers in the process.

In March, RGGI released a draft model rule for public review and comment. More than 100 comments were submitted by private citizens, energy companies, investment banks, environmental groups, government agencies and other interested parties. The states will now review the comments and make revisions to the Draft Model Rule as warranted; the tentative date for the release of the final model rule is July 2006. The Final Model Rule will be the basis from which the states develop regulatory or statutory proposals to implement the program.

Under the Draft Model Rule, RGGI proposes to cap the total amount of emissions to be allowed from all of the sources in the region-the annual regional emissions cap-with the goal of reducing emissions to 1990 levels over the next nine years. Each state would then receive an emissions budget, their share of the regional budget or cap, and would determine which CO2 emissions sources within the state are subject to a cap. Each state would then issue one CO2 emissions allowance for each ton of emissions up to the amount of its state emissions budget. Each RGGI emissions allowance would be assigned a unique identification number that would include the year for which the allowance is allocated. Each state would distribute its emissions allowances among the covered sources within the state, as well as the market, potentially through auctions. Covered sources within each state would have a three-year compliance period in which to reduce emissions, buy RGGI emissions allowances or generate credits through a CO2 emissions offset project. Sources that reduce their CO2 emissions and have excess RGGI emissions allowances would be permitted to bank or sell in the market any excess emissions allowances.

The Draft Model Rule includes two categories of price mitigation mechanisms intended to curb potential price spikes in the RGGI emissions allowances market. First, RGGI proposes extending the compliance period if the spot price for RGGI emissions allowances equals or exceeds the predetermined “safety valve” threshold ($10.00, as adjusted by the Consumer Price Index plus 2 percent per year beginning Jan. 1, 2005) for 12 months on a rolling average basis after the first 14 months of each compliance period, the “Market Settling Period.” The compliance period could be extended by up to three one-year periods.

RGGI also proposes expanding the permissible use of offset credits if prices reach certain levels. Under the Draft Model Rule, a covered source typically would only be permitted to use offset credits for compliance up to a limit equivalent to 3.3 percent of its reported CO2 emissions in any compliance period. However, if the price of RGGI emissions allowances were to reach $7 per ton for a period of 12 months after the Market Settling Period, a covered source would be permitted to use offset credits for compliance up to a limit equivalent to 5 percent of its reported emissions in a compliance period. If, after two years of a compliance period extension, as described above, emissions allowance prices were still above $10 per ton, a covered source would be permitted to use offset credits in an amount up to 20 percent of its reported CO2 emissions.

The geographic scope of authorized offset projects would also broaden when certain price triggers are reached. For example, if the price of RGGI emissions allowances was to reach $7 per ton for a period of 12 months after the Market Settling Period, then the use of verified emissions reductions from offset projects in non-participating states would be permitted. However, the relevant state regulatory agency would only award one offset credit for each two tons of verified emissions reductions from non-participating states. If, after two years of a compliance period extension, RGGI emissions allowance prices were still above $10 per ton, the geographic scope would also be expanded to allow for the use of offsets from international trading programs. These price mitigation measures, although designed to protect utilities from large price spikes, may limit the willingness of marketers and dealers to participate in the market.

The proposed RGGI allowance trading procedures are substantially similar to the EPA SO2 Allowance Tracking System process. Under the Draft Model Rule, RGGI emissions allowances would be tracked and transferred through compliance accounts and general trading accounts. Any person would be able to apply to open a general account to hold and/or transfer RGGI emissions allowances.

The CCX has proposed establishing two new regional trading exchanges, the New York Climate Exchange (NYCX) and the Northeast Climate Exchange (NECX), which should provide greater liquidity and price transparency for RGGI emissions allowances, by linking them to the broader global GHG emissions allowance market. CCX also operates a European subsidiary, which has added to the liquidity and price transparency of the European Union emissions trading scheme for reducing CO2. Product development is scheduled to begin shortly and NYCX and NECX plan to be ready for operation in accordance with the implementation of the final RGGI trading program. The RGGI Draft Model Rule calls for an initial three-year compliance period to run from 2009 through 2012.

Some commentators argue that RGGI may have a negative economic impact on power plants within the participating states, but many of the comments that have been submitted to RGGI as part of its rulemaking have been positive. The participating states recognize that climate change demands a progressive response and many industry participants welcome a new emissions trading market to compete with, or potentially connect with, the European Union and Kyoto emissions trading markets. While it is possible that RGGI may face legal challenges and the Final Model Rule may diverge significantly from the originally proposed Draft Model Rule, RGGI will likely be instrumental in the development of any forthcoming federal GHG reduction and trading program.

The CCX and the RGGI have paved the way for additional state initiatives with respect to GHG allowance trading. For example, in 2005, Oregon’s governor established the Oregon Carbon Allocation Task Force to examine a cap-and-trade approach to reducing CO2 emissions for Oregon. The Task Force is authorized to cooperate with neighboring states that may be interested in developing a regional standard, and will make its recommendations to the governor in the fall of 2006.

California may implement a CO2 emissions allowance trading program. In April, the California Public Utilities Commission (CPUC) issued an order to begin a rulemaking to adopt and implement a GHG emissions performance standard that would include a GHG emissions allowance cap-and-trade component.

federal program potential

Although U.S. CO2 cap-and-trade programs are currently being implemented only at the state and regional levels, the states are increasing pressure on Congress to implement a federal program. New York, California, Connecticut, Massachusetts, Maine, New Mexico, Oregon, Rhode Island, Vermont and Wisconsin sued the EPA in April for refusing to regulate CO2 emissions from power plants. New York City, the District of Columbia and three environmental groups also joined in the suit. The suit seeks to force the EPA to regulate the emission of heat-trapping gases, like CO2, from power plants and to tighten the regulation of conventional smog-forming pollutants.

The states argue that because CO2 is a major contributor to global warming, CO2 emissions are a threat to the “public health and welfare” and, thus, should be subject to federal regulation. Under the Clean Air Act, the EPA is obligated to review and revise emissions standards every eight years to ensure the protection of public health and the environment. The EPA issued revised regulations in February 2006 in accordance with a court order, but the revised standards do not address power plant emissions of CO2. The states, therefore, claim that the EPA has not met its Clean Air Act obligation to ensure public health. The lawsuit will likely affect the timing of any federally-mandated GHG trading program. Congress is currently considering legislation to establish a federal system for the regulation of CO2.

It appears unlikely that federal regulation will occur in the near future, but, given the increased pressure that the states and others, including a surprising number of large retailers and industry members, have been exerting, the federal government may be induced to develop a national program sooner than previously expected.

Ms. Larsen is a partner and Ms. Velie is an associate in the Washington, D.C., office of McDermott Will & Emery LLP, both practicing in the firm’s Energy and Derivatives Markets Group. The authors would like to thank Ms. Melissa Dorn for her assistance with this article. The views expressed herein are solely those of the authors and do not necessarily reflect the views of McDermott Will & Emery LLP or its clients.

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