Obama’s Climate Action Plan: Good News for AB32, Bearish Signal for California Carbon Prices

Obama rolls up his sleeves and gets to work on climate change
Obama rolls up his sleeves and gets to work on climate change

A little late to the game, but with renewed enthusiasm, President Obama laid out on June 25 a comprehensive climate action plan for the United States with greenhouse gas (GHG) regulations from the Environmental Protection Agenday (EPA) as the centerpiece. How will the regulations interact with California’s carbon market? Is federal action good news or bad news for California?

EPA regulations – a warm embrace for state action

EPA regulations have been years in the making – EPA’s authority to regulate GHG under the Clean Air Act was affirmed by the Supreme Court in 2007 by finding that GHG were, indeed, a harmful pollutant that fell under the authority of the Clean Air Act. The environmental agency has since been laying out all the pieces of the puzzle to prepare for comprehensive GHG regulations. EPA started with regulating “mobile sources” (cars and trucks) – and California played a key role in pushing, pulling and otherwise massaging its cutting-edge state GHG-intensity standard for transportation emissions into federal policy. Similarly, California and other states like New York and Massachusetts were prime movers in the newly announced standards by suing EPA, and they have been have been closely engaged with academic and advocacy groups since to think through how their cap-and-trade programs could fit snugly within the broader EPA regulations rather than be squashed by federal preemption.

It turns out the Clean Air Act (CAA) lends itself well to this exercise. The EPA will unroll its proposal under Section 111, which mandates the EPA to regulate harmful pollutants for new and existing “stationary” sources (power plants, industrial plants, boilers, etc). For existing sources, this section essentially follows the federalist model frequently used in the CAA. It directs EPA to set the standard – for example, how much GHGs power plants should be allowed to emit for each MWh they generate – and let states develop individual plans to implement and enforce this standard.

By many reports, a robust conversation has been taking place over the past years between California, RGGI states and other climate-friendly states, and the EPA, on whether and how the existing state cap-and-trade programs would be an acceptable way for those states to reach whatever standard the feds would eventually set. The answer is, in principle, yes, although much modeling and technical analysis will need to take place to support the states’ argument that they will reach at least an equivalent emission reductions from the pre-existing programs.

Implementing EPA regulations through state cap-and-trade

California and RGGI are grappling with different issues. The issue for California is that its cap-and-trade program covers more than just the power plants in California that EPA’s standard would cover. Instead, the cap-and-trade program covers plants that emit over 25,000 tonnes (instead of EPA’s threshold of 25 MW capacity). It also covers power imports and emissions from most industrial sectors and the transportation sector. It accepts offset credits from a diverse and growing list of altogether different sectors across the country and, potentially, internationally. Finally, the program is also linked to the province of Quebec, which means some of California’s emission reductions might take place out of the U.S. altogether. All these scope questions will need to be disentangled from the effect on California’s specific, regulated facilities. Yet California officials following Obama’s announcement were confident [LINK] that their program would qualify for some form of equivalency under the upcoming regulations.

RGGI has a different challenge ahead: unlike California, the northeastern carbon market covers only the power sector in participating states, and uses the same capacity threshold, but states will need to get the EPA to agree on one plan for all nine states. That’s the essence of emission trading, reductions take place in the most cost-effective location, not necessarily evenly split amongst states – but that might require tweaking to fit under the upcoming regulations.

This could have an unforeseen effect as other states that were hesitant but contemplated local cap-and-trade, like Washington, Hawaii or Illinois, might find that this is their preferred way to meet EPA’s future standards. And if states are allowed to bundle their target and emission reductions, they could even consider linking their program, making for a larger, multi-state carbon market. Many of the former WCI states have remained closely involved in the development of the cap-and-trade program until fairly recently, and could come back into the fold without too much trouble. Besides the politically liberal coastal states Washington and Oregon, heavy emitters with major electricity customers in California, like Utah and Arizona, could find that piggy-backing on California’s program is the cheapest option for their own residents and ratepayers.

Implications for California businesses and regulated entities

For California businesses, federal carbon regulations means going from a situation where California businesses might have faced higher production costs than their out-of-state competitors due to higher electricity and gas prices, to a situation where California companies may be more competitive than the other guys. Cap-and-trade is, in theory, the most efficient way to reach an emission reduction target, so that the cost will be lower than it otherwise might have been under plain regulations.

Moreover, California businesses have been following these rules for five years already. They mostly know what to expect, and can get on with business while their counterparts in other states are still getting up to speed and staffing up their compliance office. Many have made, or plan to make, significant investments in efficiency and other strategies to reduce their carbon costs. Potentially, California businesses that have been engaged with AB 32’s progress to date will have a leg up on companies struggling to follow and comply with new rules, and new uncertainty, in other states.

Market Implications: bearish signal for prices in California

These developments send conflicting price signals. In the short run, Obama’s commitment to climate policy sends a bullish signal for the market’s political viability and long-term support. It bolsters its foundations and makes it less likely to be turned over by a new Governor or struck down for legal reasons. Yet prices have remained flat since Obama’s announcement, possibly indicating that traders were not too worried about the program’s longevity.

A lot of the measures from the climate plan, however, will contribute to bringing emissions down in and out-of-state. In-state, Obama’s climate plan will bring new funding for energy efficiency and renewable projects, and set standards for buildings and appliances that will help meet and further California’s climate goals. In additiona, by forcing all power plants to reduce their emissions in neighboring states, EPA regulations will lower emissions from imported power in California, which are covered under the cap. The combination of the two should lower the cost of compliance for market participants and therefore sends a bearish signal over the long term. The actual impact on emissions will only be quantifiable when the detailed regulations come out, along with details on grants, funding and new standards for the energy sector.