(February 9, 2011) Aldyen Donnelly writes that cap and trade schemes can be a source of protectionism.

The EPA Will Likely Introduce US “Cap and Trade” Sometime Over 2012/13, but What Will Likely Go Missing–at Least Temporarily–is a US Offset System

What is much less certain–even unlikely–is that any EPA-administered, permit-based, CAA-authorized US GHG cap and trade system will incorporate/allow for GHG offset credit imports/use as compliance instruments.  It is unlikely that the US Supreme Court will agree that either domestic or foreign GHG offset credits could be accepted as compliance units under the existing CAA authority.

So it is the offset side of the market , not “cap and trade” entirely, that is on hold unless Congress passes a discrete new law to govern GHG regulation.  Note that this really only makes a difference to US domestic obligated parties.  The Waxman-Markey bill (passed by the House in 2010) and the recently CARB-adopted California cap and trade bill (adopted on December 16, 2010, to become a regulation within 12 months) both stipulate that:

• if a foreign nation/state applies to link their GHG emission market to the US/state market, the US/state shall first have to approve the foreign authority’s offset system as well as its GHG quota supply and allocation scheme; and
• if the foreign nation/state issues offset credits to any source/sector that is covered under the mandatory cap and trade provisions in the US/state, GHG emission market linkage will not be approved; if
• the design of the foreign nation/state’s offset system meets with the US/state’s approval, GHG emission market linkage can be approved, but;
• “linkage” will allow only for cross-border trade in “allowance”-type quota (quota issued to sources with permit-based emission caps) and will not allow for cross-border trade in offset credits when the US trading partner is a developed nation.

The issue is that once the “endangerment finding” was made and as long as the US Supreme Court upholds it, the EPA is very limited in its authority to exempt stationary sources from regulated, mandatory GHG limits.  Exemption from the mandatory nation-wide permitting and cap and trade regime can be justified for very small sources and sources for which reliable and cost-effective emission estimation or measurement methods are not yet available.  However, if/when an unregulated source succeeds in developing an emission estimation protocol stringent enough to qualify for offset credits, the existence of that protocol undermines the argument for exempting that source from the national cap.  So under existing CAA authority, and in the absence of a new bill to govern GHGs, any proposed offset system design becomes self-defeating.

This complication is significant, but is likely only relevant to US domestic sources, particularly US forest and agriculture sector businesses, due to the bias in all US climate change bills to date against the import of offset credits originating in developed nations.  Foreign offset credits will only be recognized in any final US GHG market if  they originate in a developing nation (i.e. NOT CANADA).  And offset credits–even US domestic ones–likely cannot be recognized under US federal regulations as long as the federal GHG regulations derive from the authority of the existing CAA.

The California Complication

So far, I have only addressed what can happen under federal GHG regulations developed under the authority of the existing US CAA.

In principal however, each US state will have a choice:

• to directly comply with the US federal GHG regulations, or
• to adopt the California cap and trade and offset regulations, if the US EPA finds that the California regulations equate to aggregate GHG control and reduction forecasts equal to or better than those that would be realized if the state was to adopt the California regulations.

If the US EPA approves the final California cap and trade and offset system rule, the EPA can issue a “waiver” for the California regulation.  After California has a waiver, other state could incorporate an offset system with cap and trade but only if they elect to adopt the California regulations in whole (not in part).  No other state can create a regulation that may be considered an alternative to the US EPA regulations under existing US law.  (This stems back to the original agreements the federal government and states signed in 1965 when states agreed that authority over environmental regulation–originally under the exclusive authority of state governments and not under federal jurisdiction–would be transferred at least in part to the federal government.  At that time all states agreed that California could still do its own thing, as long as it meet or beat federal standards.  Later, US Courts interpreted the original agreement to mean that all states would have the option to adopt one of the federal or California state regulations if/when California state regulations meet the test of being at least as stringent as the federal regulations.)

So a vibrant US offset market will only emerge, in the short to medium term (by 2013), if a number of states elect to adopt the California regulation (which is scheduled to be final before the end of 2011).  But, again, please note that the California cap and trade and offset regulation, as adopted by CARB on December 16, 2010, does not contemplate offset credit imports from linked developed nations (i.e. CANADA, just like the Waxman-Markey bill limits offset credit imports to those originating in developing nations) and does not allow for the California/US import of offset credits that originate at sources that are covered under the regulated “cap”, i.e. at sources that are covered by some entity’s obligations to surrender US GHG “allowances”.

Note that under the California cap and trade regulation–consistent with the Waxman-Markey cap and trade bill in this regard–entities that distribute or “supply” natural gas, biofuels and petroleum-based products to US consumers will be obliged to surrender US GHG allowances covering their: (1) production of GHG emissions plus the (2) US GHG emissions arising from US consumer end use of the products they sell.  In other words, 100% of US residential, commercial and mobile source end-use GHGs are covered by the US “cap” and included in the GHG liabilities that most be covered by US natural gas, petroleum product and biofuel suppliers’ obligations to surrender US GHG allowances.

This means that only a limited number of project types could be covered by an offset system in the US or in any nation/state that wished to link with the US GHG markets, and this is only if many/most US states opt to adopt the California cap and trade and offset system regulation (if, of course, the final California rule qualifies for a US EPA waiver…I find this a highly likely scenario):

• small industrial processes that are otherwise exempt from the federal GHG permitting requirement;
• forest management;
• agricultural soils, manure and fertilizer management;
• municipal waste and landfill gas management;
• coalbed methane management and utilization.

We Still Face One Very Basic Question: Why Would Any Government, Acting Prudently, Approve the Export of Any Sovereign GHG Quota–In Either “Allowance” or “Offset Credit” Form?

We must soon–very soon–step back and consider first principals.

First, each nation binds to an absolute nation-wide GHG cap for 2020.  This cap constitutes an absolute national sovereign GHG quota supply limit.  Any such agreement covers its citizens’ combined rights to (1) produce and consume fossil fuels, (2) produce building products (aluminium, cement, iron & steel, wood products, pulp paper and paperboard), and (3) produce food (beer, pork products, rice and grains).

This is a zero-sum game.  What nations, managed by prudent persons, would ever:

• sell a unit of perpetually bankable sovereign GHG quota to a private entity and
• allow that private entity to extract that sovereign quota from the Canadian economy, reducing and exporting Canadian wealth-generating and job creating potential.

Note that under any given GHG quota cap, Canada cannot increase energy, building product or food exports without cutting back domestic consumption proportionately, and vice versa.

Canada‘s priority should be:

Putting Canadian GHG regulations in place that will ensure that Canada secures our fair share of sovereign national GHG quota.  At this time US, Japanese and South Korean regulations that assign baseline title to supply chain GHGs to the historical consumers of Canadian energy, building product and food exports expropriates GHG discharge title that should fairly be included in Canada’s baseline and assigns that title to the US, Japanese and South Korean national baselines.  Canada can only reverse this unfair allocation procedure by implementing domestic product/performance standard regulations–as opposed to point of production GHG regulations–which will serve the multiple purposes of (1) incenting markets to cut Canadian commodity supply chain GHGs and (2) proving that clear title to total life cycle GHGs must be assigned at the point of origin, not an historical point of end-use for regulated carbon-intensive products.

Canadian regulators should:

• Regulate only supply chain product standards (carbon content, renewable energy content, energy efficiency and/or supply chain GHG footprints) for products that are sold in Canada (same standard for a sales portfolio, applicable to all sales regardless of country of origin)
• Where the obligated party (the party that has a reporting and compliance obligation) is the first suppliers/distributor of the regulated product (fewer than 10 product standards need to be implemented to cover over 90% of Canada’s GHG inventory); and
• Avoid, at all cost, regulating emissions at the point of production (as opposed to supply chain emissions at the point of sale).

If Canada regulates GHG outputs of sectors, participants in sectors and/or at points-of-production, we then eliminate all viable defences we might have against unfair, highly protectionist US, Japanese and South Korean GHG regulations that expropriate–potentially in perpetuity–Canadian title to our resource assets

Aldyen Donnelly is the President of WDA Consulting inc., and Greenhouse Emissions Services inc. (GEMserve), based in British Columbia.