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Cap-and-Trade: First auction cancelled with new legal challenge

The California cap-and-trade and attendant carbon market became effective January 1 2012 and was scheduled to have its first auction in August 2012.  There has been much talk of a legal challenge.  And now we have one.  On March 28, 2012, two environmental groups, the Citizens Climate Lobby and Our Children's Earth Foundation filed suit in San Francisco Superior Court challenging the use of greenhouse gas emission offsets by regulated entities to meet their compliance obligations.

Background on Cap-and-Trade

Greenhouse gas emissions (GHGs) have proven to be sources of climate change. We are experiencing unstable weather, rising sea levels, changes in shorelines, and impacts on agriculture and wildlife. As a response to climate change, the California legislature enacted the Global Warming Solutions Act, more commonly referred to by its Assembly Bill number – AB 32. The purpose of AB 32 is to accomplish a 30% reduction of GHGs and 33% of all energy to be from renewable sources by 2020.

To accomplish these lofty goals, the AB 32 Scoping Plan identifies several strategies, including a cap-and-trade program. Cap-and-trade is a regulatory system that has a government limit on overall emissions of pollutants (e.g., GHGs, which scientists link to global warming or sulfer dioxide, which was the cause of acid rain). This program will help put California on the path to meet its goal of reducing GHG emissions to 1990 levels by the year 2020.

The cap-and-trade program has a five-step process, which begins by tallying GHG emissions for a facility, setting a cap, distributing permits, enforcing the cap then gradually lowering the cap; and as a result, lowering emissions.

The main purpose of the cap-and-trade program is to impose a limit on GHG emissions from facilities. The "cap" will be the legal limit on the quantity of GHGs California companies can emit each year. Caps will be measured in metric tons of specified gases. The "trade" aspect of the program refers to how companies may swap allowances among themselves to emit GHGs. If a particular covered entity’s operations will be over the "cap," that facility may buy extra allowances to meet its limit. In contrast, if a covered entity is under the "cap," that facility may sell unneeded ones. Some sectors will receive allowances through free allocations from the California Air Resources Board ("CARB"), while other sectors will be required to purchase allowances via auctions or market-based trades. Allowances are allocated by industry sector and then distributed within sectors to specific regulated entities. Free allowances will decline over time with the objective of incentivizing reductions.

Legal Challenges to AB 32

Not surprisingly, there have been a number of legal challenges to AB 32 and more litigation is contemplated. The most effective challenge was to the Low-Carbon Fuel Standard ("LCFS"), which was designed to accomplish 15-20% of the planned GHG emission reductions by 2020. The National Petrochemical & Refiners Association sued on constitutional grounds, alleging that the LCFS discriminated against out-of-state and foreign crude oil sources and therefore violated the Interstate Commerce Clause. There are two types of Commerce Clause challenges. If the statute on its face discriminates against out-of-state businesses, then a strict scrutiny test is applied. This standard favors the challenger. On the other hand, if the statute is discriminatory as applied, then a balancing test is applied and more deference is given to the government. Here, the court found the statute to be facially discriminating against interstate commerce and impermissibly controlling of out-of-state conduct. Applying the strict scrutiny test, the court found that CARB failed to consider alternative methods to advance its goals of reducing GHGs.

Another industry group has been soliciting plaintiffs to join a challenge to cap-and-trade by arguing that it constitutes a tax that was not approved by a super majority of the legislature as required by Proposition 26. Proposition 26, passed in November 2010, articulates that any change in state statute that results in any taxpayer paying a higher tax must be passed by at least a 2/3 vote.

The Citizen Climate Lobby Suit

The first challengers (but probably not the last) were two environmental groups.  The Citizens Climate Lobby and Our Children's Earth Foundation filed suit in San Francisco Superior Court on March 28, 2012 challenging the use of GHG emission offsets.  Although the suit will not necessarily delay implementation of cap-and-trade and the offset program, if the court in Citzens Climate Lobby v. California Air Resources Board ultimately invalidates the offset protocols and eliminates the use of offsets to meet cap-and-trade obligations, the cost of compliance for industry could be substantially increased. Plaintiffs are alleging that the offset program, with its four adopted offset protocols, are reductions that would have occurred in the normal course of business, and are therefore not "additional” greenhouse gas reductions and threaten the overarching integrity of the cap-and-trade program.  The lawsuit seeks a repeal of the four offset protocols approved in December 2011 and a prohibition on using offsets instead of limiting emissions to GHG allowances.

Additional legal challenges are expected.  With the first auction date now set for November 2012, those actions must come soon. The longer the potential challengers sit on their hands, the stronger CARB’s defense of laches will be if a suit is ultimately filed.

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