AB 32 Update: Summary of the Basics of Transacting in Offsets Under AB 32

by Reed Smith
Contact

This Client Alert serves as an executive summary for a supplementary white paper, The Basics of Transacting in Offsets under AB 32, and will assist clients in addressing offset transaction risks. The white paper offers an in-depth discussion of the following:

  • "Primary" vs. "Secondary" markets for offsets
  • Options and strategies for buying offset credits
  • Benefits and challenges of buying offset credits

To access the white paper, please click here.

Introduction

Many entities subject to compliance with emissions limits under the California Global Warming Solutions Act of 2006 ("AB 32") have some experience with cap-and-trade programs, such as the Acid Rain Program for trading sulfur dioxide allowances under the Clean Air Act, or perhaps Renewable Energy Credits under a state’s Renewable Portfolio Standard. This expertise will give these compliance entities a leg-up on commercial procurement of allowances under AB 32. However, none of the systems mentioned above had offsets – and the buying or selling of offsets is very different from the mere purchase of allowances. Compliance entities and other interested market participants will need to know how to effectively buy offsets (that is, how to pick a good project at a good price under commercially reasonable terms) to achieve cost-effective compliance under AB 32, since offsets are an essential component of cost-effective compliance as envisioned by the California Air Resources Board ("ARB") under AB 32.

Reed Smith predicts a brisk business in offsets early in the AB 32 scheme as players attempt to snap up the available offsets, allowing them to sell at a profit later or achieve cost-effective compliance. To take advantage of these opportunities, parties need to understand the basics of transacting on offsets in the California market.

Trade in the California Offset Market

In the California offset market, a large number of offsets are expected to trade in advance of these offsets having secured all of the necessary approvals for compliance-grade ARB Offset Credits ("ARBOCs").1 Trade in these pre-compliance offsets constitutes the primary offset market. In the primary offset market, buyers and Offset Project Operators ("OPOs") transact for Registry Offset Credits ("ROCs"), which are offsets issued on one of the two ARB-approved Offset Project Registries ("OPRs"). The ROCs are issued under one of four Compliance Offset Protocols ("COPs") under which offsets may be generated.2 Only ARB can issue ARBOCs for use in compliance with the cap-and-trade program, however, so ROCs are not yet compliance-grade and must be converted to ARBOCs in accordance with ARB’s complex requirements.

Because primary market offsets are not yet compliance-grade, buying these offsets involves certain risks. The major categories of risk associated with buying primary market offsets are different from those associated with buying allowances and can generally be set forth as follows:

  • Conversion Risk: the risk that the project’s primary offsets will not generate compliance-grade offsets
  • Credit Risk: the seller may be a relatively small, unrated project development company with a limited track record and limited recourse
  • Prepayment Risk: if the buyer prepays for primary offsets before delivery, there is a risk that the primary offsets may never be delivered and its prepayment will be lost
  • Delivery Risk: because primary offset sellers typically do not guarantee delivery, buyers face the risk that they may receive fewer offsets than they counted on
  • Price Risk: this stems from overpayment at the time of contracting

Addressing Major Risk Categories under AB 32

  • Conversion Risk: Although the risk of non-compliance during project development ultimately rests with the buyer, issuance of a ROC by the OPR may provide the buyer with some comfort that the applicable COP has been satisfied and the ROC will be converted into an ARBOC. By the time a ROC is issued, the offset’s compliance with the COP has been reviewed by the OPO, the Verifier, and the OPR itself. That’s two sets of independent eyes in addition to the OPO. Further, to be approved as a Verifier or an OPR by ARB, every Verifier and OPR must apply, pass certain conflict-of-interest requirements, and demonstrate competency and depth of understanding of the COPs. There is some assurance, therefore, that these "independent eyes" are competent assessors of the offset’s compliance with the COP. Next, in order for an ARBOC to be issued, the OPO or its Authorized Project Designee ("APD") must submit an Offset Project Data Report ("OPDR") and Offset Verifier Statement ("OVS") to ARB for ARB’s use in determining the offset’s compliance with the applicable COP. By this point in the process, the OPDR and OVS submitted to ARB have already been reviewed and approved by the OPR that issued the ROC. Thus, the AB 32 Regulations provide some additional comfort that if a ROC is issued by the OPR, which by virtue of having been approved by ARB under the regulations is knowledgeable in the COPs, then there is a smaller risk that an ARBOC will not be issued because of an error or shortcoming in that same information later submitted to ARB. For that reason, the Conversion Risk is small. However, the COPs are not regulations, and failure to comply with the COPs will be enforced by ARB against the compliance entity that relies on the credits to meets its compliance obligation, not the OPOs. Failure to comply with the applicable COP, therefore, is a penalty borne by any buyer of the offsets in the primary market.
  • Timing of Conversion Risk rests with buyer: The AB 32 Regulations expressly require that only the OPO or APD submit the OPDR and OVS to ARB for ARBOCs to be issued.3 Importantly, the AB 32 Regulations allow for designation (or re-designation) of an APD only once within each calendar year.4 If the buyer does not want to obligate the OPO after delivery of the ROCs, then the buyer – and any subsequent buyer of the ROCs – must make sure that it can be designated as an APD and not exceed the once-per-year limit.5 These provisions may substantially hamper trade in ROCs prior to conversion to ARBOCs.
  • Credit Risk and Prepayment Risk is somewhat mitigated for a buyer of ROCs because the OPO has passed a certain level of scrutiny by ARB and the Compliance Instrument Tracking System Service ("CITSS"); further, registration with ARB and CITSS is subject to revocation by ARB, such revocation meaning that the OPO could no longer generate offset credits under AB 32.6 The OPO is required to register with ARB and provide information, documentation, and attestations to ARB.7 Registration with ARB is mandatory for all OPOs prior to listing an offset project on an OPR, and is defined in the regulations.8 Registration also brings with it a requirement for the OPO to register in the CITSS,9 the management and tracking system for accounts and compliance instruments issued through ARB under AB 32. While no "credit worthiness" requirements are included in registration in CITSS, such registration requirements include certain "know your customer" provisions and other rather lengthy documentation.10
  • ARB inaction on ARBOC issuance creates Delivery Risk for buyers. To date, ARB has not authorized the issuance of any ARBOCs. With nothing to go on as to how and what ARB will look to in issuing (or denying the issuance of) ARBOCs, this is a Delivery Risk.
  • ARB inaction on approval of additional COPs creates Price Risk for buyers. On March 8, 2013, ARB listed its first 25 offset projects, which if accepted, would generate as many as 3 million compliance offsets.11 But those 3 million potential offsets would not be enough to satisfy potential demand, leading to price volatility and, therefore, increasing Price Risk. Analysts predict that unless ARB adopts new protocols, the total number of offsets available between 2013 and 2020 under the existing four protocols will be 66 million, which is only 30 percent of the nearly 220 million that could theoretically be used to achieve compliance.12 This significant supply shortfall could result in significant Price Risk going forward.

Conclusion

At this time, there is no standardized "market" contract for commercial procurement of primary offsets. Therefore, it is up to the contracting entities to allocate risk, and this means that the savvy party will get the better end of the deal.

Reed Smith’s transnational Environmental and Climate Change team has more than 22 years of collective experience dealing with buying, selling, and trading offsets under existing carbon trading systems. Our substantial experience working with offset trading in existing international carbon markets provides insight into the buying, selling, trading, and holding of offsets for compliance with the California cap-and-trade program.


1. Italicized terms throughout mean these are defined terms under ARB’s regulations implementing AB 32 at 17 C.C.R. § 95800 et seq.
2. http://www.arb.ca.gov/cc/capandtrade/offsets/offsets.htm.  
3. 17 C.C.R. § 95981(b) (stating that "the Offset Project Operator or Authorized Project Designee must provide the following information to ARB for issuance of ARB offset credits….").
4. 17 C.C.R. § 95974(b).
5. Thus, due diligence into previous designation is recommended.
6. 17 C.C.R. §§ 96011, 95875(a)(2).
7. 17 C.C.R. § 95975.
8. 17 C.C.R. § 95975(a)(1); see also § 95830 (listing registration requirements).
9. Registering with CITSS requires proof of identity, including a bank account, and know-your-customer documentation. See ARB, CITSS User Guide, Volume 1 – User Registration and Profile Management 8, 33-34 (Dec. 2012), http://www.arb.ca.gov/cc/capandtrade/markettrackingsystem/vol1citssguide-12-20.pdf.
10. See ARB’s Compliance Instrument Tracking System Service website: http://www.arb.ca.gov/cc/capandtrade/markettrackingsystem/markettrackingsystem.htm.  
11. See ARB, Early Action Projects website (May 9, 2013), http://www.arb.ca.gov/cc/capandtrade/offsets/earlyaction/projects.htm (listing accepted projects); Air Resources Board Announces Listing of Early-Action Carbon Offset Projects (March 8, 2013), http://www.arb.ca.gov/newsrel/newsrelease.php?id=418.  
12. Bailey, et al., Forecasting Supply and Demand Balance in California’s Greenhouse Gas Cap and Trade Market 3, Emissions Market Assessment Committee and the Market Simulation Group (March 12, 2013).

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Reed Smith | Attorney Advertising

Written by:

Reed Smith
Contact
more
less

Reed Smith on:

Readers' Choice 2017
Reporters on Deadline

"My best business intelligence, in one easy email…"

Your first step to building a free, personalized, morning email brief covering pertinent authors and topics on JD Supra:
Sign up using*

Already signed up? Log in here

*By using the service, you signify your acceptance of JD Supra's Privacy Policy.
Privacy Policy (Updated: October 8, 2015):
hide

JD Supra provides users with access to its legal industry publishing services (the "Service") through its website (the "Website") as well as through other sources. Our policies with regard to data collection and use of personal information of users of the Service, regardless of the manner in which users access the Service, and visitors to the Website are set forth in this statement ("Policy"). By using the Service, you signify your acceptance of this Policy.

Information Collection and Use by JD Supra

JD Supra collects users' names, companies, titles, e-mail address and industry. JD Supra also tracks the pages that users visit, logs IP addresses and aggregates non-personally identifiable user data and browser type. This data is gathered using cookies and other technologies.

The information and data collected is used to authenticate users and to send notifications relating to the Service, including email alerts to which users have subscribed; to manage the Service and Website, to improve the Service and to customize the user's experience. This information is also provided to the authors of the content to give them insight into their readership and help them to improve their content, so that it is most useful for our users.

JD Supra does not sell, rent or otherwise provide your details to third parties, other than to the authors of the content on JD Supra.

If you prefer not to enable cookies, you may change your browser settings to disable cookies; however, please note that rejecting cookies while visiting the Website may result in certain parts of the Website not operating correctly or as efficiently as if cookies were allowed.

Email Choice/Opt-out

Users who opt in to receive emails may choose to no longer receive e-mail updates and newsletters by selecting the "opt-out of future email" option in the email they receive from JD Supra or in their JD Supra account management screen.

Security

JD Supra takes reasonable precautions to insure that user information is kept private. We restrict access to user information to those individuals who reasonably need access to perform their job functions, such as our third party email service, customer service personnel and technical staff. However, please note that no method of transmitting or storing data is completely secure and we cannot guarantee the security of user information. Unauthorized entry or use, hardware or software failure, and other factors may compromise the security of user information at any time.

If you have reason to believe that your interaction with us is no longer secure, you must immediately notify us of the problem by contacting us at info@jdsupra.com. In the unlikely event that we believe that the security of your user information in our possession or control may have been compromised, we may seek to notify you of that development and, if so, will endeavor to do so as promptly as practicable under the circumstances.

Sharing and Disclosure of Information JD Supra Collects

Except as otherwise described in this privacy statement, JD Supra will not disclose personal information to any third party unless we believe that disclosure is necessary to: (1) comply with applicable laws; (2) respond to governmental inquiries or requests; (3) comply with valid legal process; (4) protect the rights, privacy, safety or property of JD Supra, users of the Service, Website visitors or the public; (5) permit us to pursue available remedies or limit the damages that we may sustain; and (6) enforce our Terms & Conditions of Use.

In the event there is a change in the corporate structure of JD Supra such as, but not limited to, merger, consolidation, sale, liquidation or transfer of substantial assets, JD Supra may, in its sole discretion, transfer, sell or assign information collected on and through the Service to one or more affiliated or unaffiliated third parties.

Links to Other Websites

This Website and the Service may contain links to other websites. The operator of such other websites may collect information about you, including through cookies or other technologies. If you are using the Service through the Website and link to another site, you will leave the Website and this Policy will not apply to your use of and activity on those other sites. We encourage you to read the legal notices posted on those sites, including their privacy policies. We shall have no responsibility or liability for your visitation to, and the data collection and use practices of, such other sites. This Policy applies solely to the information collected in connection with your use of this Website and does not apply to any practices conducted offline or in connection with any other websites.

Changes in Our Privacy Policy

We reserve the right to change this Policy at any time. Please refer to the date at the top of this page to determine when this Policy was last revised. Any changes to our privacy policy will become effective upon posting of the revised policy on the Website. By continuing to use the Service or Website following such changes, you will be deemed to have agreed to such changes. If you do not agree with the terms of this Policy, as it may be amended from time to time, in whole or part, please do not continue using the Service or the Website.

Contacting JD Supra

If you have any questions about this privacy statement, the practices of this site, your dealings with this Web site, or if you would like to change any of the information you have provided to us, please contact us at: info@jdsupra.com.

- hide
*With LinkedIn, you don't need to create a separate login to manage your free JD Supra account, and we can make suggestions based on your needs and interests. We will not post anything on LinkedIn in your name. Or, sign up using your email address.