Key Takeaways

1. Senate Bill 1391 introduces measures to review allowance overallocation and the use of offsets.
2. The bill introduces measures to ensure offset additionality and could work to align CA market rules with that of the new WA system.
3. SB 1391 may also act to ease current tensions between CA ETS regulatory bodies.
4. If SB 1391 passes it could result in price increases across CA compliance instruments.

Washington State’s emissions trading system is set for implementation on 1st January 2023 and will join California, Quebec, and Nova Scotia as part of the Western Climate Initiative. Washington’s ‘cap and invest’ program features many similarities to other cap and trade systems under the WCI, as well as some key differences. Although WA’s program will initially stand on its own, the program was designed from the start to accommodate linkage to other WCI markets such as California and Quebec, a process that could begin as early as 2025.¹

Linking Washington and California

Linking Washington’s emissions market with that of California and Quebec would introduce opportunities for WCI participants, as well as challenges. One of the most significant and contentious differences between the two systems is the way they deal with offset accounting. In WA’s program rules, when an offset is retired it also produces an equal reduction in allowances for the next compliance year: one ton of CO2e offset in 2021, therefore, also means one less allowable ton of CO2e in 2022.² This feature effectively ensures offset additionality. The California ETS currently has no mechanism for offset-triggered allowance reductions and the debate over CA offsets continues to be a prickly issue.

Debating the Benefit of Offsets

In an effort to address offset-related concerns Assembly Bill 398 was introduced in 2017 to put limits on offset use and requirements for the locality. However, the CARB’s own Environmental Justice Advisory Committee (EJAC) maintains that AB 398 does not go far enough, and in their most recent scoping plan recommendations have called for the complete elimination of both offsets and free allowances.³ The EJAC recommendations also reference the CalEPA’s Independent Emissions Market Advisory Committee’s (IEMAC) 2021 report which recommends addressing CA program loopholes by “reducing the supply of new allowances, raising the allowance price floor, conditioning offset availability on auction price (if offsets are not eliminated), and retiring allowances to account for shortcomings in offsets.” The IEMAC report goes on to reference the WA program rules as an example of CA ETS reform.⁴

Adjusting CA Offsets: California Senate Bill 1391 

Senate Bill 1391 was introduced in February of 2022 with the intention of reviewing allowance overallocation and addressing concerns of offset additionality before linking with any additional carbon markets. Although the bill has now been amended to eliminate language regarding linkage, it retains its purpose of reviewing CA allowance allocation, introduces a system for tracking banked allowances, and seeks to ensure the quality of offset credits. Overall, SB 1391 opens the door to addressing what some see as a key flaw in the CA Cap and Trade Market, the overallocation of allowances. The bill does not specifically mandate any changes to this system, but it does suggest that if allowances are found to be overallocated and need to be reduced, they could be reduced using an offset-triggered allowance reduction system similar to that planned in WA. This would mean that future allowances could be reduced either by the number of offset credits retired or by the number of offset credits issued.⁵ SB 1391 passed the CA senate in May and awaits a final vote in the California Assembly, which ends its session on August 31, 2022. If passed, SB 1391 could have significant market implications and may also serve to address the concerns raised by the EJAC and IEMAC.

Analyzing Offset Use Incentives in the Context of SB 1391

If the changes to offset use that SB 1391 references do indeed come about, it would significantly change the dynamics in offset credit use, in some ways making it resemble the prisoner’s dilemma in game theory. Historically, the market for California Carbon Offsets (CCO) has been slacker in supply than the California Carbon Allowance (CCA) market. Because individual compliance entities seek to benefit from the cheapest cost of compliance, they are incentivized to use the maximum allowance of offset credits. Under SB 1391, the use of these offset credits would equally reduce the future allowance supply. For an individual entity, this is unlikely to have a significant impact on CCA price trends. However, if all compliance entities follow this logic a larger number of allowances will be removed from the annual allowance supply, and CCA prices will increase more rapidly. So, en masse, using offsets generates savings today, but expenses tomorrow in the form of a higher CCA price. Additionally, offset prices tend to be anchored to CCA prices, so as CCA prices rise because of tightening supply, offset prices will rise as well. Overall, the more rapid price increase of CCAs will increase total compliance costs, benefiting the State’s GGRF auction revenue fund and leading to earlier and larger reductions in emissions – the central goal of the WCI Cap and Trade market.

Analyst Contact:

• Gabriel Stoltzfus (gstoltzfus@ckinetics.com)
• Megha Jha (mjha@ckinetics.com)