A hasty move by California’s emissions regulator to rescind their endorsement of the state’s voluntary offset methodologies dealt a blow to early actors in California’s emission reduction program and may reverberate in global carbon markets.

While not fatalistic, the negative consequences of such a disruption at the hands of a regulator, just months before they introduce a compliance regime have begun to surface. Since the announcement in February, carbon projects verified under the state’s endorsed voluntary protocol experienced a decline in their present value as the market ‘prices-in’ enhanced regulatory risk. One can presume that future financial due diligence of outside project’s will cite this case as an example of the high potential for regulatory fickleness in the early years of emissions reduction programs.

Over the past two years, more than 200 carbon reduction projects were developed and funded based on the assumption that their credits would soon quality for recognition under the California’s mandatory cap-and-trade scheme. This assumption was not the result of an overly optimistic misinterpretation, rather, a collective interpretation of actions that were seen to be deliberate initiatives to encourage early action in reducing emissions.

The Relationship Between Compliance and Voluntary Protocols

In 2006, California passed Assembly Bill 32 (AB 32), a comprehensive program of regulatory and market mechanisms aimed at lowering the state’s greenhouse gas emissions. The bill paves the way for the introduction of a cap-and-trade scheme and directs the Air Resources Board (ARB), as the regulator of emissions, to ‘adopt methodologies for the quantification of voluntary greenhouse gas emissions’ and ‘design the regulations, including the distribution of emissions allowances where appropriated … and encourage early action to reduce greenhouse gas emissions.’

A year later, the ARB acted as instructed by the legislative text, adopting its first methodology, a forest carbon offset protocol. The protocol, or methodology, was introduced by the Climate Action Reserve (CAR)- a state sponsored not-for-profit created to develop the rules and protocols in the California voluntary market. The collective interpretation of the relationship between CAR and the ARB was that CAR served as the testing ground for emissions reduction projects, allowing innovation to flourish while at the same time tweaking the rules and role of oversight agencies. Where CAR protocols satisfied compliance standards, the ARB would adopt them into the compliance framework.

Over two years, the ARB adopted three more CAR methodologies – an updated forest carbon protocol, as well as methodologies for livestock management and urban forestry.

The decision of the ARB – as the future compliance regulator – to adopt methodologies currently serving as voluntary standards sent the market a clear signal: projects that qualify under CAR’s voluntary protocols will be grandfathered into the compliance scheme. In fact, staff at ARB themselves believed that by adopting the voluntary emissions reduction protocols they were delivering early actor initiatives required by AB 32. They aimed to provide some certainty for projects moving forward, which is how project developers and those entities with a future emissions liability saw the ARB’s actions.

Under these conditions, the CAR voluntary market grew. In 2009 the transactions of credits from CAR projects reached 8 million tons of CO2-e, with a market value over $52 million USD.

Procedural Mix-ups, Confusion and Disruption

Earlier this year, the ARB unwound the relationship between voluntary and compliance protocols. The catalyst for the confounding decision was the release of an updated version of CAR’s forest protocol. In the call for public comments, the Center for Biological Biodiversity, a conservationist NGO, submitted a harsh criticism of the amendments. No corrective actions were taken by CAR and in November 2009 the ARB, once again, unanimously adopted the updated version of the forest protocol.

The NGO reacted by issuing a press release asserting the illegal adoption of the protocol, due to the ARB’s failure to assess the environmental impact of the amendments included in the updated version. Only one of CAR’s four protocols was being challenged, yet on February 25th, under the weight of legal scrutiny, the ARB withdrew the adoption of all of its previously endorsed protocols.

In short, they said each voluntary project verified under the previously adopted protocol must be reevaluated based on compliance measures; Media covering the story aptly described the event as the ARB effectively moving the goalpost for verification of emissions reductions.

The NGO’s legal threat may be have merit under California’s environmental laws. Similar to New South Wales and other jurisdictions, California’s environmental legislation calls for an environmental impact assessment of any major policy or development project that may significantly impact the environment. The NGO community argued the amendments of the forest protocol, especially the broadening of the definition of natural resource management, would trigger the required environmental impact assessment.

The legal and environmental integrity of the cap-and-trade program are vital for its success. A revamping of the ARB procedures to promote transparency of environmental impacts and public review for policy action may have been necessary to uphold California’s environmental laws.

But their move not only revamps procedure – it also disowns all actions taken thus far, severing the link between compliance and voluntary markets. This knee-jerk reaction unwinds a core element of a pre-determined strategy to encourage early actors. It indicates the ARB underestimated the long-term ramifications of its actions to the future of California’s voluntary market and beyond.

Demand Drivers

The growth of the market for CAR carbon reduction tonnes (CRTs) is a testament to the potential of market forces when, as the ARB so eloquently described it, ‘certainty for projects moving forward’ is present. Prior to 2007, the CRT market did not exist. But by late 2009, CRTs accounted for 70 percent of the value of voluntary emission reduction credits transacted in North America and a lion’s share of the growth in the voluntary market during the same period.

Since the decision by the ARB to withdraw its endorsement of voluntary methodologies, trading prices of CARs have dropped by roughly 15 percent. While price depreciation remains somewhat muted, most of these transactions represent bilateral agreements between project developers and investors. Due to the relative illiquidity in this market, prices do not respond immediately to market events. This means the future price of CRTs is much more uncertain.

A survey of the U.S. voluntary carbon market participants showed that 65 percent of buy side participants seek to manage a future compliance risk. Pre-compliance purchasers are made of utilities, mining companies and other energy intense industries that will most likely have an imposed emissions liability in the future cap-and-trade scheme. By buying credits early, they can begin to meet this liability while prices are still low.

The same survey indicated that without a clear knowledge of the rules and targets most buyers are content to wait rather than risk purchasing credits that may prove worthless down the road. This is especially true for pre-compliance purchasers: From their perspective, there is no incentive to act early when the rules of a future compliance regime are murky.

Early actors incur higher costs to initiate projects because more time and research are required to develop projects. The first projects to conform to new protocols determine the practical interpretation of the principles behind it. The scope and depth of information as well as the basis for verification become standardized by a process of trial and error during the first few project’s path to implementation.

Developing the protocols themselves is a costly endeavor. Despite the free service they give to the future of the industry by providing a model for development, no price premium is given to their credits. The only form of benefit for early actors derives from managing a future ‘known’ risk.

The Ripple Effect

Survey after survey indicates that a higher probability of regulatory uncertainty reduces research spending and innovation exponentially. Consequently, the best way to catalyze early action is to provide knowledge of the future risk and a certain path to manage it. This theory is heard echoed in each public debate surrounding carbon reduction policy decisions.

By laying out a clear path to a compliance regime, California and the ARB showed the rest of the U.S. (and other jurisdictions) a model path to a formalized compliance regime. While other jurisdictions vacillated between different regulatory options, or whether to act at all, California demonstrated leadership by engaging the investment community in early action to trial project types and regulations necessary to bring about desired emissions reductions.

Unfortunately, their leadership role makes their hasty action that much more damaging. Instead of actions which propagate a vacuum of certainty, the ARB has shown that certainty itself may not be so certain. This heightened uncertainty will be quantified and integrated into financial modeling tools used by project investors to gauge the investment potential. Higher quantified uncertainty means a project produces lower ‘risk-adjusted’ returns, which, in the long run, means fewer projects get off the ground. The drop in CRT price after the ARB decision validates this occurrence.

Just as California’s AB 32 and its early actor initiatives became the model for low carbon policy making, so too will the regulator’s back flip become exemplary of the potential dismantling of carbon reduction programs by their creator. While Californians sit at the gates of a compliance regime, where certainty will have more of a legal backbone, other markets slowly scale below political cross-firing, edging towards certainty. But with the California case in mind, what will the words or actions of regulators bring?

Unless California can quickly re-institutionalize the voluntary – compliance links, this time with legal procedures, early actors and the investment community in other markets will conceptualize a new dimension of uncertainty – even when a clear path to compliance exists.