www.e2.org Executive Summary Proposal to Expand the Market November 18, 2011 (Revised) A major benefit of the California Low Carbon Fuel Standard is the creation of a market for lower Carbon Intensity (CI) fuel. Unlike the Federal Renewable Fuel Standard (RFS2) that rewards fuels based on a minimum reduction of CI, the LCFS rewards fuels for reductions beyond RFS2 minimum levels. A clear, timely and transparent price signal on the value of reduced CIs will encourage businesses to produce and distribute more low CI fuel in California. To promote the maximum production of low CI fuels in California, the LCFS credit trading system can be expanded to allow more trades and more frequent reporting of the value of the trades. The goal is to increase delivery of low carbon fuels into California by regularly reporting the value the market places on reduced carbon intensity. The proposal envisions Air Resources Board maintaining ownership of the data but getting the private sector to accept the cost of implementation in exchange for transaction fees based on future market activities. The ultimate goals are: 1. Reduced operating costs for ARB 2. Increased fuel deliveries into California 3. Transparent market with reliable enforcement 4. Increased competition Introduction A recent report by E2 (see Advanced Biofuels Report 1 ) provided an assessment of the advanced biofuel industry and the challenges to producing biofuels at commercial scale. A key takeaway of the report, and one of the most commonly cited challenges by industry stakeholders is an expansion of the LCFS credit trading market. Stakeholders told us: 1. There needs to be a way to easily monetize an LCFS credit in order to justify the business decision to deliver and sell low CI fuels in California. 2. Fuel needs to have a market price for its carbon reduction (just like solar has a value for energy and in some markets a value for its renewable attributes) 3. The pricing of a credit needs to be broad- based and transparent The problem for new participants is that they cannot charge a consumer extra for delivering low carbon fuel. They need a way to monetize the benefit of reduced carbon through other means. For example, if an E85 station operator wanted to use low carbon ethanol that cost an extra N cents per gallon and California had a transparent 1 http://www.e2.org/jsp/controller?docname=biofuelmktreport2011 NORTHERN CALIFORNIA, PACIFIC NORTHWEST & ROCKY MOUNTAINS 111 Sutter Street, Fl 20 San Francisco, CA 94104 TEL 415 875-6100 FAX 415 875-6161 NEW YORK & NEW ENGLAND 40 West 20th Street New York, NY 10011 TEL 212 727-2700 FAX 212 727-1773 SOUTHERN CALIFORNIA 1314 Second Street Santa Monica, CA 90401 TEL 310 434-2300 FAX 310 434-2399
and accessible carbon market trading above N cents, the station would have a viable business opportunity. California needs this type of market today but it cannot exist without an open and timely credit trading program. This document proposes an expansion of the credit trading market that will act in accordance with LCFS goals: it will provide a market- based solution to develop low carbon fuels for California, thus reducing our greenhouse gas emissions. E2 has developed this proposal based on interviews with ARB staff, advanced biofuel producers, and experts who have direct experience in the implementation of other environmental trading schemes. The potential benefits of timely, market- based credit trading will be more investment in the California low- carbon fuels market, and an associated higher likelihood that the state s policy objectives will be met. Price signals in the form of an accessible, transparent credit market can be captured and monetized by investors, which, in commodity markets without long- term off take agreements (such as the LCFS), is the best opportunity to drive investment. The long- term benefits of this program also include: a reduction in ARB resources required to run the market; a more robust trading platform; enhanced protection of trading and therefore the LCFS program; harmonization with existing programs; and less risk to ARB to secure and run a credit market. Why should the trading market be expanded? As explained to E2 by ARB staff, the proposed LCFS credit trading market allows participation only by entities that handle fuel directly (or are brokered directly on their behalf), with Air Resources Board staff reconciling and issuing any credits on a quarterly basis. The system is paper- based and is intentionally limited to reduce ARB staff time and to make the implementation as simple as possible. It appears to us that the goal of the initial system is limited to allowing surpluses or deficits of carbon to be traded among the regulated parties. While this is an important capability, we expect most regulated parties will hold their credits for compliance in later years and as a result, there will be little real price discovery. Without that price discovery, the incentive for new investors to embrace this market is greatly diminished there is no ability to project financial returns, or plan a path into the marketplace that is not constrained by a few, potentially inaccessible customers. As currently planned, credits by regulated parties are certified on a quarterly basis and accounts are reconciled 90 days after each fiscal year. New market entrants will look for more timely price signals and a more liquid market, which will be available in other industries capital providers will be judging a fuels investment against a range of other options, and will be less inclined to join a market that is as illiquid as the one proposed. Additionally, the burden of developing and running this program will lie in ARB s hands, rather than leveraging private sector experience and capital. ARB staff has told us that they see a broader credit trading market as a long- term need but current resources and timing prevent them from starting with a more ambitious credit trading program. Environmental Entrepreneurs page 2
Proposal: In 2012, expand the credit trading market to all registered parties and leverage the private sector to supply the electronic infrastructure E2 believes that the next three years will determine the overall success of the LCFS and the desire for other states to adopt a similar program. California should have an open market that allows willing participants to invest in production and delivery of low carbon fuel without being dependent on the established players. Proposed Expansion: 1. Any entity wanting to participate in the LCFS credit trading market would have to register with ARB and be subject to California Law. 2. A single registry would exist that holds the chain of custody of the fuel including the federal Renewable Identification Numbers (RINs) when applicable. 3. The amount of credit is defined by the difference between the carbon intensity of the fuel below the reference standard for gasoline or diesel established by ARB. 4. Multiple private trading systems, or exchange platforms, can exist on top of the single registry in order to allow competition for convenience and services to the fuel providers and market makers. Design of this framework would embrace the need of ARB to maintain visibility into the marketplace and the ability to monitor and correct for potential manipulations. 5. Reports can be produced to insure the integrity of the transactions - for example, to verify that the same RIN does not exist in two transactions. This style of system is very similar to state implementations of tradable renewable energy credits (TRECs) and complete implementations already exist where a state agency has ownership of the data and a third party customizes and operates the registry system under contract. The immediate advantages of such a registry system are better accuracy from automation and reduced paperwork involved in the implementation. The data quality of an automated system is a benefit over the proposed paper system because errors can be caught at the time of data entry and a computerized system lends itself to more flexible analysis and reporting. Since such registry systems already exist, we believe that a pilot and/or RFP issued by ARB would discover several bidders who could adapt their current registry systems in a timely manner. Ideally the proposal, bidding and award process could be completed by mid- 2012 and the system delivered by the end of 2012. The rapid implementation would only be possible by selecting a private firm that could extend an existing system rather than build something from scratch. To reduce costs and delivery risk, an RFP might require a working prototype to be demonstrated as part of the bid. Under the proposed system, the State retains its power to scrutinize all credit trading through its quarterly reconciliation with an optional ARB authorization of credits and transactions. Only registered parties would be able to participate in the credit market, and to register one is subject to California state law. This provides enforcement power to ARB. Environmental Entrepreneurs page 3
While we would prefer to open the trading system to any party willing to register and agree to enforcement under California law, ARB could open trading in a more limited manner initially: the exchange platform could be opened to regulated parties, LCFS registered biorefineries, and opt- in parties (utilities, natural gas producers, hydrogen etc), and authorized brokers using the system. At a later predetermined time, ARB could open the market to additional willing participants. The RFP would include the following elements: 1. The service provider would provide the infrastructure to customize, host and operate the system for an initial time period. 2. All data would be owned by ARB. 3. ARB would have access to the registry at any time to review the registry at any point. 4. Provider must have the ability to generate standardized monitoring reports from the registry for ARB on all credit issuances and credit transactions. 5. Credit transactions would be reported in near real- time. 6. The registry should meet market best practices for security and should include second tier security i.e. on transactions. 7. Development costs would be borne by the service provider and could be recovered through fees paid by the users of the system. 8. Fee schedules would be agreed with ARB, need to be reasonable and not discourage the use of the system. 9. The registry would have secure APIs that would enable third parties to develop value added products and services including trading systems connected to the registry system. Key elements: The registry of credits would be under the jurisdiction and operated under the rules determined by ARB. This registry would clear every deal from a regulatory perspective. A separate and secure connection to trading system(s) with multiple service providers would allow the purchase and sale of verified LCFS credits. The exchange platform would handle the price discovery and financial aspect of the trades. Competition among private trading system service providers would encourage more participation and better service to the parties participating in trading. ARB becomes the regulator and overseer of the market, not the broker. This would alleviate a large resource burden on ARB once the market is functioning. In addition, it would reduce the legal risks to ARB since solicitation of trades and completion of transactions would not involve ARB. Participants: E2 has approached several potential participants that could provide bids to the State to develop the credit market. We believe at least two bidders would emerge and probably more. Enforcement and Protection: The protection and security of a credit trading market is tantamount to the integrity of the LCFS program. Each private trading system must meet a set of predetermined standards and practices, must share data Environmental Entrepreneurs page 4
Precedents through an established protocol; all of which is approved by ARB and administered by the registry. The registry would be instrumental in developing these standards and protocols. Renewable Fuel Standard (RFS2) The RFS2, overseen by the Environmental Protection Agency (EPA) is a volumetric standard that will significantly increase biofuel use in the U.S. to 36 billion gallons by 2022. Volumetric targets are tracked through RINs, unique identification numbers assigned to each gallon of biofuel that specifies how and where it is produced, and provides a system that could be adapted to the LCFS program. RINs can be traded between obligated parties and non- obligated parties, such as renewable fuel producers through private brokers. 2 Excess RINs can be used by obligated parties to meet the requirements in the following year or sold to another obligated party. Information on RIN generation and transaction is submitted to the EPA using the EPA Moderated Transaction System (EMTS). Through the use of this system, the EPA was able to identify and address early shortcomings of this credit trading platform, which would further ease ARB s integration of RINs for the LCFS program. A RIN is generated by the producer or importer of renewable fuel representing gallons of renewable fuel produced/imported and assigned to batches of renewable fuel that are transferred (change of ownership) to others. Producers are required to transfer all RINs attached to a batch of biofuel along with the fuel. Assigned RINs are transferred when a change in ownership of a batch of fuel occurs. A RIN provides a secure method to track and audit the origin of all fuels sold within the market. Renewable Energy Certificates (REC) The Renewable Portfolio Standard (RPS), is a state- level policy strategy that requires electric services providers to have a minimum amount of renewable energy in their electric supply, similar to the LCFS intended impact on the fuels markets. REC trading, available in many states, provides a second precedent for this proposal. Some REC program allows the registration of private companies to act as brokers of RECs, who independently verify and sell all certificates. 3 California only does this in a limited way currently, but has been exploring a further expansion of the opportunity to enable greater investment and cost efficiencies 4. Since RECs can be sold separately from the underlying electricity, the possibility for fraud can exist unless the RECs are tracked from their point of creation to their final point of use. Tracking ensures every REC represents 1 megawatt- hour (or 1,000 kilowatt- hours) of renewable electricity placed on the grid. Any double sales are protected against, as registries do not allow the same individual credit to exist in more 2 http://www.epa.gov/otaq/fuels/renewablefuels/compliancehelp/ 3 http://www.epa.gov/greenpower/gpmarket/rec.htm 4 We note that, due to the different structure of the electricity markets which enable project-financeable long term off take agreements the imperative for REC trading is lessened, as compared to its potential role in driving investment in the LCFS program. Environmental Entrepreneurs page 5
Next Steps than a single account at any one time, thus ensuring that credit ownership and status is assured. The REC program combines both compliance and voluntary markets. The RPS is a compliance market that requires electric services providers to have a minimum amount of renewable energy in their electric supply, similar to the LCFS. In addition, there are voluntary markets, which allow a consumer of a REC to choose to offset the environmental impact of their electricity use. A REC program can demonstrate best practices for maximum environmental impact through a voluntary market, and alleviating a regulatory agency of the burden of certification. Current regulation language will need to be amended as required to allow such an expansion of the credit market. Upon this amendment, staff may solicit competitive bids from interested registry service providers. After the selection of a service provider, ARB staff can work with the registry service provider to enable trading platforms in accordance with regulatory requirements. Once the registry platform is established, additional trading service providers may register participants and begin the first phase of credit trading. During these years of lower compliance targets, it is important to build and test this platform now to ensure a fully functioning and secure platform in later years of the program. For question or more information, contact: Mary Solecki mary@e2.org 415.246.3322 Environmental Entrepreneurs page 6