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).

Client Alert 2013-139