The California Carbon Market

Implications for Forest Carbon Offset Investment

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New Forests has been an active investor in the California carbon market for several years through its joint-venture Eco Products Fund, which has financed some of the largest forest carbon projects being developed for the California market. Our San Francisco office has also closely tracked carbon offset policy development in California. In this article, New Forests’ San Francisco carbon team summarizes the opportunity presented by the California carbon market for forest carbon offset investment.

Introduction

In 2006, the State of California enacted the “Global Warming Solutions Act” (AB32), which established a program to significantly reduce California’s greenhouse gas emissions by 2020. A core element of the implementation of AB32 is the creation of a cap and trade emissions market in which major emitters must submit a permit (“allowance”) or offset for every tonne of greenhouse gases they emit – their “compliance obligation.” The number of allowances made available by the government is limited and declines over time, creating a declining “cap” on emissions. If a regulated business invests in technology or practices to reduce the greenhouse gas emissions of their operations, they reduce their compliance obligation and associated costs of allowance and offset purchases. They may also be able to sell allowances or offsets surplus to their needs. Businesses in certain sectors of the economy that do not have a regulatory compliance obligation may generate offsets to sell to regulated entities. The system is designed to create incentives for businesses throughout the economy to find and invest in the least-cost opportunities for emissions reductions.

The California Air Resources Board (ARB) is responsible for developing the regulations that will govern the cap and trade system, which will commence in January 2012 with coverage of the electric power sector. Liquid transportation fuels enter the system in 2015. The system requires reductions of approximately 273 million metric tonnes of carbon dioxide equivalent (MtCO2e) through 2020 as compared to business as usual, representing a reduction in emissions to 15% below 2012 levels.

California’s carbon market will be among the largest in the world and may transform the world’s eighth largest economy. New Forests expects the market to rely extensively on forest carbon offset supply.

The Offset Market

Offsets are credits produced through voluntary emission reductions in sectors of the economy that do not have a compliance obligation, such as forestry and agriculture. Businesses in such sectors can implement offset projects to reduce emissions in exchange for the issuance of offset credits. When sold to a regulated electric power or transportation fuels company, the use of offset credits results in net zero emissions within the system. Offsets are included in the cap and trade system to contain costs, as it is expected that offset projects will often be able to reduce emissions more cost effectively than some internal emission reduction investments available to regulated entities.

Under the California cap and trade system, regulated businesses may meet up to 8% of their compliance obligation with offsets. Most private and public analyses of the system predict that businesses will make full use of offsets as one of the least-cost emissions reduction opportunities available. Estimates of offset demand range from approximately 214-232 MtCO2e through 2020. As of December 2010, current offset supply eligible for use in the California market is approximately 8.3 MtCO2e.

At present, there are four offset project types that are eligible in the California market: domestic forestry, urban forestry, livestock (manure/methane) management and the destruction of ozone depleting substances (ODS). California will “grandfather” 2005-2014 vintage offsets issued under the voluntary Climate Action Reserve (CAR) protocols for projects registered with CAR before January 1, 2012. After that date, all offset projects must be developed according to protocols adopted by ARB, which will closely resemble the CAR protocols. In addition, California is developing a pathway for the admission of offset credits from sector-wide emissions reductions in developing countries, beginning with Reduced Emissions from Deforestation and Degradation (REDD).

The table below illustrates New Forests’ calculations of the maximum offset use (expressed in million metric tonnes carbon dioxide equivalent [MtCO2e] per annum) allowed under AB 32 for the first three compliance periods. During the first compliance period, sector-based offsets, such as from REDD, can be used for up to 25% of the total volume of allowed offsets. In the second and third compliance periods, the limit increases to 50%. These maximums as well as the 8% limit apply to each regulated entity’s annual and triennial compliance obligation. For example, if a regulated entity has a compliance obligation of 10MtCO2e in 2012, it may submit up to 800,000tCO2e of offsets of which 200,000tCO2e (25 percent) may be sourced from REDD. As offsets and allowances can be banked, entities can strategically manage their liability from year to year and across compliance periods. New Forests expects that most regulated entities will aim to maximize offset use in each period and bank allowances for use in the later years of the system.

Estimated Maximum Offsets Allowed in California Cap-and-Trade System, 2012-2020 (MtCO₂e)

Forest Carbon in the California Offset Market

California’s cap and trade market is the first compliance carbon market in the world to accept forest carbon offsets³, and the market will likely rely extensively on forest carbon offset supply. Only domestic forestry, ODS and international Reduced Emissions from Deforestation and Degradation (REDD) projects can deliver the necessary volume to the market. The charts below illustrate this reality by comparing the number of projects registered with CAR to the volume of offsets issued as of October 2010. Domestic forestry and ODS projects have provided 50% of the offset volume to date, while representing only 11% of all projects registered. New Forests expects ODS offsets to capture a 25-30% of the California offset market through 2020. As the only other available sources of high volume, low-cost offset supply, domestic forestry and REDD projects together may capture a 50% share of the California offset market through 2017 and a higher market share thereafter.

ARB committed to incorporating REDD offsets into the California market through market regulations approved in December 2010. To that end, the Governor of California signed a MOU with the states of Acre in Brazil and Chiapas in Mexico to implement a working group that will recommend REDD regulations to ARB by October, 2011. Acre and Chiapas will likely be early pilot provinces that link to the California system to provide REDD offsets; other sub-national states and provinces will be able to follow. ARB envisions a fully developed REDD market in operation by 2015 that will include activities both at the project and state level, involving both government-led and private sector investment.

New Forests’ Market Position

New Forests is an early and significant investor in the California forest carbon offset market. New Forests' joint-venture Eco Products Fund has made several significant investments in compliance-grade forest carbon offsets eligible in the California market, including financing the development of some of the largest forest carbon offset projects to date. New Forests has also played a leading role in advocating smaller forest owners who manage the vast majority of US private timberland, and we are developing an aggregated group of forest carbon projects with smaller forest owners in Northern California. New Forests Asia is developing REDD projects in Indonesia that will protect intact tropical rainforest, aiming to deliver high volumes of low-cost offsets to the California market, and New Forests’ work in Brazil on developing forest carbon opportunities for large landowners aims to catalyze new models for conservation finance in the Amazon region.

With our track record and current market-leading position, New Forests plans to maintain and build its market share in the California carbon market over the next few years. Forest carbon offset investment represents an opportunity to capitalize on a significant regulatory shift in the California economy while simultaneously accomplishing meaningful forest land conservation.

More Information

For further information on our California-compliant forest carbon investment programs please contact:

Brian Shillinglaw
New Forests U.S.
bshillinglaw@newforests-us.com

Notes and References

1. These figures do not subtract for the cost containment reserve, which increases from 1% to 4% to 7% in successive compliance periods. ARB will release these allowances only if auction prices reach certain thresholds.
2. Maximum offset demand is calculated by assuming available allowances meet 92% of compliance obligations and offsets are used to cover 8% of compliance obligations.
3. Forestry offsets (tCERs) in the Kyoto Protocol’s Clean Development Mechanism represent less than 1% of market volume and are not accepted in the EU ETS. Forestry is significant in New Zealand’s Emissions Trading Scheme as a capped sector, not a provider of offsets.