The limits of administrative law as regulatory oversight in linked carbon markets.

• Author: Cullenward, Danny
• Position: The California-Quebec Adventure: Linking Cap and Trade as a Path to Global Climate Action

ABSTRACT I. INTRODUCTION II. A TALE OF TWO ADMINISTRATIVE PROCESSES A. California's Linking Regulations B. California's Domestic Reforms C. Regulatory Timeline III. LEAKAGE FROM RESOURCE SHUFFLING A. Expert Opinion in the Administrative Process B. Some Legal and Practical Consequences IV. CALIFORNIA'S RESPONSIBILITIES UNDER THE BILATERAL AGREEMENT V. LINK UNTO OTHERS: A THOUGHT EXPERIMENT A. The Review Process 1. The Stringency Requirement 2. The Enforceability Requirement B. Administrative Law to the Rescue? VI. CONCLUSIONS I.

Introduction (1)

Many believe that sub-national climate mitigation policies offer a meaningful path forward by simultaneously encouraging global negotiations and persisting in the absence of international agreements. Although state and provincial governments certainly deserve credit for early action on climate, everyone understands that no local government can solve a global problem on its own. Thus, a critical task for sub-national climate policymakers is encouraging others to join or harmonize efforts with their systems. With this goal in mind, the link between California's and Quebec's carbon markets appears to offer the first major victory in linking climate policy systems since the contentious integration of the Kyoto Protocol's Clean Development Mechanism into the European Emissions Trading Scheme. (2) Will the partnership between California and Quebec set an example for others?

Here, I argue that excitement over the link between the carbon markets in California and Quebec is both unwarranted and premature. Fundamentally, proponents of this link have overlooked the practical challenges of maintaining the integrity of linked carbon markets through parallel administrative legal processes. Rather than demonstrating a successful example, the link between California and Quebec provides a useful illustration of how governments are likely to fail to anticipate significant risks in recognizing one another's market-based compliance mechanisms. The California-Quebec experience also highlights a critical tension in the drive to link carbon markets: with each new jurisdiction's entrance into a linked market, the burden of regulatory and civil society oversight increases for all involved. (3) These problems suggest that linking carbon markets is more difficult than previously imagined, raising questions about the viability of expanding sub-national carbon markets as a path towards regional and international policy harmonization.

Reflecting on these challenges, I argue that administrative law is an inadequate tool for maintaining the integrity of technically complex policy instruments like carbon markets. Even in the relatively simple case involving two linked jurisdictions whose market designs share common origins--California and Quebec both developed their respective policies through the Western Climate Initiative ("WCI"), an effort to develop a regional cap-and-trade program for greenhouse gases (4) -substantial flaws in the California-Quebec linkage have become apparent.

While the two governments were engaged in the detailed and laudable work required to harmonize the joint operation of their market systems, California was modifying its own regulations through formal and informal processes. These reforms resulted in significant adjustments to the liability regime underlying California's market structure. (5) The new rules allow regulated entities in California to transfer the liability for their high-emitting electricity imports to unregulated parties in neighboring states. This allows parties to replace their dirty imports with cleaner resources via transactions that create the false appearance of emissions reductions in California's market, without reducing net emissions to the atmosphere. Because California has historically imported a large amount of high-emissions coal power from neighboring states, there is a significant potential for regulated entities to exploit the new rules. As a result, the reforms have major implications for the demand for compliance instruments-not to mention the environmental integrity of California's flagship climate policy. Presumably, changes of this magnitude would have been relevant to the Quebecois government, which, by this time, had already amended its market regulations to accept California-issued compliance instruments and was negotiating a bilateral agreement with California concerning the joint operation of their linked markets. Yet nowhere in the state's own administrative record does the California Air Resources Board ("ARB") recognize the impact of its internal reforms on the market's integrity. Only in response to public comments--issued after the two governments formally linked their markets--did ARB consider the argument that its reforms undermined the integrity of its cap. Ultimately, ARB dismissed these concerns, despite its own economic advisers' observations to the contrary. (6)

This article focuses on the extent to which formal administrative processes are capable of preserving the integrity of linked carbon markets. Section II begins with a review of two simultaneous administrative processes in California: one enabling the link with Quebec and another amending the core carbon market regulations. Next, I describe the effect of California's internal reforms on the carbon market's integrity in Section III. Section IV reviews the bilateral agreement between the two governments, asking whether California satisfied its obligation to keep Quebec informed about the expected impacts of its new regulations. Finally, I consider the safeguards California law imposes on ARB when considering new market partners in Section V. Consider the hypothetical situation in which another state relaxed its resource shuffling rules, as California did in reality, but that California did not. Would that jurisdiction meet California's stringent standards for evaluating prospective partners? I conclude that the answer would be no, but only if state policymakers were to look beyond a formalist analysis of the legal standards in prospective linking partners. In practice, actual market conditions will be determined as much by informal guidance documents and discretionary enforcement strategies as by codified legal standards. This suggests that the regulatory oversight cost of pursuing a bottom-up, state-by-state strategy for linking carbon markets raises significant and underappreciated challenges. It also highlights the inadequacy of administrative law as a mechanism to anticipate problems from linking carbon markets.

II.

A TALE OF TWO ADMINISTRATIVE PROCESSES

Like complex financial contracts, which are generally reviewed by specialized attorneys and signed by each client organization's executives, linked carbon markets are the product of sequential negotiation and review. The key difference is that, while discussions about linking carbon markets begin through private discussions between policymakers, they are formalized through parallel administrative law processes. In turn, administrative law places the burden of due diligence on agencies. Agencies evaluate prospective partners and promulgate linking regulations, all while remaining subject to the standard requirements of public notice and comment periods. Once linked, the markets are designed to operate as a single, dynamic financial system, with regulatory oversight divided among participating governments.

As a result, environmental regulators--which legislatures typically task with operating carbon markets--must now accept the duties of international (or at least interstate) financial regulators. Their new currency is tradable compliance instruments. The fundamental legal mechanism in carbon markets is the requirement that regulated industries (known in california as "covered entities") surrender one compliance instrument for each metric ton of greenhouse gases they emit. (7) When one market links with another, it does so by allowing its regulated entities to use the compliance instruments of its linked partner. (8) When two markets mutually recognize each other's instruments they form a bilateral link. (9) Thus, a regulator that previously might have been worried about putting catalytic converters on car tailpipes now faces a new and challenging task: harmonizing the details of its domestic market regulations with those of prospective partner jurisdictions.

In practical terms, bilateral linking allows the regulated parties in one jurisdiction to employ compliance instruments from either system to meet the requirements of their home jurisdiction. Due to the mutual recognition of these instruments, the entire linked market is affected if either regulator makes a mistake or a harmful change in domestic policy. Therefore, it is essential that jurisdictions choose their linking partners carefully.

As I describe below, California's process for vetting and approving a link with another cap-and-trade market unfolded at the same time ARB decided to modify its core market regulations. Because these reforms occurred in parallel, they offer an interesting opportunity to examine how the administrative law process conducts due diligence when assessing prospective market links, as will be discussed in Sections IV and V in greater detail. Here, I provide an overview of the process by which California linked its market to Quebec's (Section II-A), a review of California's internal carbon market reforms (Section II-B), and a comprehensive timeline of the key events in both processes (Section II-C).

1. California S Linking Regulations

   California never intended to be the only jurisdiction pricing carbon. In fact, its climate policy was developed with the goal of participating in a regional carbon market. After all, the state's program has its origins in the Western Climate Initiative ("WCI"), a regional effort among state and provincial leaders to harmonize sub-national climate policies across the western

   United States...