Not all carbon credits are created equal: the constitution and the cost of regional cap-and-trade market linkage.

• Author: Howland, Juliet

1. INTRODUCTION II. THE CURRENT STATUS OF CALIFORNIA'S CAP-AND-TRADE PROGRAM III. THE BASICS OF LINKAGE IV. THE BENEFITS AND COSTS OF LINKAGE A. Benefits of Linkage B. Costs of Linkage 1. Costs Associated With Any Linkage 2. Costs Associated With Linking With a Poorly Designed Cap-and-Trade Market V. DESIGNING CALIFORNIA'S CAP-AND-TRADE MARKET A. California Should Link With Other Well-Designed Cap-and-Trade Markets B. California Should Seek to Avoid Linkage With Poorly Designed Cap-and-Trade Markets C. How to Avoid Linkage With Poorly Designed Cap-and-Trade Markets 1. Proposed Set Standards Law 2. Proposed Discretionary Discount Law 3. Evaluating Proposed Laws Under the Dormant Commerce Clause 4. Analyzing the Set Standards Law Under the Dormant Commerce Clause 5. Analyzing the Discretionary Discount Law Under the Dormant Commerce Clause 6. Seeking Congressional Approval to Enact the Set Standards Law or Discretionary Discount Law VI. CONCLUSION I. INTRODUCTION

   In the absence of federal leadership, states have banded together into regions to address the issue of climate change. (1) This patchwork approach has raised serious legal questions. As states seek to create independent cap-and-trade markets, they must avoid constitutional pitfalls. One issue that has yet to gain much attention is the question of how these independent regional cap-and-trade markets will, or will not, interact.

   Each of these regional groups has chosen to create its own cap-and-trade market that will trade in credits equaling one metric ton of C[O.sub.2]e. (2) Because these regional markets will trade in credits of equal carbon value, any carbon credit could be traded between regional markets and satisfy any regional market's carbon requirements. This trading between cap-and-trade markets--commonly referred to as linkage--is likely to take place through formal agreements. Yet it is possible that one state or regional group could refuse to link and refuse to honor another state's carbon credits. It is also possible that one state will honor another state's carbon credit only at a fraction of its stated carbon value. Given that carbon credits are, at first glance, a fungible good, (3) this type of restraint on interstate trade appears to be directly at odds with the Dormant Commerce Clause.

   And yet, there is a good reason why a state might want to avoid linkage with another state. The differences in the way regional markets are designed have a substantial effect on the value of the carbon credits. In a cap-and-trade scheme, the market auctions or distributes a certain number of carbon credits that equal a cap. Regulated entities can then conduct a cost-benefit analysis and choose to either purchase carbon credits or reduce their greenhouse gas emissions. If a cap-and-trade market is not well designed--due to poor monitoring and enforcement, low standards for carbon offsets, or through excessive use of safety valves--more greenhouse gases will be emitted than are allowed under the cap. This could undermine the market's ability to reduce greenhouse gases to the desired level and cause carbon credits to become undervalued, reducing the effectiveness of market signals. Linking with a poorly designed cap-and-trade market allows these deficient carbon credits to flood an otherwise sound market. The end result is to decrease the effectiveness of two cap-and-trade markets instead of one. This Comment will focus on issues that arise with linkage and poorly designed cap-and-trade markets.

   With one regional cap-and-trade market already in action, and several more in the planning and design phases, it is important to consider how to structure these markets in order to allow for beneficial trade while protecting market integrity. (4) President Barack Obama stated during his 2008 presidential campaign that he plans to institute a federal greenhouse gas cap-and-trade market. (5) Though this federal market is likely to preempt regional markets, it is also likely that a federal market will not be in place for several years. (6) During the interim time period, if regional cap-and-trade programs are successful, they will help make a federal program more politically palatable. (7) Regional markets are also likely to serve as a model for the federal market. (8) Moreover, though the Dormant Commerce Clause will not be applicable for a federal cap-and-trade market, the issue of linkage will remain relevant. When the United States designs its cap-and-trade market, it must consider the costs and benefits of linking with other existing foreign markets like the European Union Emissions Trading Scheme.

   I have chosen to focus this Comment on the linkage issues facing California for two reasons. First, California's cap-and-trade market will come into effect in 2012. (9) This means that many of the policy issues relating to the cap-and-trade market have already been considered, but the recommendations in this Comment for protecting California from detrimental linkage without violating the Dormant Commerce Clause have yet to be contemplated. (10) Therefore, I hope that these recommendations will be useful as California continues to refine their market design. Second, California has long served as a leader in environmental regulation. In the past, when California has been successful in implementing new regulations, the country has often followed on a national scale. (11) Governor Arnold Schwarzenegger has made it clear that he hopes that California's actions will lead to federal action on climate change as well. (12) Accordingly, it is especially important for national political sentiment that California be successful in implementing its cap-and-trade program.

   This Comment discusses the current linkage-related issues facing California and analyzes two possible solutions. Part II describes the current status of California's cap-and-trade program as well as its current plans for linkage. Part III gives a short description of the basics of linkage and its economic impacts. Part IV focuses on the costs and benefits of linkage. I start by describing the economic, environmental, and political benefits that California could gain from linkage. I then describe the costs associated with any type of linkage and those that will only occur from linking with a poorly designed cap-and-trade market. Part V discusses California's options for avoiding linking with a poorly designed cap-and-trade market. I conclude that California should seek to link with well-designed cap-and-trade markets and avoid linking with poorly designed ones. To achieve this goal, I propose two possible laws that would allow California to limit its linkage to well-designed cap-and-trade markets and analyze the constitutional implications: the Set Standards Law and the Discretionary Discount Law. While both of these options should be considered by California, the Discretionary Discount Law places a larger burden on interstate commerce and is thus more likely to violate the Dormant Commerce Clause. This Comment concludes that California should take the issue of linkage seriously in order to avoid problems down the line. The State should enact a law now in order to protect its cap-and-trade market in the future.

2. THE CURRENT STATUS OF CALIFORNIA'S CAP-AND-TRADE PROGRAM

   California is currently working diligently to design its carbon emissions program. Governor Schwarzenegger signed the California Global Warming Solutions Act of 2006 (AB 32) into law on September 27, 2007. AB 32 requires that California reduce statewide greenhouse gas emissions to 1990 levels by 2020. (13) The California Air Resources Board (CARB) is charged with designing California's program to reduce greenhouse gases as well as monitoring and regulating sources of emissions of greenhouse gases. (14) CARB has been directed to consider market-based compliance mechanisms, among many other options. (15) Under the encouragement of Governor Schwarzenegger (16) and the Market Advisory Committee, (17) CARB plans to implement a cap-and-trade system in 2012. (18) California is still working out the basic mechanics of its cap-and-trade market. It is my hope that the analysis in this Comment aids California in drafting the linkage provisions for its cap-and-trade regulations.

   It is likely that California will not operate its cap-and-trade market independently. Instead it will probably operate its cap-and-trade market as part of the Western Climate Initiative (WCI). Since its founding, California has played a key role as a member of WCI. Policymakers in California have generally supported linking California's cap-and-trade market with WCI. Governor Schwarzenegger was one of WCI's original signers. (19) In anticipation of linking with WCI, California has also played a leading role in designing WCI's cap-and-trade market. (20) Furthermore, the Market Advisory Committee currently recommends that California link its cap-and-trade market with WCI. (21)

   WCI currently consists of seven US states (Arizona, California, Montana, New Mexico, Oregon, Utah, and Washington) and four Canadian provinces (British Columbia, Manitoba, Ontario, and Quebec). (22) The goal of WCI is to reduce regional greenhouse gas emissions by 15 percent below 2005 levels by 2020. (23) This goal is approximately equal to California's goal of reducing its greenhouse gas emissions to 1990 levels by 2020. (24) WCI is also considering the possibility of linking with other cap-and-trade markets in the future and "will seek bilateral and multilateral linkages with other government-approved cap-and-trade systems so that those allowances and allowances issued by WCI Partner jurisdictions would be fully fungible." (25)

   Along with the near-certain linkage with WCI, Governor Schwarzenegger has agreed to explore ways to link California's cap-and-trade market with the Regional Greenhouse Gas Initiative (RGGI) cap-and-trade market. (26) RGGI is made up of Connecticut, Delaware, Maine, Maryland...