Carbon Trading Comes to Washington State as Supreme Court Partially Restores Climate Regulation

With recent action by the Washington State Supreme Court, carbon trading is coming soon to the Evergreen State—though on a much more limited basis than Governor Jay Inslee and the State Department of Ecology had hoped.

Clean Air Rule Background

After years of legislative deadlock over the regulation of greenhouse gas (GHG) emissions, Ecology moved ahead with its Clean Air Rule (CAR) in 2016 based on the existing Washington Clean Air Act. The CAR was designed to reduce GHGs from major sources, including both direct emissions (initially from 48 large stationary sources, like factories, power plants, refineries, and landfills, with coverage expanding to smaller stationary sources over time) and indirect emissions (from natural gas utilities and petroleum refiners and importers due to the GHGs from customers’ use of their products).

The CAR would have required most of these businesses to reduce their GHG emissions by 1.7 percent per year beginning in 2017. But in late 2017, the Thurston County Superior Court struck down the entire rule, finding that the Clean Air Act does not authorize Ecology to regulate indirect GHG emitters and refused to sever and uphold the rules that applied to direct emitters.

There things stood until last week. Then on January 16, by a 5-4 vote, the Washington Supreme Court affirmed the Superior Court’s decision regarding indirect emitters, but reversed its holding on severability, preserving the CAR as it applies to direct emissions. It now appears that, at least in limited form, the CAR carbon trading regime will soon come into effect in Washington.

The Court’s Analysis

The case turned on the regulation of the gas distribution utilities and petroleum refiners and importers with respect to the emissions from their customers’ ultimate fuel combustion. These indirect emitters cannot directly reduce emissions, so they could only comply by buying carbon credits called Emission Reduction Units (ERUs) or funding projects to create ERUs by reducing GHG emissions elsewhere.

The majority held that this exceeded Ecology’s authority, based on the statutory definitions of “emission” and “emission standard.”

The dissenters firmly contested this conclusion, pointing to language in the Washington Clean Air Act referencing “thousands of small individual sources,” which suggests a regulatory reach beyond a few dozen large, direct emitters. The dissent also embraced the maxim of statutory construction expressed in previous Washington Supreme Court opinions that the state’s environmental laws should be broadly construed to achieve the statute’s goals.

Despite acknowledging that “dramatic steps are needed to curb the worst effects of climate change,” the majority did not even address those prior decisions.

The Road Ahead

Governor Inslee responded by calling for legislation in the current legislative session to clarify Ecology’s authority with respect to the portion of the regulation that was struck down. That may be a heavy lift: the short, even-year session, already underway, is scheduled to end on March 12.

In the meantime, how much of the CAR did the Court leave in place? The short answer is that the Court green-lighted the regulation of about one-quarter of the emissions that Ecology sought to regulate, which amounts to about 18 percent of Washington’s total GHG emissions. For that 18 percent, the opportunities for trading under the CAR are extremely restrictive compared to most cap-and-trade schemes.

First, the market will have few participants. Only entities regulated under the CAR (including voluntary participants) may actually hold ERUs.

Second, any linkage to trading systems outside Washington will be very tenuous. The CAR provides for such linkage if approved by Ecology. However, because only CAR-regulated entities can hold or transfer ERUs, they are not fungible with instruments from other systems.

For example, a regulated factory in Washington might be allowed to buy a California carbon allowance and retire it to generate an ERU, but it could not generate an ERU and sell it to a party regulated under the California system. The policy rationale for this one-way compatibility is unclear.

Third, the opportunity to offset emissions by sponsoring GHG-reduction projects also appears limited. Ecology will allow the generation of ERUs through a variety of GHG-reduction activities, provided they meet specified criteria. The list includes transportation, combined heat and power, energy efficiency, demand-side management, renewables, livestock and agricultural activities, waste and wastewater management, and industrial sector activities.

However, because only regulated entities can hold ERUs, there seems no way for the sponsor of a GHG reduction project to generate ERUs on a speculative basis without a regulated entity lined up in advance to hold them. Again, the policy rationale for this limitation is unclear. And of course, the offset program could be limited by Ecology’s willingness or ability to approve sound projects without too much delay or burden.

Bottom Line

Even assuming no legislative action, about 18 percent of Washington’s emissions will likely be capped and reduced for the first time. But how and when will Ecology actually implement the truncated CAR? Will it undertake a new rulemaking to clarify the compliance obligations of regulated sources? If so, which provisions will need to be substantially changed?

Also, how hard will it be to sponsor ERU-generating projects or to import allowances from other trading systems? And of most immediate concern, will regulated parties be held responsible for emissions during the first compliance period, which ran from 2017 through 2019?

We reached out and asked Ecology for clarification, but at this early stage they’re still weighing all options, so stay tuned! In the meantime, please feel free to contact us with any questions.