A California economist says that the state's landmark, economywide cap-and-trade system for reducing greenhouse gases has a fatal flaw that is now emerging.

Utilities, and even a state agency, are ending contracts for electricity from coal-fired power plants, which have high levels of carbon dioxide emissions. That would be no problem, and, in fact, good for the state's climate goals, but the electricity is still being generated and consumed out of state.

The issue is known as "resource shuffling" -- a thorny problem that stems from the basic fact that California has capped its carbon emissions before anyone else in the West. Reducing emissions within California does no good for the climate if the emissions simply resurface elsewhere.

A University of California, Berkeley, economist has noted three transactions already that could be transferring emissions out of state:

Southern California Edison sold its interest in the Four Corners coal-fired power plant to Arizona Public Service Co. in December 2013.


The California Department of Water Resources ended its contract with the Reid Gardner coal-fired plant in Nevada in July 2013, while its owner, Nevada Power Co., plans to continue operating the facility until roughly 2017.

The Los Angeles Department of Water and Power is preparing to divest its 21.2 percent interest in the coal-fired Navajo Generating Station in Arizona next year and has contracted with a natural gas-fired plant in Nevada to replace part of it.

Out of state, out of mind

All three actions mean that a total of 30 million to 60 million tons of CO2 has leaked or is currently leaking out of California, according to Danny Cullenward, a research fellow at Berkeley's Energy and Climate Institute.

The California Air Resources Board (ARB) is set to approve a suite of changes to the state's cap-and-trade program today that would permit these activities, along with increasing the number of free allowances that emitters receive and adding a new sector -- coal mines -- that can produce offset credits for trapping and destroying methane emissions.

Resource shuffling could send as much emissions out of state as the state's economywide cap-and-trade system is intended to reduce through 2020, Cullenward said. The emissions market is expected to pitch in about 20 percent of the emissions reductions required under the state's 2006 law, A.B. 32, which set a target of 1990 emissions levels by 2020. Other policies, like solar installations, vehicular emissions standards, green building rules and a low-carbon fuel standard, are expected to result in the majority of emissions cuts.

"With all eyes on California, every step the board takes sets a crucial precedent for how forward-thinking governments can address the climate crisis," he wrote in October. "That's why it is critical that the board's next step not undo its early success."

Cullenward calculated the rate of leakage based on the difference between the coal-fired power and the replacement power (either natural gas or some type of zero-carbon resource), the average output of the coal plants and the coal plants' retirement dates.

It's a similar type of calculation to that used in creating carbon offsets, another component of the state's market. Offsets represent a given amount of carbon that has been taken out of the atmosphere by tree planting, methane capture and other climate-friendly activities. Since both resource shuffling and carbon offsets transfer credit or liability for carbon emissions across the state border, policymakers have taken steps to ensure that they're not somehow undermining the regulatory part of the plan, which is the emissions cap and mandatory purchase of greenhouse gas credits aimed at reaching 1990 levels of CO2 by 2020.

Environmental groups sued the state over its offset system, arguing that some projects would have happened without financial incentives and that companies shouldn't be allowed to use their emissions reductions in place of some of their carbon credits.

The state won the lawsuit, with a judge ruling that the courts must respect the agency's authority over environmental policy decisions (E&ENews PM, Jan. 28, 2013). Companies are permitted to use offsets for up to 8 percent of their emissions under the cap.

Cullenward said that the state's rules are written in such a way that resource shuffling also makes the market less reality-based.

"When we get to 2020, the market will produce compliance -- on paper, if nothing else," he said. "The question is, will that compliance represent real emissions reductions or just an accounting trick that exports liability to neighboring states?"

FERC worries about grid reliability

In 2012, the Federal Energy Regulatory Commission raised the possibility that the state's rules against resource shuffling were too broad and could have a chilling effect on interstate power trading, causing electricity shortages -- a longtime third rail in California politics, stemming from the energy crisis of 2000-01 (ClimateWire, Aug. 21, 2012).

ARB issued a list of 13 "safe harbor" electricity purchases that wouldn't count as resource shuffling. They include emergency deliveries; electricity bought to replace expired contracts; electricity to replace contracts that run afoul of a 2006 law that sets an emissions limit for long-term power plant contracts; and supplies that replace contracts that are canceled "for reasons other than reducing a GHG compliance obligation."

That list is too broad, Cullenward said.

He estimates that through 2020, there could be leakage of 108 million to 187 million tons of carbon dioxide just from shuffling of old contracts for coal-fired power. Other economists have found leakage of 74 million to 319 million tons.

Market observers have also noted leakage's potential effect on allowance prices. Legal shuffling has removed about 15 million tons from the state so far, lowering demand for allowances, according to Andre Templeman, managing director of Houston-based energy consulting firm Alpha Inception.

If ARB were to make its rules more stringent, "it could have a big effect in tightening up the market, so this should not be ignored," he wrote in a report last month by the website CaliforniaCarbon.info.

An economist who has advised ARB on its market agreed. "Resource shuffling is part of what is creating the breathing room in the market," said Severin Borenstein, director of the University of California Energy Institute, based at the University of California, Berkeley.

Cullenward and other economists have raised concerns about leakage before. Cullenward, in particular, has been a vocal critic, taking to the San Jose Mercury News last fall to protest the upcoming changes.

"To the extent that regulated parties in California rely on resource shuffling to comply with climate policy, the carbon market will produce the false appearance of emissions reductions," he wrote in an April 4 letter to ARB. "Put another way, resource shuffling means that the cap is no longer firm."

ARB officials said that they would enforce the ban if a violation occurred but declined to comment on the examples Cullenward raised.

"This letter does not raise any new issues," said agency spokesman Dave Clegern. "Resource shuffling is illegal under the cap-and-trade program, which will be enforced if a violation should occur. We constantly review the regulations and make adjustments if we determine they're needed. We would not comment on allegations like these."

A West-wide market has disappeared

Preventing emissions from escaping California's regulations is difficult. But the question of whether leakage is occurring -- and how serious an issue it is -- is also hard to answer.

Economists agree that resource shuffling is likely to occur. They are split on whether it is a threat to the success of California's program and whether it can or should be restricted.

"Resource shuffling is the same thing as serving the interests of your shareholders or your customers, and therein lies the big problem and the challenge in trying to prohibit it," said Frank Wolak, an economics professor at Stanford University who has advised ARB on its market. "It's analogous to telling utilities not to do what is least-cost to comply with the regulation."

Wolak and others argue that the best solution is not to exert greater control over electricity imports, but to get neighboring states to join California in capping carbon. As many as seven states and four Canadian provinces had explored joining California in the late 2000s, but most have backed down, with Quebec now its only official trading partner. Washington state and Oregon have now rejoined the effort, but face legislative hurdles (ClimateWire, March 28).

"The best thing you could do is to try to expand the program as quickly as possible so the geographic area covered by the program is the same geographic area covered by the electricity supply industry, and all your problems go away," Wolak said.

Borenstein agreed. "I certainly would not want to see ARB try to eliminate all reshuffling unless they also had a hard price cap in the market, which they don't," he said. "I think that the political crisis that would cause would likely doom the cap-and-trade market. If we could get a Westernwide cap-and-trade system, this would make it a much easier problem to deal with."

An environmentalist praised Cullenward's attempts to publicize the issue.

"I think he's doing an incredibly useful service by continuing to beat this drum," said Alex Jackson, legal director of the Natural Resources Defense Council's California Climate Project.

Fixing the problem, he said, involves walking a fine line, as environmentalists want to encourage utilities to divest from coal-fired power but also to avoid simply sending the emissions to other states. Requiring electricity importers to prove that their actions fall into one of the safe harbors would be a good start, he said.

"Certainly, the ultimate solution involves getting other jurisdictions on board, but in the near term, we know that's not going to happen overnight," Jackson said. "There are improvements we can make to tighten up the rules and help ensure that the reductions reported in the program are in fact real reductions."

Southern California Edison sold its 740 megawatts of capacity in Four Corners to APS in December 2013 and replaced it with electricity from its general portfolio -- a clear example of emissions escaping the state, Cullenward said. But a company spokeswoman said the divestment was in order to comply with a 2006 state law, S.B. 1368, that requires utilities to limit their long-term investments to plants that emit less than 1,100 pounds of CO2 per megawatt-hour. That form of shuffling is provided for in ARB's revisions.

As well, APS actually shut down 560 MW of older coal-fired generation at the same time that it bought SCE's share, in order to comply with U.S. EPA regulations, so the net increase in coal-fired capacity was 180 MW. And the utility is planning to install new equipment on the SCE units to reduce CO2 by 30 percent.

When DWR ended its contract with NV Energy, the power company diverted the roughly 235 MW of coal-fired capacity to its own customers. DWR replaced the power with a combination of renewable energy power purchase agreements, market purchases and a new natural gas plant, an agency spokesman said. The contract, which began in 1979, was scheduled to end last year, he pointed out.

"The contract terminated due to the expiration date, and DWR did not request negotiations to extend or renew the contract," said Ted Thomas.

New rules coming today

Both of those activities would be permitted by ARB's proposed standards, Cullenward said. LADWP's action is more questionable, he said, because the utility has said that one of the benefits of divesting from Navajo early is to relieve it from "having to purchase emission credits to comply with the statewide cap-and-trade program." But even though it violates ARB's proposed rule against switching between high- and lower-emitting electricity "for the purpose of reducing a compliance obligation," it qualifies for the safe harbor of the emissions performance standard.

"What's remarkable about the LADWP transaction is that the utility admits it is motivated by avoiding the carbon market," Cullenward said. "The takeaway here is that even when a utility admits it is resource shuffling, CARB says it isn't."

LADWP officials said that they thought the switch was permitted by ARB's rules. They are planning to replace Navajo's power with energy efficiency, renewables and a new natural gas-fired plant in Nevada. The Navajo power is expected to go to one of the plant's other five existing co-owners.

"We believe that when we've divested from Navajo, that would fall into one of the safe harbor categories: early divestiture of a resource," said Eric Tharp, the utility's director of fuel and power purchases. "If we don't own it, we don't believe we would need to report the greenhouse gas emissions associated with that. We will certainly discuss with the ARB when the deal gets closer to being finalized to make sure we are in compliance with their regulations."

Both of the California utilities have tried to influence ARB's rules on resource shuffling.

LADWP suggested to the agency last year that it add an exemption for utilities that ramp down a higher-emitting source in exchange for a lower-emitting one, even when the higher-emitting one has not retired but has simply reduced its output.

SCE asked ARB to add a provision allowing utilities to sell high-emitting power outside the state if they had first tried and failed to sell it into the state's wholesale market.

The agency declined to incorporate those recommendations into its proposed version of the regulations to be voted on today.

"We're very comfortable we'll be able to meet all the requirements," said Mark Sedlacek, LADWP's director of environmental affairs. "Our main point there was trying to provide more clarification."