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First Thoughts
  By Dan Gilmore - Editor-in-Chief  
  Oct. 27, 2011  

Supply Chain News: Cap and Trade - It's Here!


In what I believe is a far under-reported story, California as required a 2006 law unveiled this week a carbon emissions reduction program supported by a new cap and trade regime.

California represents about 12% of the US economy, more than 50% more than its nearest rival Texas. It has often started trends that move nationwide. And this happening not long after many were (correctly) writing obituaries for cap and trade or other carbon emissions programs on a national level in the US and on a global level for at least some years. Now have a true cap and trade program going on-line in the Golden state just next year.

Gilmore Says:

So that means if you have a factory in California that isn't "carbon efficient" right now, you are already behind the eight ball.

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The supply chain impact could be huge.

In 2006, the California legislature, with then Governor Schwarzenegger's signature, passed the Global Warming Solutions Act, also known as AB 32, which called for the state to reduce carbon emissions to 1990 levels by 2020 - an incredibly tall order. We reported on that law then and occasionally over time, but in my mind now nearly not enough.

The law has unleashed dozens of programs and actual or soon-to-be new rules, but the cap and trade program is the one element of the total program that has generated the most interest and business concern. With no carbon emissions law coming out of Washington, California is going it alone (though supported by the EPA, which has been in effect legislating its own carbon emissions program nationally through a series of regulations).

The new rules announced this week come after the program survived a statewide vote last year to delay execution of the rules until unemployment levels in California dropped, and also pressure by some environmental groups to have a direct tax on carbon-based fuels rather than a cap and trade regime, which delayed implementation by about one year. In the end, cap and trade won out.

One thing I have learned is that getting actual details on anything government related is very difficult, so I have spent a good chunk of the last few days trying to get my arms around this.

Here is what I am pretty confident is true:

Beginning January 1, 2012, 350 California businesses representing approximately 600 facilities, will be covered by the program. Those businesses will be electric utilities and large industrial facilities and will need to comply in 2013. Distributors of transportation, natural gas and other fuels will need to become compliant in 2015. So, you will be impacted if you have a large production facility (don't have the details), or use fuel. Think that is most of us.

Importantly, the cap for 2013 emissions, which will drive the number of "allowances" created, was set at 2% below the forecast for 2012 emissions. This is highly unusual. In Europe, for example, the cap was set at some level of predicted future emissions, so that businesses would have time to adjust. But I guess if you are trying to get to 1990 levels by 2020 (which of course will never happen, by the way), you have to be more aggressive.

The statewide caps will decline another 2% in 2014 and 3% each year until 2020 and beyond. Holy carbon emissions Batman! That's an aggressive goal.

Under the program, "allowances" will be initially created based on current carbon emissions levels. The California Air Resource Board (ARB), which developed and approved the program, says that allowances for each industrial sector will set at about 90 percent of average emissions, based on a benchmark "that rewards efficient facilities." Distribution of allowances will be updated annually for industries according to the production and efficiency of each facility

So that means if you have a factory in California that isn't "carbon efficient" right now, you are already behind the eight ball.
Some 90% of these allowances will be distributed to businesses at no charge. Each allowance equals one ton of greenhouse gas emissions.

The other 10% will be sold on the open market. Estimates are these allowance sales will generate as much as $500 million. Unlike the recommendations of even many environmentalists, these proceeds will not be "revenue neutral" for California citizens. Many believe that the rising costs in energy and purchases consumers will experience as a result of cap and trade or carbon tax programs should offset by returning the revenue raise back to the citizens as a tax rebate or something.
Not happening in California - the state will keep that money to fund other environmental programs.

Businesses will be able to use "offsets" for up to 8% of their annual emissions allowances (planting forests, etc.), but those offsets must be executed in the US and must be independently verified (smart business idea - start offsets verification business right now, kind of like a home inspector for tree plantings).

Rain forest projects in Latin America will not be considered (as I believe they are in the European program). As an aside, doing these offsets projects elsewhere was in part how Al Gore justified his mega-electricity bill at his mansion when it came to light a few years ago.

As their individual caps are decreased each year, businesses must either reduce their emissions, or compete in the exchange for allowances. As caps are reduced, the allowances will become more valuable and the price will go up.

How high? Well, that's among the challenges with a cap and trade plan. You really have no way of predicting. A really hot summer requiring lots of air conditioning could cause allowance prices to skyrocket. (A carbon tax, for example, would have a cert clear cost impact that could be better planned for).

This means energy efficient companies that can already operate at less than their caps produce can sell their extra allowances and make a tidy profit. The theory also is that as the allowances become more expensive, more and more companies will find it makes financial success to find some way to their emissions rather than pay for more allowances, of which there will be only so many to go around.

In other words, no company will be directly forced to limit greenhouse gas emissions. But there will be an increasing financial penalty to not do so.

The capped industries must continue to report emissions annually, which they have been required to do since 2008. These industries must also register with ARB to participate in the emissions trading market, and will be subject to Independent third-party verification of reported emission levels.

Of course, the trading in allowances requires setting up a giant exchange, where these permits will trade like pork bellies at the Chicago Mercantile Exchange. Someone will make a lot of money there. The ARB says RFPs are going out soon for someone to develop and manage the allowance exchange. The LA Times says as much as $10 billion in allowances could be traded in such a market by 2016.

The first auctions are set to be held in August, 2012 - less than a year away. This requirement is coming like a freight train.

So, what do to?

1. Get educated. We are doing more research, and will provide updates soon, so SCDigest can help, but I would talk to local experts for sure.

2. Recognize that there will be increases costs, and choices to make. Relooking at your network design will be critical. Will it make sense to move current facilities in California to somewhere else, or simply close them down at make more at existing facilities? Maybe - and part of that will have to involve looking at different scenarios relative to how much these allowances will cost over time. Some network design software tools already support carbon emissions costs in their models. It is important to note, though, that if you are very efficient right now at a factory, you could make some money for awhile selling allowances.

3. Similarly, it is not just you - carriers, 3PLs, contract manufacturers and other service providers will also be impacted. Will a move to LA/Long Beach to the Port of Tacoma or Houston make sense, for example? It just might.

4. Consider that outsourcing may be the smart move even if you stay in California - let someone else worry about direct compliance, and make it easier to leave the state later if costs get too bad.

5. Understand the details. For example, the Orange County Register warns non-utility businesses could get really screwed. That's because by law utilities have to provide service, and they can include the cost of the allowances in their rate structures. The point is they may buy the majority of the allowances, leaving few (and therefore high prices) allowances for everyone else.

This law could also result in some odd scenarios. I am going to verify this, but I believe, for example, that the impact on diesel fuel prices will only be felt for fuel that is purchased in California (meaning, I don't think the law envisions somehow tracking miles driven in the state with fuel purchased elsewhere). So, will the instruction to truckers coming into or out of the state be to minimize purchase of fuel in California itself, making sure you stop in Reno or whatever city is just across the border in Arizona or Oregon to fill that semi to the brim? The delta in diesel costs could be huge.(Of course, consumers will realize this too for their gasoline).

We can debate the reality of global warming, the merits of cap and trade, etc., but to me there are only a couple of things that are clear in this right now:

(1) The impact on supply chains could be seismic (an appropriate term for an action taken in earthquake prone California)

(2) The only ones that should be really happy about how this is scheduled to progress are really strong environmentalists - and the people in Texas.

We will keep you informed.

What's your reaction to this California law? Do you agree the impact can be huge on supply chains? Is your company knowledgeable on the details? Let us know your thoughts at the Feedback button below.


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