Of the many system design or “architecture” challenges facing U.S. lawmakers now crafting cap-and-trade legislation for greenhouse gas (GHG) emissions, one of the toughest is how best to ensure that a national GHG emissions reduction program does not undermine the competitiveness of domestic manufacturing industries.  The challenge lies in the prospect that such industries, if required to purchase emissions allowances in the context of declining emissions caps, will lose out to foreign-based competitors not subject to comparable emissions compliance burdens.  The problem is most acute for domestic manufacturing industries that compete with imports and cannot pass along higher compliance costs to their customers.  For such industries, which include steel, cement, glass, chemicals and a range of other emissions-intensive goods, inclusion in a cap-and-trade system could lead to “carbon leakage” - that is, pressure to move production, and the associated jobs, to foreign locations under no or less onerous emissions restrictions.

A series of Congressional hearings in recent weeks suggest the emergence of two leading options, already floated in draft legislation in the prior Congress, to preserve the competitiveness of U.S. manufacturers in a cap-and-trade system.  One option would be the distribution of emissions allowances to U.S. manufacturing industries exposed to carbon leakage at no cost (while other industries covered by the cap-and-trade system would still be required to purchase their emissions allowances).  One advantage of this approach is that it would be less likely to invite retaliatory action from U.S. trading partners than alternative proposals that would, in essence, impose new costs on imports.  Moreover, the free allowance model has already been adopted by the EU, which has the world’s largest and most mature GHG emissions cap-and-trade system.  However, the free allowance approach may be at odds with the Obama Administration’s policy goal of requiring all sectors covered by a national cap-and-trade system to purchase allowances.

A second option for preserving the competitiveness of domestic manufacturing industries in light of carbon leakage would be the imposition of so-called border measures, which could take the form of taxes to be paid by importers of emissions-intensive goods from countries with no (or less onerous) emissions restrictions regimes.  A variation on this option would require importers to submit emissions allowances in an amount that would place imports on the same emissions compliance footing as U.S.-made products.  Border measures could, thus, create an incentive for foreign countries exporting to the U.S. market also to curb greenhouse gas emissions.  However, they would also be vulnerable to attack under World Trade Organization (WTO) rules, which prohibit discriminatory treatment of imports over domestically produced goods, as well as discriminatory treatment of imports from some countries over imports from others.  It may be possible to design border measures, so that they do not run afoul of these WTO principles.  Border measures could also potentially be justified under the WTO’s environmental exceptions, so long as any trade restrictions can be shown to advance the border measures’ environmental objectives.

The possibility of border measures imposed as part of a cap-and-trade program has generated considerable controversy in recent years.  Susan Schwab, U.S. Trade Representative during much of the Bush Administration’s second term, repeatedly spoke out against border measures, arguing that they would irritate U.S. trading partners, hurt U.S. exporters and slow progress towards an international climate accord.  The controversy flared up anew last week when Energy Secretary Steven Chu stated that the U.S. might impose duties under a cap-and-trade system to offset any unfair advantage that foreign producers not under similar emissions restrictions would have.  Secretary Chu’s comments prompted a letter from several House Republicans to U.S. Trade Representative Ron Kirk, asking him to clarify the Administration’s policy on this point.

Several committees in the U.S. House of Representatives are currently at work on the issue, including the International Trade Subcommittee of the Ways and Means Committee, the Energy and Environment Subcommittee of the Energy and Commerce Committee, and the Science and Technology Committee.  Rep. Ed Markey, who chairs the Energy and Environment Subcommittee, has announced that he will release a draft bill by the end of March.  The development of draft legislation in the Senate appears to be progressing more slowly.  But Senator Barbara Boxer, chair of the Environment and Public Works Committee, has issued a series of six principles to guide work on a cap-and-trade bill, the last of which is to “ensure a level playing field” for U.S. industries.

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On January 26, President Barack Obama outlined the first steps his administration will take to change American energy and transportation policy. Along with other initiatives, the President directed the Department of Transportation to establish rules and regulations which will raise the automotive fuel efficiency standard to an average of 35 miles per gallon by 2020.  The increased fuel efficiency is expected to be accomplished in part by continued development of electric vehicles (EVs) and plug-in hybrid electric vehicles (PHEVs).  Many major automakers have announced a roll-out of EVs or PHEVs within the next few years, including GM, Toyota, Honda, Volkswagen, BMW, and others.

Auto manufacturers have expressed concerns about the increased costs associated with higher fuel efficiency standards for some time.  One such cost increase may result from an escalating global demand for rechargeable lithium-ion batteries. These batteries have already been tested and adopted by a number of auto manufacturers for their electric fleets, and increasing demand for the batteries will put increasing strain on international lithium markets.

Lithium-ion batteries currently charge (and re-charge) various electronic consumer products, such as cellular phones and laptop computers.  In 2007, batteries became the leading end-use product for lithium, comprising 20% of the global lithium market, and the world market for lithium batteries grew to $5.2 billion. Because EVs and PHEVs will likely play a crucial role in allowing auto manufacturers to achieve elevated fuel efficiency standards, the demand for the batteries that power those vehicles should increase. This will lead to a substantial increase in the size of the lithium market.

According to the U.S. Geological Survey, the U.S. already consumes more lithium than any other country, despite possessing less than five percent of the world’s estimated supply of lithium resources. Because of the disparity between domestic supply and demand, the U.S. imports effectively all of its lithium from South America, specifically Chile—the world’s leading lithium producer—and Argentina. Some auto companies have already become concerned about a global shortage of lithium, which could constitute a potential roadblock to the success of lithium-ion batteries, and which some are projecting could happen as early as 2015.

Another problem affecting the global lithium market is the infrastructure issues of countries with large reserves of the mineral. For example, while the salt flats of southwestern Bolivia are estimated to possess more than half of the world’s total lithium deposits, Bolivia does not have the necessary infrastructure to extract lithium in amounts sufficient to affect the market.

These types of supply and demand issues are not uncommon in the energy industry.  In 2004, the solar industry began to feel the effect of a supply crunch for high-quality silicon, which is used to manufacture solar panels as well as computer chips.  This silicon shortage contributed to increased emphasis by the solar industry on thin-film solar cell technology, which uses a smaller amount of material than traditional photovoltaic solar technology.

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 As part of its commitment to implement its Carbon Pollution Reduction Scheme (CPRS) by 2010, the Australian government yesterday released its eagerly awaited White Paper on the national emissions trading scheme.  The key platform of the paper is the government’s commitment to reduce greenhouse gas emissions by at least 5% from 2000 levels by 2020, with the potential for a 15% cut if a global agreement is reached.  The government also restated its commitment to a long-term cut of 60% from 2000 levels by 2050, with the ultimate goal of stabilizing greenhouse gas concentrations at 450 parts per million.

Coverage and liability

The CPRS is the broadest emissions trading scheme outside of the EU ETS and is scheduled to start on July 1, 2010.  It comprises an extremely broad-based cap-and-trade scheme, which will cover at least three-quarters of Australia’s emissions, including stationary energy, transport, fugitive emissions, industrial processes, waste and forestry and all six Kyoto Protocol gases.  Excluded from the scheme are agriculture (until at least 2015), deforestation (with future possibilities for inclusion) and biofuels and biomass combustion for energy.  In general terms, liability is placed on large emitters (those who annually emit 25,000tCo2-e or more) for their own direct emissions, and obligations on upstream fuel suppliers for emissions resulting from the combustion of fuel. 

Auctioning

At least a quarter of the allowances will be given away to compensate vulnerable industries, with the remainder to be auctioned.  Banking will be unlimited while borrowing will be limited to 5%.  The allowances will be treated as personal property and assignable, and will also be classified as financial products with Australian Securities Investment Commission oversight.

International linking

The government has indicated it expects an initial permit price of A$25 per tonne.  However, to protect against price hikes, it has introduced a price cap (initially A$40 per tonne, then indexed annually at 5%) and unlike the EU ETS, there will be no make-good provision.  There will also be transitional cuts to fuel excise to lessen the burden on consumers.  The existence of a price cap could have important implications for linking with other schemes.  Possibly to counter this and avoid overseas players shoring up Australian allowances, there will be a transitional ban on the export of Australian permits.  However, the CPRS allows unlimited linking of Kyoto credits but will not allow Joint Implementation projects to be hosted in Australia’s covered sectors.

Compensation

The emissions intensive trade exposed industries (e.g. steel, cement, primary aluminum, pulp and paper, chemical and refinery industries, including LNG) will be protected under the scheme, based on the level of emissions intensity.  Lesser assistance will be provided to coal-fired power stations.

Renewable technologies

The government reiterated the importance of CCS.  Like the EU ETS, the CPRS will treat CCS as “net emissions” (i.e. the emissions will not form part of the originating entity’s emissions), and the CCS facility will be responsible for any leakage.  The government also reaffirmed its commitment to its existing suite of renewable technologies such as the Renewable Energy Target of 20% by 2020.

The government plans to publish draft legislation in February 2009, with an aim to pass the legislation later in 2009.  It also plans to establish an interim carbon regulator in early 2009, and a national permit registry early the following year.  How the scheme framework will grow and adapt as it moves through Parliament will provide important lessons for the US, given the similarities between the US and Australian economies, as it grapples with the concept of introducing its own emissions trading scheme.  In addition, and despite the price cap, the emergence of Australia as a likely net importer of credits creates important opportunities for international trade. 

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In the second post of our series examining the incoming Obama administration and its push for a national climate change policy, we turn to the current political environment; firstly examining the domestic climate, at both the state and national level, and then toward  to international negotiations to replace the 1997 Kyoto Protocol, which continued last week in Poznan Poland.

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President-elect Obama inherits a dysfunctional domestic climate change policy: while the federal government has either stalled, or actively opposed, greenhouse gas (GHG) control, state governments have established their own control programs. While recent efforts to enact federal legislation have exposed many challenges to a national climate policy, opportunities for strong national leadership exist. Three significant areas of action in domestic climate policy are outlined below.

National Climate Change Legislation

The current Congress has made progress on energy efficiency and renewable energy—most notably, the extension of the Investment Tax Credit (ITC) and the Production Tax Credit (PTC), and the increased stringency of auto mileage standards in the 2007 Energy Independence and Security Act.  While, a comprehensive statute to control GHG emissions advanced further than ever before, there remain substantial roadblocks to passage. The two most significant efforts of the last year are the Lieberman-Warner Climate Security Act (Lieberman-Warner) and Dingell-Boucher bills. Lieberman-Warner failed on a vote to end debate in early June, despite significant support from industry. The Dingell-Boucher bill was released only as a discussion draft, and with Congressman Waxman taking over as chairman of the House Committee on Energy and Commerce, its future seems bleak.

President-elect Obama’s campaign platform contained a cap and trade system similar to those in the failed legislation, but also included both more aggressive reduction targets and a 100% auction of carbon credits. As the fight over the Lieberman-Warner bill and the Waxman/Dingell face-off show, divisions within the Democratic caucus will remain a significant obstacle.

A side note: because of the perceived mishandling of the Lieberman-Warner bill before the Senate, Akin Gump lawyers suspect that Majority Leader Sen. Harry Reid will turn to Sen. Jeff Bingaman of New Mexico to help shepherd any climate legislation through the Senate. While Sen. Bingaman has been an advocate of GHG control, his previously introduced legislation on climate change has included much more modest emissions control targets and limited carbon auctions; the Senator’s leadership may provide a significant moderating influence on any potential legislation.

Executive Agency Action

The Environmental Protection Agency (EPA) has largely opposed efforts to regulate carbon under exiting statutes, primarily the Clean Air Act.  For example, it opposed state efforts to have carbon dioxide ruled a “pollutant” for purposes of the Clean Air Act, a position rejected by the Supreme Court in Massachusetts v. EPA.  The Agency also denied the state of California’s petition to regulate emissions from automobiles. President-elect Obama has criticized the EPA’s recent actions and it seems likely that he would act quickly to reverse course in a number of areas.

Important changes are coming to the EPA’s regulation of GHG’s even before the accession of the Obama administration. In recent weeks, EPA issued a landmark decision on power plant construction. In a case about a power plant on American Indian land in Utah, the agency’s own appeals board ruled that EPA erred in refusing to consider requiring best available control technology (BACT) for GHG emissions control. For the short term, this essentially the freezes the permitting and construction of new power plants; the decision places the burden on the incoming administration to determine what will meet BACT standards and how power plants will be permitted going forward.

State Action

In stark contrast to the federal government, state governments have pushed ahead aggressively with GHG control pacts, both as individual states and as part of regional compacts. In the northeast, ten states (Connecticut, Delaware, Maine, Maryland, Massachusetts, New Hampshire, New Jersey, New York, Rhode Island, and Vermont) created the Regional Greenhouse Gas Initiative (RGGI), the first mandatory, market-based emissions control program in the United States. RGGI’s goals are modest—a 10% reduction in GHG emissions by 2018—but it provides an important guidepost for future programs.

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 On Monday, December 1 the U.N. Framework Convention on Climate Change (UNFCCC) commenced in Poznan, Poland.  The conference, if all goes as planned, will lay out a schedule for consensus on a successor to the Kyoto Protocol for agreement by December 2009 in Copenhagen.  While many see an agreement in the near future, many fear that a lack of U.S. support due to the recession and change of administration will hinder an international agreement.

During the first week of discussions, five major issues confronted conference participants:

1. Shared vision.  This issue, which encompasses both emissions reduction targets and the differentiated responsibilities for reaching those targets, has already received significant discussion at the conference, as the working group tasked with long-term cooperative action met on Tuesday, December 2. At that meeting, a number of proposals were issued: the Japanese endorsed a 50% reduction in emissions from 1990 levels by 2020, while the EC suggested a more ambitious 85% decline. The Chinese, while not endorsing a long-term goal, did support a 20-40% reduction by 2020; the Chinese also stressed equity issues, noting the divide between developing and developed country responsibility for historic emissions and pushing for industrialized countries to take dramatic action as a leadership gesture.
2. Tech transfer. Perhaps the most contentious issue at the conference is how to transfer low carbon technologies to developing nations. Strong words leading up to the COP from the Chinese and Indian governments threatening to undermine intellectual property rights and utilize compulsory licensing have laid the foundation for heated discussions during the second week of the conference.
3. Financing.  This issue is shaping up to be another contentious one, as developing countries push for further help in mitigating climate change, as well as adapting to its effects; at the same time, the global economic slowdown makes developed nations less interested in significant outlays of financial aid. Senator John Kerry, an observer at the conference and an ally of President-elect Barack Obama, said “The bottom line is we are not going to be in the position we were two years ago in the short term to do as much technology transfer or economic assistance in terms of transitional issues that might have led other countries to participate.”
4. Adaption.  Many developing countries are pushing for funding not just to prevent further greenhouse gas emission, but also to adapt to the effects of climate change that have already come.
5. Mitigation.  Though significant discussion on this topic is likely, many participants find it unlikely that hard emissions reduction targets will come out of the Poznan conference. So far, only European countries have committed to hard reduction targets, and it is unlikely that many other countries will join them.

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 In April of 2008, Tesla Motors, Inc. sued Fisker Automotive, Inc., Fisker’s founder and CEO Henrik Fisker and other related entities in the Superior Court of San Mateo County (California), alleging that Fisker stole trade secrets to design Fisker’s own electric car, the Fisker Karma.  Tesla further alleged that Fisker committed fraud and breach of contract, among other claims. 

Tesla claimed that it hired Henrik Fisker to design the interior of its high-performance electric sedan, the Model S, previously known as the “White Star” project.  According to Tesla, Fisker took confidential technical information from Tesla while working on the White Star project and used that information to design and build its own four-door, plug-in, luxury sedan.  Tesla stated that it paid Fisker more than $800,000 for the design work performed on the White Star project and sued Fisker for the return of this money, along with other unspecified damages.

In May, Fisker requested that the judge assigned to the San Mateo case direct the parties’ dispute to private arbitration.  Fisker’s request was based on a clause in the contract between Fisker and Tesla, which required that any disputes between them be decided by an arbitrator in Orange County, California within 90 days.  The judge granted Fisker’s request for arbitration in June, and the San Mateo case stayed pending the result of the arbitration.

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Deutsche Bank has released a white paper entitled “Investing in Climate Change 2009: Necessity and Opportunity in Turbulent Times,” which asserts climate change investing can be suitable for all asset classes, including listed equities, private equity, venture capital, infrastructure and hedge funds.  Citing the $45 trillion of investment the IEA predicts will be needed in clean energy technologies by 2050 and the driving forces of government regulations, economic/market trends, and the development of new technologies, the white paper identifies four fast-growing markets likely to see increased returns and reduce expected risks in future years-

• Clean energy (power generation, cleantech infrastructure, power storage technology, and transport & sustainable biofuels);
• Environmental resource management (water, agriculture, and waste management);
• Energy and material efficiency (advanced materials, building efficiency, and power grid efficiency); and
• Environmental services (environmental protection and business services).

Investment-Side Analysis

The white paper identifies factors that should be considered in assessing the commercial breakeven point for various climate change technologies and investments, as well as considerations for assessing an industry’s or company’s adaptability in the face of updated or changed regulations.  The report suggests that investors can mitigate and hedge risk by diversifying the risk associated with the breakeven of a clean technology across carbon risk/return, energy price risk/return and regulatory risk/return.

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The International Organization for Standardization (ISO) is currently debating whether to develop standards for measuring the carbon footprint of business activities.  The ISO is the largest standardization organization in the world, having published more than 17,000 standards for a broad array of industries, including several related to environmental topics. 

The Greenhouse Gas Protocol (GGP) is the most widely-used standard today for quantifying and managing greenhouse gas (GHG) emissions.  The GGP was created by the World Resources Institute and the World Business Council for Sustainable Development, and is actually used by the ISO as a basis for its current three part “Specification with guidance at the organization level for quantification and reporting of greenhouse gas emissions and removals.”  These current ISO specifications with guidance serve more as informal guidance for business, and are not as rigorous as ISO’s actual standards.  The GGP on the other hand does not provide detailed standards for individual industries, but rather focuses on the theoretical framework for designing GHG accounting systems. 

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The failure of the recent WTO Doha Round ministerial in Geneva seems to have doomed the chances that a comprehensive multilateral trade agreement can be reached during the remainder of the Bush Administration. However, as trade ministers consider whether and how to resume negotiations under the Doha Round, initiated in 2001, momentum is building among key WTO Members to carve out specific trade sectors where prospects for agreement seem to be within reach. One such prospect is an Environmental Goods and Services Agreement (”EGSA”), which would liberalize trade in certain deemed “environmental” goods and services. The fundamental goal of EGSA is to harness trade liberalization to encourage the global dissemination and deployment of environmentally friendly technologies that, among other things, help mitigate climate change.

The Bush Administration has strongly supported EGSA over the last year, promoting it both as an important component of the Doha Round negotiations towards a comprehensive trade deal as well as a complement to ongoing efforts to negotiate an international greenhouse-gas emissions reductions pact to replace the Kyoto Protocol commitments, which expire in 2012. Since the failure of the WTO ministerial in Geneva, U.S. Trade Representative Susan Schwab and her General Counsel, Warren Maruyama, have both spoken publicly of possible U.S. interest in pursuing EGSA on its own track. Also, the National Association of Manufacturers (”NAM”) recently announced the formation of an international coalition of companies and industry associations to press for EGSA.

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The Lieberman-Warner Climate Security Act has emerged as the leading legislative vehicle for the creation of a national cap-and-trade system for greenhouse gas (GHG) emissions. Recently described by the Wall Street Journal as “the most extensive government reorganization of the American economy since the 1930s,” the Climate Security Act would, among many other things, require U.S. importers of a wide range of manufactured goods to purchase and surrender emissions allowances representing the GHGs associated with manufacture of the imported goods.

This requirement, intended to ensure that U.S. emissions caps do not diminish the competitiveness of domestic manufacturing industries vis-à-vis their foreign rivals, would only be excused for goods produced in countries that have adopted GHG emissions requirements as stringent as those in effect in the United States. In this way, the Climate Security Act would use U.S. market access to compel foreign exporting nations to limit GHG emissions, and could significantly affect trade flows.

In anticipation of the floor debate scheduled to begin in the Senate next week, Senator Boxer issued a substitute bill (S. 3036) that significantly alters the regulation of imports. One of the principal trade-related changes in the substitute bill is that it would create an International Climate Change Commission (ICCC) that would determine which foreign countries have taken “comparable action” to the United States in curbing GHG emissions. A negative determination would trigger the requirement for importers to provide emissions allowances pursuant to an International Reserve Allowance Program. The ICCC’s duties would also extend to determining the scope of manufactured goods falling under the import provisions, as well as modifying the import emissions allowance requirements as warranted.

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