Aspirational adjustments: Oil companies grapple with California's LCFS

California has often been a test bed for environmental regulations, implementing clean air and water laws that later become models for the nation. In a recent example, the US Environmental Protection Agency in 2014 finalized a 10 ppm sulfur limit on gasoline that matches regulations California put in place in 2006.

One of the latest state programs that is being closely watched nationwide is the California Low Carbon Fuel Standard, which mandates a 10% reduction in the carbon intensity (CI) of transportation fuels sold in the state by 2020.

The program has been the bane of the state’s refineries, who have spent millions of dollars lobbying for its repeal and fighting it in court, to no avail so far.

Environmentalists hail it as a landmark program that will drastically lower greenhouse-gas emissions and reduce the state’s dependence on petroleum by promoting alternative fuels, such as biofuels, landfill gas and electrification.

But one of the oil industry’s main complaints is that the lofty goals of the California Air Resources Board, which administers the LCFS, do not match the reality of the fuels market. The industry warns that insufficient quantities of alternative fuels will be available to meet the 10% CI reduction target by 2020, and that the state’s refineries could shut down or decide to export their fuel, rather than bear the cost of complying with the LCFS.

“This is all a crap shoot right now,” said Jay McKeeman, a lobbyist with the California Independent Marketers Association, which opposes the program. “People are praying and hoping with little contingency plans. Enormous investments are being made, with no guarantee.”

CARB officials say the LCFS was designed to be aspirational, and that the fuels industry will have to adjust.

With California remaining the US’ largest fuels market by far, “it’s hard to believe refiners would get out of the state,” said Dan Sperling, a CARB board member.

The program is technology neutral, meaning that CARB does not mandate which alternative fuels are used to meet the CI reduction targets and what quantities. Rather, CARB merely sets the targets and the fuels have to compete on their merits.

Still, Sperling acknowledges that the program has taken some unforeseen turns since it was launched in 2009.

Alternative fuels, such as cellulosic ethanol, that were expected to contribute heavily to the LCFS’ goals, have not always materialized as envisioned. Meanwhile, the emergence of biodiesel and renewable diesel has made compliance through heavy-duty fleet fuels consumption more likely, he said.

“It’s impossible to forecast or predict what will happen,” he said. “When we set up the LCFS, we fully expected gasoline would be easy to figure out and that diesel would be hard. It’s the opposite, actually.”

Credit where it's due

The way the LCFS works is this:

CARB sets a CI reduction target each year, and refiners generate deficits if they sell fuel with a CI above that year’s target, while alternative fuels producers generate credits.

Refiners who can not meet the CI reduction target for a particular year by blending or offering alternative fuels for sale must acquire credits, which do not expire, on the open market.

The uncertainty over whether the program can succeed is reflected in credits prices, which averaged $28 in June but now are trading around $125, according to market sources, with each credit representing 1 mt of carbon emissions. Holders of the credits appear to be hoarding them in anticipation of the CI reduction targets becoming harder and harder to achieve.

Since the credits don’t expire, traders are acquiring them now, when the CI targets are relatively easy to meet.

“People are frustrated at the ‘If you build it, they will come’ attitude at CARB,” said Josh Bledsoe, an attorney at Latham Watkins whose clients include LCFS participants. “CARB isn’t acknowledging that there’s a possibility fuels won’t come to the market as quickly as needed. The regulatory structure incentivizes people to hoard the credits.”

The program calls for CI cuts of 2% below 2010 levels in 2016, 3.5% in 2017, 5.0% in 2018, 7.5% in 2019, and 10% in 2020 and beyond.

CARB, for its part, has said the credits prices will incentivize alternative fuels development.

Diesel substitutes, lower CI ethanol and improvements in oil refinery efficiency could provide pathways for meeting the LCFS’ 2020 target, and as long as credits are at $100 or above, biofuels supply would be sufficient to support raising the CI reduction targets to 15% in 2025, according to a study by Promotum commissioned by the Natural Resource Defense Council, Union of Concerned Scientists and the Environmental Defense Fund.

To prevent credits prices, which are ultimately passed on to the consumer, from skyrocketing if there is a shortage of compliant fuels, CARB last year a cap of $200/credit in a so-called credit clearance market, a special marketplace where those who are short on their obligations for a particular year can purchase credits from willing sellers.

But many observers and participants in the LCFS are highly dubious that the credit clearance market will be effective or that participants will even be willing to use it, since their identities will be disclosed.

As one consultant told Platts at the Clean, Low-Carbon Fuels Summit in Sacramento last month, “A company like Chevron, if they’re short, isn’t going to want to announce to the world that they’re short by entering the credit clearance market.”

Oil economist Phil Verleger says he doubts companies will be willing to carry a credits deficit, since it will be perceived by shareholders and boards of directors as an unfunded liability.

Therefore, firms will use the regular open market — which is not subject to the $200/credit cap — to buy credits to fulfill their annual obligations, potentially at prices above $200.

“The people buying credits now are really smart,” Verleger said.

Change the constant

Market participants also expressed frustration at the LCFS’ continual changes.

The program was first drafted in 2009 under then-Governor Arnold Schwarzenegger, then amended a few years later, then tied up in federal and state court in 2011 and 2012, with the CI targets frozen at 2013 levels until last year, when CARB resolved the legal challenges and readopted the LCFS with some technical tweaks and expanded pathways for fuels to qualify for credits.

The LCFS still faces a lawsuit filed last year by ethanol producer Poet, which says the readopted program unfairly discriminates against Midwest ethanol by giving it a higher CI score, a similar claim that it filed suit over the original LCFS in 2012.

With CARB intending to launch a rulemaking next year to extend the LCFS to 2030, traders say they have no idea what to expect, which makes it difficult to plan.

“The next set of amendments to the LCFS are already being discussed at CARB, [and] it’s hard to project into the future with any certainty what the program will look like in 2018, let alone 2020 or 2030,” one trader said.

CARB says the oil industry’s objections are the product of inaction, and Sperling dismissed any criticism over the LCFS’ goals.

“If the LCFS gets oil companies to think differently and motivate significant investments, then it’s a success,” he said. “The LCFS is performance-based, it’s life-cycle based, and it harnesses market forces. It’s fundamentally good policy.”

LCFS proponents have envisioned a robust West Coast credits trading market, with Oregon slated to begin enforcing its LCFS next year and British Columbia, Canada, already having one in place.

Efforts in Washington state to institute an LCFS have been stymied, however, by Republicans in the state legislature, as Governor Jay Inslee, a Democrat, has since dropped his LCFS plan in favor of a yet-to-be-announced carbon emissions cap.

How the California LCFS works and whether it succeeds in the coming years will certainly bear watching.