Cap and Trade, RINs, and the Risks of the Future

Mike Newman is a Director of Parhelion Underwriting

Special to The Digest

The best climate policy – environmentally and economically – limits emissions and puts a price on them. Cap and trade is one way to do both. It’s a system designed to reduce pollution in our atmosphere. The cap on greenhouse gas emissions that drive global warming is a firm limit on pollution. The cap gets stricter over time. The trade part is a market for companies to buy and sell allowances that let them emit only a certain amount, as supply and demand set the price. Trading gives companies an incentive to save money by cutting emissions in the most cost-effective ways. Companies that cut their pollution faster can sell allowances to companies that pollute more, or “bank” them for future use. This market – the “trade” part of cap and trade – gives companies flexibility. It increases the pool of available capital to make reductions, encourages companies to cut pollution faster and rewards innovation.

In the European Union’s Emissions Trading System, capped emissions from stationary structures were 26 percent lower in 2016 than when the program started in 2005. In the United States, California’s climate policies have led to a steady decline of the state’s carbon dioxide pollution. The centerpiece is the cap-and-trade program and California’s emissions from sources subject to the cap declined 8.8 percent between the program’s launch in 2013 and 2016. Meanwhile, the state’s economy is thriving. Cap and trade makes even deeper cuts possible when countries cooperate, such as the United States and Canada. California and Quebec connected their systems in 2014, building a strong market that shows great potential.

Trading in the climate finance market – the systems designed to reduce greenhouse gas emissions – sometimes create areas of uncertainty. The risk of invalidation of credits worry market participants – but insurance risk capital can be used to mitigate these concerns and in fact already works successfully in several markets. One example of this is in the California Cap-and-Trade program where “buyer liability” has created a price differential between carbon offsets depending on the level of risk associated with them. By removing this risk from both offset buyers (typically refineries and utilities) and sellers (project developers), insurance adds certainty and therefore liquidity to the market because it’s a guarantee with investment-grade A+ security.

Starting in January, similar insurance coverage is offered to RIN buyers and sellers. “Platinum-RIN” is a risk-free credit that can be bought by any market participants and applied to any RIN type. It can complement QRINs by removing the residual risk or it can wrap non-Q RINs. It also can remove the need for expensive in-house procurement protocols.

The highly publicized fraud cases have created a continued wariness in the RIN market that — combined with EPA’s “buyer beware” approach which holds obligated parties liable for invalid credits — has led some credit buyers to deal only with long-standing and trusted sellers. And that has worked to reduce liquidity in RINs trading and put smaller renewable fuel producers at a disadvantage.

Insurance is a solution that can allow market participants to buy RINs free of any fraud and invalidation risk. And that should help inject more liquidity into RIN trade because if you are holding one of those credits and it’s invalidated, your investment is worthless, and worse still it exposes the compliance entity to civil fines and penalties. Insurance can take that risk away. In the RINs market many refiners simply don’t want to do business with smaller biofuel producers without pretty solid assurances that the credits are valid.

While EPA has attempted to address the issue of bogus RINs in 2014 when it established its Quality Assurance Program (QAP), which allows for third-party validation of credits, the market use of the program has been limited, because the process can be expensive and because it does not fully remove the risk. As a result, many parties have opted instead to trade only with well-known parties, implement their own verification programs or buy only ethanol RINs. But managing an in-house verification program requires significant management time and expertise. Further, it can enable biofuel producers to increase the number of buyers to whom they can sell and permit marketers that assume RIN invalidation risk in sales contracts to offer clear title. For obligated parties like refiners, the insurance can support their due diligence program — a “belt and braces” approach — at a relatively small additional expense.

The cost of the insurance varies depending on the category of RIN, for example 2% of the credit value for D6 RINs (1.5% for Q-D6) and as much as 4% for a D4 RIN (2% for a Q-D4). All of EPA’s documented cases of RINs fraud have involved D4 or biomass-based diesel credits.

In addition, insurance for California’s Low Carbon Fuel Standard (LCFS) program can also be purchased, although the extent of liability for invalidated credits is still “fuzzy.” But that may be changing. The California Air Resources Board didn’t want to be seen coming out of the gate with a punitive LCFS program, but that is starting to tighten up now as regulatory changes made last year started to bring more clarity to who is liable for bad credits.

So, although risks often act as barriers to investment in innovative changes in commerce, it takes the huge pool of global insurance and reinsurance capital that has traditionally taken the risks that other forms of capital (debt and equity) can’t or won’t take, to ensure liquidity in new markets and to finance the risks of the future.

Mike Newman is a Director of Parhelion Underwriting, a risk finance company specializing in risks impacting investment in clean energy and climate finance markets.