Latham & Watkins operates as a limited liability partnership worldwide with an affiliate in the United Kingdom and Italy, where the practice is conducted through an affiliated multinational partnership © Copyright 2007 Latham & Watkins. All Rights Reserved. Instrument Choice Bob Wyman April 9, 2010

1 Regulation One Way or Another International diplomacy has stalled Increased interest in sectoral programs This coincides with California’s focus Congress has stalled But EPA will play a resurgent role Endangerment Finding December 2009 Light Duty Vehicle Rule to be Final as of March 31, 2010 New and Modified Stationary Source GHG Controls as of April 2010 State programs will likely not be preempted State and regional efforts continue to develop on schedule California’s AB32 and Other Programs (AB1493, SB1368, SB375, low carbon fuel standard, 33% RPS by 2020): economy-wide program Western Climate Initiative (WCI) Midwest Greenhouse Gas Accord Regional Greenhouse Gas Initiative (RGGI) already governs electricity sector Courts are plugging the gap 2 nd and 5 th Circuits – recognize federal common law of nuisance NEPA, CEQA, ESA claims challenging individual projects based on climate impacts

2 How Tough Will This Be? YearUS PopulationPer Capita Emissions GDPTotal Emissions Million (projected) 2.4 Tons (to meet target) ?1 Billion Tons (BT) 2005 (Base)303 Million20.3 Tons$ 14 Trillion6 BT Million10.9 Tons$ 572 Billion1 BT Million2.4 Tons$ 147 Billion

3 Caveat A carbon price signal is not enough Infrastructure gaps are material Example – transmission lines Technology gaps are material Example – energy storage limitations Regulatory barriers are material Examples – California Environmental Quality Act (CEQA), National Environmental Policy Act (NEPA) reviews substantially delay and often stop even new, low-carbon investment (e.g., cogeneration increases local emissions despite reducing regional emissions) A state (or nation) that cares seriously about addressing climate change needs to identify strategic energy investments and clear the way Stimulus package is directionally correct, but sorely deficient

4 Types of Market Programs Cap and trade/allowance-based Sources must surrender allowances for their emissions Traded commodity is certified in advance Examples: acid rain program, EU ETS, RECLAIM Averaging/performance-based Sources average to a performance standard and must make up any shortfall by purchasing credits Credits/debits generated automatically by reference to credit line Performance standard can be periodically adjusted, if necessary Examples: lead phase-out from gasoline, low carbon fuel standard, EPA recreational marine engine standards Discrete emission reductions (Offsets) Requires case-by-case certification Credits generated for surplus reductions relative to baseline Examples: ERCs, Clean Development Mechanism (CDM) Emissions Charges and Financial Vehicles Examples: carbon tax, clean air investment fund (e.g., AQIP) Encourages demand-side reductions

5 Potential Benefits from Market Programs Minimize costs (typically 25+% savings) Preserve operational flexibility Deliver price signal Encourage conservation Encourage innovation Plug gaps in legal authority Provide source of financing Increase penetration of clean fuels and products through cost signal and monetary reward Preserve political will for ambitious environmental goals by minimizing cost impact and preserving economic opportunity

6 Desirable Elements of Market Program Large scale and diversity of market Banking (and borrowing when appropriate) Safety valve/transitional safe harbor Ceiling price payment to investment fund until market matures Transparency Confidence in estimation or quantification methods Select a market design that takes into account the variability or uncertainties regarding sector activity levels Offsets (cost and liquidity benefits) Clear and consistent enforcement Provision for mid-course corrections Linkage to and ultimate integration with other jurisdictions

7 Challenges and Specific Problems Gaps in legal authority No binding international agreement Incomplete Congressional action Legal impediments (in addition to policy concerns) for state action Mixed and somewhat inconsistent goals Desired technology outcomes Cost minimization Leakage and Competitive Issues Narrow market – price spikes Distributional impacts

8 Gaps in Legal Authority In absence of Congressional action, and following Mass v. EPA, if EPA’s endangerment finding is upheld, then it is likely to regulate GHG emissions under the Clean Air Act CAA Title II – motor vehicle standards EISA – renewable fuels standards Stationary sources Preconstruction permit program Potential section 111 new and existing source performance standards Other authorities may be available (e.g., NAAQS, hazardous air pollutants, stratospheric ozone protection, international measures), but are not likely to be used State role (Compact Clause and policy concerns) International

9 Mixed Goals Strategic technology development Cost minimization – reducing GHG tons at least cost

10 Structure of Markets – Possible Hybrid Approach Targeted technology markets – sector-specific performance standard plus averaging and trading “Siloed (or Closed)” Categories Renewable electricity standard Low carbon fuel standard Motor vehicle standards Possible accelerator - Innovative technology credits (ITCs): forward-generated Open Sectors – tonnage reductions at lowest cost

11 Leakage and Energy Balance Concerns

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13 Source: Sweeney/Weyant Draft Analysis of Measures to Meet the Requirements of California’s Assembly Bill 32

14 At Stake for California Development If California’s program remains its own Each GHG ton could be 2-5 times more expensive in CA than in other states and regions CA marginal cost ~ $100+/ton GHG in 2020 ~$18-22/ton for other regions of the country Significant cost differences will drive investment (even low carbon investment) outside of the state, partially thwarting the state’s GHG reduction goals AND distorting the state’s energy balance Climate stabilization requires that we bring energy supply close to energy demand to minimize transmission losses and transportation emissions A national program avoids these problems, but also could reward CA investment if the national program provides a mechanism to monetize the low carbon characteristics

15 Distributional Concerns Different starting points among sources Fuel differences Technology differences Difference in entity’s ability to recover costs Power sector – differences between utilities and merchant plants Commodity manufacturers – need to compete in international markets

16 Illustration of Potential Challenges – Starting and End Points, Rates of Reduction A B Common start, common end, common rate A starts in the hole T/MWH

17 Illustration – Separate Credit Trading Line for Performance-Based System A B Credit generation line T/MWH

18 OPEN MARKET TECHNOLOGY MARKETS innovative technology credits (ITC) CAP AND TRADE P-B AVERAGING AND TRADING Deliverers of electric power Refineries Glass Plants Cement Plants Landfills Other Transition to cap and trade or integrate with national program ONE-WAY TRADING + OFFSETS TONS Internal Trading and Banking Only; No Safety ValveUnrestricted Trading, Banking; No Safety Valve IF Program Linked at Outset; Otherwise Transitional Safety Valve renewable portfolio standard Advanced battery, advanced combustion, other vehicle and engine advances Renewable power low carbon fuel standard motor vehicles Other qualified advanced low carbon technologies and programs low-carbon biomass fuels (cellulosic ethanol, biodiesel), carbon capture and sequestration