Regulating Carbon: New Challenges for Environmental Lawyers

01 October 2007

David J Hayes, Latham & Watkins LLP

Legal developments in the US illustrate the phenomenon. Despite being a non- signatory of the Kyoto Protocol and the Bush Administration’s objections to mandatory controls on greenhouse gas emissions, environmental lawyers are addressing complex new climate change issues on multiple fronts, including: a directive from the US Supreme Court that requires the Environmental Protection Agency (EPA) to consider potential regulation of greenhouse gases under the Clean Air Act; state-based restrictions on greenhouse gas emissions, led by the state of California; robust proposals in the US Congress to regulate greenhouse gas emissions; non-US-based requirements that are affecting US companies; and disclosure obligations that arise from new financial risks associated with carbon emissions. Each of these separate developments is significant in its own right; together, they represent a virtual tidal wave of new legal challenges that environmental lawyers operating in the US – and on the world stage – need to master.

The US Supreme Court and Climate Change. 

On 2 April 2007, the US Supreme Court issued a landmark decision concerning global climate change, Massachusetts v Environmental Protection Agency No. 05-1120. In a 5-4 split, the Court rejected the EPA’s position that it did not have authority under section 202 of the Clean Air Act to regulate greenhouse gas emissions from automobiles. In reaching this result, the Court held that greenhouse gases fall within the Clean Air Act’s definition of an “air pollutant”, and it ruled that unless the EPA affirmatively concludes that greenhouse gases are not causing climate change (a conclusion that the Court pointedly noted that the EPA has not made), the Agency must regulate greenhouse gas emissions from automobiles under the Clean Air Act. 

The Court’s decision in Massachusetts v EPA will have important ramifications in a number of contexts. First, and most directly, the EPA will be obligated to revisit its decision not to regulate automobile greenhouse gas emissions. The Court explained that “EPA can avoid taking further action only if it determines that greenhouse gases do not contribute to climate change or if it  provides some reasonable explanation as to why it cannot or will not exercise its discretion to determine whether they do.” Unless the Agency takes the small opening provided by the Court, the EPA must initiate a process for regulating such emissions. 

Second, the Court’s conclusion that greenhouse gases are “air pollutants” covered by the Clean Air Act appears to apply with equal force to stationary sources of greenhouse gases. Because the Clean Air Act does not regulate stationary sources in the same way as mobile sources, however, it is not yet clear to what extent the Agency would be required to regulate greenhouse gas emissions from stationary sources. 

Third, Massachusetts v EPA may further test the agency’s ability to fashion market- based approaches to environmental regulation under the Clean Air Act. Some may argue that just as Congress enacted a new, separate title of the Clean Air Act in 1990 to institute a ‘cap-and-trade’ system to address acid rain caused by sulphur dioxide emissions, it should take the lead here in addressing, and balancing, the multiple environmental and energy considerations involved in any economy-wide climate change programme. 

In sum, the Supreme Court’s decision in Massachusetts v EPA will force the agency to enter the climate change arena in a new, serious way, while ratcheting up the stakes in ongoing litigation regarding the appropriate roles for federal and state governments in addressing greenhouse gas emissions, and increasing pressure on the US Congress to enact comprehensive restrictions on greenhouse gas emissions. 

State-based Regulation of Greenhouse Gas Emissions. 

In 2006, Governor Arnold Schwarzenegger signed into law Assembly Bill 32 (AB 32), the California Global Warming Solutions Act 2006 – legislation that commits California to reduce greenhouse gas emissions to 1990 levels by 2020. AB 32 places the primary responsibility on the California Air Resources Board (CARB) to develop a plan and implement regulations suf- ficient to achieve the approximately 25 per cent required reduction in greenhouse gas emissions by 2020. CARB’s regulatory programme must include several ambitious steps, including the adoption of mandatory reporting rules, the establishment of the 1990 greenhouse gas emissions baseline that will be used as a statewide 2020 emissions cap, the identification and near-term adoption of discrete early-action measures to reduce greenhouse gas emissions, the development of an overall scoping plan to allocate responsibility among California businesses and greenhouse gas sources operating in or serving the state, and the adoption of specific emission limits and control measures reflecting the “maximum technologically feasible and cost-effective reductions in greenhouse gas emissions”. 

The legislation gives CARB significant and broad new authority to implement these steps, including the ability to determine which sources should be regulated, whether and to what extent to use market mechanisms as a compliance strategy, the ability to implement alternative regulations if the state’s current mobile source regulations do not survive legal challenge, the ability to raise funds necessary for the programme and the ability to prosecute violations of the provisions they adopt. 

The legislation specifically requires that the state’s greenhouse gas emissions reduction strategy address emissions from imported power as well as those from California generators, thereby setting up legal disputes based on the authority of the state to affect interstate commerce. 

State officials are now in the process of designing a cap-and-trade system that will meet the ambitious goals of AB 32, including the scope of the programme, the allocation of allowances, the treatment of offsets and the like. Other states also are moving out forthrightly and developing their own cap-and-trade programmes to address climate change, including, most notably, the northeastern states, who are working together to launch the Regional Greenhouse Gas Initiative – a programme that is designed to cap and reduce utility-based emissions in the participating states. 

These state developments are forcing the hand of federal policymakers and are  spurring increased interest in putting a national cap-and-trade programme in place before a patchwork of state-based requirements segments and complicates what otherwise could become a well-functioning, national carbon market. 

Congressional Action on Climate Change. 

Global warming has arrived on Capitol Hill and is quickly moving to the forefront of Congress’s agenda. A number of factors have contributed to this change in the legislative climate. Perhaps most importantly, the November 2006 elections gave the Democrats control of both the House and Senate. This has put strong proponents of climate change legislation in charge of the key Senate committees with relevant jurisdiction (Senator Barbara Boxer for Environment and Public Works and Senator Jeff Bingaman for Energy and Natural Resources). On the House side, House Speaker Nancy Pelosi has announced her desire to make climate change legislation a top legislative priority, and the House Energy and Commerce Committee, which has jurisdiction over regulatory responses to climate change, has embarked on a robust agenda of hearings. In addition, the House has established a Select Committee on Energy Independence and Global Warming – which, though it will not have legislative jurisdiction, will no doubt help to focus further attention on climate change. 

Several major legislative proposals have already been introduced in the 110th Congress, most of which would establish an economy-wide market-based regime for capping greenhouse gas emissions. More are expected to follow. And while the Bush Administration remains opposed to mandatory greenhouse gas emission limits, many observers agree that enactment of such limits is now a question of ‘when’, not ‘if ’. To that point, the legislative debate is focused on how a federal scheme would be implemented, including key design issues such as: (i) the nature and stringency of emissions caps; (ii) the scope and point (upstream versus downstream) of regulation; (iii) mechanisms for distributing emissions allowances; (iv) revenue recycling; (v) use of carbon sequestration, international, and early-reduction credits; and (vi) pre-emption of state regulation. 

International Requirements Affecting US Companies. 

The Kyoto Protocol entered into force on 16 February 2005, requiring industrialised, signatory nations to reduce their greenhouse gas emissions 5.2 per cent below 1990 levels between 2008 and 2012. Although the US is not a party to the Protocol, the development of an international market for carbon has important implications for US companies and financial institutions and, by extension, for US-based environmental lawyers. 

First, many US companies have operations in signatory nations and will need to develop Kyoto compliance strategies for their business units that operate in those signatory countries. Second, the cheapest carbon reduction projects (including projects certified under Kyoto’s Clean Development Mechanism (CDM)) will likely be taken first by Kyoto signatories and their companies, leaving US companies at a competitive disadvantage if they later become interested in using offshore offsets as an emissions hedge. Third, US investors should evaluate whether they can structure projects in developing countries to include a CDM component, as they may find that the additional revenue that can be derived from CDM projects can contribute significantly to the economic viability of their projects. 

Because of this interplay between Kyoto requirements and the global markets in which US companies participate, environmental lawyers in the US need to be adept at understanding implementation of the Kyoto Protocol, just as they must be knowledgeable about state and federal US legal developments, if they are to advise their clients effectively on climate change issues. And with the Kyoto commitment only in place until 2012, environmental lawyers will also need to watch developments carefully as leading nations discuss the shape of a potential international agreement for the post-2012 period – perhaps including US participation. 

Disclosure Obligations

Advocates are turning to disclosure requirements to prompt US public companies to provide information about potential climate change-related risks that they face, and strategies that they are pursuing to address such risks. Organisations such as the Investor Network on Climate Risk and the Coalition for Environmentally Responsible Economies (CERES), for example, have formally requested that Securities and Exchange Commissions (SEC) Chairman Christopher Cox acknowledge that climate change risks can qualify under SEC disclosure requirements, and to enforce such requirements. CERES made the same point in a recent petition to President Bush that was signed by ten state treasurers, executive officers from more than twelve leading companies (including Alcoa, BP America, DuPont, Exelon, PG&E and Sun Microsystems), institutional investors and asset managers (including Merrill Lynch) and state pension funds (including CALPERS). 

Of special pertinence are the Securities Act of 1933 and the Securities Exchange Act of 1934, which require the disclosure of liabilities to provide investors access to material information necessary for informed decision-making. Disclosure is currently governed by Regulation S-K, which requires certain narrative disclosures in a company’s annual filings with the SEC. The sections potentially applicable to climate change disclosures by issuers of securities include items 101, 103 and 303. Item 101 regulates disclosure of the material effects that compliance with laws “which have been enacted or adopted” may have on an issuer’s capital expenditures, earnings or competitive position. Disclosure is required for the current and succeeding fiscal years, as well as any other periods believed by the issuer to be material. Item 103 requires disclosure of material pending legal proceedings (including proceedings “known to be contemplated” by governmental authorities) to which the issuer is a party. Climate change-related litigation has been filed against several utilities seeking greenhouse gas regulation and by various automobile manufacturers challenging proposed climate change regulations. Disclosure may be necessary by the parties in these proceedings. And item 303 regulates disclosure of information necessary to understand the issuer’s “financial condition, changes in fi- nancial condition and results of operations” in the management’s discussion and analysis (MD&A) section, including the disclosure of “known trends, events or uncertainties that are reasonably likely to have material effects”. 

As the states move to regulate greenhouse gas emissions, and as the courts and the US Congress also proceed against emitters of greenhouse gases, companies that have significant emissions must increasingly pay heed to disclosure obligations and to how they may apply to this new and evolving field of environmental law. It is another example of how the exploding new field of climate change is implicating a wide variety of important legal areas, ensuring that environmental lawyers in the US – and globally – will be very important counsellors to their clients for years to come.

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