After the EU ETS Crash – Is California Headed the Same Way?

EU Allowances at a Record Low after Backloading Rejection

Carbon allowances in the European Union Emission Trading Scheme hit an all-time low last week, falling to €2.46 a ton on April 17, 2013. The price collapse followed a vote in the European Parliament on “backloading,” an attempt to address the massive overallocation of the market by setting aside a large number allowances for the current year, and releasing them to the market in later years as needed. European regulators had been working on this fix for months, and the April 16 negative vote marked the political death of the proposal, sending European Union Allowances crashing as hope of a quick, meaningful fix, were crushed in minutes.

Historically, the EU ETS has set the path for other carbon markets globally. It has been hailed as a model and served as a laboratory for large-scale emission trading and cap-and-trade design features for the rest of the word. Yet it has also been plagued by a chronic overallocation of allowances, eluding the many changes made to the program over the years to prevent the distribution of excess allowances. In the U.S., the Regional Greenhouse Gas Initiative (RGGI), which regulates emissions in the power sector of nine Northeastern states, has suffered with the same issues – for different reasons – and seen prices steadily below $2 a ton for most of the past 3 years. The recent decision to lower the annual cap and hold back excess allowances from the past years has nudged prices above $3.35, and may have fixed the problem through 2020.

Is California Headed the Same Way?

In this context, some observers of the California cap-and-trade program wonder if California is headed the same way – massive overallocation, rockbottom prices and laughing stock of commodity markets. Fueling these concerns is the fact that reported emissions data published by the Air Resources Board in January 2012 shows 2011 emissions were below the allowance budget for 2013 and market analysts at Bloomberg, Thomson Reuters expect 2013 emissions will indeed be a few million tons below the 2013 cap.

Yet in my view, the California market is fairly immune to these concerns. Here’s why.

Define “Low”…

Reason #1 why prices won’t crash in California the way they have in Europe: there is a price floor. And reason why they won’t fall as low as RGGI, which also has a price floor: the price floor is fairly high. Allowances offered for sale at quaterly auctions come with a reserve price of $10 a ton in 2012, rising annually by 5 percent plus inflation – compare that to $1.98 reserve price in RGGI. Ten dollars or so may not be high enough in the opinion of some constituents, it may not be high enough to incentivize radical new emission reduction initiatives, but it certainly looks better than current prices in other markets.

They Have it All Planned

Reason #2 why prices won’t crash in California, even with an expected excess of emissions in 2013: it’s part of the plan. The California cap-and-trade program rules, in its first draft back in December 2009, set the 2012 cap at “2012 emissions,” rather than trying to blind guess, sorry, I meant forecast a number years ahead of time, which is largely what hurt the EU ETS and RGGI. While the actual number for the annual budget has now been set through 2020, California regulators (and emitters!) are perfectly comfortable if 2013 and even 2014 emissions turn out to be slightly below the cap: this will enable emitters to build a bank of allowances, which they will need in Compliance Periods 2 and 3 (2015-2017 and 2018-2020). The bank is a way to smooth price variations over the year, and limit the price increase when the cap becomes more binding year after year. The 2020 cap looks ambitious enough in today’s context, and maybe more importantly, there is a broad expectation that the program will continue, with a more stringent target, past 2020, which will largely drive prices in early years even if the annual balance in these years isn’t as tight.

Getting Allocation Right

Reason #3 why California is better positioned to avoid an overallocation debacle: the allocation formula allows for more year-on-year adjustments, in particular in the industrial sector, but also through auctions.
In Europe industrial allocation is based on historical levels (2005-2008), weighed by sectoral benchmarks and a “carbon leakage” factor comparable to California’s Energy-Intensive, Trade-Exposed ratings. But according to Thomson Reuters Point Carbon’s presentation to the EU commission on April 19, production levels have fallen by 10-25 percent for the oil and gas, metals, and cement, lime and glass sectors. The baseline is adjusted only if production levels for a given facility are below 50 percent historical levels. Quite logically, this means a number of industrial facilities are bound to be long allowances year after year through 2020 in Europe.
In California the industrial allocation formula is output-based, and the baseline was set based on 2008-2010 output data, and will be updated with the most recent data available going forward. This makes is less likely that a large amount of allowances will be handed out automatically to emitters who don’t need it.

Avoiding Over-Auctions

What happens to the allowances not distributed to the industrial sector? They stay in the Air Resources Board’s auction holding account, and may be offered for auction. But the good thing, probably learned from RGGI’s struggles, is that California is not bound to offer for auction all the allowances in this account. If an auction is undersubscribed, the unsold allowances are set aside until auctions have been fully subscribed twice. This feature ensures that California doesn’t reproduce RGGI’s struggle over the past years with a growing “public” bank of unsold allowances that hung like Damocles’s sword over any attempt to lower the cap and fix the overallocation system. The 2012 RGGI Review’s bold move was to not reoffer for sale unsold allowances from 2012 and 2013, but it took years of political negotiations between RGGI states to reach this welcome conclusion.

Are Low Prices Bad?

This is probably the most important question. First, let’s remember what the goal is. The goal of AB32 is to reduce California’s emissions in 2020 back to their 1990 level, 427 Mt – preferably at a low cost. The goal is not to reach a certain price level, or market value. State regulators set a minimum price to provide some degree of certainty for investors, but it is quite clear that for regulators and regulated entities alike, reaching the target with low prices, at or near the price floor, would be the best possible outcome.
Second, California’s cap-and-trade is part of an array of policies developed under AB32, and in many ways is only the backstop for the overall program. If other policies are wildly successful, then there will be less pressure on the cap-and-trade program to deliver additional reductions, and therefore less upward pressure on prices. This structure is not without raising concerns for some market participants, who fear the dependency on those other ‘complementary’ policies are a source of uncertainty and price volatility within the market, but that’s another discussion. In the big picture, if complementary policies are so successful that the cap-and-trade program is long, then it will mean California will have achieved its AB32 goal.

Is California Perfect Then?

No. Let’s be realistic – there are concerns with how the market is designed, in particular with regard to holding limits, offsets, and price containment reserve among others. This excellent study from the Batten Institute at the University of Virginia demonstrates with force why holding limits are problematic as a limitation of banking and market liquidity. On offsets, a detailed forecast from the American Carbon Registry have shown how the protocols currently in the rules won’t be enough to provide sufficient supply to the market, a concern that will be only be partially addressed with the current rulemaking process to add two new protocols to the program.
More importantly, I would argue the biggest concern with California is how high prices may get, not how low. I’m not the only one with this concern – the Energy Institute at Haas (UC Berkeley) in their recent emission forecast sees an 11 percent chance that the Price Containment Reserve could be exhausted, with nothing to keep prices from above $88 a ton in 2020. This may change as the ARB is currently working on amendments that would “ensure that allowance prices will not exceed the highest price tier” of the PCR while “maintaining the environmental objectives of the program” (Board Resolution 12-51, October 18, 2012) – a key development for the California market that we’ll be keeping tabs on.