Price Outlook for California: Still Waters Run Deep

On Thursday May 16, California will hold its third carbon climate allowance auction. The state will offer 14.5 million Vintage 2013 allowances and 9.6 million Vintage 16 allowances, which can only be used in for compliance 2016 or later. I expect this coming auction’s results to be fairly similar to the last auction’s results back in February: healthy demand for current year allowances, with a clearing price between $13.50 and $14.00, and muted demand for future year’s vintage, which will likely clear at the price floor.

Today’s market

Prices have been very stable since the last auction, staying consistently in the $14-$15 a ton range on the secondary market according to data from the Intercontinental Exchange (ICE) and Point Carbon’s OTC price assessment. Volumes are not huge but the market seems liquid enough. The emergence of option transactions is also a positive development as market participants start taking advantage of the entire range of financial instruments available to hedge risks. In line with these developments, I don’t expect any big surprise in Thursday’s auction. But history is not guarantee of the future, and the summer could bring more volatility on the market – here’s why.

California SONGS

Southern California Edison’s woes with San Onofre Nuclear Generation Station (SONGS) constitute the main driver and biggest source of uncertainty for the market over the next months. The Atomic Safety and Licensing Board just announced on May 13 that the licensing process would need to follow an extensive public review process, which pushes a potential restart of the plant back in time and create additional uncertainty as to the final outcome. Without SONGS, the California ISO indicated in their 2013 Summer Assessment that they expect to be able to serve the load from California electricity consumers under normal conditions. However, heat waves or wildfires could disrupt those plans, bringing power outages, electricity rates increase and potentially higher carbon prices as higher emitting generation or increased imports may need to be brought online.

Policy Matters

Regulatory developments from the California Air Resources Board (ARB) also have the potential to drive market prices outside of this $14-15 price range. The ongoing effort to approve offset projects and new protocols is slowly infusing the sense that the credit supply will be there in time to meet demand before compliance is due in 2014-2015, relieving some of the upside pressure on prices.
The regulatory amendment package due in September should in theory be price-neutral, as it does not involve any changes to the actual market supply, but in practice the implementation mechanism for the $50 price ceiling could impact long term supply, while the increase in free allocation to industrial players could limit the incentive to abate emissions within those industries, potentially putting upward pressure on prices.
The other major development providing support to prices is of course the linkage with Quebec approved back in April – read more on what this means for the market. Prices went up a little bit following the confirmation of the linkage, but Quebec is unlikely to have a noticeable impact on prices until the markets are actually linked, in January 2014.

Other sources of uncertainty

Lawsuits remain a source of uncertainty – the lawsuits directed at the cap-and-trade program itself are not so much the worry as the lawsuit against the Low Carbon Fuel Standard (LCFS). A successful challenge to the LCFS would send a major bullish signal to the market as it would mean higher emissions from the transportation sector through 2020.
Furthermore, the continued lobbying from a number of oil companies to change the cap-and-trade provisions for 2015 and after could also bring sudden shifts in supply and demand outlook if the Legislature lent a friendly ear to the concerns of the oil industry and agreed to change the way oil companies are covered in future compliance periods.

Conclusion

Prices have been very stable and may well stay so, unless external events create disturbances to the supply and demand balance. These external events could be weather-driven or could have to do with lawsuits and politics. This makes them difficult to forecast and anticipate, and means turbulence could appear with little to no warning in the still waters of the California carbon market.