We expect the 5th auction for California carbon allowances will see fewer bidders, a lower ratio of bids to supply, and a lower clearing price than previous auctions. These are normal developments for the last auction of the year, and in line with recent price trends on the secondary market. We expect the long term prospective will outweigh current concerns regarding market over-allocation, and we anticipate that the reserve price growth rate will prevent the auction from being undersubscribed.
Auction: Price and Volume Outlook
The November 19 auction will see 16,614,526 Vintage 2013 (V13) allowances offered for sale, a volume noticeably higher (12-22 percent) than previous auctions. This additional volume comes in part (0.3 Mt) from small adjustments to ARB inventory data, and for the rest, likely from consigned allowances by publicly-owned utilities (POU).
We expect the V13 allowances will sell in the range of $10.71-10.85 per ton, at or just above the reserve price of $10.71. There is a small risk that V13 allowances will be undersubscribed, due to a widely shared view amongst market participant that the California cap-and-trade program will be long in the first compliance period and beyond. Nevertheless, we think it is unlikely that V13 allowances will remain unsold: allowances bought at $10.71 in November 2013 can be turned around and sold in early 2014 for close to $11.45, the 2014 floor price. This 5 percent interest rate with near-zero risk acts as an incentive for compliance entities and financial investors to bank extra allowances in the early years. Five percent return over a few months’ time is nothing to sneeze at in today’s financial markets, so we expect enough bidders will see it as a worthy investment to prevent the auction from being undersubscribed.
The ‘Advance Auction’ will see 9,560,000 Vintage 2016 (V16) allowances offered for sale, at the same reserve price. Similarly, we anticipate that the general confidence that the program is here to stay will lead the ‘advance auction’ of V16 allowances to be fully subscribed and clear in the range of $11.00-$11.25. Indeed, all V16 allowances in the August 2013 auction sold at a clearing price of $11.10, and if anything confidence in the long term viability of the market has been bolstered since.
The Short Term Prospective: the Annual Compliance Cycle
The California cap-and-trade program is structured around two- or three-year compliance periods: this structure is meant to provide flexibility for compliance entities that have large year-on-year variations – such as the power sector – and avoid price spikes.
However, most entities on the market still look at their emissions on an annual basis, and purchase allowances accordingly. They may take advantage of the flexibility afforded by the two-year compliance period ex-post, but not necessarily by on an annual basis. At this point, most compliance entities have likely already purchased enough allowances to cover their 2013 allowances, except for the largest ones – the IOUs and large oil companies, which need to purchase as much as possible at each auction to meet their compliance needs. The majority of firms – and so many of the potential bidders – will likely wait until 2014 to start purchasing their 2014 allowances rather than banking allowances at the last 2013 auction, even at bargain prices. They simply may not have the budget or strategy to start purchasing their 2014 allowances.
The same dynamic could be observed in the Regional Greenhouse Gas Initiative in the first compliance period (2009-2011), as shown in Figure 1.
In each of the first three compliance years, participation in the auction was lower in the last two auctions (Sept and Dec) than in the first half of the year. In 2010 and 2011, participation was also lower in December than in September – the only exception was December 2009, where the RGGI auction attracted unusual interest from financial investors in the context of the debate over the Federal cap-and-trade bill ahead of the Copenhagen global climate negotiations.
The trend in California looks very similar so far (see Figure 2), with the number of participants decreasing from 91 to 79 and the subscription rate dropping from 2.47 to 1.6 between February and August.
The main difference with RGGI is that we don’t expect the overall number of auction participants in California to decline so dramatically over the years, but rather to remain overall stable as participants will have to come back to the auctions in 2014 and 2015 to procure the allowances they need. California market participants will be unable to build a bank as large as RGGI emitters because of holding limits and because California is nowhere near as over-supplied as RGGI was in 2010 and 2011.
Is California Really Over-Allocated, and Does It Matter?
In September 2013, Thomson Reuters Point Carbon published a report forecasting that California emissions will remain lower than the cap through 2018 due to the rapid decline of emissions observed since 2011 and anticipated through the end of the decade. 2012 GHG emissions data published by ARB on November 8, 2013 confirm the downward trend in most sectors except the power sector, where emissions increased slightly due to a dry year (leading to lower levels of hydro generation) and the shutdown of the SONGS nuclear plant. If emission reductions continue to outpace the cap decline, this would be good news for the program, since it would mean reductions mandated by complementary policies – the Renewable Portfolio Standard, Low Carbon Fuel Standard, etc. – are bringing about enough emission reductions, and prices are likely to stay low over the coming years. If this proved true, prices would likely stay at the price floor (the auction reserve price), rising moderately to reach about $17.50 in 2020.
Yet such over-allocation is not a done deal by any means. Tight offset supply, additional demand from California’s trading partner Quebec, and an economic revival could put upward pressure on prices through a combination of rising demand and rigid supply. The lack of readily available low-cost emission reductions means a short market could see rising prices in the third compliance period, albeit most likely kept in check by the price containment reserve.
And even if California were indeed over-allocated through 2020, the annual supply and demand balance would matter less and less as 2020 approaches. In a carbon market, prices are largely driven by policy expectations. Even if there are more allowances than emissions in 2018, prices could still rise above the reserve price if the market anticipates a tight cap after 2020 will bring scarcity. Market participants could well start buying allowances to bank for post-2020 period.
Long Term Prospects for the California Carbon Market
Two noteworthy developments have reinforced the long-term viability of the program in the past couple of months.
On November 14, the California Superior Court upheld the cap-and-trade auction provisions, which had been challenged by the California Chamber of Commerce. This decision once again sends the signal that the program will be resilient to legal challenges, and that it is unlikely it will be brought down by a lawsuit.
More importantly, the Discussion Draft for the Scoping Plan Update, released early October, reiterated ARB’s intent to continue the program past 2020, and proposed a state-wide GHG emission target for 2030 in the range of 30-55 percent below 1990 (and 2020) levels. While the final target will be a political decision from the Governor and the Legislature, the will to continue aggressive carbon reductions in the state is clearly there, and cap-and-trade will remain part of the arsenal. We expect California will set a target of at least 40 percent below 1990 emission levels for 2030, halfway to the 2050 target of 80 percent below 1990 levels. As shown in Figure 3., a 40 percent target would be a fairly linear continuation of the current cap, while a 55 percent target would see an acceleration of reductions after 2020.
Because California has done so well at reducing its emissions so far, and political support for climate policy remains at an all-time high, we wouldn’t be surprised for the Governor to embrace the more ambitious target as part of his 2014 re-election campaign. Such a bold commitment would provide support for carbon prices before 2020.
The upcoming auction will likely see lower clearing prices and less participation than previous auctions, but this is a normal development for an end-of-the-year auction. The long term perspective for the program remains strong, and the reserve price will sustain prices until California decision-makers finalize the target for 2030.