What Happened in California’s Second Auction?

California hit a home run with its second auction on February 19, 2013: more participants, more bids, and higher – but not too high – clearing price. These auctions results, released February 22, provide some useful insights into the state of the nascent California market, how market participants view the future, and who is acting on it.

What was for sale?

There were two types of allowances offered for sale in this second auction. Vintage 2013 (V13) allowances, which can be used for compliance this year, or any other year in the future, and Vintage 2016 (V16) allowances, which may only be used for compliance in 2016 or later. The demand dynamics for these two different vintages are therefore very different: V13 are all the rage, while V16 are more of a long-term investment – and a leap of faith for some buyers.

What did it sell for?

V13 allowances were indeed very much in demand: auction participants bid almost 2.5 times the volume that was offered for sale. This is a sign of a healthy, competitive auction – and quite an increase from last time, where demand was only 10 percent over the volume offered for sale. Because of this competition, the auction clearing price was also quite a bit higher than at the November auction: this week’s auction cleared at $13.62, against $10.09 last time. California Carbon Allowances had previously been trading in the secondary market in the $14-$15 range.

Don’t underestimate the future

This clearing price should not come as a surprise (though really, it did for most people). I see two reasons why prices went up the way they did. First, in carbon markets, prices are largely driven by long-term expectations. In this case, while there is most likely enough allowances to cover emissions this year and next, the market is going to get very short over the long term – if not by 2020, then certainly after 2020. Now, market participants tend to factor in uncertainty when they look at the long term. The more uncertainty, the less the future will impact today’s prices – a phenomenon economists capture with a “discount rate.” Uncertainty went down a lot between the first and the second auction: the first auction took place, the cap-and-trade program started, and the sky hasn’t fallen. Talk about a good omen! So market participants discounted less the outlook for a future market with high prices, and that pushed prices up at the auction.

Mismatched supply and demand

The other reason prices went up is the current mismatch between supply and demand. Many power generators, especially those owned by utilities, are trying to keep current and purchase as many allowances as they need to match their current emissions. But the supply from auctions is limited, and supply on the secondary market is even more limited. It is possible that some market participants have more allowances than they need, but those are most likely industrial companies. In Europe, many industrial companies sat on their allowances for years until they figured out the market. If Europe is any lesson, industrial players could take months, or years, before coming to market. So even if, overall, by the end of the year, there should be roughly as many allowances as emissions, right now, there is more demand than supply – which also pushed prices up, though maybe just temporarily.

Who was (trying to) buy allowances?

The February auction saw 91 participants – a 20 percent increase over the first auction. This is consistent with, and a driver for the price increase. It shows market participants are taking the program seriously, and putting their money where their compliance obligation is. I would expect the number of participants will keep growing a little bit over the next auction, as more regulated entities enter the market and start procuring allowances.
I counted 22 participants who only bid in the first auctions – odds are they got what they wanted, and did not need to come back for more this time. 51 participants were repeat bidders, and I would expect a number of them to be regulars at future auctions as well as they need to purchase large volumes over time. This leaves us with 40 new participants at this auction, for a total of 113 single players over the two auctions.

Power companies dominate

Out of these 113 participants, over half came from the power sector – a dozen utilities and 45 power generators and marketers. The industrial sector came next, with 26 bidders, and the oil industry with 15 participants. Note that this doesn’t tell us anything about how much people bid and who was successful in purchasing allowances.
The Air Resources Board reported that compliance entities purchased 88 percent of the V13 allowances – and indeed, I counted only seven “pure play” financial institutions amongst the auction participants. But really, many of the power marketers are part of large financial institutions – small and big – and it’s impossible to know whether the allowances they purchased were solely to cover their compliance obligation, or also for speculative purposes. So it’s quite possible that there were more “non-compliance” purchases than on the face of it. This may be a good thing if it helps bring liquidity to the secondary market, and as long as those entities don’t capture an excessive volume of allowances.

What will happen with revenues?

Last but not least – how much money was raised, and where is it going? An important point here is that allowances offered from auctions come from different buckets, which in turn affects how the proceeds from the auctions are used.
Most of the allowances are consigned for allowances by the utilities. Not that they have a choice – it’s part of the regulation. The revenue from the sale of these allowances goes straight into lowering bills for electricity ratepayers. The money raised by utilities on behalf of ratepayers was 140 million dollars.
A smaller chunk of the allowances comes directly from the state and goes into a special greenhouse gas reduction funds. All the proceeds from the sales of those allowances will go into reducing carbon emissions in California. The governor is yet to announce the details of how these will be used, but has mentioned transportation and energy efficiency as a key focus. At the February auction, the state sold 2.7 million V13 allowances, and 4.4 million V16 allowances, for a total of 84 million dollars.
The Air Resources Board is currently holding public workshops to gather input on the investment plan for the auction proceeds.

Image credits: www.bidsinmotion.com