After a fairly quiet start to the year, the California market saw an increase in activity last week as the first auction of the year coincided with the last days to file bills in the California legislature. One such bill filed last week proposes to remove transportation fuels from the cap-and-trade program and impose instead a tax on gasoline starting in 2015, and was opportunely leaked right when the auction was in process, on Wednesday February 19 midday.
Auctions: All Quiet on the Western Front
Auction participants seemed – thankfully – unfazed by the surprise proposal, if they even heard of it in time, and the auction cleared slightly below secondary market prices, in line with expectations. The current auction for V14 allowances cleared at $11.48 a ton, just 14 cents above the 2014 reserve price of $11.34 a ton, while the advance auction for V17 allowances saw a clearing price of $11.38. All of the 15.5 million V14 and 9.3 million V17 allowances sold out. The auction raised $175 for the benefit of ratepayers and $130for the GHG reduction fund. This confirms our forecast that the state is on its way to raising at least $529 million in fiscal year 2013-2014.
The bid-to-supply ratio was lower than at previous auctions, but the volume offered was quite a bit higher, for a total of 71 participants, also lower than at previous auctions. It is impossible to say if the bill leakage had any impact on the auction – in our view, the slight drop in interest is to be expected in a long market and not reflective of last minute rumors on possible changes to the program design.
Cap-and-Dividend, Here We Go Again…
While the market impact was limited, the fuel tax bill garnered quite a bit of media attention. The bill comes from the office of State Senator pro tempore Darrell Steinberg, a powerful Democrat who represents the Sacramento region and is supportive of California’s climate policy. Steinberg’s main concern is the risk of spikes and wild fluctuations in gas prices due to the carbon market, which he argues would affect disproportionately the low and middle-income families through higher energy costs. According to the Senator, such fluctuations would also give fodder to the fire of climate change skeptics who “[would] use the crisis to unravel AB 32 and weaken our essential climate goals.”
To remedy these concerns, the bill proposes to establish a carbon tax starting at 15 cents a gallon in 2015, rising to 24 cents a gallon in 2020, which is roughly equivalent to carbon prices of $16 a ton in 2015, rising to $25 a ton in 2020. The bill supporters argue that this would provide better price certainty, slightly higher than the reserve price, and without the upside price risk of the market.
In addition, the bill proposes to return most of the carbon tax revenues to poor and middle-income California families through a new state Earned Income Tax Credit, and inject the remaining revenues into a multi-billion dollar 21st century development of California’s mass transit infrastructure. This stands in contrast with the use of the auction revenues, which by law must be entirely spent on emission reduction efforts, and per the Governor’s proposed budget, would see over two thirds of the monies go to clean transportation and sustainable communities investments rather than tax credits.
None of the bill’s ideas are bad per se – a carbon tax is a very respectable way to price carbon, and returning revenues to poor household is certainly an important concern. The only real problem with this bill is that we’re in 2014, over one year into the program and ten months before the start of the second compliance period (CP2) and the inclusion of fuels under the cap. Such a proposal would have been fine to consider in 2008 while the Scoping Plan was studying at length the merits of cap-and-trade vs. carbon tax. Right now, it is disruptive and possibly counterproductive.
Disruptive because reopening Pandora’s Box so late in the game creates uncertainty for market participants and discourages long term investments, and counterproductive because it could potentially cause short term volatility on the market. Indeed, fuel providers are already actively buying allowances to prepare for next year’s compliance obligation. Sending mixed signals less than a year before CP2 creates uncertainty not just for fuel providers at a loss of how to best prepare for compliance, but also indirectly for all the other compliance entities wondering what the implications might be in terms of liquidity and volatility for them.
If fuels were actually excluded from the cap, the market would remain its current size instead of doubling overnight, leaving only power plants and industrial facilities in the program. This would mean a continuation of the market as we know it today, with low liquidity and limited offset demand. Also, a smaller market can be more prone to volatility due to changes in the demand side price drivers – for example, a heat wave would have a comparably larger impact in a market where the power sector drives over half of the demand than it would in a much larger market with more sectors covered.
As it stands, the market mostly shrugged the news, sliding down a few cents on Thursday, possibly on the back the proposed bill, but this could change if some of the bill’s provisions gained traction. Yet an extended discussion on the fate of fuels under the cap could create a sluggish buyer mood and hamper liquidity in an already slow market until the road is clear for fuel distributors to enter unreservedly the market.
A Low Probability, High Consequence Event
The bill in its current form is very unlikely to pass. In California, a new tax needs a 2/3 majority in the Legislature. Democrats have a bare majority, and Governor Brown has said: “now is not the time for new taxes”. He and the Legislature face elections later this year. Furthermore, most environmentalists oppose the bill, and while the fuel trade associations have expressed interest in the bill, they’re not openly leading the charge. All of these mean the bill’s odds are very, very low.
Yet the fact that the President of the Senate is willing to propose changes to the design of the program at this point in time is something worth paying attention to. While a fuel tax is unlikely to go anywhere, a bill requiring the Air Resources Board to impose a tighter price collar or offering an alternate compliance mechanism through a flat fee for fuel providers would not necessarily require a super majority. Neither would a bill to remove fuels from the cap entirely, for example if gas prices endured a sudden or significant increases and legislators faced urgent and widespread calls to act.
The bill also signals the Democrats are intent on seeing their spending priorities better reflected in the investment plan for carbon auction revenues. The Governor’s focus on the high-speed train is not exactly popular in the State Capitol, and many legislators would like to see more revenues directed to poverty reduction, possibly through a climate dividend, and mitigation of general cost of living increases. The amount of money forecasted to be raised from the carbon auctions, over ten billion dollars cumulative through 2020, should and will undoubtedly be the object of a healthy democratic debate in the Legislature this spring.
At this point however, it would be best for the success of the cap-and-trade program if this debate were limited to revenue allocation. One of the best ways to ensure price stability in the carbon market is to provide policy certainty, and questioning core design elements of the program at this point in time may not conducive to the price stability the bill seeks to foster.