Update: The carbon auction results are in and allowance sales were even better than we had predicted: 100% of current vintage allowances sold at $13.80 per allowance, significantly above the floor price of $13.57. Energy Innovation offers more detailed discussion here.
California’s carbon market should receive a boost when the California Air Resources Board (CARB) releases its latest quarterly auction results on Wednesday, May 24th. This may surprise many carbon market observers, because it has been buffeted by low demand, with three of the last four auctions selling 35% or less of offered allowances. Fundamentals – in market and policy design – are key to this predicted reversal.
To be sure, the carbon market is still dogged by political and legal uncertainties. The cap-and-trade program underpinning it is the subject of vigorous political debates in Sacramento, as legislators consider reforming it or reauthorizing it past 2020, and this uncertainty has depressed demand. An ongoing lawsuit challenging the government’s ability to raise revenues through the sale of carbon allowances at auction, originally filed in 2012, has also reduced demand. While California recently won an appeals court victory, the California Chamber of Commerce’s decision to petition the case to the state Supreme Court will delay resolving legal uncertainty.
Despite these headwinds, we predict a strong rebound in this quarterly auction, held on May 16th. When results are released tomorrow, we expect 50-65 million allowances (or between 67- 80%) of the 75 million current vintage offered will have sold at auction at the auction reserve minimum price, or floor, of $13.57. There is a slim chance that last week’s auction sold the full volume, and if that happened, we expect the clearing price to be very close to the floor.
Sales of future vintages, 10 million of which were offered in this auction, have always been highly variable, so current vintage results are the most meaningful signals.
Reading Carbon Market Indicators
Secondary market prices, firmly above the auction floor price, are one reason for our confidence in a strong rebound in upcoming results. Prices jumped more than $0.50 following the favorable appeals court decision on April 6th, and despite a slight price decline following Senate Bill 775’s May 1strelease, the prompt-month secondary market price stood at $13.93 on May 15th. This is well above the $13.57 per-allowance price floor set by CARB and its Quebec partner, below which allowances cannot be sold in auctions.
The full supply of current vintage allowances offered might have sold out with prices above the floor, if not for a rise in uncertainty – Senate Bill 775’s proposed language would portend a clean break from the current program, and shook market confidence. This is playing out in decreased liquidity, a measure of the number of buyers and sellers in a market, and weaker prices as speculators have reacted to this new source of uncertainty.
Cap And Trade Fundamentals – The Roots Of Recovery
So if the same problems dragging down recent results – legal and political uncertainty – still linger across California’s carbon market, why are we predicting an auction result rebound tomorrow?
In a word, fundamentals: market fundamentals and fundamentally strong policy design, particularly the program’s robust price floor. 143 million allowances (each entitling the holder to emit one ton of carbon dioxide) have been held back by the price floor since auctions began underperforming in February 2016, effectively removing them from supply for at least nine months or longer.
Since the last market auction sold only 18% of current vintage allowances, emitters have accumulated a shortage in terms of anticipating their allowance needs for the second compliance period, which concludes this year. Our analysis finds emitters must purchase at least 75-80% of allowances over the next three auctions or risk relying on the secondary market for covering their compliance needs – a small number of eligible allowances could be available at auction in 2018, but those offers are not guaranteed. Therefore, if fewer allowances sell than expected in the May auction, the remaining auctions this year should sell close to 100% to cover compliance needs in the second compliance period.
The point is, negative market sentiment can only go so far. Positive market sentiment, what John Meynard Keynes called “animal spirits” and Alan Greenspan called “irrational exuberance,” has no theoretical limit. But in commodity markets generally, and in environmental markets more specifically, market fundamentals (or the need to cover emissions) place a floor on how far market sentiment can depress demand.
One lesson for California policymakers is that once oversupply is in the rearview mirror, auctions should start selling out continuously, for the simple reason that every single allowance will be needed for compliance.
Recent analytical work estimated the market’s long-run trend will mirror the expected demand trend for the rest of 2017. Between now and 2020, auction sales will need to average 70-80% based on the simple math of what emitters need for compliance under reasonable emission forecasts. Plans for Ontario to link its program with the California-Quebec market would increase overall program stringency through 2020, raising demand at auction above these levels.
How It Connects To Debates In Sacramento
While revenue is not the purpose of cap-and-trade, it is an eye-catching side effect. More than $4.4 billion has been raised so far for California’s Greenhouse Gas Reduction Fund, the main investment vehicle for auction proceeds. Our research finds upcoming auctions should raise at least $8 billion by 2020 (see Table 5) for the fund by 2020, even before accounting for the demand boost expected if questions around post-2020 authority and the shape of the program are settled.
California’s cap-and-trade program is the world’s best-designed system, doing the job it was given under the state’s 2020 package of emissions-reduction policies. It provides a cost-effective tool for sweeping up the last increments left over beyond reductions from the state’s building codes and other performance standards for vehicles, fuels, appliances and electric utilities. The reductions delivered by these other policies, faster-than-expected technology advancements and economic trends mean cap-and-trade hasn’t needed to carry as much of the emission reduction burden so far. The result has been emissions below cap levels, and a temporary allowance surplus.
The price floor is helping correct oversupply, and once caps fall below expected emissions levels and doubts about legal authority are settled through 2030, 100% auction sales will return.
Though the program is working, concerns are understandable. Auction variability complicates effective planning for investments and feeds perceptions that the program is underperforming, while environmental justice advocates representing communities hardest hit by pollution are demanding reforms to improve local results. In light of expectations that clear environmental improvements would have happened by now, these demands for faster air quality progress are understandable. Once cap-and-trade begins to force more significant emissions reductions, these reductions should provide the greatest benefit where pollution is most concentrated.
Reforms to the existing program can accommodate changes demanded by environmental justice advocates and the legislature, while continuing to build on a successful track record now being followed by other jurisdictions, evidenced by the linkage to Quebec and the pending linkage to Ontario. The good news is that outlines of a legislative deal to strengthen the current system appear to be emerging, likely including new guardrails to create confidence about local air pollution improvement matched by cost-containment controls.
The sooner California’s legislative debate is resolved, the better. Uncertainty is depressing auction results and drags down emission reductions investments. Our hope is that a May auction rebound will remind policymakers of the program’s value, spurring quick legislative agreement on an extension bill for Governor Jerry Brown’s signature.