California’s cap-and-trade program, which anchors North America’s largest carbon market, is starting 2017 on a strong note ahead of its first quarterly auction on February 22. The market has generated more than $4 billion in revenue for carbon emission reductions and, despite an uneven performance last year, is strengthening through rising prices as legal certainty over the program’s future takes shape.
Last year, the program’s second and third quarterly auctions posted weaker-than-average demand for carbon allowances, the currency of compliance under the program. Some observers interpreted the results as a carbon market in a tailspin, but this failed to see the forest from the trees.
Falling Emissions Reduced Allowance Demand
Several events accounted for the less-than-stellar performance of these auctions. First, California has progressed toward its 2020 emission reduction target much faster than anticipated due to the success of other state policies like efficiency standards for cars and buildings. Faster-than-expected technology innovation, as well as the 2008-2009 economic slowdown that hit after most program design occurred, also contributed to sub-par auction performance. These factors reduced emissions and thus demand for carbon allowances.
The first time 2016 auction demand was low, analysts did not widely recognize secondary market data provided advance indications of what was to come in advance of the weak auction results. Prices for allowance trading on the secondary market had remained consistently below the auction price floor—the minimum price the California Air Resources Board (CARB) will accept for allowances at auction—before each auction.
The same secondary market data, which reflects transactions between allowance holders and buyers outside of government-managed auctions, now indicate the rebound that started in the November 2016 quarterly auction will continue in February’s auction. Allowance prices have recently risen to a high of $13.80 per ton of carbon dioxide emitted — $0.26 above this year’s auction price floor— which could portend strong demand in the upcoming auction.
Increased Legal Certainty Over Cap-and-Trade Authority Spurring Demand
The jump in secondary market prices is attributable to growing legal certainty over cap-and-trade authority. On January 24, a state appeals court heard arguments over whether the state’s auctioning of carbon allowances should be considered a tax (the purpose of which is revenue) or a fee (the purpose of which is regulation).
On one side, a lawsuit by the California Chamber of Commerce contends the cap-and-trade program’s auctions should be deemed a tax on businesses. On the other side, CARB defended the auction revenue as fees. The deciding factor is whether or not the spending is closely tied to the purpose of the program.
Under pertinent California law, taxes must pass with a two-thirds legislative majority, whereas a fee would need a simple majority. Since Assembly Bill 32—the law underpinning the cap-and-trade policy—passed by a simple majority vote, a court ruling that auction proceeds reflect a tax instead of a fee would jeopardize auction authority.
Uncertainty about this legal challenge’s outcome depressed allowance demand, created murkiness over the state’s carbon market future, and likely played a role in low carbon allowance demand during the second and third quarter auctions. However, optimism is growing that the courts will uphold the program.
First, CARB has dedicated auction revenue to a Greenhouse Gas Reduction Fund, with the intention of complying with the fee classification. Second, some of California’s sharpest legal minds give the pro-fee argument an edge, and their reading of questioning by the three judge panel at the appeals court hearing strengthened confidence in the program’s validity. “[T]he justices appear inclined to rule in CARB’s favor, upholding the cap-and-trade program’s auction component and rejecting the business community’s constitutional challenge,” said UC Davis Law Professor Richard Frank. The court must rule by the end of April (and two of the three judges appear to be leaning toward upholding the program), but an appeal to the California Supreme Court is expected regardless of their decision.
Secondary market allowance pricing has accordingly risen with confidence in cap-and-trade authority being upheld by the appeals court. Following the hearing, the secondary market price jumped 22 cents.
Carbon Allowance Demand Set To Stay Strong Through 2020
A strong auction later this February would build upon strengthening demand from the carbon market’s final 2016 auction. In that auction, 88 percent of available allowances for the compliance period sold at $12.73 per allowance.
In fact, Energy Innovation forecasts most auctions going forward should yield results more like the November 2016 auction than the two preceding it. The market’s “animal spirits” always have potential for surprise outcomes in any given auction, but our analysis suggests future auctions through the end of 2020 should sell about 90 percent of allowances on average (85-95 percent under low- and high-demand scenarios).
Recent events indicate growing market confidence in program longevity. Over the long haul, last year’s underperforming auctions will likely be viewed as aberrations rather than representing a trend. By sending a market signal nudging investments toward lower emissions and generating billions for emissions reduction investments, the cap and trade program can help California hit its 2020 decarbonization target, and should play an increasingly important role in the state’s efforts to hit its much more ambitious 40 percent reduction by 2030 goal.