April 12, 2015 by CaliforniaCarbon.info
CaliforniaCarbon.info, April 12, 2015: Earlier this week, the California Air Resources Board (ARB) released the latest update to the Compliance Instrument Tracking Service System (CITSS) in use for the Western Climate Initiative (WCI) cap-and-trade program. The WCI program comprises California and the Canadian province of Quebec, after both jurisdictions linked their individual systems at the beginning of last year.
The CITSS inventory has hitherto been updated on a quarterly basis, and the most recent figures are believed to represent the state of play at the end of March 2015. They show that over a third of all V2015 WCI allowances that have so far entered the market (whether through allocations or auctions) have already been moved from entities’ general to compliance accounts. Once an allowance is moved into the compliance account, it may no longer be removed for transfer to another entity. The V2015 is the first allowance vintage to have been offered through an advance auction. Alongside 23.1 million V2013s, 5.56 million V2015s entered the market through this means at the first ever California carbon auction in November 2012.
However, according to previous inventories none of this volume had yet been moved into compliance accounts at the end of Q4 2014. Some 76.7 million (of the 210.4 million so far distributed) V2015s have been moved from holding to compliance accounts in Q1 2015 alone. The V2015 started to be offered again through the auctions in February, when 73.6 million cleared at USD12.21 with a modest cover ratio of 1.14. In addition, entities would have received their 2015 free allocations at the beginning of November 2014, while allocations of V2015 true-up allowances (for changes in production occurring in 2013) were made by late October 2014. Of the 11.6 million true-up V2015 allowances, 1.76 million were immediately retired at the first annual surrender in California.
Put another way, almost three times as much volume has been moved directly into compliance accounts as traded as futures on the InterContinental Exchange (ICE) in Q1 (Q1 exchanged volume = 25.3 million). Compliance instruments for 2015 emissions are in fact only mostly due in November 2018, over three and a half years from now (only California has a 30% annual surrender requirement for November 2016). Theoretically, engaging in a ‘carry trade’ – one in which allowances are first sold to another entity offering a competitive implied annual funding rate, then later bought back closer to surrender time – should offer entities improved cost-effectiveness in managing their carbon compliance, but for several reasons this dimension of the market is not meeting its full potential.
Firstly, the annual funding rates on offer on ICE are not as competitive as they have historically been in other cap-and-trade markets. Where the EU ETS has frequently provided rates below 2%, the rolling 6-month average for the V2015 Dec 15/Dec 16 spread stands at a shade under 4%. While probably still lower than many firms’ internal cost of capital, the undercut may not justify the transactional cost and counterparty risk involved in secondary market activity. In addition to (what is believed to be) an uncompetitive market amongst speculative carry providers, the promised 5% real increase in the floor price (which has proven to guide secondary prices in the last year and a half at least) also seems to provide significant support for high premiums through the forward curve. The rising floor prices provide an incentive to move early in covering carbon exposure, yet work against possible solutions to carry this position in ways that improve cost-effectiveness.
Secondly, the holding limits imposed on participants in the market – which work out to just under 13.4 million for the V2015, or only 2.9% of the total budget – compromise the total available supply of carry trade services. The absence of many financial sector giants also suggests that these restrictions make the market an unattractive one for speculative capital. Furthermore, they may serve as an incentive for entities to move their allowances into their compliance accounts, since doing so would qualify these allowances for the limited exemption from the holding limits (up to the sum total of reported 2012, 2013, and 2014 emissions). These work to constrain liquidity in the carbon market.
Thirdly, it is believed that many entities, particularly in the transportation fuels sector which entered the program at the beginning of this year, are simply buying allowances ‘as they go along, and directly building these carbon costs into the pricing of their retail products’, as one consultant put it earlier this year. In not working to a concerted and deliberate carbon strategy, they may be choosing to overlook more efficient options to manage their cap-and-trade obligations.
Aside from the V2015s, 27.2 million V2013 and 17.2 million V2014 allowances were moved from the holding to compliance accounts, bringing the respective totals up to 90.6 million and 46.2 million respectively. This November, California entities will have to cover the remaining 70% of their 2013 obligations (101.1 million) and all their 2014 obligations (144.6 million according to our forecast, true figure to be revealed by ARB in November), while Quebec entities will be liable for the entirety of their CP1 obligations (33.5 million, according to our forecast). Given the 106,000 offsets already placed in compliance accounts, if all entities were to meet their obligations, we might expect a further 142.3 million instruments (allowances or offsets) to be moved out of holding accounts in the next six months or so.
Numerical breakdown of transfers into compliance accounts in Q1 2015:
Remaining instruments held in holding accounts, versus ICE open interest as at end-Mar 2015:
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