March 22, 2017 by Ronjoy Bezbarua
Demand fell for carbon allowances in the California-Quebec cap-and-trade program’s first auction of 2017, continuing a string of uneven results over the last year after auctions sold out for the program’s first three years. Much of explanation for this reversal revolves around legal uncertainty regarding the future of the program, however new quantitative analysis also points to emissions allowance oversupply.
Since the program was first being designed in 2008-2009, emissions covered under the program have fallen below the cap levels, the total allowances issued for a year (leaving aside the complication of offsets, which are a small fraction of compliance). This overall emissions reduction below cap levels has been driven by the success of California’s portfolio of climate policies, and broader economic and technological trends.
The new analysis also indicates long-run auction demand will be much stronger than recent low levels, generating average sales of approximately 76% of offered allowances through 2020. Using these demand forecasts, auction revenue will range between $7.6-$8.5 billion between 2017-2020.
Recent Carbon Allowance Auction Results In Context
In the first auction of 2017, 18% of current vintage allowances were sold, a stark decline from the 88% sold at the last quarterly auction of 2016. In addition to current vintage allowances, which can be used this year or in the future, the program also offers a smaller amount of future vintage allowances, which are only usable in the next compliance period. Demand for advance-auctioned allowances has been low for the last four advance auctions, though as the figure below shows, current vintage sales dominate market volume.
This figure outlines the sudden uneven demand over the last four joint California-Quebec auctions. February’s auction demand decline came despite a favorable reading of a January court hearing regarding a lawsuit brought against the cap-and-trade program. The uncertainty created by this lawsuit is one of the main factors that commentators have discussed in explaining market dynamics. And the secondary market, i.e. trades outside of auctions, seemed to confirm that the court’s questioning showed an inclination to accept the government’s defense, as secondary market prices for allowances jumped almost 20 cents shortly after the hearing. All this leaves observers asking how to make sense of these results in light of the apparent reduction in legal uncertainty.
Three Causes Of Low Demand At 2017’s First Quarterly Carbon Allowance Auction
We conclude at least three factors were at work in February’s auction results: (1) market fundamentals, (2) the program’s relatively long three-year compliance periods and (3) the increasing crescendo of debate in Sacramento around the future of carbon pricing in California.
The first two factors allow considerable time for emitters covered under the program to wait to acquire allowances, should they choose. Many emitters built up an allowance surplus early on and already have enough allowances to cover most of their emissions for the second compliance period, creating low demand at recent auctions. However, the recent low auction sales do not reflect market fundamentals: Long-term demand, through 2020, will have to recover and average sales of 70-80% of offered allowances at auction in order for emitters covered under the program to secure compliance.
Meanwhile, the program’s three-year compliance periods give emitters until November 1st 2018—a timeline spanning six more auctions—before they need to submit allowances and offsets to cover their emissions for the second compliance period (2015-2017). With about 200 million more allowances needed for second period compliance, and with each auction releasing upwards of 70 million current vintage allowances, emitters could still achieve compliance by purchasing less than 50% of allowances at the next six auctions.
Enter the last factor, increasingly vigorous debates in Sacramento about the future of carbon pricing. An effort is underway to secure a two-thirds legislative majority and extend carbon pricing post-2020, which, thanks to a state ballot initiative passed in 2010, will be necessary if the program is deemed a tax rather than a fee.
Even as the legal uncertainty around the program has ebbed, this political uncertainty appears to have risen. While the Brown administration is working for the extension of cap-and-trade, much of California’s environmental justice community has never supported this approach. In light of the lack of urgency around securing additional allowances for near-term compliance needs, it seems that market participants are waiting to see a resolution to the political uncertainty.
Future Prospects For Carbon Allowance Demand
While our analysis shows potential for auction sales to remain below 50% over the next few auctions, this is not a prediction. The market swings have gone beyond rational reactions and market psychology is clearly playing a role.
The auction results point to at least one clear fix – the resolution of political and legal uncertainties about the future of the program. Once the market is fully confident in what will be required for the long term, strong auction sales will return.
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