On November 22, 2013, the California Air Resources Board (CARB) announced the results of its fifth auction of California Carbon Allowances (CCAs or allowances) under the Cap-and-Trade Program. The auction results, marking a full year since the first auction was conducted in November 2012, indicate continued strengthening of the California carbon market, notwithstanding that the clearing price for current vintage allowances has declined from prices seen in both the auctions and secondary markets earlier this year. Additionally, there was increased participation among covered entities in the auction for 2016 vintage allowances, suggesting that market participants are becoming increasingly confident that CARB’s Cap-and-Trade Program will not be invalidated. Indeed, on November 14, 2013, one challenge filed on the eve of the first auction was dismissed by the court in California Chamber of Commerce v. CARB.
Together, these results send a strong signal that—whatever hesitations may have suppressed interest in the first auction—the market is coalescing around a clear price for allowances and reflecting participants’ views that the Program will continue to be implemented well into the second compliance period (2015-2017). While the softening price for 2013 allowances may be taken by some as an indication that the allowance market is currently over-supplied, a higher price is not necessarily in CARB’s long-term interest, notwithstanding the revenue the State is destined to receive as a result of the auction. Continued implementation of the program without radical price shocks and dislocation throughout the economy can only help CARB demonstrate the role that an economy-wide cap-and-trade program can play in achieving a defined GHG reduction target, a goal which has become almost as important as the emissions reduction itself mandated by the Global Warming Solutions Act of 2006, Assembly Bill (AB) 32.
The Cap-and-Trade Regulation establishes a declining cap on approximately 85 percent of total statewide greenhouse gas (GHG) emissions in order to achieve California’s goal of reducing GHG emissions to 1990 levels by 2020. Entities subject to the cap (i.e., covered entities) must surrender to CARB compliance instruments equivalent to their GHG emissions. Compliance instruments include both CCAs, which are freely allocated by CARB or obtained from auctions or the secondary market, and offset credits, which represent GHG emissions reductions achieved in sectors that are not subject to the cap.
Allowance auctions are held quarterly. Each auction includes a Current Auction of allowances from the current calendar year’s allowance budget (e.g., 2013 vintage allowances are sold at the Current Auction in 2013) and an Advance Auction of allowances from the budget year three years subsequent to the current calendar year (e.g., 2016 vintage allowances are sold at the Advance Auction in 2013). Both covered entities and non-regulated entities can participate, but with different limits on the volume of allowances they can purchase. The November 2013 auction was the fifth auction of CCAs under the Program. The results of the five auctions held thus far are shown in the following table.
Click here to view table.
November 2013 Auction Results: 2013 Vintage Allowances
All of the 2013 vintage allowances available for sale—16,614,526 in all—were sold at $11.48, 77 cents above the price floor of $10.71. While the settlement price for 2013 vintage allowances climbed in each of the first three quarterly auctions CARB conducted, it has declined in the most recent two auctions. Given the fact that the November 2013 auction was the last auction of vintage 2013 allowances, this decline may reflect an increasing understanding among market participants that the cap-and-trade market is currently long, relative to recent emissions estimates, due primarily to the economic recession and notwithstanding the announced retirement of San Onofre Nuclear Generating Station (SONGS).
The 2013 vintage allowances sold at the November 2013 auction consisted of allowances consigned to auction by investor-owned utilities (IOUs) and publicly-owned utilities (POUs) as well as State-owned allowances. In all, IOUs consigned 13,049,523 allowances and thereby generated $149,808,524 in revenue; POUs consigned 892,229 allowances and generated $10,242,789 in revenue; and California sold 2,672,774 allowances and generated $30,683,446 in revenue for the State’s Greenhouse Gas Reduction Fund (in addition to the revenue from the sale of 2016 allowances described below). Utilities must use the revenue they receive from consigned allowances for ratepayer relief, consistent with the direction of the California Public Utilities Commission for IOUs or each POU’s governing board.
November 2013 Auction Results: 2016 Vintage Allowances
All 9,560,000 2016 vintage allowances available for sale were sold at a settlement price of $11.10, 39 cents above the price floor of $10.71. The same quantity of 2016 vintage allowances was sold at the exact same settlement price in the August 2013 Advance Auction. The fact that all future vintage allowances were sold at the last two auctions represents an improvement over the first three. This trend suggests that the market for future vintage allowances is further solidifying, which aligns with market analysis indicating that the market for allowances will be tighter during the third compliance period (2018-2020). Allowances purchased today—for vintage 2013 or 2016—are fully bankable and good for use in the latter compliance periods. Because the reserve price for allowances increases by 5% plus the rate of inflation each year, the next time 2016 allowances are available from the auction (in 2016), their reserve price will likely be in the $13 to $13.60 range. Thus, irrespective of any tightening of the market, the $11.10 price obtained in the last two auctions for 2016 vintage allowances may reflect a bargain for those who can afford the carrying costs. At the very least, the purchase of all future vintage allowances in the last two auctions reflect market participants’ confidence that the program will continue to be implemented in the near term.
All 2016 vintage allowances were State-owned, which means that the Advance Auction generated $106,116,000 for California (in addition to the $30,683,446 in revenue obtained from the sale of State-owned allowances in the current vintage auction). In total, the auction of State-owned allowances has generated more than $530 million thus far for California, which is deposited into the Greenhouse Gas Reduction Fund. In turn, the State’s usage of these proceeds is governed by an “Investment Plan” that CARB developed in coordination with the Department of Finance pursuant to a trio of bills—AB 1532 (Pérez, Chapter 807), SB 535 (De León, Chapter 830), and SB 1018 (Budget and Fiscal Review Committee, Chapter 39). The investment decisions are guided by the principle that all projects receiving funding must be for the purpose of reducing GHG emissions and that at least 25 percent of program funding must be directed to projects that benefit disadvantaged communities and at least ten percent of program funding expended be directed to projects located in disadvantaged communities.
Although the State’s GHG reduction efforts will be greatly enriched by the auction proceeds, a high auction clearing price is not necessarily in CARB’s long-term interests. CARB’s purpose on embarking on its ambitious Cap-and-Trade Regulation in the absence of any broader regional coalition (and notwithstanding linkage with Québec or the recently announced Pacific Coast Action Plan on Climate and Energy) is in part to demonstrate the role that setting an economy-wide price on carbon emissions can have in achieving defined GHG reduction targets. If CARB truly wants to demonstrate that such a program can be implemented, without causing economic dislocation or emissions leakage, then a clearing price slightly above the floor may represent the “goldilocks” outcome: The market is not so long as to cause under-subscription or prices to collapse below the floor; nor is it so short as to cause the increases in costs and exodus from California predicted by some opponents to the program, who would no doubt call for legislative intervention if such impacts were to manifest.
The Impact on the Market from the California Chamber of Commerce V. Carb Ruling
As a result of a court ruling released the week before the November auction, CARB will be able to continue conducting auctions in which it sells allowances and generates revenue for the State, at least until resolution of likely appeals. On November 12, 2013, Judge Frawley of the Sacramento Superior Court denied the petitions in the California Chamber of Commerce v. CARB and the related Morning Star Packing Company v. CARB case, deciding the Cap-and-Trade Regulation’s auction provisions did not run afoul of AB 32. More significantly, the Court also held that the auction provisions do not constitute unlawful taxes in violation of Proposition 13 (i.e., California Constitution, Article XIII A, § 3), which requires two-thirds of the Legislature to approve any changes in state taxes enacted for the purpose of increasing revenues. The Court held that, while it was “a close question” and “an unusual case”, the requirement to buy allowances—although having essentially the same effect on covered entities as would a carbon tax—is more like a permissible fee than a tax. As the Court stated, “because the [auction] proceeds can only be used to advance the regulatory purposes of AB 32, by definition, the total amount of fees collected will not exceed the costs of the regulatory programs they support.”
Judge Frawley’s extensive discussion of the similarities between CCAs and taxes may provide petitioners with hope that their arguments will find a more sympathetic audience with appellate judges. Indeed, although the markets expressed little surprise with the ruling, the petitioners have already vowed to appeal. As time goes on and further auctions are conducted, the question really becomes whether appellate judges will be willing to overturn a decision that evinces a lower court’s painstaking efforts to apply the law to the facts and, in so doing, throw into question the value of allowances that regulated parties have already spent massive sums of money to obtain.
While the softening price for allowances in the past two auctions may reflect market participants’ assessment that the market is currently over-supplied, the increasing demand for the future vintage allowances reveals increasing confidence among market participants that the Cap-and-Trade Program will continue through at least the second compliance period of 2015-2017. Indeed, with the recent ruling in California Chamber of Commerce v. CARB, a significant cloud over the launch of the Cap-and-Trade Program has been resolved in CARB’s favor. Moreover, a high allowance price is not necessarily in CARB’s favor and might only impair the message that CARB is trying to send through implementation of the program: An economy-wide, market-based mechanism can, in fact, be relied upon to achieve a predetermined amount of reductions, without causing massive economic dislocation or emissions leakage. Whether the program can ultimately achieve these goals or others are willing to follow California’s lead is still uncertain, although one should not expect CARB to wait around for the proof of concept, before it begins planning for the extension of the Cap-and-Trade Program beyond 2020, with an eye towards a goal of reducing GHG emissions to 80% below 1990 levels by 2050.