Future uncertain over cap-and-trade auctions

On Tuesday, the California Air Resources Board (CARB) released the latest quarterly allowance auction results for California’s cap-and-trade program.  While demand rose compared to the previous auction in May, a majority of allowances still went unsold due to uncertainty over the program’s future past 2020 – suggesting policymakers should take action, not solace, from better August auction results.

Allowances are the main way large polluters covered under cap-and-trade can comply with the state’s emissions requirements.  Buyers in the latest auction purchased 34 percent of allowances eligible for use in this compliance period (through the end of 2017) at the price floor of $12.73 per ton of carbon dioxide.  Demand for allowances was stronger than the May auction, when 90 percent of allowances went unsold.

The future of cap-and-trade beyond 2020 is strongly linked to what is happening today because California is making such fast progress toward meeting its 2020 target of reducing statewide emissions to 1990 levels.

But uncertainty persists about the future of California cap-and-trade. CARB has maintained existing AB 32 authority provides the necessary legal grounding for auctioning allowances, and the Brown Administration is moving to solidify the legal foundation via legislative action or ballot if needed.

Much of the legislative wrangling can be traced back to Proposition 26, which passed in 2010 and expanded the definition of what counts as a tax versus a fee.  While a two-thirds vote supporting cap-and-trade program extension would be the cleanest option for meeting California’s emission reduction targets, it’s not alone.

Policymakers could also consider continuing the cap-and-trade program without auctions by distributing allowances directly to citizens.  This possibility for this approach will put additional pressure on the oil industry to support solidifying the legal authority for auctions.

However, legislation is not the only option.  A ballot initiative is the third route to solving uncertainty over the legality of cap-and-trade auctions, which were created by a ballot measure in the first place.  Proposition 26 only received 52.5 percent of the vote..

Until the legal foundation for the program is solidified, auctions are likely to be unstable and undersubscribed on average, resulting in a surplus of unsold allowances – a problem for two reasons:

First, long-term certainty is needed for low-carbon investments.  Many larger investments—like infrastructure, power plans, and many capital investments—last for decades, meaning investors need to be confident California’s climate policy will have staying power.

Second, an erratic revenue stream is more difficult to spend efficiently.  The cap-and-trade program’s purpose is reducing emissions, but to protect consumers and avoid windfall industry profits, most allowances are auctioned for a price rather than being given away.  This creates a revenue stream government officials must use wisely, made more difficult under current circumstances of lackluster demand.

The future of cap-and-trade beyond 2020 is strongly linked to what is happening today because California is making such fast progress toward meeting its 2020 target of reducing statewide emissions to 1990 levels.  Data show the state is just three percent above the 1990 levels, putting California on track, if not ahead of schedule, in its decarbonization efforts.

If the current pace is maintained, the state will easily beat its goal.  The fast pace of emission reductions is the most important factor behind weak demand for allowances.  In cap-and-trade terms, the system is currently oversupplied, meaning more allowances are available than companies regulated by the program need to cover their emissions.

Original technical analysis by Energy Innovation documents the extent of this oversupply.  The analysis shows businesses covered under the cap-and-trade program banked 62 million metric tons (MMT) in allowances, or 17 percent of all allowances,^[1] in the first compliance period ending in 2014.

California is in the middle of its second compliance period, which covers 2015 through 2017 and we estimate an oversupply of more than 30 percent—over 200 million tons—in terms of allowances yet to be distributed.  This is the key fact for auction stability – the market is long, in traders’ terms, and only the promise of more stringent post-2020 caps will revive demand.

Because of the relatively modest pace of emission reductions needed through 2020 and continued ramping up of other decarbonization policies, demand during the third compliance period (2018 through 2020) is very unlikely to significantly boost allowance purchases.  In fact, CARB’s own assessment reveals emissions under the cap-and-trade program are expected to remain below cap levels through 2020 (as shown here, in slide 7-8).

Teething pains notwithstanding, California’s cap-and-trade program design is fundamentally sound and a useful tool with an important role to play helping the state reach its 40 percent below 1990 emissions by 2030 goal.  The 2030 goal, defined in Governor Brown’s Executive Order and just approved by the California legislature in SB 32, is ambitious and the cap levels CARB has proposed to help meet it would surely lift allowance demand, returning stability to California’s cap-and-trade auctions.

The imminent signing of new 2030 legislation is a tremendous step forward.  Unfortunately, allowance auctions will remain in the new normal of low allowance demand until legal questions around post-2020 allowance auctions are truly vanquished — all of the allowances made available at auction will simply not sell.  California’s political leadership deserves great praise as the 2016 legislative season comes to a close, but even more leadership is needed before auction stability will return.
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Ed’s Note: Chris Busch, Ph.D, is the director of research at San Francisco-based Energy Innovation. He has 20 years’ experience on clean energy policy and emissions market economics, and served as a member of the California Air Resources Board’s (CARB) Economic and Technology Advancement Advisory Committee.