California's carbon market: The 6 factors to pay attention to right now
The price of carbon allowances in California has increased by around one-third since early March, rebounding from the Ukraine-Russia induced sell-off to trade near $30-32 per tonne.
So where do we go from here? Here are the 5 factors you need to pay attention to: rainfall levels and the potential for hydroelectric generation, Diablo Canyon’s future, gas-coal fuel switching, the impact on gasoline demand from high prices, progress on policy reform, and investor appetite for an inflation hedge.
1) Wet weather increases the amount of hydroelectric power available, reducing demand for carbon allowances
Hydroelectric power generation is one of the most important factors influencing Californian power generation emissions. Historical data shows that when California is clear of drought and water levels are high, hydro’s share of state power generation rises to 20-25%. However, when its dry and water levels are low, hydro’s share of the generation mix drops to 5%. Lower hydro generation increases the call on gas and coal fired power generators, increasing emissions and the demand for CCAs.
Warmer temperatures in spring and summer melt the snowpack on the Sierra Nevada mountain range helping to replenish reservoirs. Snowpack was well above average by late December 2021 but a dry January has meant snowpack levels have dropped, reducing water availability for hydroelectric generation.
California is experiencing plenty of wet weather at the moment which might make up for some of that shortfall. The state is forecast to see plenty of rainfall through to the end of April with snowfall in the mountains. Crucially it is the north that is getting deluged as that is where most of the state’s reservoirs are located.
Most of the state’s precipitation comes between December and April. The end of that period is a significant time of year because that’s when accumulated snow is typically at its peak. It’s also when utilities know for sure how much water will melt from the snow over spring and summer and be available for power generation. If its low then they will have to turn to fossil fuels to meet the gap.
2. Diablo Canyon nuclear power station closure gets a potential reprieve
In early December I highlighted why investors in California’s carbon market should monitor for any sign of indecision over the Diablo Canyon nuclear plant. Diablo Canyon’s two reactors are currently scheduled to close completely in 2025 when its federal 40 year license expires.
The facility accounts for 15% of the states zero carbon power generation. If the plant remains in operation beyond 2025 then there would be less demand for emission allowances, and would be bearish for the longer term price outlook.
In the past week Diablo Canyon and other nuclear plants in America nearing closure have been tossed a $6bn lifeline. In the program’s first phase, grants are restricted to plants that had publicly announced they would close down prior to end September 2026. Of the 93 operating nuclear reactors in the US, just three meet that qualification. The Palisades reactor in Michigan, which is scheduled to close in May 2022, and the Diablo Canyon reactors 1 and 2 in California, with planned closing dates of November 2024 and August 2025, respectively.
It’s not clear at the moment whether the grant will ultimately change the course of Diablo Canyon’s future. The decision to close was not simply a matter of finances. It also relates to the environmental objectives of the state - the state’s politicians reason that the continued reliance on nuclear may serve to back out the required investment in renewables.
3. Fuel switching by power generators unlikely given coal availability
The relative price and availability of natural gas and coal influence the degree of fuel switching between the two fossil fuels, and hence affects the demand for California’s carbon allowances.
One of the reasons why CCA prices have been supported in recent weeks relates to the spike in natural gas prices, and expectations that this would translate into significantly higher thermal coal burn and hence demand for carbon allowances.
Last week US natural gas prices hit $8 per million British thermal units (MMBtu), the highest since September 2008 and the fifth straight week of gains. Natural gas prices typically rise in the winter as cold weather and supply disruptions tighten the market. However, record high natural gas prices in Europe, unseasonal cold weather in the North East and strong LNG demand are pulling US prices higher.
Normally this would result in an increase in thermal coal burn. However, US models for coal-to-gas switching have broken down over the last 18 months as gas-fired power generation has proven to be very inelastic, partly due to limited thermal coal supplies.
A lot can happen in a week. Natural gas prices have since plummeted to 6.5 per MMBtu. This reduces demand for thermal coal as an alternative generation fuel.
4. Impact of higher gasoline prices on transportation demand
A key feature of the Californian carbon market is that suppliers of transportation fuels are obligated emitters. Cap-and-trade obligations for California’s transportation fuel suppliers took effect from 2015. Transportation accounts for around 40% of the state’s annual emissions. Gasoline sales can have a significant impact on demand for carbon allowances (CCAs).1
Californian gasoline prices rose to over $6 per gallon in late March, supported by high crude prices in the aftermath of Russia’s invasion of Ukraine. Drivers in the state are use to paying more than the average American (the area west of the Rocky Mountains operates as an almost separate market from the rest of the US), but at $6 they were paying almost 50% more than the US average.
High gasoline prices - combined with inflationary pressures elsewhere - could see drivers reducing the number of miles travelled. This would cut into gasoline demand and mean that fuel suppliers carbon obligation is less.
In response to the hike in gasoline, California’s governor announced $9 billion would be distributed to residents in the form of tax refunds: $400 for each vehicle they own, with a limit of two. If approved by the state legislature residents could receive stimulus checks starting in July. Even if approved its unlikely that this would result in an increase in fuel consumption. It’s more likely that it will be saved or spent on other non-transport related products or services.
5. Pessimism about carbon market reform
The demand for allowances is vital, but the supply side is also vitally important. And here investors have been focusing on the potential for reform of California’s carbon market. Carbon allowance prices have risen in recent weeks as investors bet on reform, especially policies that could result in a reduction in the the overhang of excess allowances.
However, the state’s environment regulator, ARB has proposed sticking to its existing current carbon neutrality target, rejecting other emissions pathways that could have sped up abatement. The lack of ambition perhaps a signal that carbon prices do not need to increase as rapidly as some had hoped.
6. Speculative inflation hedge
The surge in prices has also been driven by increased interest from investors seeking refuge in an asset that gives some protection from inflation.
Recall that the Californian carbon market includes an Auction Reserve Price (ARP) which increases at 5% annually plus inflation (CPI). The ARP started at $10 per tonne in 2012 and has since increased to $19.70 per tonne in 2022. The ARP acts as a ‘floor price’ gradually increasing over time.
Investors need to be aware that there is a significant annual roll yield - around 6% - that eats into the potential returns. Although prices were attractive early in March, that is not the case now, especially if CPI starts to roll over in coming months. And so while CCAs offer some inflation protection, they are far from safe - prices could fall by 40% and still remain above the inflation protected floor price.
California’s Air Resources Board (CARB) defines a fuel supplier as “a supplier of petroleum products, a supplier of biomass-derived transportation fuels, a supplier of natural gas including operators of interstate and intrastate pipelines, a supplier of liquefied natural gas, or a supplier of liquefied petroleum gas.”
Fuel suppliers are subject to cap and trade obligations if they “hold inventory position of fuel in the bulk transfer/terminal system, or import fuel into California outside the bulk transfer terminal system”. As with other sectors of the California economy covered by the carbon market, sources that account for 25,000 MT CO2e or more of annual emissions are obligated under the scheme.