The green light from the Golden State

The California carbon market opportunity

California operates one the most established major carbon trading schemes after the EU ETS.

Carbon emissions from the state may be around one-sixth of the EU’s but as the fifth largest economy - ahead of India but behind Germany - its carbon market is still a big carbon market, an important case study for other countries emission trading schemes, and also an opportunity for investors seeking exposure to higher carbon prices.

California’s Cap-And-Trade Program (CTP) launched in 2012 with the first year devoted to testing the systems underpinning the program. The first compliance obligations were introduced at the start of 2013, and in 2014 the program was expanded to cover Quebec.

California’s overarching climate change target is to reduce carbon emission levels to 60% of 1990 levels by 2030, and to achieve carbon neutrality by 2045.

The program is now at the start of its fourth compliance period. Each successive period has gradually expanded the scope of the emissions covered, while at the same time also increasing the rate at which the emission cap declines on an annual basis:

• 1st compliance period (2013-2014): The system started in 2013 with a cap of 162.8 MtCO2e, declining to 159.7 MtCO2e in 2014.

• 2nd compliance period (2015-2017): With the program expanding to include fuel distribution, the cap rose to 394.5 MtCO2e in 2015. The cap decline factor averaged 3.1% per year in the second compliance period (2015-2017), reaching 370.4 MtCO2e.

• 3rd compliance period (2018-2020): The cap in the third compliance period started at 358.3 MtCO2e and declined at an average annual rate of 3.3% to 334.2 MtCO2e in 2020.

• 4th compliance period (2021-2023) and beyond. During the period 2021-2030, the cap declines by about 13.4 MtCO2e each year, averaging about 4% per year and reaching 200.5 MtCO2e in 2030. The Cap-and-Trade Regulation sets a formula for declining caps after 2030 through 2050.

Looking forward to 2030 the amount of allowances available to the market is set to decline by 42% versus 2020 levels. The gradual reduction in supply provides a powerful support to higher prices, much like the Linear Reduction Factor operates under the EU ETS.

California’s ETS (or CTP to use their terminology) accounts for roughly 85% of all emissions in the state and covers large industrial plants, large electric power plants, and natural gas and petroleum distributors.

Emission allowances are auctioned on a quarterly basis. The industrial sector receives about 90% of its allowances for free in order to minimise carbon leakage. The utility sector also receives allocations for free but must sell them at auction and use the proceeds to benefit their customers. Finally, the transportation sector must purchase allowances through the quarterly auctions or on the secondary market.

Banking of allowances is allowed but is subject to a general holding limit which varies based on the year’s emission cap. Borrowing from future vintage allowances is not allowed.

The ability to bank allowances has meant that a fourth entity has entered the Californian carbon market - financial institutions. According to the California Air Resources Board, investors purchased around 30% of the allowances on offer at the August 2021 auction, almost 6 times more than they had purchased twelve month earlier.

The impact of investors is set to increase. KraneShares launched a California carbon ETF in early October. Meanwhile, alternative investment fund Sarkis Ltd. based in London (~$0.5 bn AUM) is planning to launch a new physically-focused environmental fund after receiving approval from the California regulator to participate in auctions and hold carbon credits. This mirrors developments in the EU ETS where The SparkChange Physical Carbon EUA ETC (CO2), launched on the London Stock Exchange in November.

Proceeds from the auctions have generated $15.4 billion since 2013. The revenues that are accrued from the program go directly to California’s Greenhouse Gas Reduction Fund, which disperses funding to state agencies that are working to reduce greenhouse gas emissions further. Thirty five per cent of the revenue is mandated to go to low-income and environmentally disadvantaged communities.

California has a complex series of price controls, including 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 $16.68 per tonne in 2020.

The ARP acts as a ‘floor price’ gradually increasing over time giving confidence to investors (e.g. looking for an inflation busting inflation hedge), and compliance market participants (e.g. looking to invest in carbon abatement technology).

There have only been two times in which the California Carbon Allowance (CCA) price fell below the floor price. In February 2016 litigation (later quashed) brought by the California Chamber of Commerce contributed to low demand for allowances. The second time was in spring 2020 when covid-19 lockdown fears sent CCA prices down sharply.

The Allowance Price Containment Reserve (APCR) is the price at which additional allowances are released. A portion of allowances are set aside in two reserves which are triggered at different price points. In 2021 the reserves triggers were set at $41.40 per tonne (APCR Tier 1) and $53.20 per tonne (APCR Tier 2), also increasing by 5% plus CPI annually. The price ceiling is set at $65 per tonne in 2021 (APCR Tier 3) and also rises by 5% plus CPI. If this threshold is triggered, units from the reserve will be offered to the market.¹

In 2020 the program was put under review by the state's Environmental Protection Agency as doubts emerged over whether the plan was stringent enough to meet 2030 goals. In a statement issued in early November 2021, Richard Corey, Executive Officer of the California Air Resources Board attempted to put those doubts to rest:

"Today's data makes it clear – California's comprehensive regulatory structure continues to deliver greenhouse gas reductions. This high level of compliance with the cap-and-trade regulation demonstrates the continued rigor of the program and the important role it played in California meeting its 2020 emissions reduction target four years ahead of schedule."

As of mid-December the Dec-2011 CCA futures contract was trading at around $30 per tonne. In euro terms this equates to €26.50 per tonne. In comparison, on the other side of the world in Europe the equivalent contract under the EU’s ETS is trading at almost €85 per tonne - over 3 times higher.

The design of the emissions trading schemes are very different. California’s system supports higher carbon prices over time, but favours a low volatility approach guided higher by an inflation protected floor. The trigger point for when authorities in California intervene in the market is completely clear.

In comparison, the EU ETS could be described as more of a free market where prices are allowed to reach the level that the market requires much faster. In comparison to California, the point at which authorities would look to intervene in the EU ETS to temper prices is opaque.

One risk to keep an eye on is the decision to close the Diablo Canyon nuclear plant. The plant accounts for 15% of the states zero carbon power generation. Gas fired generation accounts for some 50% of power output and renewables and imports from other states account for the rest.

The plant is due to close in 2025 when its federal 40 year license expires. However, a recent report from MIT and Stanford have suggested that the plant should be kept open to 2035 to reduce emissions and cut costs for tax payers. US Energy Secretary Granholm has suggested the decision to close be reconsidered, but this would require the plant to be sold as its existing owner PG&E has committed to closing the plant.

If the plant remains beyond 2025 then there would be less demand for emission allowances, bearish for the longer term price outlook. But without high carbon prices its unlikely that the state will attract the necessary investment in renewables it needs in the long term.

Both the EU and California have ambitious emission reduction targets over the next decade. Even with the risk of Diablo Canyon staying open, meeting California’s emissions targets will still require much higher carbon prices than exist at present.

1. Assembly Bill 398 lowered the three tiers starting in 2021. APCR Tier 1, 2 and 3 were introduced in 2013 at $40, $45 and $50 per tonne respectively and increased by 5% + CPI each year.