NewEnergyNews: TODAY’S STUDY: HOW TO PROTECT A CAP AND TRADE PROGRAM

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    Wednesday, July 16, 2014

    TODAY’S STUDY: HOW TO PROTECT A CAP AND TRADE PROGRAM

    Report of the Market Simulation Group on Competitive Supply/Demand Balance in the California Allowance Market and the Potential for Market Manipulation

    Severin Borenstein, James Bushnell, Frank A. Wolak, and Matthew Zaragoza-Watkins, July 2014 (Energy Institute at Haas/U.C. Berkeley)

    Executive Summary

    California’s Cap and Trade market in greenhouse gases (GHG) is now in its third calendar year, with the first allowance auction taking place on November 14, 2012 and compliance obligations commencing on January 1, 2013. A key design element of the system is its limited price-collar mechanisms that place soft lower and upper bounds of allowance prices. To date the market prices have held at or near the lower bound “floor” prices established by the allowance auction reserve price. However, the market will be entering important new phases over the next 18 months. The first firm information on covered emissions during the first compliance phase (2013-2014) will emerge in November of 2014. Coming near the end of this compliance phase, the release of this information is the first opportunity for the market to confirm expectations of the supply and demand balance of allowances during the first phase. Starting in 2015, the market will expand to include several new sectors, most significantly transportation fuels and the bulk of natural gas consumption in the state. It is therefore important to anticipate any possible shocks to the market that can arise as it matures and expands over the course of the next two years.

    One central issue is the status of the price-collar mechanisms. While the details of California’s price-collars are described in regulations developed by the California Air Resources Board (ARB), recently approved regulatory changes would alter the exact manner in which the price ceiling – known as the allowance price con tainment reserve (APCR) mechanism – would be applied and the degree to which it could mitigate uncertainty over prices.1 A key question relating to this issue is the extent to which either the auction reserve price or APCR price is likely to be relevant, that is, the probabilities that market prices may be near the price floor or the APCR soft price ceiling.2 A second key question is whether some market participants may be able to strategically change the allowance price, in particular by buying more allowances than they need and withholding them from the market in order to sell a portion later at a higher price.

    In this report, we simulate distributions of possible market outcomes in order r to address these questions. We first develop estimates of the distribution of competitive allowance prices and the probabilities that one of the price containment mechanisms may be binding. A key factor driving these probabilities is the amount by which GHG-producing entities will reduce their emissions. This reduction is likely to be a highly non-linear function of allowance price. Specifically, we find that a large quantity of emissions reductions are mandated by programs auxiliary to the cap and trade mechanism, and will therefore be available at or below the auction reserve price. Other businesses can reduce their need to purchase allowances at a cost that is below or only slightly above the auction reserve price. Relatively little additional emissions abatement is likely to be available as the price climbs, at least before the price rises high enough to trigger additional supply of allowances from the price containment reserve.

    Our key simulation findings are

    1) The steeply rising cost of emissions abatement between the auction reserve price floor and the price containment reserve ceiling, along with relatively inflexible supply of abatement below the price containment reserve, implies a bi-modal distribution of prices with most of the probability mass at either low or high price outcomes.

    2) Under most scenarios, the most likely 2020 market price will be very close to the auction reserve price floor.

    3) However, under all scenarios, there is a smaller but significant risk that the allowance price containment reserve will be exhausted at or before 2020.

    For scenarios in which there is low or medium availability of carbon offsets and relatively little reshuffling of electricity imports, this probability ranges from as 4%-25%.

    4) The probability of reaching, but not exhausting, the APCR by 2020 falls between 8% and 31% under low and medium abatement scenarios. We find there is low risk of exhausting the APCR before the third compliance phase, which begins in 2018.

    5) There are small but significant probabilities that the market could reach the APCR during one of the first two compliance phases. Under our low and medium abatement scenarios, there is a 2%-4% chance of reaching the APCR (assuming no strategic withholding behavior by market participants, which we investigate later) during the first compliance phase. Under our low and medium abatement scenarios, the probability of reaching the APCR (assuming no withholding) during the second compliance phase ranges from 4%-17%.

    6) There is a straightforward mechanism in which firms can withhold allowances from one phase of the market by banking them into compliance accounts for future compliance phases. We study the risks that such strategies could inflate prices during the first and second compliance phases. The largest risk is that one (or more) of a small number of large firms acquires signifi- cantly more allowances than it requires for the first compliance phase, and deposits these extra allowances into compliance accounts for use in later periods. This could result in 10% of available allowances or more being removed from an approximately 330 million metric tons (MMT) market in the first compliance period. Such a strategy, if attempted, would increase the probability of reaching the APCR from 2% (absent withholding) up to about 7% or higher with medium abatement and from 4% to about 13% or higher under a low abatement scenario.3

    This strategy would be most likely to affect the allowance price for the first compliance period during 2015, after the first compliance period ends but before the final surrender of allowances for this period.

    7) During the second compliance phase, a similar strategy could increase the risk of needing to access the APCR from around 15% to as much as 30% or higher.

    We provide several recommendations to reduce the risk of very high allowance prices due to either the competitive supply/demand balance or a withholding strategy. It is important to emphasize that the higher prices are allowed to rise, the more potentially profitable a withholding strategy becomes. Therefore an unambiguous policy that credibly limits the maximum allowance price is important to market stability and a strong deterrent to attempts at market manipulation.

    Our major recommendations are:

    1) Establish policies that reinforce the viability of the allowance price containment reserve. The recently adopted rule changes that make adjustments to the APCR only address transient shortfalls and therefore do not address the threat that there could be a supply/demand mismatch for the entire 8-year program.4

    If there were not enough allowances over the 8-year period to cover the cumulative emissions under the cap, then there would be no policy in place to further restrain prices. It is likely that an ad-hoc government intervention into the market might occur under such a circumstance.

    This would prove to be extremely disruptive to both the market and to the broader policy goals of AB 32.

    We therefore recommend that a policy be established to ensure that the APCR could not be exhausted. The Air Resources Board should stand ready to expand the pool of allowances in order to maintain the market price at or below the highest price step of the APCR. Two alternatives that could achieve this goal are allowing sales of post-2020 compliance period allowances or allowing direct or indirect use of compliance instruments from other GHG markets such as the European Union Emissions Trading System (EU-ETS) or the Regional Greenhouse Gas Initiative (RGGI) under such circumstances.

    2) Allow Conversion of Allowance Vintages.

    Currently, market participants are not allowed to use allowances from later vintages for compliance in earlier phases. For example a vintage 2015 allowance cannot be used for compliance obligations in phase I, which concludes on December 31, 2014, but for which final surrender doesn’t occur until late in 2015. This boundary between phases creates the prospect of transitional shortages in which allowance prices in the expiring phase rise to the APCR while current vintage allowance remain near the price floor.

    As we demonstrate, the potential for withholding increases the probability of such an outcome.

    A second concern with the current design is the potential that allowances could end up inefficiently owned ex post. As firms acquire allowances according to their expectations of needs, shocks to individual firms or even sectors could result in too few allowances from a current phase being available to some sectors while others hold a surplus they are unable to sell, if their surplus is held in compliance accounts rather than holding accounts. Conversion – for a fee – of the vintages of allowances held by market participants would greatly reduce the risk and consequence of both problems.

    Under this proposal firms would be allowed, for instance, to purchase 2015 or later vintage allowances during 2015 and convert them to meet their phase I obligations, for which final allowance surrender would occur in November 2015. To prevent stakeholders from casually undertaking such conversions, a cost in terms of either a conversion fee or the number of allowances sur rendered could be imposed. For example, ARB could require 1.25 vintage 2015 allowances be converted to yield 1.0 2014 vintage allowance, thereby imposing an implicit 25% cost on the conversion. Alternatively, a conver sion fee, for example $2.50 or $5 per allowance, could be applied to each converted allowance. Firms would only avail themselves of this option if the allowance price in the expiring phase rises above the price of the later vintage allowance by an amount greater than the conversion fee. At the same time, this option would bound the extent to which prices in the ex piring phase could rise above later vintage allowance prices. This would greatly reduce the incentive to attempt to raise prices in the expiring phase by withholding allowances from that phase.

    The proposal would also address accidental over-compliance by some par ticipants, as well as strategic withholding, either of which could create an artificial shortage at the end of a compliance period. Firms would be able to purchase future vintages (at a premium) to meet their needs.

    3) Maximize the Timeliness and Quality of Information Available to the Market. Currently the market suffers from opacity in several important areas. First, there is almost no way to observe, even indirectly, the emissions ass ociated with electricity imports and the only source of official information will arrive with up to a nearly two-year lag on the market. Second, current proposals would limit the public availability of information on the allowance holdings of individual firms. We recommend steps be taken to increase the frequency with which key emissions figures, particularly from electricity im ports, be provided to the market. We also recommend that if individual allowance holdings must be held confidential, statistics on the overall con centration of allowance holdings be made available. In this way, market participants would be able to detect attempts by one firm to acquire a sub stantial long position and take measures to defend themselves against any attempts at withholding allowances from the market.

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