Compliance Instrument Trends in the California Cap-and-Trade Program
The California cap-and-trade program recently completed another successful allowance auction, providing an opportunity for lessons learned regarding compliance instruments. The market demand for California Compliance Allowances (CCAs) continues to increase. In turn, the market for offsets (which tend to be less-used) will also continue to grow, providing attractive transaction opportunities for both landowners with potential projects throughout the U.S. and covered entities who are seeking a less costly option to CCAs.
To provide some context, the historic AB 32 California Global Warming Solutions Act of 2006 requires sharp reductions of greenhouse gas (GHG) emissions to approximately 1990 levels by 2020. Covered entities, or sources that emit more than 25,000 tons per year, are required to address their emissions-reduction obligation in three compliance periods: 2013-14 (CP1), 2015-2017 (CP2), and 2018-2020 (CP3). At the end of each compliance period, each facility is required to turn in compliance instruments, including CCAs and a limited number of California Air Resources Board (ARB) offset credits.
In the most recent November 2015 auction, three years after the first auction, all 75.1 million current vintage allowances offered were purchased at an average settlement price of $12.73. This price is 63 cents above the floor price set by ARB. Additionally, all of the 10.4 million future vintage allowances offered also sold out at a price of $12.65. These are positive signs for the California carbon market, and demonstrate that the system is proceeding as planned.
Strong interest from regulated entities around future CCAs are also generating continued interest in offsets. California Carbon Offsets (CCOs) are the first compliance instrument in a covered entities’ portfolio that must be retired. Offsets are generated from sectors that are uncapped in California like forestry, livestock methane and ozone-depleting substances (ODS). ARB has rigorous greenhouse gas accounting protocols for each of these project types that allow quantity and vintage to be determined. Covered entities purchase these credits from individual landowners, project developers, brokers or other sellers.
We believe that the number of covered entities or companies that use offsets in the California system will continue to grow because offsets are less expensive than CCAs. Over the past few years, offsets have traded at approximately 15 to 25 percent below the price of CCAs. The Climate Trust, as well as several other organizations, track price on a weekly (and sometimes daily) basis to inform term sheets used for offset supply and sales contracts.
Of note, under the California Carbon Offsets moniker, three products have emerged:
- CCO8s: These are basic program CCOs with an eight year invalidation period, meaning that the buyer accepts the risk of project or credit invalidation until eight years after initial ARB issuance.
- CCO3s: These are CCO8s where a second verification is conducted that reduces the invalidation period to three years.
- Golden CCOs: GCCOs are CCOs that are backed with a promise to replace with CCAs or cash further reducing buyer risk and giving them premium market value.
There have also been rumors of a potential “Platinum” product that is secured by an insurance offering, similar to a home owner’s insurance policy, but this has yet to be introduced to the market.
Current price for compliance products are listed below:
|DISCOUNT TOALLOWANCE PRICE($)
|CCA (aka allowance)
|Golden CCO (GCCO)
|CCO8 (CCO or offset)
A CCA cannot be invalidated, so it is the lowest risk compliance product. Offsets are less costly due to the invalidation risk associated with individual projects, such as a potential federal, state or local environmental law violation at the project site. Offsets are viewed as a cost containment measure by large covered entities, such as oil companies that have the financial wherewithal to manage invalidation risk. Many of the large utility companies are interested in offsets as well, but are more likely to purchase Golden CCOs due to constraints placed on them by the California Public Utility Commission that oversees regulated utilities in the state.
It is likely the California offset supply will be constrained in the long run because there are very few approved project types, and the time to get projects approved is quite lengthy and arduous. For these reasons, a shortage of offset volume is anticipated by many market players, particularly in the latter part of compliance periods 2 and 3. In the meantime, offset volume issuance continues to grow. Forest project offsets were the most rapidly growing project type in the California compliance market in 2015. As of November 25, 2015, ozone depleting substances, livestock, and mine methane capture consists of 12.9M or 38% of ARB Offset Credits Issued. U.S. Forests constitute 21.4 million or 62% of issued offsets, approximately double that of all other project types combined. It is expected that this forestry growth trend will continue in 2016. There are still several early action eligible projects in the queue to be reviewed and potentially approved by ARB staff, which will add a significant number of forestry offsets to the market in 2016.
On November 2, 2015, ARB adopted new Common Practice values for all U.S. Forest Assessment Areas (essentially ecoregions). Over 65 forestry projects were listed as potential ARB compliance projects before this date in order to use the older Common Practice Values, which in many instances are lower and thus more favorable for offset volume generation. This includes over 35 projects with Climate Action Reserve, and over 30 projects with American Carbon Registry. Newly listed projects will increase the offset volume from forestry projects in 2016 as well.
Stabilized and predictable auctions, a growing offset supply, more defined products and a rising CCA and offset price are all great signs the carbon market is here to stay. Entities with emission liability in California and landowners with potential projects should consider building an offset portfolio to take advantage of this supply-constrained market.